The Ins and Outs of the Offshore Structure

May 12, 2024

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Embarking on the offshore business trend has become a game-changer for self-employed digital nomads eyeing tax benefits. It's like unlocking a secret vault of tax savings, but the key to success lies in navigating the complexities without rousing the IRS. Picture this: setting up your own company in a tax-friendly haven, minimizing tax burdens, and maximizing your hard-earned dollars—all while eliminating the dreaded self-employment (SE) taxes.

Here's the scoop: creating an offshore structure can be your golden ticket to reducing tax liabilities. Whether you opt for a pure offshore setup or a hybrid US/offshore arrangement, the goal is to route your income through a foreign entity to sidestep those hefty self-employment taxes. But hey, the path to tax paradise is paved with regulations. From meticulous record-keeping to steering clear of IRS red flags, it's essential to play by the rules to make this tax-saving strategy work like a charm. 

What is an offshore structure?

An offshore business structure is one where a company (usually a holding company) is set up in a country where the controlling owners are not residents that has more favorable tax laws. You may have heard other names for offshore structure, including: 

Bottom line, it’s basically the same idea, which is to set up a more tax advantageous structure.  From here on out, we’ll refer to an offshore corporation as an FC–short for foreign corporation.

What are the tax advantages of an offshore/IBC/CFC structure?

All working individuals that are residents of the United States are required to pay into the social welfare systems of Social Security and Medicare, with two notable exceptions:

  1. If you are paying into the social welfare systems of another country that the United States has a totalization agreement with, or
  2. If you’re paid by a non-US company.

The offshore structure’s goal is to put you in the second category - an employee of your own FC, and there are two ways you can do this:

  1. Pure offshore setup.  In a pure offshore setup, a self-employed individual would set up a corporation in a tax advantageous jurisdiction, receive all income and pay all expenses from that company, and pay themselves a salary through the FC (usually in line with the Foreign Earned Income Exclusion, aka the FEIE). As the owner's salary is now coming from a non-US entity, it is not subject to self-employment taxes, and, if done right with the FEIE and foreign housing deduction (FHD), you can reduce federal tax as well.
  2. Hybrid US/Offshore setup.  If you need a US facing company for any reason (banking, clients, etc.), you can form a US LLC that is wholly owned by the offshore corporation. You can run all of your income and expenses through the LLC, and then either have the income pass through to the owner (the FC) or you can bill the LLC for management fees from the FC. The owner pays themselves from the FC, and, as the salary is coming from a non-us entity, it is not subject to self-employment taxes, and again, if done right with the FEIE and FHD, you can reduce federal tax as well. 

Sounds like a pretty tax advantageous setup, right? 

What's the Catch?

There are some hoops the IRS wants to see you jump through, mainly with the hybrid setup, in order for this not to be considered a sham transaction or shell corp setup (both of which are not good in the eyes of the IRS and would result in very large penalties). Here are the biggest mistakes I’ve seen when dealing with the hybrid setup:

What taxes do I need to worry about?

The FC is not a completely tax free structure, especially for service based businesses. When looking at the profit of an FC, we need to consider global intangible low taxed income (GILTI).   Now, GILTI involves a pretty complex calculation, but the key thing to remember is that it includes income from sales and services involving related persons, conducted outside the country of incorporation with some exceptions. Generally, GILTI tax ranges from 10%-13.125%. While this tax is still lower than personal, corporate or self employment tax in the US, it’s crucial to be aware of this tax obligation. Strategizing with your tax advisor and leveraging the FEIE and FHD can be helpful for reducing GILTI tax.

Tax Filing requirements for offshore setups

There are two tax forms that you need to familiarize yourself with when it comes to the offshore setup. 

  1. Pro Forma 1120 with Form 5472 - Information Return of a 25% Foreign-Owned U.S. Corporation
  1. Form 5471 - Information Return of U.S. Persons With Respect To Certain Foreign Corporations

The penalties for not filing these forms correctly and in a timely manner are brutal - $10,000 for the 5471 and $25,000 for the 5472, so make sure you’re fulfilling your filing obligations when it comes to these setups. Also starting in 2024, FinCEN is requiring all business owners to file Beneficial Ownership Reporting, which also carries civil penalties of $500 per day and criminal penalties of up to $10,000 with up to two years of jail time for non-compliance.

The offshore setup can be an incredibly tax advantageous setup for those who are not physically running their businesses from the US, but it’s not without its hassles.  Before going this route, make sure you’re up for the tasks that are required to maintain a good appearance in the eyes of the IRS.