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:
- IBC, which stands for International Business Corporation, meaning legal corporation set up by a non-resident, or
- CFC, which is the acronym for a Controlled Foreign Corporation, defined as a corporation that is registered in a different country than the controlling owners;
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:
- If you are paying into the social welfare systems of another country that the United States has a totalization agreement with, or
- 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:
- 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.
- 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:
- Not maintaining separate recordkeeping. The IRS tax code § 6038A states that if a US company is 25% owned by a foreign entity, they must maintain records regarding related party transactions - namely the movement of money between the US LLC and the FC. The penalty for not maintaining these records is $25,000, and therefore making an effort to maintain the proper financial records for these transactions is strongly encouraged.
- Not having the US LLC owned by the foreign corp. A US LLC is a passthrough entity, meaning that the income from the LLC passes through to the owner. If the LLC is owned by you, the individual, that means the income passes through to you, not to the FC, and as such will be subject to self-employment tax.
- There’s been debate about the difficulty of identifying an LLC owner in places like Wyoming. But does this detail really hold weight? While it may be impossible for the public to find out who owns an LLC, it is relatively easy for the IRS to find out the owner of an LLC. With the ease of an assignment of membership interest, or setting it up properly from the get go, is this really a risk you’re willing to take?
- Not paying the owner’s salary from the foreign corp. The whole point of this setup is to move the owner’s salary from a domestic company, which is subject to Social Security and Medicare taxes, to a foreign company that is not subject to these taxes. If the owner’s salary is coming directly from the LLC’s bank account or books, then it can be viewed by the IRS as being paid by a domestic company and not a foreign company. This is low hanging fruit for an IRS auditor. I highly recommend taking the extra step to maintain a separate bank account for the foreign entity and pay yourself from that account only.
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.
- Pro Forma 1120 with Form 5472 - Information Return of a 25% Foreign-Owned U.S. Corporation
- This is the form filed for an LLC that is wholly owned by (or at least 25% owned) by a foreign corporation. This is where your § 6038A comes into play.
- Form 5471 - Information Return of U.S. Persons With Respect To Certain Foreign Corporations
- This form (filed with your 1040) reports your ownership interests in a foreign corporation.
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.