Income Tax Planning for Expat Entrepreneurs Olivier Wagner, CPA 1040 Abroad
Who is this presentation addressed to? u US Citizens and green card holders u Living outside the US u Self-employed or start-up
What to think about (taxes beyond income tax) u Income tax - the USA taxes your income no matter where you live or work u Self-employment tax (or Social Security tax) - the tax on your profit from self-employment u Paperwork - lots of it, and complicated, too u Penalties - the default is $10,000 and up for international-related penalties
Where Tax Savings Come From Is Taxed Why it works Example Never Less Later Specific reason for zero tax is built into the tax laws Lower tax rates built into the tax laws Time value of money using tax laws as designed by Congress Foreign Earned Income Exclusion Long-term capital gains Rental property (and depreciation)
Foreign Earned Income Exclusion u Up to $100,800 (2015) of foreign earned income u Plus some housing expense (amount varies)
How to Win at Form 2555 Requirement #1 u Tax Home - an itinerant contractor working in one place after another has a tax home wherever he/she is. Deamer v. Commissioner, 752 F.2d 337 (2012). You win without trying.
How to Win at Form 2555 Requirement #2 u Physical Presence - days you are outside the United States (needed: 330 days in a 12-month period) Be OCD. Track the days. Keep the evidence. OR u Bona Fide Residence - you really live in a foreign country You don t have to track your days outside the USA
How to Win at Form 2555 Requirement #3 u Have foreign earned income u Foreign earned income means your body was outside the United States when you did the work that made the money
Your foreign earned income
Bona Fide Residence Test u Why you want this u You can stay more than 35 days a year in the United States u You don t have to deal with tracking your life and where you were every day
Bona Fide Residence Test u Full year only u The bona fide residence rule only applies to full years u If you were a bona fide resident of a foreign country or countries during the entire year, you get the entire foreign earned income exclusion amount for the year u For partial years, you will have to use the physical presence test (aka count the days )
What does bona fide resident mean? u Intention to remain indefinitely u Intention is shown by what you say and what you do u What you do is more important that what you say
Problem with the bona fide residence test u It depends on your intentions (which can be hard to prove) u Do I intend to remain a resident of this place for an indefinite time, eventually to return to the USA? u Unless you have the right visa status to live and work in another country, it is easy to prove that you are not a bona fide resident of that country u An audit is an all-or-nothing event expensive to lose!
Moment of Truth: Form 2555, Line 13 u Please give me a tourist visa to LovelyCountry. I m only staying for 3 months. I m sightseeing and enjoying your fabulous beaches. Not working. Srsly. u Hey IRS, I really live in LovelyCountry. Srsly.
What does applying for a tourist visa say? u Publication 54, page 14: u Statement to foreign authorities. You are not considered a bona fide resident of a foreign country if you make a statement to the authorities of that country that you are not a resident of that country, and the authorities: Hold that you are not subject to their income tax laws as a resident, or Have not made a final decision on your status.
Something better than a tourist visa u If you get a better visa one that allows you to live in the country you answer correctly u But now you are on the radar to pay income tax in that country
Bona fide resident? Only if you really are u Claiming the bona fide resident test is unsafe unless you really are a resident of the other country You have the proper visa to live there, putting on the radar for paying income tax you Losing on this point means you do not qualify for the foreign earned income exclusion at all. The results are binary, and your tax cost goes from zero to very large u The day count method is safer
Physical Presence Test u 330 days fully outside the USA in any 12 month period
Do you get it, and if so, how much? u The physical presence test serves two purposes Do you get the foreign earned income exclusion at all? Assuming you do qualify, how much income is excluded?
Counting the days u Pick any starting date. It need not be January 1 and it need not be in the current year Pick the day before that date, 12 months ahead Count the full days outside the USA 330 or more? You qualify for the foreign earned income exclusion Now we just have to figure out how much foreign earned income you get to exclude for 2015
First year outside the United States u March 1, 2015 - December 31, 2015 = 306 days u 306/365 x $100,800 = $84,506 is not taxable
Full Year: $100,800 of Income Not Taxed
A new 12-month period starts every day
You can overlap 12-month periods (used in 2 separate tax returns)
Even one day will work u 1/365 x $100,800 = $276 income excluded
How to win a day-count audit u Prove days in the USA, outside the USA, and traveling to/from the USA with: Passport - those unintelligible rubber stamps that are never in the right order Airline tickets/receipts better Credit card records Moral: keep good records
Self-Employment Tax u The self-employed person s version of Social Security Tax Schedule SE 15.3% of your net profit from self-employment on the first $118,500 of net profit The foreign earned income exclusion eliminates income tax, not self-employment tax
Let s Get Really Tax-Free How to eliminate self-employment tax
Method the First - totalization agreement u Live in a country that has a Social Security tax treaty with the USA Do some paperwork Contribute to the Social Security system of the country you are living in, not the USA No net tax savings you re paying tax to another country instead of the USA
Method the First - totalization agreement u Which countries? unot China Australia Denmark Ireland Norway Spain Belgium Finland Italy Poland Sweden Canada France Japan Portugal Switzerland Chile Germany Luxembourg Slovak Republic United Kingdom Czech Republic Greece Netherlands South Korea
Method the Second - be the boss of you
Method the Second - what you do u Form a foreign corporation, make $100,000 profit u Pay yourself a salary of $100,000 (all the profit) u No corporate income tax (no taxable profit!) u No income tax to you (keep your salary under $100,800) because it is foreign earned income u No self-employment tax because you are not selfemployed you re a wage slave working for The Man
You cannot use a U.S. corporation u Wages paid to you by a U.S. employer can be taxfree foreign earned income no income tax u But wages paid to you by a U.S. employer are subject to Social Security tax u If you are looking to save self-employment tax by being an employee of your own corporation and working abroad, setting up a Delaware corporation will not help you
Going completely tax-free...... at what price?
Should you do My Corporation Hires Me? u Tax savings: about $15,000 at $100,000 net profit from self-employment u What will you pay to buy $15,000 of cash?
The money part of the price you pay First Year Following Years Projected Tax Savings 15,000 15,000 Formation cost -2,000 0 Annual fees -1,000-1,000 U.S. tax work -500-500 Net Tax Savings 11,500 13,500
Other money costs u Penalty risk for screwing up Form 5471 or Form 926 u Additional accounting and tax return preparation fees u Banking, merchant account, etc. complexities how will your customers pay you? Can you take credit cards? What are the fees on your merchant account?
Someday you will be old u And you will want Social Security u And you will want Medicare u Don t engage in short-term thinking
Your focus and attention is valuable u If you want to build a business, you can create $10,000 (and indeed some multiple of that) by creating new customers for your products no upper limit on what you can generate from X hours plus Y dollars u Your time spent on tax savings has a maximum value of $10,000 u Your purpose in life is to create a customer
Foreign Tax Credit u It s either/or. You can not take the Foreign Tax Credit on income which was excluded using the Foreign Earned Income Exclusion (although it is possible to combine the Foreign Earned Income exclusion with the Foreign Tax Credit for income not excluded (i.e. not foreign earned or in excess of the limit)
Foreign Tax Credit u In many cases, more valuable. Must pay more tax to home country than owing to the US (and have documentation to prove it). u Carryovers to future years u Can offset all kinds of income u Ability to claim the Additional Child Tax Credit u Less invasive to your privacy
Foreign Tax Credit u How does it work? u Foreign Tax paid is allocated between General Category and Passive Category income u US tax owing is also allocated between General Category and Passive Category income u Excess is carried forward within that category of income
Foreign Tax Credit u Example #1 u Chinese sourced wages: $100,000 u Chinese tax paid on wages: $30,000 u US tax owing on wages: $25,000
Foreign Tax Credit u General category u Income: $100,000 u Foreign Tax: $30,000 u Foreign Tax Credit claimed in 2015: $25,000 u Carryforward (up to 10 years): $5,000
Foreign Tax Credit u End result: zero tax owing plus: u Carryforward (up to 10 years): $5,000 u Possibility to claim the Additional Child Tax Credit u Whereas the Foreign Earned Income Exclusion would only bring you down to zero
Foreign Tax Credit u Disadvantage u The standard deduction is prorated (hence the part paid on the category on which foreign tax credit is applied is lost)
Foreign Tax Credit u Example #2 u Chinese sourced wages: $90,000 u Chinese tax paid on wages: $27,000 u US tax owing on wages: $22,000 u Capital gains: $10,000 u Chinese tax paid on capital gains: zero u US tax owing on capital gains: $1,500
Foreign Tax Credit u General category u Income: $90,000 u Foreign Tax: $27,000 u Foreign Tax Credit claimed in 2015: $22,000 u Carryforward (up to 10 years): $5,000
Foreign Tax Credit u Passive category u Income: $10,000 u Standard deduction (6,200 X 10%) = $620 u Personal exemption: $4,000 u Taxable income: $5,380
Foreign Tax Credit u Passive category (continued) u Foreign Tax: zero u Foreign Tax Credit claimed in 2015: zero (ain t not foreign tax to claim) u Carryforward (up to 10 years): zero u Tax payable: (5,380 X 15%) = $807
Foreign Tax Credit u Example #2 (with the Foreign Earned Income Exclusion) u Total income: $100,000 (wages of 90,000 + capital gains of 10,000) u Minus Foreign Earned Income: 100,000 90,000 = 10,000 u Minus Standard Deduction + Personal Exemption: 10,000 (6,300 + 4,000) = -300 u Taxable income: zero (it doesn t go negative) u Tax: zero
Finally Why Good Bookkeeping is More Valuable Than Good Tax Lawyering
The problem is bookkeeping, not clever tax tricks
The cost of not capturing a business expense u Don t capture a $100 expense? u Your profit is $100 higher u Tax is just self-employment tax at 15.3% u You spent the $100 on a real business expense u And you paid an avoidable $15-ish in extra selfemployment tax u That business expense cost you 115% of reality
The cost of bad bookkeeping u You lose tax deductions, so your income is higher, so your tax is higher u Your tax return preparer has to work harder because your accounting data is poopy, so you pay higher professional fees u You cannot document your expenses; you guess. If you are audited, you pay more tax, plus penalties and interest
Stop doing low ROI activities u u u u u Use Freshbooks / xero.com, not QuickBooks Dedicated bank account(s), credit card(s), PayPal account for business transactions only Never run personal expenses through business accounts A smartphone app to capture expenses (make it sync to Freshbooks / Xero) Hire a bookkeeper; do not DIY
Summary u Use the count the days method to get the foreign earned income exclusion u Bookkeeping will keep you sane and distraction free. u Your focus is valuable. u Ignore any strategy you think is clever
Thanks! And now for questions.... Olivier Wagner 1040 Abroad International Tax 1040abroad.com owagner@1040abroad.com