Offshore Corporation - Pros & Cons
Quite a few business owners have been made aware of all the benefits of opening an offshore corporation and failed to take the time to become familiar with all the negative aspects of having an offshore corporation. Here we will take a look at both the pros and cons of establishing a corporation overseas.
Many people are led to believe that owning an offshore corporation will help prevent them from paying US taxes. At times, this statement is true, but there are circumstances in which it couldn’t be farther from the truth. Unfortunately, many people believe that offshore corporations are beyond the jurisdiction of taxation by the IRS. While this is partially true, US shareholders – as well as deemed shareholders – are within the jurisdiction of taxation by the IRS. An important fact of which to be aware, also, is that an overseas corporation doesn’t so much allow for tax avoidance as it allows for tax deferral. If the owner of the corporation is a United States Citizen and it is a Controlled Foreign Corporation (CFC), he/she will owe US taxes once dividends or liquidating distributions payout or when the corporate stock is sold.
One of the most important questions you are going to want to ask yourself when deciding whether or not to start a corporation overseas is: Will there be additional profits which are sizable enough to justify the cost of doing foreign business?
For example, you found a tax haven country where you will be free of corporate taxes from the United States. Here you will be able to hire employees, perform office tasks, hire a bookkeeper, and more. What you may not be able to do, however, is perform business in your chosen country. There are 2 reasons why you may be limited to the business you’re able to conduct, and the first one is that of poverty. Most tax haven countries are limited in resources and may not be the best target market for a new corporation.
The second reason you may not be able to conduct business in your chosen country of residence is that of the said country having any policy besides a standard corporate charter which would allow you to work and conduct business in the country of your choosing. Many countries, however, wind up deciding that your corporation is an IBC, which prohibits you from competing with its business owning citizens by providing services to its residents. As an IBC, you are able to operate within the country in which you’re incorporated and you can hire that country’s citizens to help with office work; but you may not provide services or goods to those living within that country.
Some people decide this isn’t that big of a problem and they decide to incorporate elsewhere and still conduct business from the United States. In this case, however, the IRS could argue that because you conduct business of a foreign corporation within the United States the US is your primary source of income. If this is the case you will still be taxed as if you had incorporated within the United States.
Taking a look at these circumstances alone, it becomes apparent that avoiding US taxes altogether without additional drawbacks can be challenging. In order to benefit from an offshore corporation, you must be a resident of the country in which it 9is formed, it must have a permanent establishment inside the country in which it is incorporated and it must have a standard corporate charter. Additionally, it must not be a CDC or the United States Citizen must not have significant control over or share of stock in said corporation.
In order to abide by all these rules and open an offshore corporation completely independent of the United States you would need an impressive amount of capital used to secure your office building, hire personnel, and make your business self sustaining until it begins to churn out profits – which raises an entire list of other questions. Before investing in an overseas corporation, one must ask him/her self a series of important business questions which may include:
- Is the currency in the country I’m investigating stable?
- How often would I have to travel between the US to the country which holds my business?
- Would I be able to perform work at my stateside home without being subject to US taxes?
- Would it be necessary to open an office in both locations?
- Would I need employees in both the US and my chosen country of incorporation?
- Are rent, utilities, and salary requirements significantly lower in one location over the other?
- Are there sizable tax benefits to operating entirely or by a majority in either country?
US Corporation Taxation
Here are the current US Federal tax rates of a United States Corporation by range of taxable profit:
- Initial $50,000 federal tax rate is 15%
- Subsequent $25,000 federal tax rate is 25%
- Subsequent $25,000 federal tax rate is 34%
The average federal tax rate on the first $100,000 of taxable corporate profit is 22.5%. When profit figures exceed $100,000 there is a federal tax rate increase to 39%, followed by a decrease to 34%.
Aside from federal tax liability, the US Corporation may also be liable for state income taxes, depending on the state of incorporation, office location, and the working location of its employees. The highest state income tax in the US is Pennsylvania, leading with a 9.99% state tax rate. There are 9 states in the US which do not subject its businesses and corporations to state taxes, and income from foreign origins are not subject to state taxes.
If you were to open a corporation overseas, the added cost of doing business would have to be less than that of US tax liability. If the additional costs were around $15,000 per year, for example, you would have to produce $75,000 in profits just to break even with the amount you would have owed in US Federal taxes. To save on the cost of US taxation your corporation would have to earn $100,000 in taxable profits.
Many business owners wish to claim some of the business’ profits as personal income. An important consideration is: Double taxation is avoided on distribution of corporate assets if it is received by the business owner in the form of salary or compensation. Salary which is paid to a business owner is only subject to personal income tax, which can range from 10% to 35%, depending on the level of income. Social security taxes are the responsibility of both the business owner and the corporation in regard to salaries paid to domestic corporation owners. If you physically lived abroad, however, and you meet the additional requirements of the foreign earned income exclusion, you may be able to exclude some or all of your income.
One of the major costs of owning a corporation abroad is the cost of the CFC tax return, which is at least double the cost of a stateside return.
From a point of view considering taxation, the largest benefit to operating an overseas corporation is that of tax deferral. You can use tax-deferred money to generate extra profits by re-investing the tax savings amount into the corporation. This practice can produce enough extra income to equal – and possibly surpass – the amount in taxes which would be owed. For instance, if $20,000 is deferred for the time period of 1 year and the return is 10%, the corporation would have earned $2,000 instead of having spent it on tax liability. Over the course of the next 10 years, the minimum value would be $20,000; and that’s not even considering the compounding interest that would begin to take place as the total value of the investment grew.
As we have outlined, there are benefits to having an overseas corporation, but it’s important to take into consideration any relevant tax treaties with the US, as well as other potentially negative aspects and obstacles to establishing a foreign corporation.
I.J. Zemelman, EA is the founder of Taxes for Expats