Tax Traps & Retirement Planning Opportunities for American Entrepreneurs Abroad
By David Kuenzi, Thun Financial Advisors
David Kuenzi of Thun Financial Advisors weighs in on American expat-entrepreneurs’ tax obligations and pension opportunities.
It has never been easier for Americans to start businesses while living outside the U.S. If you are an American entrepreneur operating abroad, however, be aware of U.S. tax reporting obligations on non-U.S. businesses operated by Americans and make sure you are leveraging the value of U.S qualified retirement accounts set up for your business.
If a U.S. taxable person (U.S. citizens or U.S. green card holders) owns a controlling stake in a foreign business, that business is likely a Controlled Foreign Corporation (CFC) for U.S. tax purposes. CFCs are subject to potentially complex U.S. tax reporting requirements and, at a minimum, must file U.S. tax Form 5471 every year, whether or not the business is profitable. Even if no tax is due, failure to file a Form 5471 can result in large penalties.
CFC income reporting requirements (most importantly, the so-called “subpart F income” and “passive foreign investment income” rules) are designed to prevent Americans from using foreign businesses to shelter income from U.S. taxation. On the other hand, many American expat entrepreneurs have an often overlooked opportunity to employ conventional U.S. qualified retirement plans to significantly mitigate tax due on foreign sourced income and build retirement account assets.
Non-U.S. businesses with U.S. owners are generally eligible to use standard U.S. qualified retirement plans. An individual 401(k) plan and/or a defined benefits pension plan can be used to defer large amounts of foreign-sourced income into retirement accounts. U.S. domestic business owners often find such plans of limited use, because so-called “anti-discrimination” rules prevent them from deploying the plans without providing prohibitively expensive retirement benefits to all employees.
In contrast, a non-U.S. business with U.S. owners but no American employees is not bound by these anti-discrimination rules. That opens the door for a U.S. entrepreneur to defer up to $53,000 of income annually into an easy-to-set-up and manage Individual 401(k). If a slightly more complicated defined benefits plan is employed, hundreds of thousands of dollars of tax deductible contributions can potentially be made on behalf of the U.S. business owners.
Plan carefully, however. Local taxation may reduce or eliminate these tax benefits. Note that bilateral tax treaties may also play an important role in determining the net tax advantage of such plans.
American entrepreneurs abroad who partner with non-U.S. persons may find that their U.S. connection brings unwanted U.S. reporting requirements and scrutiny. Aside from the CFC rules discussed above, the new Fatca (Foreign Account Tax Compliance Act) requires ownership stakes in non-U.S. private business to be reported on Form 8938. Effectively, these reporting requirements force any business with U.S. partners to prepare financial statements to U.S. standards and submit that information to the IRS so that the U.S. partners’ tax liability can be determined. Enforcement of such onerous rules has significantly ratcheted up with the introduction of Fatca and has resulted in many cases of U.S. partners being shunned from foreign business ventures.
It should also be noted that where a U.S. partner (or even a U.S. employee) has signing authority over a business-related financial account, a Foreign Bank Account Report (FBAR) must be filed annually to disclose the account to the U.S. Treasury Department. Failure to properly make FBAR disclosures can result in extraordinarily high U.S. penalties, even when no tax is due.
Finally, self-employed Americans abroad are normally required to pay 15.3% U.S. self-employment tax (Social Security and Medicare) on self-employment income. Social Security Totalization agreements maintained by the U.S. with other countries may exempt the entrepreneur from paying U.S. self-employment tax when similar taxes are being paid locally.
Mr. Kuenzi is the founding partner of Thun Financial Advisors, a U.S. investment firm based in Madison, WI, that provides investment management and financial planning services to Americans abroad.