One benefit of being self-employed is that you can structure your business so you are not constrained by geography. As more of our lives move onto the Internet, more business owners are able to take their life abroad while continuing the income. If you are like me, a US business owner living overseas, you might want to know how to plan your income as a globally mobile US business owner.
Do you want to become location independent now that your business is on track? Or do you want to start a business because you are following a spouse with an international career? Or perhaps you have found a new home in another part of the world and want to take your business with you?
Whatever your reason is, this post is for you. For the seasoned entrepreneurs, some of the information below might be basic, but you will find that when there is an international twist, things can become complicated very quickly.
Are you allowed to conduct business at your location?
Before we go on, there are two primers that are important to you as a globally mobile entrepreneur. While your business may be established in the US, and you are able to conduct business wherever you are, it doesn’t necessarily mean that you are allowed to do so in the country you are in. Remember, every sovereign nation has its own rules regarding who is able to make money within its borders and under what conditions. Make sure you are doing it legally.
Just as you wouldn’t want anyone to enter the US illegally and conduct business there, you should follow the law of the country you intend to stay in, no matter how long. Some types of visas may allow you to stay for extended periods of time in country, but don’t allow you to work or conduct business.
Local laws and regulations
After making sure you are legally allowed to work in country, you may also need to find out regulations pertaining to your specific profession, industry, and type of business. You might be required to register in country, which may come with extra cost.
In the age of online businesses, you may be thinking that your line of work falls in the gray area. I completely agree with you. It’s hard to tell how long it will take the governments around the world to catch up and come up with regulations that apply to your situation. Before then, you just have to consult legal professionals and use your best judgement.
How to plan your income as a globally mobile US business owner
Many people only think about revenue when they decide how much income they need. However, your revenue is far from the actual income you get to keep. The graph below summarizes what eats into your revenue before you arrive at your take home pay.
Basically, your take home pay = gross revenue – expenses – social security / medicare taxes – income tax – savings. How much you pay in overall taxes is a result of the coordination between your US and foreign tax liability. The type of accounts you use to save, business location, where you are physically, and the tax structure of your business all determine how much tax you need to pay.
Below we will go through each category as detailed in the graph, and the planning steps you may want to take to optimize each category.
Imagine a world without taxes and cross-border complications. In such a world, what really dictates how much you get to bring home to spend or save is your profit margin. In other words, you want to be able to make more income with the same or even lower level of cost.
This is true even in the world with extra tax or legal considerations. However, often times we end up focusing too much effort on gaming the tax system, instead of trying to increase our profit margin, or to increase our revenue without cutting our profit margin.
I’m not going to pretend to be a business guru and tell you how to make more money in your unique line of work. However, one thing many new business owners need to set up is a way of tracking your expenses properly.
Separate business accounting
I’m a strong believer in keeping your business accounting separate from your personal expenses. In my opinion, the easiest way to do this is to keep a separate business account, and formally “pay yourself” by making transfers to your personal account. This allows you to have a clear picture at any given time how your business is generating cash flow.
On the other hand, sometimes you may have to transfer money from your personal account in order to keep your business account afloat. Again, the fact you need to do so gives you a sober view of how much in personal assets you are devoting to your business in order to generate revenue.
If you are self-employed or run a US based business, you will have to pay into the US social security system. How much you pay depends on how your business is structured legally and for tax purposes.
Schedule C, S Corp or C Corp
It’s beyond the scope of this post to go into all the differences between various legal and tax structures you may choose for your business. In any case, I am not a CPA or attorney, so you should definitely consult a licensed professional in this area.
What I do want to mention here is how the selection makes a difference on what is considered “compensation for your labor” versus “return on investment.”
If your business profit is considered compensation for your labor, then it will be covered under the social security system in the US, just like any employee. And because you are both the employer and employee, you will need to pay both portions, which amounts to 15.3% of your profits.
The election of S-corp or C-corp allows you to wear dual hats as employee and investor. The employee compensation, including the contribution on behalf of the employee to social security, will become part of the business expense, and you receive some dividends or full profits as an investor after all the expenses are accounted for. In the US, return on investments may receive more favorable tax treatment.
Most tax professionals who focus on small business operations will be able to advise you which structure is most beneficial to you from a US tax standpoint. Nevertheless, it gets tricky if you also become a tax resident in a second or even a third country.
If you are legally operating a US business from a second country, you might want to find out whether you are required to pay into that country’s equivalent social pension system.
Since you are not able to avoid social security taxes while running a US based business, you will need to find out whether there is a totalization agreement for the country you are a resident of. This may prevent you from paying into two social security systems based on the same income.
Unfortunately, there are only 26 totalization agreements in force between the US and other countries. It is possible to find yourself in the situation where you have to pay into two systems. You may find comfort in the possibility of claiming benefits in both systems when you are eligible.
US Federal Income Tax + State Taxes
In addition to social security taxes, you will also need to consider three types of US taxes: federal income tax, state income tax, and state business-related tax.
Whether or not you are an American living in the US, you may have US tax liability if the business is based in the US. However, here we are only going to discuss what applies to US citizens and permanent residents (green card holders), who have tax liability on their worldwide income, regardless of their physical location.
Only liable for US taxes
If you do not become a tax resident in any other country, you just need to plan for your US taxes. (How do you do that? Some people country hop; others find unique visa classes that do not tax foreign income.)
Federal income tax
In this situation, most people take advantage of the Foreign Earned Income Exclusion for federal income tax. As the name suggest, you only get exclusion if it’s your earned income. So being overseas may play into your decisions on how you structure your compensation vs. business profits.
Tax-deferred and Roth type savings
You are able to take advantage of the tax-advantaged accounts to lower your US tax liability and increase tax-free investments. You can find more information about tax-advantaged accounts for small business owners in my past posts.
It’s worth noting that if you choose to save in tax-advantaged accounts, it generally means you cannot access your investments without penalty until you meet certain eligibility. (The Roth IRA might be the one exception as it comes with a more flexible withdrawal possibility.) Therefore, I consider this to be something outside of your take home pay.
Having a US based business means you are also under the jurisdiction of the state where your business is incorporated, conducting activities, or hiring. It can get complicated very quickly. Here I just want to point out just because you get FEIE at the federal level, it doesn’t mean you will avoid state level taxes automatically.
If you do not have employees or product sales across state lines, generally it’s most beneficial to incorporate in states where there is no personal or business income tax. Once your operation gets bigger, you may need to employ specialists in this area to cover all of your responsibilities.
Foreign tax liability
What if you choose to become a tax resident in a second country? It means you need to be aware of the coordination of the tax laws in two countries.
The US has entered into tax treaties with over 60 countries. (Much better than totalization agreements!) The first thing you should do is find out whether there is a tax treaty that applies to you. (Of course, you may soon decide it’s time to hire an expert to help you.)
What you will also learn is that tax treaties are also negotiated by type of income. Therefore, what part of your income counts as compensation vs. return on investment plays a role in how the treaty is applied.
Furthermore, many countries may not recognize the US business or tax structure and apply a different standard on how much of your income is taxable. Just because you are able to reduce current US income tax by maximizing 401(k) contribution doesn’t mean that treatment is recognized in another country if you are liable for taxes there. This is another reason why you should not take the decision of becoming tax residents in any given country lightly. Do your homework and proceed with caution.
So there are still over 100 countries in the world the US does not have a tax treaty with. Or in the specific treaty, it may not cover how you run your business. What do you do in this case?
In short, you simply have to satisfy your tax obligations in both countries. If you feel like you are paying double taxes on the same income, at least on the US side there is a way to mitigate double-taxation by claiming foreign tax credit. If you are paying more taxes overseas than in the US, foreign tax credit may reduce your overall federal income tax liability to no more than what you would have paid as a US tax resident only.
To summarize, running your own business while being globally mobile amplifies the need to do proper cross-border tax planning in advance. It’s likely a part of the business expense that you cannot do without.
Should I consider incorporating outside of the US?
At this point, you might be wondering if you are better off just moving your business to your new location, or even to a third “tax-haven” country that facilitates your globally mobile lifestyle.
Eventually, it requires a cost benefit analysis for your unique situation. The goal is to reduce overall cost, not just taxes; or hold cost steady, but increase revenue. Below are some of the areas you might consider:
- To continue or even expand your operation, does your local law require you to register in country? If so, does it require you to move the business, open a branch, or simply declare income?
- Does the new country offer favorable tax treatment in the long-term? If so, what are the requirements?
- Does moving the company overseas lower your overall cost of running the business (assuming you do not give up US citizenship or green card)? What do the tax treaty and totalization agreements say?
- While moving your financial base overseas may lower your US tax liability, it likely may increase your reporting requirements, such as ownership of foreign entity and foreign accounts. Is that a tradeoff you are willing to make
Lastly, the new tax law in effect for 2018 took away the tax-deferred treatment for retained earnings of foreign business owned by a US taxpayer. On the other hand, it reduces tax rates for US C-Corp and introduces incentive for pass-through small business entities. This is why it is probably wise for all globally mobile American small business owner to re-evaluate their business and tax structure this year.
Not sure what to do next? Speak with financial planner focused on global planning to help you get organized, make critical decisions, and move forward.