The following article is for U.S. citizens and describes the type of income that can be retained offshore in a foreign corporation. It also defines foreign source and U.S. source income and how to allocate between domestic and offshore activities.
Let’s start with the basics. We U.S. citizens are taxed on our worldwide income. If we’re living and working abroad, we can use the Foreign Earned Income Exclusion to exclude the first $102,100 in salary from our U.S. taxes.
Also, if you’re living and operating a business abroad, you can retain ordinary business income in excess of the FEIE in an offshore corporation.
For example, you’re living in Panama, operating an internet marketing company, and net $300,000. You can take out $100.000 tax free and defer U.S. tax on $200,000 by leaving it in the corporation.
- Ordinary business income is earnings and profits from an active business… from the sale of a product or service. It does not include capital gains, passive income, rents, royalties, or any type of passive income.
Only foreign source income is eligible to be retained offshore. Foreign source income is ordinary business income earned by work done outside of the United States.
For example, you have a U.S. division and an offshore division in Panama. Income earned from work performed in Panama is foreign source. Income earned from work done in the United States is U.S. source income.
U.S. source income is always taxable in the United States. Foreign source income is eligible to be held tax deferred in your foreign corporation.
The key to creating foreign source income that can be retained offshore is to set up an active foreign division with employees. Whatever income they generate from work performed offshore is foreign source and eligible to be retained offshore.
Note that this requires a real company with employees that’s managed outside of the United States and which operates independently. If you form an offshore corporation without any substance behind it (employees), that company will provide zero tax benefit.
If you form an offshore company, hire independent contractors around the world, and manage those contractors from the United States, your offshore structure will provide zero tax benefit. This is because the foreign entity is providing no benefit and all management and control of these independent contractors is being done in the U.S.
Instead, you set up an offshore corporation, move abroad, qualify for the Foreign Earned Income Exclusion, manage independent contractors from around the word, and otherwise run your active business from a tax free country. Then you have a solid tax plan that can operate tax free or tax deferred.
The most common form of income that can be retained offshore is ordinary business income generated from work performed outside of the United States by employees of your offshore corporation.
Here is a complete chart of foreign source income and U.S. source income:
Summary of Source Rules for Income of Nonresident Aliens
|Item of Income||Factor Determining Source|
|Salaries, wages, etc.||Where services performed|
|Where services performed|
Sale of inventory -purchased
Sale of inventory -produced
|Where produced (Allocation may be necessary)|
|I have not considered royalties in this post. Royalties create a complex web of sourcing rules based on where the technology was created (onshore or offshore) and where the product is sold.|
If you’re planning an offshore division which will have foreign sourced income and retained earnings, you must hire a U.S. expert to build your structure and advise you on the U.S. tax issues. When done right, an offshore company with employees is a powerful tax savings tool… just ask Apple. When done wrong, the penalties and risks from the IRS can be severe.
I hope you’ve found this article on what type of income can be retained offshore in a foreign corporation to be helpful. For more information on setting up an active business offshore, please contact me at firstname.lastname@example.org or give us a call at (619) 550-2743. All consultations are free of charge and confidential.