The Evident Accounting Complexity of Section 951AJanuary 19, 2018 - Phil HodgenFriday Edition
There has been a lot of ballyhoo over the last few years about mega-multinationals (like Apple and Google) and their international tax structures. The amounts of money stashed abroad are staggering. But frankly, spending time complaining about Apple and Google’s tax planning is a mug’s game — the political ideologue’s version of smugly judgmental nattering about the Kardashians.
Meanwhile, real people roam the surface of Planet Earth, living real lives. Think of a normal American citizen living abroad, running a consulting business with $1 million of revenue and $500,000 of expenses. That’s real, and his problems are worth talking about.
Our American citizen abroad is the human embodiment of a multinational business enterprise. A mini-multinational.
The country where the American citizen lives will tax the business operation, and the Land of the Free™ will tax our American citizen because, well, he carries the magic blue passport by an accident of birth.
I suspect most of you live on Planet Earth with me. We talk to normal people doing normal things. And they ask normal questions, like “I’m starting a business. How do I set it up for minimum brain damage?”
For our American abroad, the question of how to set up his business gets weird because of U.S. tax constraints. And it just got a bit weirder because of the new tax law passed in December.
For simplicity’s sake, let’s put our American entrepreneur abroad in Dubai, simply to eliminate the complexity of talking about the foreign tax credit.
The Schedule C Choices
There is a group of business structure solutions that all look, to the U.S. tax system, like a sole proprietorship. All of the net income from the business is reported on the owner’s Schedule C and U.S. income tax is imposed in the year the income is earned.
These structures are unaffected by the new tax law.
You just start doing business, as a human being. Income and expenses are reported on Schedule C. Net income from Schedule C is reported on Form 1040, Line 12. Certain magic happens on Lines 23 through 62 of Form 1040, resulting in your total tax liability on Line 63.
This is unremarkable.
Domestic Disregarded Entity
The second method of doing business is a domestic disregarded entity. Our American abroad might form a Delaware limited liability company and do business.
For U.S. tax purposes, this is functionally equivalent of a sole proprietorship: All income flows from Schedule C to Form 1040 just as before.
Foreign Disregarded Entity
Many foreign companies look like corporations to the outside world, but for U.S. tax purposes the American owner can cause the company to be disregarded, just like a Delaware limited liability company. This is done by filing Form 8832.
Again, the company’s net income is reported on Schedule C and flows through to the American owner’s Form 1040, to be taxed.
For all three scenarios, the net profit from operations will be treated as self-employment income, and self-employment tax will be imposed in addition to income tax.
This can cause a bit of a double-taxation problem if the income is simultaneously subjected to social security tax in the country where the American owner happens to be living. Totalization agreements may help solve the problem, temporarily at least.
Again, the self-employment tax problem is unaffected by the new tax law.
Eliminating Double Income Tax
The big problem is always double taxation. If business profit is simultaneously taxed in the United States and another country, we have a problem. The U.S. tax system offers two possible solutions:
- Foreign tax credit. This is Form 1116. An income tax paid in another country can reduce, dollar for dollar, the U.S. income tax payable.
- Foreign earned income exclusion. This is Form 2555. Up to $104,100 of earned income can escape U.S. income entirely. Additional amounts attributable to housing can be excluded, too.
Both of these remain unchanged by the new tax law.
Foreign Earned Income Exclusion Inefficiency
The foreign earned income exclusion is not efficient for self-employed people. The exclusion amount for 2018 is $104,100. But the income that is excluded is GROSS income, not NET profit.
Our American abroad collects $1,000,000 of revenue and has $500,000 of business expenses. As a result, he has $500,000 of taxable net profit.
Applying the foreign earned income exclusion to this business (when structured as a sole proprietorship) we reduce gross revenue by the foreign earned income exclusion amount, not the net profit.
We also make an additional adjustment: some of the $500,000 business expenses apply to gross revenue that is taxed, and some of the expenses apply to generating gross income that is excluded from taxation by the foreign earned income exclusion.
We must reduce the amount of the tax deduction for business expenses appropriately. This is done by multiplying business expenses by a fraction. The numerator of the fraction is the foreign earned income exclusion, and the denominator is total gross revenue.
|Less business expenses||-500,000||-500,000|
|Add back disallowed business expenses||52,050|
This is not so much fun. Note that our American entrepreneur abroad probably thinks that he will earn $104,100 tax-free because of the foreign earned income exclusion, but in fact only $52,050 is tax-free.
In summary, the structures taxed as sole proprietorships provide no protection from self-employment tax, and are inefficient for use of the foreign earned income exclusion
There is a single structure in the second category of business structures: a U.S. S corporation. Again, all net income is currently taxable for income tax purposes. This is the way S corporations work.
The game for S corporations is with the foreign earned income exclusion. The American owner is an employee of the S corporation and receives a salary equal to the foreign earned income exclusion.
The individual has $104,100 of wage income (Form 1040, Line 8) and a foreign earned income exclusion of -$104,100 (Form 1040, Line 21). Note how much more efficient this is: the entire $104,100 foreign earned income exclusion is enjoyed.
The corporation has taxable income of $395,900, which is passed through as an S corporation distribution to the American owner and subjected to income tax, but not Medicare tax.
Social Security tax is imposed on the $104,100 salary paid to the American entrepreneur. Ordinarily wages earned abroad would not be subjected to U.S. Social Security tax but if the wages are paid by an “American employer” this rule does not apply. Pay the tax.
Bottom line: an S corporation allows for more efficient use of the foreign earned income exclusion than the sole proprietorship solutions.
C Corporation Structures
The final category of business structures are the classic C corporation structures:
- The consulting business is operated through a U.S. corporation taxed as a corporation under Subchapter C; or
- The business is operated through a foreign corporation taxed as a corporation for U.S. income tax purposes.
I will ignore the domestic C corporation structure. The foreign C corporation structure, however, is interesting to us. This is treated in a substantially new way for U.S. tax purposes because of the new tax law.
Social Security Savings
There are a lot of good reasons to use a foreign corporation that is taxed as a C corporation. One great one is to completely eliminate U.S. Social Security tax.
Wages paid to a U.S. person by a foreign corporation will not be subject to Social Security tax — for the employer or the employee.
The Old Days
In the good old days (before December, 2017), the reason to use a foreign C corporation was to achieve tax deferral. Can you earn a foreign profit this year and NOT pay U.S. income tax on that profit until a future year? This was the mega-multinational’s game, and mini-multinationals played it, too.
The New Law
The new tax law eliminates the deferral game for the mega-multinational. Now there is no need for Apple to play games. Foreign income is received from its foreign subsidiaries without any U.S. income tax at all.
This only works when a foreign corporation is owned by a U.S. corporation. It does not work when the foreign corporation is owned by a human. Thus, foreign corporations (taxed by the U.S. as corporations) will probably be a poor choice for our American abroad.
What about foreign corporations for the mini-multinational? Let’s avoid technical discussions here, and look at friction costs as a deciding factor.
Making Structure Choices By Avoiding Accounting Fees
Even if you ignore technical details and math (never ignore math), the overhead and complexity of the new law make foreign C corporations unappealing.
I point you specifically at a lovely (heh) new piece of the Internal Revenue Code, Section 951A. Read this description of new Section 951A from ThomsonReuters:
New law. For tax years of foreign corporations that begin after Dec. 31, 2017, and for tax years of U.S. shareholders in which or with which such tax years of foreign corporations end, a U.S. shareholder of any CFC has to include in gross income for a tax year its global intangible low-taxed income (GILTI) in a manner generally similar to inclusions of subpart F income. GILTI means, with respect to any U.S. shareholder for the shareholder’s tax year, the excess (if any) of the shareholder’s “net CFC tested income” over the shareholder’s net deemed tangible income return. The shareholder’s net deemed tangible income return is an amount equal to the excess of (i) 10% of the aggregate of the shareholder’s pro rata share of the qualified business asset investment (QBAI) of each CFC with respect to which it is a U.S. shareholder; over (ii) the amount of interest expense taken into account under Code Sec. 951A(c)(2)(A)(ii) in determining the shareholder’s net CFC tested income for the tax year to the extent the interest income attributable to the expense is not taken into account in determining the shareholder’s net CFC tested income.
Do you understand it? Nor do I, barely. It’s hard for me to parse those words in my head, and I do this stuff for a living in my day job.
You don’t need to understand what the words mean, however. Just know that every defined term, every piece of jargon, evern acronym–each of these mean you must pay for a lot of expensive accounting:
- “Shareholder’s net deemed tangible income return”.
- “Qualified business asset investment”.
Mini-multinationals should avoid structures that require them to pay to get answers to questions raised by jargon like that.