Choosing among alternate realities (the consultant edition)April 2, 2015 - Phil HodgenFriday Edition
LLC or what?
This week’s Edition is triggered by an email I received from a reader. This is a nonresident and noncitizen of the United States who works in the United States from time to time – a consultant.
I have a US company – an LLC. I am considering a “check the box” election to convert the LLC to an S corporation, owned by a non-US company that I control. What are the pros and cons of this corporate status?
N.B. I am calling him a consultant because, well, we are hiding his identity. You can find him on the internets quite easily. But, boiling away the specifics, the reality is that he is performing a service, doing so in the USA, and getting paid. Exactly what is done is irrelevant.
S corporation: not possible
The first (and easiest) response is that S corporation status is not possible.
Quick aside: an S corporation is a corporation that does not pay corporate income tax. Instead, it passes all of its profits through to the shareholders, who pay tax on the corporate profits on their personal income tax returns.
Only U.S. resident humans (and in a few situations, trusts) can be shareholders in S corporations. So this type of taxable entity will not work for my correspondent. His non-US corporation is not a permitted shareholder for an S corporation. Nor is he (as a non-US taxpayer) a permitted shareholder, either.
There is no particular logical reason for this, except obscure historical ones. I hope someday sanity will prevail and S corporation status will be permitted regardless of the shareholders’ resident status.
The hard work starts
Now the hard work starts. My correspondent works occasionally in the United States. This income will be taxed in the United States. His task is tax minimization and cost overhead minimization. He is seeking a sort of Nash Equilibrium with the IRS.
This is done by calculating the cost of current reality, then identifying all other alternate realities and their expected costs. The least bad among all of the choices (current reality and all possible parallel tax universes) is the one you pick.
Current reality: what it costs
The current reality is that when he performs consulting services in the United States, he is taxed. The LLC is a disregarded entity, and he is considered to be earning the income directly as a human being. Thus:
- Income tax is imposed on his net profit from the consulting services he performs in the United States (i.e., what he is paid minus his business expenses associated with generating that income and minus 50% of his self-employment tax);
- Self-employment tax is imposed on that net profit;
- He also pays State income tax anywhere he goes to do his work;
- He files Form 1040NR (with Schedule C and Schedule SE attached) for Federal tax;
- He files whatever State income tax returns are required, anywhere he goes;
- He pays for the annual upkeep of the US limited liability company; and
- He pays for decent accounting to track all of this stuff and avoid personal brain damage from excess OCD tax paperwork (consultants should consult; they should not do their own bookkeeping).
The way to find the Nash Equilibrium is to first start by totaling up all of the costs of staying with current reality.
The alternate realities
There are alternate realities. In order to select which of these you want to live in, you need to do the math. This is a financial problem, for the most part. (The exception is describe below – the very real business problem of getting paid by your customers).
The choices are:
- Work in the United States as the employee of a non-US corporation. (Your non-US corporation signs a contract with the customer promising to provide a service, then the non-US corporation ships you to the United States to do the actual work).
- Work in the United States as the employee of a US corporation. (A US corporation signs a contract with the customer promising to provide a service, then the US corporation hires you as its employee to go and do the actual work).
- Work in the USA by using a partnership of some kind; you might be a partner or you might be an employee of the partnership. (The partnership signs a contract with the customer promising to provide a service, then the partnership sends you to do the work). Note: an LLC with two members is a partnership for US tax purposes. This is a fact that is not always fully appreciated, shall we say.
I am going to ignore the partnership possibility because … I don’t want to write forever.
Basic premise: personal income taxation
The basic premise is that personal compensation to the consultant for doing work in the United States will be taxable, no matter which tax reality is selected. Income tax and self-employment tax (or Social Security/Medicare taxes if the consultant is an employee) will be paid no matter what.
The only tax saving possibility here is to control the level of the consultant’s compensation. If current reality is used (the customer signs a contract with the LLC and the consultant provides the service) the only way to reduce the consultant’s compensation is by asking the customer for less money. That is not appetizing. 🙂 [Well, there is a second way to reduce the consultant’s taxable income, and that is by loading up on business expenses. But why spend an extra $100 just to reduce your tax by $30?]
When the consulting work is performed through a corporation (US or non-US) there are two points at which the consultant’s taxable income can be controlled (thereby reducing his personal income tax and Self-Employment or Social Security taxes):
- at the point of interaction between the customer and the corporation that promises to provide consulting services; and
- at the point of interaction between the corporation and the individual consultant as an employee.
The corporation could ask the customer for less money. But that’s dumb, right?
But the corporation could certainly pay the consultant (as its employee) a smaller salary than the amount of money that it collected from the customer. In fact, that is the way capitalism works. The employer (the corporation) collects $10,000 from the customer, and pays the employee $2,500. The employer uses whatever is left over for overhead and then puts the profit in its pocket.
So a $10,000 consulting job paid directly to the LLC (and then onward to the consultant) would generate personal income tax and Social Security/Self-Employment tax on $10,000. But $10,000 paid to the corporation will only trigger $2,500 of personal taxable income to the consultant – from salary.
Where does the employer’s profit go?
That’s good, but it points up an obvious problem. The corporation has $7,500 of taxable profit. If you have just shifted $7,500 of taxable income from one place to another – but it is still taxable – you have achieved nothing.
Here is where the problem lies. How will you deal with the taxable profit of the employer (which the USA will want to tax)? You must find some way to minimize the US corporate income tax on that profit.
What business expenses does the employer entity have that will reduce its profit? This is where you must look next. If you can identify these, then you can reduce the corporation’s taxable profit (ideally to zero or close to it). Note that these must be expenses that the individual consultant could not have taken as an independent human doing business through his LLC.
In other words, by adding in a second layer to the method by which you do business in the United States, you have added a second point of control over your destiny in the form of reducing taxable income by appropriate business expenses:
- The business expenses – noncompensation – needed to enable the consultant for his services (the same whether using current reality or one of the alternate realities); and
- The business expenses of operating the employer entity (this is new, and the expenses of running this entity are not strictly related to just providing a specific service to a specific customer).
Can you identify expenses that are appropriate for the employer entity that would otherwise not be deductible against U.S. taxable income for the consultant?
If you can completely or largely evaporate the employer’s taxable profit via real business expenses, then you can take a serious look at the alternate realities.
Tax cost comparison
Compute the tax cost you expect at the employee level (pay the consultant a salary) and at the employer level (the entity has profit minus deductible expenses, taxed at the appropriate tax rate). Compare that total tax cost (for all alternate realities) against the tax cost for current reality. If the difference is small, don’t bother going any further.
Next you need to consider the overhead cost of owning and operating one or more entities. This is just legal, accounting, and government fee costs. Plus of course you should add a number that compensates you for additional clutter in your life. The number for THAT is the amount of money you could pay someone to handle it all for you.
Finally, and assuming that the difference in tax cost between current reality and your alternate realities is high enough to consider changing your reality, you need to look at one final factor. What are the tax risks? You are seeking a Nash Equilibrium, which means that you need to find a solution that the IRS will accept. And in particular, will the IRS accept:
- The level of salary that the employer entity pays the consultant?
- The business expenses claimed by the employer entity, both in character and amount?
This can be done. You need to be willing to go through an audit if necessary, but sooner or later the right point of balance will be found.
Math, simplicity, and profit
Math is your friend. Math will tell you everything you need to know about choosing between current reality and an alternate reality.
But math will not adequately assign a value to time. Someone who is highly skilled will make more profit by optimizing for maximum revenue rather than optimizing for minimum tax. If you cannot completely outsource the entire bookkeeping, accounting, and tax return filing process to someone else, I would pretty much tell you to optimize for simplicity and be done. If you spend 50 hours a year on bookkeeping or you spend those 50 hours writing an article that gets published and brings you new customers – what’s the smart thing to do?
Brains across borders. Create opportunities by introducing complexity can definitely save tax. But do the math first, then be willing to outsource everything financial and tax to someone else to do.
You know the drill by now: this isn’t legal advice, hire someone competent.
See you next week, and feel free to email me and say hi.