American Digital Nomads With U.S. Corporations
This article is for entrepreneurs who, for valid reasons, need to have a U.S. corporation to operate their businesses. Maybe the customers are in the United States. Maybe there is an office full of employees in the United States. Maybe banking and financial transactions are simpler when there is a U.S. corporation.1
The entrepreneur, however, decides to live abroad. Let’s use the phrase “digital nomad” (the current favorite appellation). This person is going to travel from place to place, working for the U.S. business, but staying below the radar in the various foreign countries.
Since U.S. citizens are taxed no matter where they live, our digital nomad will be filing a U.S. income tax return every year, and paying U.S. income tax. The U.S. corporation — which is an operating business, after all — will also file U.S. income tax returns.
How can our digital nomad minimize U.S. tax costs?
How Americans Abroad are Taxed on Wage Income
Americans abroad can eliminate income tax on salary income using the foreign earned income exclusion. It does not matter whether they are employed by an American or foreign employer.2 For 2017, this shelters the first $102,100 of earned income from U.S. income tax.3
This means that our digital nomad can draw a salary from his U.S. corporation of up to $102,100 and pay no Federal income tax on that salary.4.
The foreign earned income exclusion is not the topic of this article. Here, we talk about eliminating Social Security and Medicare tax. Here is the critical piece of (tax) wisdom that allows us to do this:
- Wages paid to an American abroad working for a foreign employer will not be subjected to Social Security and Medicare taxes.
- However, an American abroad working for an American employer will be subjected to Social Security and Medicare taxes.
Objective: Save $15,300
The objective is simple. If our digital nomad can configure himself to be receiving a salary from a foreign employer, he can eliminate Social Security and Medicare tax on his salary.
To give you a sense of the money at stake, assume $100,000 salary paid to our digital nomad in 2017 while he is working abroad. Assume further that the foreign earned income exclusion applies to the entire salary.
If we can make that $100,000 salary exempt from Social Security and Medicare tax (payable by the employer and the employee), our digital nomad can save $15,300 per year in tax:5
|Tax||Employer Rate||Employee Rate||Total Tax|
|Social Security Tax||6.2%||6.2%||$12,400|
|Medicare (HI) Tax||1.45%||1.45%||$2,900|
We consider the tax cost for the employer and the employee because our digital nomad is the 100% owner of the employer, and thus bears the burden of the employer’s tax cost of Social Security and Medicare tax.
American Employer vs Foreign Employer
Social Security and Medicare taxes are imposed on “wages” from “employment”.6 Defeat either item and the taxes will not be imposed. We are going to defeat “employment”.
“Employment” is defined in IRC § 3121(b):
For purposes of this chapter, the term “employment” means any service, of whatever nature, performed (A) by an employee for the person employing him, irrespective of the citizenship or residence of either, (i) within the United States, or (ii) on or in connection with an American vessel or American aircraft under a contract of service which is entered into within the United States or during the performance of which and while the employee is employed on the vessel or aircraft it touches at a port in the United States, if the employee is employed on and in connection with such vessel or aircraft when outside the United States, or (B) outside the United States by a citizen or resident of the United States as an employee for an American employer (as defined in subsection (h)), or (C) if it is service, regardless of where or by whom performed, which is designated as employment or recognized as equivalent to employment under an agreement entered into under section 233 of the Social Security Act; except that such term shall not include . . . .
Summarized, this means that “employment” exists when:
- You are working in the United States for anyone, foreign or domestic;7 or
- You are working outside the United States for an “American employer”.8
I will ignore the two other definitions of “employment” as they are not relevant to this article.
Good: Foreign Corporation as Foreign Employer
If the digital nomad works for and is paid by a foreign corporation rather than his U.S. corporation, then the digital nomad — as an “employee” — is employed by the foreign corporation. An “American corporation” is a corporation organized under U.S. law.9
Thus, a foreign corporation (formed under the laws of another country) cannot be an “American employer”. Wages paid to U.S. citizen employees working abroad are therefore not from “employment”, and no Social Security tax is payable on those wages.
Tax Paperwork and Risk
The typical structure will be that a U.S. corporation is the sole shareholder of the foreign corporation. In tax jargon, this is a parent/subsidiary structure.
Foreign corporations introduce significant (multi-thousands of dollars) tax return preparation costs for U.S. taxpayers. Form 926 must be filed to report capital contributions to foreign corporations. Form 5471 must be filed annually.
Additionally, because each corporation is treated as a separate tax-paying entity, great care must be taken to prevent accidentally creating taxable income where there might not otherwise be any. Payments from one corporation to another will be scrutinized by the IRS and possibly disallowed as tax deductions. This is “transfer pricing”.
Asset transfers from U.S. to foreign corporations can also trigger gain recognition under IRC § 367. While our strategy here involves pure employment of one human being, I prefer to create structures where there is no opportunity to create future failure. “Oh, look, we have a foreign corporation, so let’s transfer ownership of this software to that corporation.” Oops.
So while a simple parent/subsidiary structure is a solution and will work to achieve our objective (no Social Security tax), it does so by introducing significant overhead and penalty risk.
Better: Add a Disregarded Entity Election
You can make a foreign corporation (largely) disappear for U.S. income tax purposes. Use Form 8832 (Warning: PDF) to make a “check the box” election for the foreign corporation.
When the foreign corporation has only one owner (the U.S. corporation) it is disregarded for income tax purposes as a separate entity. This means that for income tax purposes, transfers of funds from the U.S. corporation to the foreign corporation are treated as purely internal transfers: there is no tax effect. As a result, the accounting work needed will be simpler: you no longer need to have rigorous corporate accounting for two separate corporations.
Since the foreign corporation is no longer a “corporation” for U.S. purposes, Form 5471 is no longer required. This is a complex, expensive form to prepare, with large penalties imposed for faulty or late filing. You have eliminated a significant amount of overhead.
Similarly, Form 926 is no longer required. Since Form 926 tracks transfers to foreign corporations and this is no longer a foreign corporation, the filing requirements will not apply.
Replacing Form 5471 and Form 926? Use Form 8858. This is the disclosure form that a U.S. person files to declare ownership of a foreign disregarded entity, as well as transactions with that entity. While this is additional work for your tax accounting budget, it will — in my opinion — be less work and expense than Form 5471 and Form 926.
In addition, the transactions between the U.S. corporation and the foreign disregarded corporation will be repetitive: funds are moved from the U.S. company to the foreign company, and the company pays a salary to the digital nomad. The first year of operating your system will take work, but for future years the job will be largely robotic. You will have good Standard Operating Procedures in place; tracking the accounting and preparing the Form 8858 will be efficient.
In short, making the disregarded entity election reduces administrative overhead, tax risk, and penalty risk.
Disregarded? For Income Tax But Not for Social Security Tax
The foreign corporation may be ignored when considering income tax obligations, but it is not ignored for Social Security tax purposes. The foreign corporation is still treated as existing for employment tax purposes, when we are trying to figure out if our digital nomad is being paid “wages” for “employment”.
Except as provided in paragraph (c)(2)(iv)(C) of this section, an entity that is disregarded as an entity separate from its owner for any purposes under the section is treated as a corporation with respect to taxes imposed under Subtitle C — Employment Taxes and Collection of Income Tax (Chapters 21, 22, 23, 23A, 24, and 25 of the Internal Revenue Code). For special rules regarding the application of certain employment tax exceptions, see §§31.3121(b)(3)-1(d), 31.3127-1(b), and 31.3306(c)(5)-1(d) of this chapter.10
None of the exceptions will apply to our digital nomad:
- Regs. §§ 31.3121(b)(3)-1(d) and 31.3306(c)(5)-1(d) deal with family employment situations.
- Regs. § 31.3127-1(b) deals with exemption from Social Security tax in religious employment contexts.
- Regs. § 301.7701-2(c)(2)(iv)(C) deals with backup withholding under IRC § 3406.
Details: It’s a Loanout Corporation
If our digital nomad is an employee of a foreign corporation but the services are for the benefit of the parent U.S. corporation, we have a mismatch:
- Services are rendered to the U.S. corporation, which doesn’t pay for them; and
- Salary is paid by the foreign corporation, which gets no benefit from the services rendered.
The “check the box” election (making the foreign corporation disregarded for income tax purposes) does not eliminate basic realities like this. So what you will need to do is create contracts.
This is a typical loanout corporation situation. Here are the contracts you need:
- The foreign corporation signs an employment contract with the digital nomad. Now the foreign corporation has a human being who can render services.
- The foreign corporation then signs a contract with the U.S. parent corporation, which provides the services of the digital nomad to the U.S. parent corporation. In return, the U.S. parent corporation pays the foreign corporation a fixed price for the services.
Now the entity receiving the benefit of the services (the U.S. corporation) is paying for those services (by making a payment to the foreign corporation). And the digital nomad, an employee of the foreign corporation, receives his salary from the foreign corporation.
Is It a Good Idea?
The example I have given projects a tax savings of $15,300 per year. Our digital nomad is not making contributions to the Social Security system, which means future retirement benefits will be lower. Be wary. This is short-term thinking. If the digital nomad has already made the contributions needed to maximize Social Security retirement benefits, this is a good strategy. But otherwise . . . I would not want your future 65-year old self to curse your present-day 29-year old self’s decisions.
Also, remember that a fair chunk of that tax savings will be eaten up by the cost of the foreign corporation and annual accounting and tax return preparation costs. I don’t know exactly what these will be, but let’s say an additional $4,000 – $5,000 per year in overhead is needed to buy the $15,300 per year tax savings.
Yeah, I know that everyone likes to look at Social Security benefits with disdain. The benefits exist at the whim of our Political Overlords in Washington DC. Just consider that you may end up relying on Social Security in your old age. Don’t short change yourself.
You make the decision.
Look before you leap. Hire someone to help you (that could be our firm). Don’t form a corporation until you have pre-thought the tax consequences. (We have had to tell people to dissolve newly-formed corporations that were unsuitable for check the box elections).
- Merchant fees for credit card processing will be lower if payments are processed through a U.S. company, for instance. ↩
- IRC § 911. Use Form 2555 to compute the excludable income. ↩
- Rev. Proc. 2016-55, §3.34. ↩
- There is an additional excludible amount for housing expenses that may be claimed as well. ↩
- These are the 2017 tax rates from the Social Security Administration. See IRC §§ 3101(a) and 3111(a) for the employee’s and employer’s obligation, respectively, to pay 6.2% tax on wage income, and IRC §§ 3101(b) and 3111(b) for their respective obligations to pay Medicare’s 1.45% Hospital Insurance tax. ↩
- IRC §§ 3101(a), 3111(a). ↩
- IRC § 3121(b)(A)(i). ↩
- IRC § 3121(b)(B). ↩
- IRC § 3121(h)(5). ↩
- Regs. § 301.7701-2(c)(2)(iv)(B). Emphasis added. ↩