Dateline: Belgrade, Serbia
Moving your business offshore is a great way to go where you’re treated best and keep more of your own money by legally lowering your tax rate.
Most people focus on income tax – how much money they can save now by going overseas. But if you’re building up a business that you want to sell in the future, you should also consider capital gains taxes.
In this article, I will tell you what you need to keep in mind when it comes to knowing how to avoid capital gains tax and how you should factor that into your international tax planning and offshore structures.
WHAT HAPPENS WHEN YOU SELL YOUR BUSINESS
For many people, capital gains tax is equally, if not more important than saving on income taxes.
Here at Nomad Capitalist, we talk about and help people to move their business offshore to dramatically reduce their taxes, in some cases even to zero. For many people, over a period of time, that can add up to millions of dollars in savings that they can reinvest into the business to grow it even faster or put it into their pocket to make investments, retire earlier, or whatever their priorities might be.
Almost 90% of the clients who come to us for help are interested in how they can save money on their income tax. The other 10% are more concerned with what will happen when they go to sell their business five or ten years from now and how to avoid capital gains tax.
More of them should be concerned with this second question.
Imagine you’ve saved that million dollars in the next five years. What happens then? Sometimes, clients will say that they love the business and want to do it forever. Occasionally, they’ll say it’s a business that’s not going to last forever, so they’re just cashing in now because it’ll eventually fade away. It’s a fad.
But more times than you would imagine, the person says that they plan on selling it to a private equity firm or find a buyer.
So, I’ll ask them how much they can sell this business for that’s making a million dollars or more in revenue. For our example’s sake, let’s say they’re planning to sell it for $12 million.
The next question is whether they bought the business. Most people will respond that they started it and their basis was zero because they started the business with their own two hands.
If that’s the case, most countries will consider that a $12 million gain on that business. And all 12 million of those dollars are going to be taxed as a capital gain.
Now, not every country has capital gains tax but most western countries do. A lot of countries have special lower long-term capital gains tax rates. We have seen a couple of situations where the entire business wasn’t taxed as a long-term gain because the business is acquiring new assets.
But let’s just assume you’ve got a $12 million gain in your business. In the United States, you might be paying close to three million dollars in tax on that.
That three million dollars in capital gains tax is more than the one million dollars in income tax savings you got from moving overseas. This is why it’s equally important.
So, what do you need to know to avoid that?
AVOIDING CAPITAL GAINS TAX
The main thing that you want to know is that you want to move your company out of the taxing jurisdiction as soon as possible if you want to reduce the tax burden.
There are some countries that are so aggressive that they’ll say if you just had the idea in the country – if you created some kind of intellectual property, even if it’s not formalized – they’ll want a chunk of that and will make it very difficult to get it out.
If you’re in a business where you’re creating things like intellectual property, that can be important. But I don’t want to give tax advice here. It can get very complicated. This is only meant as a general explanation to help you understand the concepts.
So, how it generally works is that you can build up your business in a certain country and when you want to move it overseas two things will happen.
Number one, depending on the kind of business and what the assets of that company are, there may or may not be some kind of tax to pay just for moving it.
Every business is different but you cannot simply take an asset that’s highly valuable and move it overseas and say it’s gone. Certain kinds of businesses have more flexibility.
The second thing that’s going to happen is that you may be subject to some kind of exit tax. As is often the case, there are two scenarios for how this may happen: one for US citizens and one for everyone else.
If you’re leaving your country as a non-U.S. citizen and you become what’s called tax non-resident or you deregister from your country, you may be liable for a tax on all of your assets because it’s their last bite at the apple. They may have you pay whatever capital gains would be owed as if you sold everything today.
If you’re a US citizen, you don’t have to do that because US citizens are liable for tax on their worldwide income no matter where they live. And while there are strategies to reduce tax on the active part of the income and earnings in the business, the capital gains are considered passive income, so there’s really no strategy for that.
So, if in the future you sell that business and you’re still a US citizen, you’re going to be subject to tax on that entire capital gain as if you never left the country.
The goal is to get things in place as soon as you can to avoid having this happen.
WHEN SHOULD YOU MOVE OFFSHORE?
People often ask me: when’s the best time to move my company offshore? My answer is not a numerical one but a human emotional answer, which is when the pain of paying the tax and dealing with the frustration where you are exceeds the hassle and cost of setting up the offshore structure.
Offshore companies are not free. In fact, most of the time, they cost more than setting up an LLC in your home state or setting up a local company. In the US, UK, and Canada, and many other countries, it’s not that expensive to set up a company. It’s more expensive and complicated offshore.
But whenever what you’re doing now is more miserable and you’re so sick and tired of it that it becomes worth making the change, that’s when it’s worth it.
However, if there’s going to be a capital gains situation – you’re not just running a cash cow but you’re running a sellable business – you want to look at how you can get to that point as quickly as possible.
A gentleman came to me a couple of years ago who was thinking of selling his business that was worth tens of millions of dollars.
He wanted my advice. He was already going to have a tax bill, but he figured he was selling it for tens of millions of dollars so he could just pay the tax bill. But the idea was to lock in that tax bill at a lower number early on, get out of the system, and then build it up bigger once he was set up offshore.
After he hired us, immediately selling the business sounded like more of a hassle than it was worth, so he continued building it up, adding tens of millions of dollars more in value by the time it came to sell the business.
Unfortunately, at that point, there wasn’t as much that could be done about the tax. We could pick at things and pulled a million dollars here and a million dollars there and saved him a couple of million bucks, but we were talking about tens of millions of dollars. The savings he could have had by moving the business earlier could have been many times higher.
Another gentleman who had built a business had quickly raised money through rounds of financing to the point that he couldn’t afford to leave without having to sell off a decent amount of his shares and he didn’t have a buyer.
You don’t want to get into a situation where you have little liquidity in your company and you just can’t afford to pay the bill to leave. And then, while you’re waiting, the company is still going up in value and the bill gets bigger all the time.
You don’t want to be in that situation.
So, the sooner you can move the company offshore, the better it’s going to be from a capital gains tax perspective
From an income tax perspective, it’s much easier in many situations to make that move and get those instant income tax savings, but it can be more difficult to do the same for capital gains.
HOW TO AVOID CAPITAL GAINS TAX FOR US CITIZENS
Let’s go through a couple of different scenarios of how to avoid capital gains tax.
Again, there are two camps when it comes to offshore tax strategies: Americans and everyone else.
We’ll start with the Americans.
Even though the US does have a citizenship-based taxation system, you can go overseas and get income tax savings relatively easily with the Foreign Earned Income Exclusion. You can set things up and see the benefits immediately.
But avoiding capital gains tax is not as easy or as quick to obtain. You do, however, have two options.
OPTION #1: MOVING TO PUERTO RICO
Option number one is to move to Puerto Rico. Puerto Rico has an interesting approach to capital gains tax compared to most other strategies for Americans (or even for citizens of other countries) because it is time-based.
Let’s say you’ve been running a business for two years. It’s relatively new. You decide to heed my advice and move it overseas to save on capital gains.
So, you move it to Puerto Rico. It’s not as easy as people make it out to be. There are some boxes to check, but you move your business to Puerto Rico.
Now, you run the business for five more years and when you sell it, you get a capital gains tax exemption. But this is where the people promoting Puerto Rico sometimes overhype it. You only get the capital gains tax exemption for the percentage of time you were in Puerto Rico.
In our example where two of the seven years that your business existed were in the United States and five of the seven years were in Puerto Rico, you will get a 5/7th exemption on your capital gains.
So, if you sell a business for $12 million, you won’t be able to exempt the full $12 million from taxation. You will only be able to exempt about eight and a half million dollars while the other three and a half will be subject to capital gains tax in the United States.
So, you can see why doing things as quickly as possible would benefit you in that situation. Sometimes, holding on to the business for more time after you move would be a good idea, too.
The thing that promoters often overhype is that you can move to Puerto Rico and immediately get the capital gains tax exclusion. That’s not how it works. You don’t just get to land in Puerto Rico and sell your business a week later and expect the IRS to simply write off the last 10 years you’ve been running it.
To learn more about Puerto Rico’s tax incentives and how they work, check out our ultimate guide to Puerto Rico’s Act 20 and Act 22, now officially known as Act 60.
OPTION #2: RENOUNCE YOUR US CITIZENSHIP
The second option for US persons is to renounce their citizenship. The tax calculation method for capital gains in the case of renunciation is similar to the methods of most other countries which base the amount due on the value of your assets at the time you expatriate.
So, let’s say you have built up a business that is worth $10 million today.
When you leave, you’re going to pay mark to market tax on capital gains (remember, it’s the last bite of the apple for the government). So, when you renounce, if you have more than two million dollars in net worth, they’re going to tax that – minus about $700,000 in gains which are free. Everything above that, you just pay as if you had sold the asset.
You can see that’s where the liquidity comes into play. If you don’t have much liquidity and you can’t get much of it, there’s some planning that has to be done.
This can even apply to things like cryptocurrency. We’ve had people who have had huge cryptocurrency run-ups in past years who didn’t have the liquidity to renounce. If you’re at a lower number, that’s the time to get out and ostensibly pay zero. Even if your company has some value, you can pay zero.
Once you get over that two million dollar number, you get some gains for free, and then you just pay and pay and pay.
This is where the gentleman who had the extra $20 million or so in added value in the course of the two years in between our conversations could have saved roughly 20% of $20 million. Saving an extra $4 million is not a bad deal, even if you still have to pay a good amount of tax.
Eduardo Saverin, one of the co-founders of Facebook, had that issue where he paid a boatload of tax to the US but he expatriated at the right time to where he still saved hundreds of millions of dollars. He paid a lot, but he was able to save even more than he would have had to pay had he paid later.
If you are considering renunciation and want to learn more, check out these other articles on our site:
- The Tax Consequences of Renouncing US Citizenship
- 4 Reasons People Renounce US Citizenship
- How to Renounce US Citizenship; the Ultimate Guide
- Why and How I Renounced My US Citizenship: My Expatriation Story
- 4 Case Studies for Renouncing US Citizenship
HOW TO AVOID CAPITAL GAINS TAX FOR NON-US CITIZENS
If you’re not a US citizen, the situation is similar to those renouncing their American citizenship in that you can leave your country but you may be subject to an exit tax. If you build up a five or ten million dollar business, your country may not just let you leave.
Again, not every country has an exit tax. Some countries do.
The difference for non-Americans is that the exit tax is based on simply leaving the country and no longer being a taxpayer there whereas US citizens must give up their citizenship to get any benefits from leaving because only the United States effectively taxes their entrepreneurs’ capital gains on sales of assets in other countries.
If you’re from Belgium, the UK, or Canada and you leave the country – even though they are making it more difficult to leave and creating more boxes to check – you can sell a rental property in other countries for a profit and keep it, free of taxation from your home country.
Obviously, the country where you sold your rental property may tax you, but your home country won’t take its bite via a capital gains tax.
The same applies when it comes to selling your business. You can put your company in a tax-free jurisdiction and your home country won’t tax your capital gains. At least you can choose to put your offshore company in a place where they may tax income but they don’t tax capital gains.
You get to choose.
And once you’re out, then you’re out and you can sell your business under the terms and conditions of where the company is located.
ACT SOONER THAN LATER
Again, be aware that if you build up a large amount of wealth before you leave your high-tax home country, they’re going to take a one-time bite at the apple in most cases. The delta here is knowing the value between what it’s worth now and what it could be worth.
Valuations become very interesting. If you have a company that has raised a bunch of money in venture capital, that valuation is pretty fixed. But if you run a business that’s more of a family business, that’s harder to evaluate.
There are a lot of situations and questions we cannot address fully in an article like this.
But suffice it to say, it’s always better to make a move when you have a mildly profitable company that doesn’t have a huge valuation, that hasn’t raised five rounds of funding, and that hasn’t got a formal offer to buy it at a very high price.
Capital gains tax is a very important thing. For someone who’s planning on selling their business, that might be your last big pile of cash that you might want to retire on.
So, imagine the difference between paying three or five million dollars in tax versus paying five hundred thousand dollars or even zero in tax on that exit.
That amount alone in tax savings could be what you live on for the rest of your life. For some people, it could be what you use to send your kids to college or contribute to charities that you like. But you won’t have that choice if you fail to avoid capital gains tax and hand all that money over to the government.
Figuring out how to avoid capital gains when selling your business is worth doing right. If you need help coming up with a plan to save on capital gains, you can contact us here.