Dateline: Tbilisi, Georgia
As exciting as it is to start your own business and be your own boss, there is always an element of uncertainty involved in every entrepreneurial endeavor.
Even once you move past the initial doubts like, Is this actually going to work? and begin to experience success, you will never be able to eliminate the uncertainty entirely.
You’re in charge of the whole show.
While that can be liberating, it also means that you have a whole new list of responsibilities to oversee. You may not have a boss breathing down your back, but you also don’t have someone taking care of your health insurance or paying your taxes for you, either.
Sure, owning your source of income means you don’t have to worry about job security the way a salaried employee worries about being laid off, but it also means that you are exposed to the possibility of someone coming after your company with a claim of any nature and taking everything you have built.
Even if you have a high tolerance for risk, this is not the type of uncertainty you want to play around with, especially when there are simple legal structures that you can use to eliminate a significant portion of this risk upfront.
How Can You Legally Protect Your Business?
The two main legal structures available to entrepreneurs in the United States are limited liability companies (LLCs) and S Corporations (or S Corps, named after subsection S of Chapter 1 of the Internal Revenue Code).
Both structures offer limited liability protection to their owners, meaning that all personal assets are protected against debts, losses, and any court rulings against the company.
Someone can still come after your company, but they can no longer come after you. With a legal structure in place, you as the individual are now considered a separate legal entity from your business.
LLCs and S Corps not only protect against litigation, they also shield you from excessive taxation. For one, you can deduct pre-tax expenses under an LLC or an S Corp, reducing your overall tax bill.
In addition, both offer the advantage of pass-through taxation, which means that business profit or loss is not taxed at the business level but is “passed through” to the owner and taxed at the individual level. This prevents business owners from paying both personal and corporate taxes on the same income.
For all the benefits that they share, there are also numerous differences between the functionality and utility of an S Corp vs. an LLC.
For instance, while both structures allow for pass-through taxation, only an LLC is considered a “pass-through entity” in which all income and expenses are reported on the personal income tax return of the LLC owner. S Corp owners, on the other hand, pay themselves a salary and then receive distributions from any additional profits their corporation may earn, which are taxed at a lower rate.
Many of these benefits vary widely depending on both the citizenship and residence of the owner. While someone living in the United States will enjoy all the benefits of limited liability protection under either structure, US citizens living abroad and foreign persons will enjoy far more tax benefits than someone operating their business from within the US.
But let’s take these differences one by one. Up next, we’ll examine the various advantages and disadvantages of S Corps and LLCs. From there, we’ll look at the best use of these structures depending on your citizenship and residence.
Advantages – S Corp vs LLC
An S Corp is called a “disregarded entity,” meaning that the business does not exist as a US taxpayer and all taxation is passed through to the owner and paid on their personal income tax return.
While LLCs have the same tax status, S Corps have several distinct characteristics vs. limited liability companies that may make them more advantageous for a business.
1. Lower Overall Tax Rate: An S Corp is allowed to pay its employees a “reasonable” salary which can then be deducted from business expenses along with federal taxes and FICA. Self-employment tax is only applied to the amount paid out as salary and not on the entire net income of the S Corp. All remaining profits can then be distributed to the owners as dividends, which are taxed at a rate lower than income.
2. The Ability to Sell Stock: While an LLC can only sell interest in the company, an S Corporation can sell stock. There are some limitations to this option, however. For instance, there is a limit of 100 shareholders. Each shareholder is taxed as a partnership, adding a fraction of the corporation’s expenses and profits on their individual tax return based on the number of shares they own.
3. Greater Appeal to Investors: The fact that S Corps can sell stock, accompanied by the legal demand for greater formalities from the structure, means that S Corps are much more appealing to investors than LLCs. However, these increased formalities can also mean more work on your end. For instance, S Corps must comply with extensive reporting requirements, maintain a firm management structure, hold initial and annual director and shareholder meetings, adopt bylaws, and keep minutes with corporate records.
Disadvantages – S Corp vs LLC
If you are running a fast-growing business and plan to bring investors onboard, setting up an S Corporation may be the right choice. However, there are several disadvantages to this legal structure that you should be aware of as well.
As mentioned, S Corps have much stricter guidelines than limited liability companies (LLCs). For instance, they have a passive income limitation that dictates that no more than 25% of total gross receipts can come from passive activities. They also cost more to set up.
Beyond these restraints, some of the bigger disadvantages include:
1. Citizenship Restrictions: One of the biggest disadvantages is that you must be a US citizen or resident in order to set up an S Corp. This means that all foreign persons are automatically barred from using S Corporations, no matter the circumstance.
2. Investor Limitations: S Corps can only have a maximum of 100 shareholders and are only allowed to offer one class of stock. While this is a step up from an LLC, there are more legal structures available within the US (LLCs and S Corps are simply the easiest and most common) that could offer a better setup for your business.
3. Harder to Deduct Losses: The fact that profits and losses are distributed to shareholders in proportion to the interest they hold in the business means that it is much harder to deduct losses under the S Corp structure. Since you can only deduct losses up to the amount invested, if you invested $10,000 and lost $30,000, you would still only be able to deduct a maximum of $10,000 on your individual tax return. LLCs, on the other hand, have no theoretical limit to the amount you can deduct in business losses.
4. Additional State Taxes: Not all state tax laws will treat S Corp and K-1 income as favorably as the IRS does. California, for instance, imposes a 1.5% franchise tax on S Corp income. And New York City doesn’t even recognize S Corporations as pass-through entities, which means that this particular structure can be subjected to a franchise tax as high as 9%.
While S Corps certainly have their advantages, the downsides are enough to make many entrepreneurs reexamine their need to attract investors and have access to a lower tax rate.
If you are considering setting up an S Corp, ask yourself whether the decision only makes sense for the immediate future or if the structure makes sense long-term. If it doesn’t, it may not be worth the tax savings to set your business up as an S Corporation. The transition from LLC to S Corp is relatively easy, but it is much harder to go back once you’ve committed to the S Corp structure.
Advantages – LLC vs S Corp
By default, a single-member LLC is taxable as a disregarded entity just as an S Corp. However, LLCs have the unique advantage of being able to choose whether or not they will be taxed as a C Corp, partnership, S Corp, or a disregarded entity.
For these reasons and others, an LLC is often considered the most flexible structure for entrepreneurs. Here are some of the other advantages that LLCs can offer:
1. Affordable and Easy to Set Up: Compared to other structures, an LLC is easy and cheap to set up. The paperwork for most single-member LLCs is only a single page and most states only charge a couple hundred dollars to register your new LLC. And, with less red tape, there is a good chance that you’ll have fewer accountant and attorney fees as well.
2. Greater Management Flexibility: The corporate governance of LLCs is less complex than for S Corps, requiring less paperwork and fewer internal formalities. While similar formalities are recommended, they are not required, giving you great flexibility in management.
3. Fewer Ownership Restrictions: Unlike S Corps, LLCs can be owned by non-US citizens and residents. They can also be owned by corporations and even certain types of trusts. As we’ll see when we examine the offshore structures available to US citizens living abroad, this is a very advantageous characteristic of LLCs. Limited liability companies can also own subsidiaries without restriction.
4. Less Complicated Taxes: With LLCs, you either file under the Schedule C of an individual return or as a partnership (whereas an S Corp must file Form 112OS). Individual LLC owners do not pay unemployment or disability tax (however, this also means that they don’t get the benefits). LLC owners do not have to take a minimum salary or pay payroll taxes, either.
5. Tax Efficient for Entrepreneurs Abroad: Because of their unique characteristics, LLCs can create very favorable tax conditions for entrepreneurs who choose to live abroad. Depending on the situation of the individual and the company, it is possible to avoid both dividend withholding taxes and double taxation. However, this is very situation specific. You must ensure that you do not have local source income and you have to avoid triggering local CFC rules at all costs.
Limited liability companies are usually the best option when there are multiple owners, or in the case of a partnership. Typically, they are also the best option for most online businesses, from internet marketing to client work and beyond.
Disadvantages – LLC vs S Corp
However, LLCs do not come without their disadvantages. The most prominent include:
- Questions for Local Tax Treatment Abroad: If you do use an LLC while living and doing business abroad and you do not fit your US company structure into an overall offshore tax strategy, you can actually create more problems for yourself. Some countries do not recognize the LLC structure, which throws into question how your company will be treated under local tax laws. For instance, LLCs are treated like corporations in Canada. In other countries, LLCs are not covered under tax treaties established with the US, impacting how dividends and losses are treated for tax purposes. If not planned properly, you can risk double taxation or lose your ability to claim deductions by utilizing an LLC.
- Self-Employment Tax: Because you do not have to take a salary with an LLC as you do with an S Corp, you will be required to pay self-employment tax on all of your business income. This also means that you must make quarterly estimated payments to the IRS.
- Potential Loss of Protection: If you do not show a distinct difference between you as the LLC owner and the LLC itself, you may lose the limited liability protection available through an LLC because you pierced the “corporate veil” by blurring the lines between the two entities.
How Citizenship and Residence Can Impact Your Options
US company structures are popular with US citizens and non-citizens alike. As crazy as it sounds, while it is anything but tax-friendly for US citizens, the United States is one of the world’s largest tax havens for folks who live outside the country.
While it is not perfect in every way, from an operational and logistical standpoint, the US may be the best option for someone looking to run a business. US infrastructure is relatively solid and there are still good reasons to have a US bank account.
Plus, setting up a legal structure within the US gives foreign persons easy access to business services like Stripe, PayPal, Amazon, and others that are otherwise difficult (if not impossible) to set up from the outside.
Another draw for foreign persons is that, as ironic as it may be, the US has not signed the global information sharing agreements (the BEPS, AEOI, and CRS) that over 100 other countries in the world have signed. While the US has forced FATCA on everyone else, they have refused to share information with other countries about who is storing money in the US.
There is no guarantee that this will last, but for now, their refusal means that US LLCs and banks are incredibly attractive to foreign persons looking for greater privacy.
However, there are limitations to the kinds of legal structures foreign persons are allowed to own in the US. And, while US citizens living in the US can use any legal structure that best fits their business, different strategies will apply to US citizens living abroad.
Let’s take a look at your options under each situation of citizenship and/or residence:
Foreign persons include foreign citizens as well as any non-US corporations, partnerships, associations, companies, estates, trusts, or governments.
No foreign person can own an S Corp, which leaves all foreign persons with the option of either forming an LLC or a C Corp. Unless you are raising investment capital, a C Corp does not make much sense, which makes limited liability companies the most viable option.
Fortunately for foreign persons, LLCs are the optimum structure for small-scale foreign investors. They are affordable to establish, easy to maintain, they provide individual protection from liability, and they allow for taxation as a disregarded entity.
However, signing up for the benefits of a US LLC will also expose foreign persons to the US legal system, FTC, FDA, and the overall litigious environment of the United States.
More importantly, owning a US LLC as a foreign person will now subject any foreign owner to IRS filing requirements. In particular, all US LLCs based offshore are now required to file Form 5472.
While this does not mean that you should stay away from US LLCs as a foreign person, you should understand what it means to get involved with anything connected to the US government before committing to it so that you can weigh the costs and benefits.
US Persons Living Abroad
If you are a US person, there are two ways to own a US company while living offshore.
1. Direct Ownership: With direct ownership, you hold the business directly in your own name or through a pass-through entity (but not a corporation). While this setup will give you some benefits compared to staying in the US, it is not the optimal situation because you are still subject to some tax and your deductions are limited. The specific limitations include:
- Self-Employment Tax: With direct ownership, you will still be subject to the full 15.3% self-employment tax (Social Security and Medicare) on up to roughly $118,000 of your income. Beyond that, your income will be taxed at a rate of 2.9%.
- Limitations on the FEIE: Unless you have a service-based business, if you own your US company directly, you will only be able to exclude 30% of your income from your business under the Foreign Earned Income Exclusion. The other 70% will be considered unearned income, which is not eligible for exclusion under the FEIE.
- Reduced Allowable Deductions: If you maintain direct ownership of your US company while living offshore, you will be subject to the “scale back rule.” This means that your allowed business reductions will be “scaled back” according to the ratio of the FEIE cap to your gross income. So, while your net income may be under the FEIE threshold, you may still owe income tax.
2. Ownership Through a Foreign Corporation: Technically, a foreign corporation is considered a foreign person, which means that if you set up a foreign corporation, it will only be able to own a US LLC. However, since the foreign corporation is not considered a US person, it will grant you several tax advantages when you set up your US LLC that you cannot access through direct ownership.
- No Self-Employment Tax: Foreign persons are not required to pay self-employment tax in the US and, since your foreign corporation is a foreign person for tax purposes, it is not required to pay self-employment taxes. Plus, you will no longer be considered self-employed because your foreign business will “hire” you and pay you a salary, making you an employee of a foreign corporation.
- The Full FEIE Exclusion: Because your foreign corporation is not considered a US disregarded entity, your business income will not pass through to your individual tax return. Instead, your offshore company can pay you a salary, all of which will be considered earned income that qualifies for the full $104,100 exclusion under the FEIE (in 2018).
- No “Scale Back Rule”: Again, because you are no longer considered self-employed, you will no longer be subject to the “scale back rule” which limits your allowable deductions in relation to the FEIE.
With this structure in place, you can legally avoid all US tax on your first $104,100 of active income by living abroad for the majority of the year. (To learn exactly how much time you must spend outside the US to qualify for the Foreign Earned Income Exclusion, read here.)
However, these benefits are only available if your foreign corporation does not have US source income and it is not considered to be engaged in a US trade or business. If you can avoid these situations and you incorporate in a low- or zero-tax jurisdiction, you can dramatically reduce your overall tax bill and still own a US LLC.
Who Can Actually Benefit from a Foreign Corporation?
Finally, a word of caution. Not everyone will benefit by setting up a foreign corporation. For instance, someone living in the US could create a full-blown tax nightmare by owning their US LLC through a foreign corporation while still living in the US.
We won’t get into all the details, but suffice it to say that trying this structure while still living in the United States will result in double taxation and liabilities to pay US federal income tax, self-employment tax, branch profits tax, tax on dividends received from the foreign corporation at ordinary income tax rates, passive income taxes, and more files to form (specifically, Form 5472).
So… don’t even go there.
Some people think they are clever and believe that they can set up an offshore company and still operate out of the US when, in reality, doing so will land them in a world of hurt.
Owning a US LLC through a foreign corporation will only work if you move offshore with your business. And, even if you are offshore, a foreign corporation will only help those who run an actual business.
Someone with a profession versus a business – like a freelancer or solopreneur – will not benefit by setting up a foreign corporation. A professional is paid for work that they do as an individual and that work cannot be assigned to another entity like a foreign corporation. (You can learn more about the specific tax situation of freelancers and solopreneurs living abroad here.)
However, while a foreign corporation will not be beneficial to someone with a profession versus a business, that does not mean that freelancers and solopreneurs cannot benefit by owning a US LLC or S Corp.
Having a legal structure in the US will still protect you from liabilities, create a more professional appearance for clients, banks, and other businesses, and grant you the benefits of being taxed as a disregarded entity.
If you choose to set up an LLC, you will be subject to US income tax and self-employment tax on all income from your profession. However, you can also set up an S Corp or elect for your LLC to be taxed as an S Corp and access slightly better tax treatment.
Remember, under this arrangement, you can pay yourself a salary that would be eligible for the FEIE and then all remaining profits would be distributed and taxed at a lower rate. You would also be able to reduce your self-employment tax to only the salaried income and not the net income of your business.
The Best Option?
Overall, business owners will benefit the most by living overseas, setting up a foreign corporation, and owning a US LLC through that foreign corporation. This is the most advantageous tax structure for US citizen business owners living abroad (even if it means another form to fill out).
Freelancers and solopreneurs living abroad, as well as all US citizens living in the United States, will have to consider their specific business setup alongside the advantages and disadvantages of S Corps and LLCs to determine which structure works best for them.
As with most everything we discuss here at Nomad Capitalist, these are general rules that only serve as basic guidelines. US companies can be the right answer for various different businesses in specific situations, but they are not always the right answer.
Definite answers can only be given on a case by case basis, which is why it is important to make decisions like this based on a holistic strategy. If done right, you can save thousands of dollars and numerous headaches. If you’d like help figuring out which structure works best for you, feel free to reach out.