US Businesses Overseas
US Business Overseas.[1]
The IRS asks international taxpayers for substantial tax information to ensure as many taxpayers as possible are compliant. They tend to view anything outside of the US as having a higher risk of non-compliance. However, with the annual disclosures becoming more and more complex, without enough IRS/call center support, instruction clarity, and more, the excess information has diminishing returns and might paradoxically wind up having the unintended consequence of non-compliance despite everyone’s best efforts.
Taxpayers, tax preparers, and tax software providers have struggled to keep up with the last decade of tax overhauls. American entrepreneurs overseas wanting to start businesses are so burdened by tax compliance that some are driven to give up their citizenship entirely rather than try to comply with the reporting and/or tax burdens. These complexities range from Forms 5471 and their 5 categories (including the three a, b, and c subcategories of category 1 and 5) to Forms 1116 and their 7 categories (mercifully no subcategories… but double them for the Alternative Minimum Tax version for each). Even choosing the “right” exchange rate can be time consuming or left up to interpretation.
DIY software providers might include “simple” Forms 1116 (just one or two categories) at a very reasonably priced tier. This leaves the taxpayers, likely unaware of the 7 categories, to rely entirely on the clarity of the software question and their own interpretation of that question. Is there an easily interpretable way of explaining the difference between “passive” income versus dividends that were “re-sourced by treaty”? Or “general” versus “foreign branch”? Most Americans abroad probably don’t consider their sole proprietorship a “foreign branch”. The Forms 5471 is such a complex decision tree of “if-then” choices, that most DIY software programs will not cover it, certainly not at their cheaper tiers. A taxpayer with a Form 5471 should expect to pay $1,000 for their tax return at the very minimum.
Fear of excessively punitive penalties (commonly $10,000 per omitted informational-only form per year) drives taxpayers to expensive accounting firms as the low-cost preparers may not have the experience or ability to help them. Accounting firms, fearing compliance themselves, will often recommend a very conservative approach and disclosures, even when the guidance is unclear. The aforementioned “foreign branch” Form 8858 comes to mind. If an expat goes to two well-intentioned and competent firms for their tax return preparation, there will inevitably wind-up being differences.
The US assumes that all countries have a calendar year tax year. One of their biggest international partners, the United Kingdom, home to several hundred thousand Americans, has an April 6th to April 5th tax year and Australia has a July 1st to June 30th tax year. Timing problems can cause significant issues for Americans and their tax preparers when trying to decide whether to “accrue” for their foreign tax credits or to simply use the calendar year amounts paid. Accruing has its own complexities and without working closely with the resident country tax preparer this can leave the taxpayer vulnerable to having to amend their tax returns if they inadvertently over accrue.
Large changes in tax laws and rules like the 2017 Tax Cuts and Jobs Act, which notably created the unforgivingly named “GILTI” tax, take a long time for the IRS to interpret, the forms to get created, software to be adapted to, and tax professionals to educate themselves. This slow-moving chain of systems and updates exacerbates the problem. To this day, K-1s are getting issued disclosing interest expense in a variety of ways. New tax laws rarely address international taxpayers. For example, The Affordable Care Act’s net investment income tax is still treated differently by different tax preparers based on their interpretation of tax treaties and whether Americans abroad are subject to it.
There is a laundry list of tax forms that accounting firms, software providers, and/or taxpayers have to keep in mind on top of the “normal” domestic ones. A not-even-close-to exhaustive list of international forms is included below. For tax preparers and software providers to prepare for cutting-edge cases to cover themselves, they need to ask questions that are incoherent to most taxpayers. Questions such as “During the tax year, did the filer pay or accrue any base erosion payment under section 59A(d)” are difficult for an accountant to know the implications of (their education time is better spent elsewhere) and to communicate them clearly to a non-tax savvy client. They are so widely unapplicable, most tax firms would not even bother confirming with a client. Nor would the client enjoy being asked, being billed by the 0.1 hours. A cost, by the way, that taxpayers consider a tax itself.
Instead, each of the well-intentioned stakeholders (IRS, tax preparer, software provider, taxpayer) has to determine their own balance of materiality—what’s worth understanding and asking and explaining to the client, and what’s not? Can we really expect companies like TurboTax to account for every customer to confirm they didn’t pay or accrue base erosion payments? If they did ask that question to everyone, would there be more false positives than false negatives? Would the taxpayer freeze up at that question and run to their favourite search engine to find twenty different answers, eating up an evening with stress?
US Expats need to expect that their life will become financially more complex when dealing with two or more countries’ tax systems. There is no question that expats have a clear disclosure requirement when it comes to bank accounts for their FBARs (commonly thought of as as account you can make withdrawals from) or foreign retirement accounts for their Forms 8938 (foreign assets). Though these will be time consuming, they are deemed necessary to help the IRS reduce money laundering and illegal tax avoidance schemes happening abroad. But there is a fine line between that foreign retirement account simply sitting on a Form 8938 or having additional 3520 disclosure requirements that are really difficult for honest people to keep track of.
In addition to all the above, US Expats doing business through some form of entity must determine how to characterize that entity for US tax purposes. In the foreign country, it’s probably not going to be called a corporation and even if it were, under US tax rules, properly applied, it might be something else. The analysis that often must be made can be challenging even for the most experienced tax practitioner.
Much like their domestic counterparts with their W-2s and 1099-Rs (which expats might have as well), the IRS already has a substantial amount of their information given that foreign institutions are reporting accounts to the US. Asking for redundant information is helpful to no one and is likely harmful to everyone as taxpayers get frustrated and the IRS tries to cross reference account balances between multiple currencies. The burden of international compliance, for compliance’s sake, needs to be lessened. The system, from the vantage point of the IRS, tax preparers, tax software providers, and taxpayers, is overwhelmed and not equipped for the current climate let alone the constantly changing one.
Common forms for US expats to come across
Form 114a for foreign bank account reporting.
Form 8938 for foreign asset reporting.
Form 3520 for foreign trust reporting (most commonly, when large amounts are received from non-US people).
Form 8621 for investors of passive foreign investment companies (“PFICs”). In simpler terms, a foreign mutual fund.
Form 8992 for the GILTI tax.
Form 8858 for foreign branches (is a sole proprietorship in France a “foreign branch”?).
Form 1116 for foreign tax credits. A different 1116 and related schedule(s) for each of the 7 forementioned categories. Doubled for alternative minimum tax purposes.
Form 5471 for foreign corporations.
Form 8865 for foreign partnerships…
…and related K-1, K-2, and K-3 forms, depending again on your category of filing.
Form 5472 For C-Corporations with foreign ownership
Form 8854 for people giving up their US citizenship or long-term resident status.
Form 8833 for any tax treaty positions on the return.
[1] This summary of US Small Business Overseas was authored by:
John York
White Lighthouse Investment Management
CFP® Professional (USA), CPA | Cross-Border Financial Planner
January 2023