Does an S-Corp Make Sense for Expats? Understand the Implications

Is S-Corporation structure suitable for a US citizen operating a business from abroad?

The Scenario
A US citizen moved to Costa Rica and continues to run a US-based business structured as an S-Corporation.

Understanding the corporation status is crucial for expats to navigate the legal and tax implications of owning an S-Corp while living abroad. Additionally, it's important to consider the eligibility and regulations surrounding S corp foreign shareholders, including distinctions between resident and non-resident aliens and recent changes allowing non-resident foreigners to indirectly own shares through entities like Electing Small Business Trusts (ESBT).

Benefits of an S Corporation

S-Corporations, known for avoiding double taxation, are popular among small US businesses. They’re pass-through entities, meaning income and deductions flow through to shareholders’ tax returns, avoiding corporate income tax. Crucially, S-Corp income isn’t subject to self-employment taxes, potentially saving significant tax.

Eligibility and Residency Requirements

To qualify as an S corporation shareholder, an individual must meet specific eligibility and residency requirements set by the Internal Revenue Service (IRS). These requirements are designed to ensure that only eligible individuals can own shares in an S corporation.

• Resident Alien: A resident alien is someone who meets the substantial presence test or holds a green card. Resident aliens are eligible to own shares in an S corporation directly, making them suitable candidates for S corporation shareholder status.
• Non-Resident Alien: A non-resident alien, on the other hand, does not meet the substantial presence test or hold a green card. Non-resident aliens are not permitted to own shares in an S corporation directly. However, they can still participate indirectly by using an Electing Small Business Trust (ESBT), which allows them to navigate the ownership restrictions.
• Substantial Presence Test: The substantial presence test is a key factor in determining residency status. It calculates the number of days an individual has spent in the United States over a three-year period. If an individual meets this test, they are considered a resident alien, making them eligible to own shares in an S corporation.

Understanding these eligibility and residency requirements is crucial for anyone considering S corporation status, especially expats who need to navigate the complexities of international tax laws.

S Corporation Status and Ownership Rules

S corporations must adhere to specific ownership rules to maintain their S corporation status. These rules are designed to ensure that S corporations are owned by eligible individuals and are not used to circumvent tax regulations.

• S Corporation Shareholders: S corporations are limited to a maximum of 100 shareholders. These shareholders can be individuals, trusts, or estates, but they must meet the eligibility requirements set by the IRS. This limitation helps maintain the small business nature of S corporations.
• Corporation Shareholders: One of the defining features of S corporations is that they can only have one class of stock. This means that all shareholders must have the same ownership rights and benefits, ensuring equality among shareholders and simplifying the corporate structure.
• Foreign Shareholders: Non-resident aliens are not allowed to own shares in an S corporation directly. However, they can own shares indirectly through an Electing Small Business Trust (ESBT). This trust must meet specific requirements and file the necessary forms with the IRS to ensure compliance.

By following these ownership rules, S corporations can maintain their status and enjoy the associated tax benefits, while ensuring that all shareholders are treated equally.

S-Corp and Self-Employment Taxes

S-Corp owners must draw a “reasonable salary,” subject to self-employment taxes. S-Corps are restricted to a single class of corporation stock, which ensures equal ownership rights and benefits among shareholders. Any remaining business income avoids these taxes. This structure can yield tax savings compared to sole proprietorships or partnerships where total net income is subject to self-employment taxes.

Again, managing non-resident alien shareholders within S corporations involves navigating complex IRS regulations. Recent legal changes affect the ability of non-resident aliens to hold shares, and they may become indirect shareholders through mechanisms like an Electing Small Business Trust.

Implications for Nonresident Alien Expats

For nonresident aliens and expats, the key consideration is how an S-Corp impacts the Foreign Earned Income Exclusion (FEIE). Expats must also consider the substantial presence test, which determines residency status for tax purposes based on the number of days spent in the U.S. over the past three years. The FEIE applies to “earned” income, as defined by the IRS. S-Corp salary qualifies, but pass-through income does not. In contrast, sole proprietorships could allow the full income to be excluded under the FEIE.

Specific Factors for Expats

• Totalization Agreements: Some countries have agreements with the US, exempting taxpayers from US self-employment taxes. Without such an agreement, the S-Corp’s benefits diminish.
• Tax Rates in Resident Country: In countries with higher tax rates than the US and no totalization agreement, the FEIE may be less relevant, maintaining the S-Corp’s advantages. Non-resident alien shareholders can consider using an Electing Small Business Trust (ESBT) to indirectly own shares in an S-Corp, thereby navigating ownership restrictions.

Tax Implications for Foreign Owners

Foreign owners of S corporations need to be aware of the tax implications associated with owning shares in an S corporation. These implications can be complex and may require professional advice to navigate effectively.

• Double Taxation: One of the primary benefits of S corporations is that they are pass-through entities, meaning that business income is only taxed at the individual level. However, foreign owners may face double taxation if they are not eligible for the foreign earned income exclusion. This can significantly impact the overall tax burden.
• Domestic International Sales Corporations: S corporations that meet specific requirements can elect to be treated as a Domestic International Sales Corporation (DISC). This election can provide significant tax benefits for foreign owners, making it an attractive option for those who qualify.
• Electing Small Business Trust: Non-resident aliens can own shares in an S corporation indirectly through an Electing Small Business Trust (ESBT). This trust must meet specific requirements and file Form 2553 with the IRS. By using an ESBT, non-resident aliens can navigate the ownership restrictions and enjoy the benefits of S corporation status.

Understanding these tax implications is essential for foreign owners of S corporations. By seeking professional advice and carefully considering their options, foreign shareholders can make informed decisions and optimize their tax situation.

Conclusion: How did this effect our Expat S-Corp in Costa Rica?

In Costa Rica, where local taxes are lower and no totalization agreement exists, it’s more efficient to forgo the S-Corp to maximize the FEIE benefits. Foreign shareholders must carefully consider the regulations and tax implications of owning an S-Corp to make informed decisions. Each expat’s situation varies, so it’s crucial to consider all factors.