A client asked a couple of interesting questions a week or two ago. First, can an S corporation have shareholder-employees working outside the country? Second, if such a shareholder-employee does work outside the country, can he or she use the foreign earned income exclusion to avoid taxes on the earnings?
The Quick Answers Are “Yes” and “Yes”
The answers to both questions are “yes.”
The foreign earned income exclusion says that anyone working outside the country can exclude roughly $100,000 of income earned outside the country as long as the person is a bona fide resident of a foreign country for the entire year or as long as the person is physically present in a foreign country for at least 330 days in a twelve month period of time.
Note: In 2013, the precise amount you can exclude because it’s foreign earned income is actually 97,600. This value changes annually, though, because of inflation. But I’m rounding the value up to $100,000 here.
The Rules for Foreign S Corporation Shareholder-employees
If you’re interested in pursuing this tax planning opportunity, you want to keep several things in mind.
First of all, you need earned income. A sole proprietorship or partner in a partnership will have earned income equal to their business profits or share of the business profits. But an S corporation shareholder-employee will only have earned income equal to his or her wages.
For example, if a single shareholder S corporation pays a shareholder $60,000 in wages and then in addition generates $40,000 in profits, only the $60,000 of wages can be excluded.
Second, rules limit the excludable foreign earned income to whatever is reasonable. For example, if a reasonable wage is $20,000 for the work you do but your S corporation pays you $40,000, you can only exclude $20,000. Not $40,000.
Also, if your S corporation employs lots of capital (say you work as a property manager in a real estate company that owns a bunch of apartment houses), you can’t call more than 30% of your profits or share of profits “earned” income.
And here’s another weird thing that might work out very favorably in some circumstances: If you and your spouse both work in the foreign S corporation as shareholder-employees, you can double the excluded income by both using the exclusion.
Some Awkward Factors
You will need to issue your foreign shareholder-employee or shareholder-employees W-2s. Which raises an interesting issue for most small business owners: Though you may be able to save big bucks on US taxes by moving offshore, you’ll be subjecting yourself to local country tax laws.
By the way, the whole reason for the foreign earned income exclusion to provide a simple way to fairly treat US taxpayers working in and paying income taxes to foreign countries.
Also, any foreign wages will be subject to Social Security and Medicare taxes unless the US and the foreign country have in effect a “Bilateral Social Agreement” also popularly known as a totalization agreement.
Because foreign earned income will probably be subject to Social Security and Medicare taxes, what you probably want to do (if possible) is set your foreign earned income high enough to take advantage of the foreign earned income exclusion… but no higher since that will only mean more Social Security and Medicare taxes.
A Quick Plug for Our Five Minute Payroll eBook
You maybe don’t know this if you haven’t poked around this blog a bit, but in another post (see here if you’re interested) we talk about how you can shortcut the work of payroll in one-employee situations.
Readers have regularly asked for a fuller ebook that goes into all the details of this payroll approach, however. (We call the approach the “Five Minute Payroll” system.) Accordingly, we created a $10 ebook, “Five Minute Payroll” that provides these more precise instructions, fully completed example IRS forms, and then also nearly complete IRS forms to which an employer adds the business name, address and EIN.
The “Five Minute Payroll” ebook gives you a really cheap, super fast way to do simple cookie-cutter payroll for most one-employee S Corporations using base salary amounts of $10,000 a quarter or $16,000 a quarter. (These amounts should work for just about everyone.)
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Money Back Guarantee: As with all of our monographs and ebooks, of course, our products come with a money back guarantee. If you don’t think our ebook is worth it, just let us know (email works best) and we’ll refund your purchase price.
By the way, we do promise the monograph delivers great value. Once you learn our “Five Minute Payroll” system you can skip paying some outside payroll service $500 or $1000 a year. And you’ll also reduce your payroll return preparation to, oh, about five minutes a year…