S Corporations with Foreign Shareholder-employees

A client asked a couple of interesting questions a week or two ago. Questions about S corporation foreign shareholder-employees.

First, can an S corporation have shareholder-employees working outside the country? Second, if an S corporation shareholder-employee does work outside the country, can he or she use the foreign earned income exclusion to avoid taxes on the earnings?

Great answers. So let me talk about this.

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 potentially exclude $126,500 of income earned outside the country. However, the person needs to be a bona fide resident of a foreign country for the entire year. Or the person needs to physically present in a foreign country for at least 330 days in a twelve month period of time.

Note: That $126,500 amount is the amount you can exclude in 2024. This value changes annually, though, because of inflation.

The Rules for S Corporation Foreign 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.

Tip: A couple of references for tax practitioners who want to dig into this topic: You may want to review the requirements for a corporation electing Subchapter S status here: Section 1361. Clients commonly confuse the requirements for making the S election with the eligible shareholder rules. And then a quick review of the regulations for the actual exclusion? Probably another good source to read again. That appears here: Reg. Sec. 1.911.

Some Awkward Factors for S Corporation Foreign Shareholder-employees

You will need to issue your foreign shareholder-employee or shareholder-employees W-2s or local equivalents. 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 employment and income tax laws.

By the way, the whole reason for the foreign earned income exclusion? It provides 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.

Finally, keep in mind that foreign wages don’t plug into the Section 199A formula as wages. Thus, in a situation where someone wants to operate a successful one person business offshore? He or she may commonly avoid income taxes on (say) the first $100K they earn. But then pay (say) income taxes on the last, most highly taxed, 20 percent the S corporation earns. Probably? That only means shareholder pays more income taxes. And that’s before considing any additional local taxes. Sorry.