These days, many emerging businesses find themselves doing business abroad. Technology has drastically changed the traditional business model, enabling even a small business to operate globally. Many companies often ask whether they should operate through their existing U.S. business (i.e., operate as an incorporated “branch”) or operate through a separate organized foreign entity.
Quite often, we see many business owners set up an elaborate foreign-based structure that is ultimately unnecessary and, in the end, will not accomplish the tax objectives promised. For example, setting up a company offshore with no substance (i.e., employees working abroad, physical location, and local officers responsible for the day-to-day operations) is a recipe for faulty tax planning that will be scrutinized and penalized by the IRS.
When conducting cross-border tax planning, you should think in terms of simplicity, transparency, and pass-through income treatment of losses and foreign tax credits, if profitable. The bottom line, with respect to small business international tax planning, is that the monies earned oversea will be repatriated to the U.S.; thus, you want to incorporate the most efficient tax structure that will combine the pass-through of foreign source income, loss, credits with applicable U.S. tax law.
From a business perspective you always want to strive for operating a legal structure that it is not too complicated to administrate and that provides you with maximum limited liability protection. When it comes to liability protection and insulating your business and individual assets, you want to make sure that you are not being penny wise and pound foolish by operating as a branch in a foreign country where your U.S. sourced assets are directly exposed.
Under current U.S. tax law there is a list of entity types by country that are per se associations (i.e., must taxed as a C corporation) and cannot be converted to pass-through status (i.e., disregarded entity if 100% owned by your business enterprise or a partnership, if only partially owned). The process of converting a qualified foreign organized entity to a pass-through entity status for U.S. tax reporting purposes is often referred to as “checking the box” and it requires the filing of IRS Form 8832 on a timely basis. Please note that there are procedures to cure late elections and other issues, which are beyond the scope of this blog.
Planning point to consider for existing, foreign-organized entities that are financially insolvent: If you are currently operating abroad through a wholly-owned, foreign-organized C corporation that is owned by a U.S. C corporation and is financially insolvent with large unused foreign net operating losses financed with the U.S. parent equity and/or intercompany debt, there is a way to generate an ordinary deduction for the unpaid debt/equity for U.S. tax purposes at the parent company level by checking the box regulation and claiming a worthless security loss and/or bad debt expense. The long-term benefit of this tax planning technique is that, for foreign reporting purposes, the entity will continue to operate as before. However, for U.S. tax reporting purposes, it has become a disregarded tax reporting entity and it should create a better combination of overall worldwide taxable income (loss).