I thought Judy was the smartest woman alive.
I met her at our annual Total Wealth Symposium a few years back. Quiet, unassuming, purposeful. Her questions were well-informed and to the point.
“I’ve run a business out of Nevis for about 15 years,” Judy said. “It’s registered there. I sell my products in South America, mainly. But I let the profits stay in the business. I don’t take dividends. That way they qualify as retained foreign earnings and there’s no U.S. tax to pay. At least until I withdraw them as dividends.”
Like I said … Judy was smart. Her strategy was perfectly legal. Like any U.S.-owned business incorporated abroad, her profits weren’t taxed as long as they stayed inside the business.
It was the perfect retirement strategy … a supercharged “IRA” that beat the domestic variety hands down.
And now she could go bankrupt … thanks to the so-called tax reform of December 2017.
A New Tax Law for Mom-and-Pop Businesses
Before the new tax law took effect, U.S. owners of foreign corporations didn’t pay tax on profits until they were withdrawn as dividends. All it took was a few simple legal arrangements.
The best-known examples of this tax deferral strategy were U.S. mega-corporations like Apple or Google, which kept billions in foreign earnings outside the U.S.
But thousands of smaller privately owned businesses did the same thing. The law didn’t distinguish between the big guys and mom-and-pop businesses.
The revised tax law does. It includes a provision that targets Global Intangible Low-Taxed Income (GILTI). GILTI — a horrible acronym if there ever was one — means profits more than a “normal” rate set by the IRS.
From January 2018, a U.S. shareholder of any foreign corporation must include a portion of GILTI in their annual gross income when calculating their income tax — whether they take it out as dividends or not.
Now, if the U.S. shareholder of a foreign corporation is a domestic U.S. corporation — say, Apple or Google — they may claim a deduction of 80% of GILTI as well as certain foreign tax credits. That radically reduces their tax liability.
But none of those goodies apply to the type of business structure used by most small businesses. The new law taxes their GILTI at the highest ordinary income tax rate. As much as 37.5%.
But it gets worse … much, much worse for people like Judy.
Congress Has Created a Tax Mess
The new tax law requires U.S. shareholders to increase the foreign corporation’s taxable income for 2018 by an amount equal to its “accumulated post-1986 deferred foreign income.” That income is to be hit with a 17.5% “repatriation tax” even if the money stays offshore.
In other words, Judy — and every American owner of a foreign small business like hers — have to pay tax on all the deferred income they’ve been saving since 1986. In one go.
That’s bad enough for people who live in the U.S. and own a foreign business, like Judy. But it also applies to people like Travis, who has lived in the U.K. for years and owns a small design company there.
Like Judy, Travis must pay a 17.5% tax on all the accumulated earnings in his company going back to 1986. But unlike Judy, whose company is in no-tax Nevis, he’ll also have to pay the high U.K. income tax on the dividend he declares to settle with the IRS.
This new tax mess comes on top of the implications for U.S. taxpayers living abroad of the Foreign Account Tax Compliance Act. I’ve written about that disaster extensively.
The bottom line is that U.S. citizens who live or own a business abroad are severely discriminated against by the U.S. tax code.
The reason is simple: Compared to U.S. international mega-corporations — whose lobbying power means they practically write the tax laws themselves — folks like Judy and Travis are irrelevant to Congress. There’s no critical mass of expats who vote in any one district or state.
That’s why the big guys get fancy deductions and offsets under the new law, and ordinary folks like us don’t.
Business Owners Are in for a World of Hurt
The new tax changes are likely to convince even more people that it’s no longer worth keeping their U.S. citizenship. Voluntary expatriation is on track to soar to a new record in 2018.
Alternatively, otherwise law-abiding citizens may feel obliged to ignore the law just to survive.
Either way you look at it, if you’re a U.S. taxpayer exercising your right to run a business abroad, you’re in for a world of hurt.
Fortunately, The Bauman Letter is chock full of strategies to fight back.
Editor, The Bauman Letter