By Vincenzo Villamena
As an expert in international taxes, on many occasions I've seen people ignore certain U.S. tax implications when making personal or business decisions. Most U.S. expats know they need to file a U.S. tax return, but they do not consider the hidden traps and factors. As a CPA, working with both expats and founders, I make sure to ask the right questions to make sure all these factors are covered.
While living abroad, have you made investments in foreign companies or investment products? Do you have a foreign startup where most of the shareholders are foreigners? Is the company sitting on mostly cash (from a big investment round)? If so, you may be subject to another set of reporting rules and elections. Below are some potential issues and what you can do when facing them. As always, I recommend utilizing the knowledge of a professional in these matters.
Becoming a Passive Foreign Investment Company
A Passive Foreign Investment Company (“PFIC”) is a foreign (non-U.S. entity) company with passive income. Examples include a foreign mutual fund, private investment company or hedge fund. A foreign company is a PFIC if it meets either an income test or an asset test. If at least 75 percent of the company’s annual gross income is investment-type income, it is a PFIC. A company meets the asset test if at least 50 percent of its assets produce or are held to produce passive income.
For example, let's say that Jeff is a U.S. citizen. He has three friends from Spain. None of them live in the U.S. They want to launch a product, so they create a Cayman corporation to develop it. They know it will take about two years to bring the product to market, and each person will contribute $50,000 in cash to develop the software. Suppose Jeff and his friends simply put $200,000 cash into an interest-bearing account and start to develop the software, spending cash as they go. This would be a bad idea (making the Cayman corporation a PFIC) for two reasons:
- Interest is passive income, even if it is earned on working capital. The interest will be the only income earned, so their Cayman corporation will be a PFIC under the income test.
- Cash is a passive asset, even if it is working capital. Since the company does not yet have IP or other business assets, it will be deemed a PFIC under the asset test.
In order to avoid this treatment, here are some solutions:
- Keep the cash in a non-interest bearing account. Not having passive income will automatically disqualify the company from the income test.
- Acquire business assets. Buying even the smallest assets like computers, office furniture, servers, etc. will help balance the rules under the asset test.
- Contribute cash on an as-needed basis. The overabundance of cash in a foreign company will trip the asset test, so asking the founders to contribute on an as-needed basis will help.
- Make a check-the-box election. This is a special election for foreign companies (but can be made retroactively up to three years in the past). Treat the foreign company as a U.S. partnership (and file a 1065 partnership return). This would help you avoid the PFIC issue.
The taxation of PFIC income or distributions can be rather onerous. In many cases, income gains or distributions must be taxed at the highest U.S. marginal tax rate. You can make certain elections to potentially mitigate adverse tax consequences relating to PFIC ownership, like the Qualified Electing Fund (QEF) election. In this case, you essentially agree to report and recognize the PFIC’s income each year, whether it is distributed or not. Another is the Mark to Market election for PFIC shares. These elections require annual filing of Form 8621, a tax form submitted with your 1040 personal return, that specifically relates to PFICs. Depending on your personal tax and financial situation, this could be a significant tax planning tool.
Smart tax planning is important for any startup, especially one with international implications. Be wary of this issue and any other reporting requirements you might have as a U.S. owner of foreign companies and bank accounts.
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Vincenzo Villamena is CEO of Online Tax Man.