This guest article was contributed by Andrew Henderson, founder of Nomad Capitalist.
Hard as it may be for some to believe, I didn’t move overseas for the tax benefits.
However, the tax benefits of legally escaping the tax net in increasingly confiscatory countries like the United States can be quite alluring. Living in Latin America can help you substantially reduce – and even eliminate – your personal and business tax obligations.
It can also be quite a pain without proper planning.
If you’re living in Latin America as an expat or digital nomad, you’ve probably heard someone talking about how to use offshore tax strategies. While there are plenty of legal strategies to keep more of your own money, there’s also a lot of bad, outdated, and downright criminal advice out right.
Even if you’re living overseas, you ought to get your taxes right… for your benefit.
I’ve seen guys who have paid the IRS tens of thousands of dollars more than they had to, merely because their domestic accountant didn’t have a clue about international tax. I had that experience myself many years ago, and I had to fight my own accountant to get the tax breaks I was entitled to.
In this article, I’m going to give you several high-level points to consider. This article will focus primarily on US citizens, although some of the principles apply to citizens of other common law countries like Canada or Australia.
This article should not be taken as formal tax advice, nor is it possible to distill an increasingly complicated world of offshore tax into one article that serves everyone’s specific needs.
Ready? Let’s go.
Table of Contents
How Offshore Tax Works for Americans
We often hear stories of how Google used a network of subsidiaries to move money around the globe and drastically reduce their tax. We also hear about how Starbucks moves money offshore for use of its intellectual property. The list goes on.
Here’s the thing: you or I aren’t Google or Starbucks. As such, our offshore tax strategies will be different… and more simple.
For most “US persons” – that’s what the IRS calls you – physically leaving the United States is really the only substantial, legal way to reduce tax. There are some cute tricks for larger businesses with managers and global staffs, but it gets rather dicey really quickly if the owner and manager is sitting in the United States.
Since I’m assuming you’re already living in Latin America, we can safely assume that won’t be a problem.
There are two types of expats for US tax law:
1. The Business Owner.
This is generally the category you want to fall into, because business owners living overseas get certain advantages under US tax law. A business is defined as something that can function without you; you may be the leader and innovator, but you’re not the only one doing the work. Imagine a coffee shop: the owner may handle marketing, accounting, or even work in the shop, but they also have a team of employees making and serving coffee… even while the owner is asleep. That’s a business.
2. The Freelancer.
Freelancers can still enjoy some benefits under US tax law, but not as many. If you’re a one-man show like a copywriter or consultant, you may want to consider building up to become a business. That could mean be as simple as hiring a number of part-time, recurring freelancers, or to hiring a couple staffers to delegate work to.
Here’s why those classifications matter…
The Cornerstone of US Tax for Expats
There are two ways for US persons to reduce their taxes overseas:
1. Move to Puerto Rico.
This process is more expensive, since you need you formally establish yourself in Puerto Rico. You also need to commit to spending at least six months per year there. In exchange, you can reduce your overall tax bill to anywhere from 0% to 4-5% all-in, but you’re tethered to the island.
2. Move anywhere out of the United States.
This process is more appealing to most people who want to live in Latin America. With a business – not a profession – you can pay $0 in tax on up to $117,900 in income, and a far reduced rate on income above that.
Moving to Puerto Rico is certainly an option… if you actually want to live there.
If your goal is to explore the rest of Latin America, you’ll be relying on the cornerstone of expat tax strategies: the Foreign Earned Income Exclusion, or “FEIE”.
The FEIE is what allows you to exclude $105,900 from your income tax return. Add a $12,000 standard deduction and you can earn about $10,000 per month tax-free if you’re a business owner. If you’re married, your spouse may also be entitled to a salary if they actually work in the business with you.
While the FEIE excludes you personally from federal income tax (and in most cases, state and city income taxes as well), it does not exclude you from Social Security or Medicare tax. Those are taxes that are paid by any US employee, which means if you work for yourself or a US company, you’ll still be left paying 16% tax on your excluded income.
The key to being totally tax-free is to become an employee of a non-US company (ie: an “offshore company”). You see, from a tax perspective you are not only the business owner, but an employee of the business. You are taxed as an employee on your salary, and as a business owner on your company’s profits after your salary. Since employees of non-US companies don’t pay US payroll taxes, you’ll legally eliminate all taxes.
This is where the freelancer misses out; being a one-man show has negative tax implications because the IRS says freelancers can’t benefit from using an offshore company for tax purposes. There are rules about what percentage of the work you can do in order to be qualified as a business, rather than just a professional who earns a salary.
Bottom line: if you’re running a business, set up an offshore company. If you’re a self-employed freelancer earning decent money, try to build out a real business so you can.
Now that you know the basics, let’s discuss the three factors you’ll want to consider.
Factor 1: How to Legally Avoid US Tax
Let’s talk about the first aspect of saving tax: your physical presence. Qualifying for the Foreign Earned Income Exclusion is the first pillar to reducing your tax rates.
In my opinion, the easiest way to qualify for the FEIE is through what’s called the “Physical Presence Test”. This is where you spend 330 days out of any 365-day period in a foreign country or countries.
This does NOT necessarily mean that you spend no more than 35 days in the United States, because there are some weird exceptions. For example, time in Cuba doesn’t count as “in a foreign country”. Nor does time spent in international waters, such as on a trans-Atlantic cruise ship. There are several “little things” to be aware of, but the bottom line is you’ll need the severely limit your time in the United States.
The benefits of the Physical Presence Test are:
1. You don’t need to be tied down to one country.
You can be a digital nomad bouncing from place to place, with wherever you are being your “tax home outside of the United States”.
2. You can use any 365-day period.
If you depart the United States on April 1, you can use April 1 to March 31 as your qualifying period. You may need to make a few minor adjustments to your tax filings, but otherwise this is straightforward.
3. There’s little room for error.
In my five years abroad before expatriating, I spent one week in the United States. As such, there was not much that could be argued. The Physical Presence test is clean and binary; you’re either in the US, or you’re not.
If one month in the US each year isn’t enough for you, you may consider the “Bona Fide Residence Test”. This gets more confusing and there are a lot of individual factors that no one blog post could cover, but the basic idea is that you’ve departed the United States for one specific home in a foreign country.
In exchange for being somewhat locked down, you can spend more time in the United States. It’s not quite as clear cut, but three months is generally a good idea.
The downsides to the Bona Fide Residence Test are:
1. You need to be tied down to one country and demonstrate primary ties there.
This likely means a resident permit of some kind, bank accounts, gym memberships, etc. It needs to be your real home. You’re still allowed to travel, but you should spend a good chunk of the year there; after all, it’s your “home”. If you have a family, they should be with you, too.
2. You can only start on January 1, and need to call the same place home for an entire year.
If you’re starting your offshore journey in February, you’ll need to wait almost an entire year to qualify. That doesn’t mean you shouldn’t get started; setting up a bona fide residence takes some time and preparation, so starting early gives you the best chances to qualify, and you can always qualify under the Physical Presence Test first.
3. There’s more room for error.
Unlike the Physical Presence Test which is binary, the Bona Fide Residence test is somewhat open to interpretation. A good advisor can arm you with everything you need to defend yourself in the event of an audit, but there are more shades of gray in this approach. That’s why I generally advise a rather conservative approach for anyone who wants to use the Bona Fide Residence Test.
Personally, I prefer the flexibility of the Physical Presence Test. It gives you the freedom to explore different countries and stay flexible. It also means that you have a wider selection of places to live; just because you can avoid US tax doesn’t mean you can go live anywhere you want and never pay tax there.
Factor 2: How to Legally Avoid Foreign Tax
That brings me to the second part of this equation: the taxes you pay overseas. Anytime someone comes to me for help, I break their personal tax situation down into two categories:
1. Where you’re leaving
In this case, the United States, but in theory any country that taxes you now.
2. Where you’re arriving
This is the country or countries you move to.
There are numerous tax systems around the world, but Latin American countries generally fall into three categories:
1. Tax-Free systems
There are very few genuine tax-free countries in Latin America. While Panama is classified by some countries as a tax haven,
2. Territorial Tax systems
Where foreign income – such as that from a foreign company – isn’t taxed provided you follow certain local rules. Under such a system, you can follow those basic rules and live in the country full-time without paying local tax. That means no US tax, and no local tax. The only tax left to deal with is the corporate tax rate on your company.
3. Residential Tax systems
Where your worldwide income is taxed by the country if you become tax resident there. Among Latin American countries, that generally means spending 183 days in any 365-day period, or tax year, or calendar year in that country. (There are other ways you could qualify, such as through a “closer connection”, but we’ll keep things simple for now.) Spend three months a year in Colombia and you’re highly unlikely to be taxed; spend nine months there and you’ll be in tax hell.
The issue here is making sure that you AND your business are properly structured to keep the US taxman off your back, but also ensuring that you don’t fall into the tax net of a new country.
The good news is that Central America has several countries – like Nicaragua – with territorial tax systems, meaning you can settle there full-time. There are often restrictions in place, usually on remittance.
Otherwise, you’ll need to move around a bit if you want to stay out of the tax net. I personally prefer to split my year up into third. Regardless of tax consequences, I like to enjoy several different cultures per year so that I never tire of any particular one. You could do the same thing to always remain a welcome guest.
Factor 3: How to Avoid Corporate Tax
The last piece that’s important to your tax equation is where your company is located. As we discussed earlier, having a company is the best way to reduce your tax burden by taking control of who employed you.
We also discussed that incorporating just anywhere isn’t an option. Even with a well-oiled personal tax strategy that results in zero tax due in both the United States and your Latin America country or countries of residence, you may owe corporate tax if you don’t incorporate your company properly.
There are several types of corporate tax systems:
1. Tax-Free.
Jurisdictions that offer tax-free companies will, as the name suggests, not tax you on your business profits. Jurisdictions like the British Virgin Islands are now imposing demands that you have a local presence there, which adds expense. Tax-free countries are encountering increasing operational risk; opening and maintaining a good bank account is increasingly difficult as good banks turn their nose at far-flung offshore companies with no oversight.
2. Tax-Exempt.
Some “midshore” jurisdictions have corporate taxes… just not for everyone. These are often easier to use, but there is more paperwork to file. This is often my default starting point for most entrepreneurs, since it’s both tax and operationally efficient.
3. Tax-Deferred.
Countries like Estonia, Macedonia, and Georgia have corporate taxes… they’re just not necessarily due now. I’ve never understood the idea of kicking the can down the road when you can simply pay zero or a very low amount of tax now, but some companies might be willing to trade paying a moderate amount of tax later (ie: up to 20% in Estonia) in exchange for operational benefits such as easier EU banking, digital tax reporting, etc.
4. Low-Tax.
Countries from Curacao to Malta to Mauritius have options with tax rates as low as 1% or 2%. For me, anything up to 10% is considered “low tax”, and depending on what you’re selling and where you’re living, paying some tax may actually be better than paying no tax. I often try to avoid the EU incorporation options because of high levels of bureaucracy and legal expenses involved with your every move.
Things can get complicated from there, with options like transfer pricing, subsidiaries, and related party companies, but that should all be evaluated on a case-by-case basis.
Now, Go Do It!
The biggest success strategies in going offshore aren’t technical; they’re in your head. Taking clear, convincing action supported by the facts of what’s working now is what helped me not only success in this area personally, but personally help hundreds of others do so as well.
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