Get to know the author
Whether you’re an expat who owns and runs a foreign business or just holds shares in one, it’s important to understand the tax implications. After all, US taxes work differently for foreign businesses than for domestic ones. Unfortunately, they can be fairly complex — like taxes on controlled foreign corporations (CFCs) and passive foreign investment companies (PFICs).
The good news? As a dedicated US expat tax firm, we specialize in navigating the tax complexities that arise for Americans abroad. Below, we’ll walk you through what you need to know about CFC and PFIC taxes: how they work, what triggers them, ways to reduce your tax liability, and more.
Understanding US tax obligations for expats
Before we jump into the details, though, let’s take a step back to clarify the basics. All American citizens and permanent residents whose income exceeds a certain threshold — even those who live abroad — must file a federal tax return. All of their income, both US- and foreign-sourced, is subject to taxes.
Controlled Foreign Corporation (CFC) taxes
A CFC is an overseas company that is at least 50% owned or controlled by Americans.
CFC owners must file Form 5471 each year — though given the complex nature of the form some elect disregarded entity status on Form 8832. This allows CFC holders to report their share of CFC income on their personal tax return and pay taxes at ordinary rates (10% to 37%, depending on overall taxable income).
Anyone who elects this option must file Form 8858 annually, after their election is made.
Those with at least 10% ownership in a CFC must report their share of income as personal income for tax purposes. This foreign income is what’s known as Global Intangible Low Tax Income (GILTI). Individual shareholders pay taxes on GILTI income at ordinary rates (10% to 37%).
A CFC owned by a US-registered C corporation, however, tends to have a much lower effective tax rate: just 10.5%, or half of the corporate tax rate of 21%. This is thanks to a provision called the Section 250 Deduction. Additionally, if the CFC pays foreign taxes at a rate of at least 13.125%, they can claim additional foreign tax credits to further reduce or even eliminate their US taxes.
Keep in mind, though, that individual owners of foreign corporations who actively participate in the business must still pay themselves a reasonable salary from the profits.
Passive Foreign Investment Company (PFIC) taxes
While CFCs actively earn income through business operations, PFICs predominantly bring in passive income, such as investment income. To fall under the definition of a PFIC, a business will be registered abroad, AND:
- Earn at least 75% of its gross income as passive income (aka income not generated from day-to-day operations), OR
- Use or purposely keep at least 50% of its assets to produce passive income
Some Americans are invested in PFICs without even knowing it. Foreign mutual funds typically qualify as PFICs, as do many foreign pensions and foreign holding companies.
Americans with PFIC holdings generally have to file Form 8621 to elect the tax treatment for their PFIC holdings. Unfortunately, it’s also typically a complex and time-consuming reporting exercise.
The US taxes PFICs in one of three ways:
Excess distributions (default method)
Under the excess distribution method, shareholders defer taxation on PFIC distributions until a) they sell or dispose of their shares or b) they receive an excess distribution. Excess distributions occur when your total distributions exceed 125% of the average distributions over the last three years.
If you receive an excess distribution, you pay ordinary income tax rates (10% to 37%) on any portion of distributions that exceeds the 125% limit that tax year. In addition, you must pay taxes at the top ordinary tax rate on all past distributions at the time of distribution.
What’s more, you’ll have to pay interest on the deferred tax payments.
Mark-to-Market (MTM)
Mark-to-market elections require you to pay ordinary income tax rates on the amount that your PFIC holdings grow each year. This is true even for unrealized growth, which occurs when holdings go up in value but are not sold or disposed of.
Example: Miki is a dual Japanese-American citizen living in Japan. She has holdings in a Japan-based mutual fund that were worth $30,000 at the beginning of the year, and has elected mark-to-market taxation on them. By the end of tax year 2023, her holdings were worth $37,000. Even though she didn’t sell her holdings, she has to pay taxes on the $7,000 in growth at 24% per her ordinary income tax bracket.
If your assets decrease in value, on the other hand, you may be able to claim a deduction (up to the amount of which you’ve previously recognized income).
B!T note: To claim mark-to-market election for the current year, you must make the election on the previous year’s tax return. Only shares actively traded on a qualified international exchange qualify for this tax treatment.,
Qualified Electing Fund (QEF)
QEF elections are very rare in practice. To even be eligible, you must meet many different conditions and provide extensive IRS reporting paperwork. If you do qualify, you will be eligible for long-term capital gains rates on your individual share of a PFIC’s earnings.
It’s worth noting that QEF tax status is also tricky to get out of — you can only choose a different PFIC tax election with IRS approval. As a result, people rarely utilize this method.
Tax planning strategies for expats with foreign business holdings
Now that you know how CFC and PFIC taxes work, you might be wondering: Is there anything I can do to reduce my tax bill? While the right choice for you will depend on your unique circumstances, it’s worth considering the following tax planning strategies:
Registering a CFC
High-earning freelancers, independent contractors, small business owners, and other self-employed individuals can sometimes realize significant tax savings by establishing a CFC owned by a US-based C corp. Doing so usually allows them to:
- Pay a 10.5% tax rate on company profits, rather than up to 37% on ordinary income
- Reduce the amount of income subject to Social Security taxes
However, you must earn enough for the tax savings to be worth the hassle of establishing and maintaining a C corp and CFC. As a rule of thumb, you probably won’t want to leverage this strategy unless you earn north of $80,000 a year.
Think twice before investing in PFICs
The US generally taxes PFICs much more harshly than they do US-sourced passive income — largely to make tax enforcement easier. After all, international tax rules and regulations are much different than that of the US.
US tax treatments on PFICs can be so harsh that they even completely offset your return on investment. Subsequently, many personal finance and tax professionals recommend that expats stay away from PFICs entirely.
Look into tax treaties
The United States has tax treaties with dozens of countries around the world, including Canada, the UK, Germany, Australia, and others. These treaties are designed to prevent double taxation, at least in theory. However, a tricky provision called the saving clause allows the US to tax Americans as if the treaty didn’t even exist.
That said, these treaties also tend to contain exceptions to the saving clause that preserve the original benefits. An exception in the US-UK tax treaty, for example, allows Americans living in the UK to make a one-time, tax-free pension withdrawal.
Eligible individuals can withdraw a lump sum of up to 25% — which cannot exceed £1,073,100 (~$1,403,488) — from their UK pension without paying any US taxes on it.
Tax breaks
The US offers many different tax deductions, credits, and exemptions that can help you reduce your tax burden. A couple of the most common options for US expats include the:
Foreign Tax Credit (FTC)
The Foreign Tax Credit (FTC) gives expats who have paid foreign taxes dollar-for-dollar US tax credits in return. This can often greatly reduce or even eliminate your US tax bill entirely. If you live in a country where taxes are higher than in the US, you can even receive surplus credits to apply to future tax bills (up to ten years).
To qualify, the taxes you have paid must be legal, based on income, made out in your name, and paid. You can leverage the FTC by filing Form 1116.
Note:
There are some limitations to the FTC. For example, you can only claim the FTC on up to 80% of income taxes levied on GILTI income. Foreign taxes that are eligible for a refund, meanwhile, generally don’t qualify for the FTC.
The Foreign Earned Income Exchange (FEIE)
The Foreign Earned Income Exchange (FEIE) allows Americans abroad to exempt a certain amount of their earned income from taxation. For 2023, expats can exempt up to $120,000 under the FEIE; for 2024, the limit increases to $126,500 to account for inflation.
To qualify for the FEIE, you must meet one of two tests:
- The Physical Presence Test: Remain physically outside of the US for at least 330 full days in a 365-day period
- The Bona Fide Residence Test: Be able to provide official documentation (residence permit, rent contract, utility bills) proving that you have lived outside the US for at least a full tax year
You can take advantage of the FEIE by filing Form 2555.
Note:
Qualifying for the FEIE also immediately qualifies you for the Foreign Housing Exclusion, which can help you offset certain foreign housing costs (e.g. rent, rental insurance, parking).
Additional filing & reporting requirements
The IRS forms we mentioned earlier are far from an exhaustive list of documents those with foreign business holdings must file. You may also need to complete these two reports, among many others:
The Foreign Bank Account Report (FBAR)
Any Americans with over $10,000 in foreign financial accounts must file FinCEN Form 114, also known as the FBAR. Failure to do so carries a penalty of $10,000 per non-willful (aka unintentional) violation, or the larger of $100,000 or 50% of the account’s value at the time of non-compliance.
If you’ve unwittingly fallen behind on FBARs, an amnesty program called the Delinquent FBAR Submission Procedures may help you catch up penalty-free. To qualify, you must:
- Have fallen behind on your FBARs by accident
- Not have been contacted by the IRS about overdue FBARs
- File your last six FBARs and include a statement explaining the delay
Statement of Specified Foreign Financial Assets (Form 8938)
Americans abroad whose assets (e.g. foreign bank accounts, stocks, trust, insurance policies) exceed $200,000 on the last day of the tax year — or $300,000 at any time during the year — must file Form 8938.
Note:
This threshold doubles for married expat couples: $400,000 on the last day of the tax year, or more than $600,000 at any time during the year. Americans living in the US are also subject to Form 8938, albeit at a much lower threshold: $50,000 at the end of the tax year, or more than $75,000 at any time during.
The penalties for not filing Form 8938 when required are $10,000 per instance which can reach up to $50,000 after continued failure to file.
If you’ve fallen behind on Form 8938 filings — or your tax returns in general — you may be able to catch up penalty-free with the Streamlined Filing Compliance Procedures (aka Streamlined Procedure).
For expats to qualify, they must:
- Have non-willfully (i.e. unintentionally) failed to file
- Not be under — or ever have been under — IRS investigation or audit
- Meet IRS criteria for time spent abroad
The procedure itself involves:
- Filing your last three tax returns
- Filing your last six FBARs
- Paying any overdue taxes and interest associated with the missing tax returns
Simplify your expat taxes with Bright!Tax
As you can no doubt tell by now, taxes for expats with holdings in foreign companies can be complex.
Those with holdings in CFCs are subject to extensive reporting requirements, although the Section 250 deduction can help them significantly lower their tax burden. PFICs, on the other hand, are taxed unfavorably just about any way you look at it. Of course, this just scratches the surface of foreign corporation taxes.
Resources:
