When starting your own virtual company, there are a host of things to consider and taxes should be at the top of the list. Depending on where you choose to operate your business or which corporate structure you decide upon, your tax liability can make or break your company.
Here are three questions you need to ask yourself before making this crucial decision.
1. Should I launch my business in the U.S. or overseas?
The first thing you need to consider is where you will be living and working. If you have a U.S. company, you will likely need to pay self-employment tax on your income. So, if you are actually living in the US, this is a no-brainer. However, if you have a U.S. company but are residing overseas, it may make more sense to launch the company in the country in which you plan to live. The advantages of establishing as an overseas company is that it may be easier to win clients in your host country, open local bank accounts and conduct day-to-day business. It is also worth noting that this would eliminate the U.S. self-employment tax, which leaves you more money to infuse into your business.
If you choose to establish an overseas company you will have additional (and complicated) reporting requirements with the IRS. Thanks to FBAR (Foreign Bank Account Report) and FATCA (Foreign Account Tax Compliance Act), which are part of the U.S. initiative to thwart tax cheats hiding money abroad, you will also be required to report your foreign bank account balances and assets in addition to your IRS federal tax returns (which you still have to file as long as you are a U.S. citizen regardless of where you live). Foreign corporations must file Form 5471, which is a lengthy, time-consuming form that you’ll likely want a tax professional to prepare on your behalf. (The IRS estimates that it takes about 38 hours to prepare!)
In addition, you need to consider the local corporate taxes for the country you choose. For example, the United Arab Emirates is one of the most business-friendly countries in the world. Regulation of companies is light and neither corporations nor individuals are liable for direct taxation. There isn’t even sales tax! So this is certainly in stark contrast to the 39.1 percent tax rate in the US or 40 percent in Japan. Bottom line: Do your homework and make sure you understand the reporting requirements both in the U.S. and your host country.
2. What expenses can I write off if I travel for business?
One of the most common (and confusing) expenses for overseas business owners is travel. To deduct your travel costs, your trip must be clearly tied to your business operations. Combining business and pleasure is common, but it is highly scrutinized by the IRS, especially if you live in the U.S .and head overseas. You’ll want to keep detailed records of the exact business activities you engage in, as you may have to allocate your travel expenses in proportion to the number of days you spend doing personal things, such as sightseeing or visiting old friends. Your travel to and from is considered bona fide business expenses, but the dinner you enjoyed in Times Square with your sister is not. You may think the IRS will never know if you sneak in a personal dinner "on the company," but you don’t want them to audit you because of suspicious travel expenses. It’s truly just not worth it.
Keep in mind that travel expenses you incur in connection with acquiring or starting a new business are not deductible as business expenses. However, you can add these costs to your startup expenses and then deduct a portion of them and amortize the remainder over 15 years.
3. Will I be able to raise capital if I incorporate overseas?
That depends on the investor. If you need to raise money to get your company off the ground, you will likely need to be set up in a jurisdiction that they are comfortable with. This would include a country with standard reporting requirements, a stable economy and a consistent interpretation of the law to ensure the company and investors are legally protected. Investors may be gung-ho to fund you in the U.S. but they may be wary of funding you to live in Costa Rica for six months while trying to build your business (and learn to surf). Of course this will depend on the individual investors, the business idea and where and why you are living abroad. If you need to raise money to start your business then you should consider looking at investors in the local market if you want to be living abroad. There are investors all over the world; its just a matter of finding one who believes in your business, vision and growth plan.