S Corporation as tax trap for US-expatriates?
von Peter Scheller
The number of US citizens who are living and working in Germany increases steadily. Although their number with circa 110,000 persons is relatively small, their economic significance is high. US-citizens who move to Germany generally have either well paid jobs or possess a significant amount of wealth. Therefore they must not only obey US but also German tax law and regulations. Even though there is a double taxation convention between Germany and the USA in place various tax risks remain. One of these unsolved tax issues is the different tax treatment of an S Corporation in the USA and Germany. This different treatment can result in a double taxation of their shareholders who are tax residents in Germany.
S Corporation: Legal and tax qualification in the USA
S corporations will be formed under the statutory rules of US states or the District of Columbia. These special type of corporations will not be taxed as such but be qualified as a transparent entity (pass through entity). Profits will be taxed on the level of its shareholders. The tax regime follows the one for partnerships. Profits of an S corporation will be taxed in total irrespective of whether the profits have been distributed to the shareholders or not. Shareholders have to declare their share in the S corporation’s profit as ordinary income in their Income Tax Returns.
S Corporation: Tax qualification in Germany
German tax law qualifies the S corporation as an independent tax subject. Since the S Corporation is not a tax resident in Germany it will not be taxed here. This seems to be good news but it is not necessarily for various following reasons.
S Corporation: Taxation of US citizens
If a US citizen relocates to Germany for business or private reasons and he is shareholder of an S corporation various tax relevant issues have to be considered.
The shareholder remains as a US citizen taxable in the USA with his or her worldwide income. In the USA his entire share in the profits of the S Corporation will be taxed as ordinary income. Germany will tax any profit distributions by the S corporation to his shareholder who is a resident in Germany as capital in income. German tax authorities qualify every amount which is to the free disposal of the shareholder as a profit distribution. It is obvious that the different processes in the US and in Germany could result in a double taxation scenario.
The Double Taxation Convention between Germany and the USA provides little support. US tax authorities qualify this income as Business Profits (article 7) and claim income tax on the shareholder’s part of the profits. Germany qualifies the profit distributions as Other Income (article 21) and taxes this income. German tax authorities do not allow the credit of US income tax against German income tax. However, it allows the deduction of 35% of the taxable amount as a fictitious US corporation tax. The remaining 65% will be taxed at a rate of about 27%.
Similar problems may occur if a shareholder of an S Corporation sells his shares while being resident in Germany.
S Corporation: Avoiding a double taxation
In most cases a partial double taxation of profit shares threatens if shareholders of an S corporation relocate to Germany. There are a few tax planning opportunities. One of these opportunities is to avoid profit distributions to the shareholder who is a tax resident in Germany by changing the bylaws of the corporation. Another possibility might be the increase of salaries of the shareholder. A third possibility is the transfer of the S Corporation into a normal taxed C Corporation before the shareholder relocates to Germany.
However, all of these measures have legal and tax relevant side effects. What might be good in the light of Germany’s tax treatment might result in a foul tax situation in the USA. Therefore careful tax planning is required before the shareholder moves to Germany.
S Corporation: The unwanted permanent establishment
If the shareholder carries on his business activities for the S Corporation while being resident in Germany another tax risk may occur. This is especially the case if he is the sole manager or officer of the corporation. If he carries out his duties as manager of the company this will be treated as a permanent establishment of the S corporation in Germany. This means that the S Corporation will be liable to German Corporation Tax with its profits attributable to the permanent establishment. The S corporation might also be liable to local trade tax. Similar scenarios threaten if the shareholder is qualified as a permanent representative of the corporation.
Double taxation is less of an issue in cases like this because the US will credit German corporation and trade tax against US income tax. The risk will be somewhere else. First of all German and US tax authorities may disagree whether or not there is a permanent establishment in Germany. These authorities can also have a different opinion about the profit share attributable to the permanent establishment. All this might result in a partial double taxation.
Even if there is no double taxation foreign corporations try to avoid having a permanent establishment in Germany. There will be unfavorable legal requirements and unwanted administrative burdens such as for bookkeeping, tax returns, payroll for the shareholder etc.
This topic also needs careful planning.
Author: Peter Scheller, Steuerberater, Master of International Taxation