Personal Service Contract Income of Foreign Professional Corporations
posted Apr 4, 2016 by Paul Oliveira, CPA
US citizens are generally subject to US taxation on their worldwide income irrespective of where in the world they may happen to reside. This includes deemed income inclusions that may arise under US income tax principles but not under the laws of the other country. It is very common for a US citizen – especially one who may be a citizen by birth, but who has never lived in the US – to organize a professional corporation in another country to carry on a personal services business. This is often done to take advantage of local country tax incentives, but has the potential to come with a substantial US tax cost.
In practice, the starting point is typically the result of advice received by the US citizen taxpayer (“the shareholder-employee”) from a local tax advisor. The local tax advisor is dutifully providing guidance that he or she would provide to any local client under similar circumstances. The local tax advisor may or may not have any idea that the shareholder-employee is a US citizen, never mind what consequences the local country planning may have from a US income tax perspective. As a result, the shareholder-employee may proceed with organizing the professional corporation in the local country and proceed with providing services and benefiting from the local tax planning.
Unfortunately, what is often overlooked is that the professional corporation may be a controlled foreign corporation under US tax principles. This is because the professional corporation is, from a US perspective, a foreign corporation controlled by a US citizen. As a result, the US anti-deferral provisions of Subpart F may apply to the income earned by the professional corporation.
Subpart F seeks to currently tax the shareholder-employee on certain types of income of the controlled foreign corporation in spite of the fact that the earnings may not have been distributed in the form of a dividend. The local country tax planning may prevent the earnings from being distributed to the shareholder-employee. This creates phantom taxable income in the US, subject to tax at ordinary income rates, without an actual distribution of the earnings. Unwittingly, the local tax planning may have created significant complexity and potential US tax cost to the shareholder-employee.
One particular type of income of the professional corporation that may be treated this way is income from a “personal services contract”, as described in section 954(c)(1)(H) of the Internal Revenue Code.
This includes income received by the professional corporation pursuant to a contract under which the corporation is to furnish personal services if, in simple terms:
- a person other than the corporation has the right to designate the individual who is to perform the services or the individual who is to perform the services is designated in the contract; and
- the services performed under the contract are performed or may be designated to be performed by a 25 percent direct or indirect owner of the corporation.
In the case of the professional corporation that has a single shareholder-employee, it is easy to see how this could create concern.
Determining whether an item of income is personal services contract income is heavily fact dependent, considering, among other things: the formal contractual agreement with the client, historical provision of services to the client, the uniqueness of a professional skill of the shareholder-employee, and the ability to substitute the work of another in place of that of the shareholder-employee.
The application of these rules to professional services income is not neatly settled by US tax law. However, the result of income being classified as personal services contract income of the shareholder-employee can have materially adverse US income tax consequences.
If you have concerns about whether your foreign professional corporation may have personal service contract income, please contact a member of the KLR Global Tax Services group.