With the dust beginning to settle on the largest overhaul of the U.S. federal tax system in several decades, tax professionals are steadily piecing together the specific implications of the Tax Cuts and Jobs Act of 2017 for each U.S. taxpayer community.
One newly emerging community of U.S. individuals that should feel the ripple effects of the tax reform is the so-called “digital nomad” community, particularly those who are globally nomadic. The growth of this group has been rapid enough that tax advisers would be well-advised to take stock of the specific reform provisions that are relevant for these taxpayers.
As defined most generally, a “digital nomad” is an individual who takes advantage of digital technology and communications to avoid being tied down to a particular office location. The ability to work from a computer, laptop, iPad, cellphone, or other device allows digital nomads to choose virtually any workspace, whether in the United States or abroad.
The digital nomad lifestyle has become increasingly popular for U.S. citizens in recent years due to a number of new programs that have been created to facilitate overseas commuting by organizing year-long trips for employees and freelancers to live in multiple cities abroad. Participants, for example, travel in groups to live in multiple cities throughout Europe, Asia and South America, for one month each over a year period.
As a result of this growing crop of U.S. citizens living abroad, a number of issues have required revisiting in order to properly frame the digital nomad lifestyle within the definitional parameters of the U.S. federal tax laws.
One prominent issue, for example, is the foreign earned income exclusion under Section 911 of the Internal Revenue Code, which allows a U.S. taxpayer to exclude a good amount of foreign earned income ($103,900 in 2018), but requires the taxpayer to have a “tax home” in a foreign country and to not have an “abode” in the United States. While a number of cases, including very recent ones, have analyzed the parameters of the “tax home” and “abode” requirements, additional judicial precedent and IRS guidance is still needed to properly analyze these requirements within the context of the digital nomad lifestyle, which embraces vocational and residential transience.
Tackling tax reform
With the tax reform firmly entrenched, we can begin to analyze the extent to which its provisions should simplify or complicate the already unique tax profile of the digital nomad living abroad. While a number of the TCJA’s provisions affect the general tax landscape for all U.S. individual taxpayers (new tax brackets, increase in the standard deduction, elimination of itemized deductions, etc.), the following focuses on those provisions that are uniquely significant for the digital nomad community.
From a personal taxation perspective, the major features of U.S. taxation that are unique to individuals living abroad generally have not changed.
Most fundamentally, individuals living abroad continue to be subject to citizenship-based taxation on their worldwide income. The same is true with respect to foreign asset and income reporting to the Internal Revenue Service. FBAR and FATCA reporting, as well as other foreign information disclosure obligations, continue to apply without significant alteration.
The TCJA also does not affect the classic safeguards against double taxation of an individual’s income when living abroad, including the foreign earned income exclusion and the foreign tax credit. Digital nomads can continue to utilize these and other methods to reduce or eliminate their tax obligations (although these methods do not eliminate the reporting obligations of the individual).
From a business taxation perspective, on the other hand, the TCJA includes a number of changes that should prompt digital nomad entrepreneurs to at least re-examine their corporate legal structures to ensure tax-efficient operations under the new rules.
Among the more taxpayer-friendly changes, the TCJA lowers the U.S. corporate tax rate to a flat rate of 21 percent. It also provides for a complete exemption for active foreign income (or non-Subpart F income) earned by certain U.S. corporate taxpayers via a foreign subsidiary. The exemption (referred to as the “participation exemption”) is provided for by means of a 100 percent dividends-received deduction for the foreign-source portion of dividends received from a “specified 10-percent owned foreign corporation” by domestic corporations that are U.S. 10 percent shareholders of those foreign corporations.
In the non-corporate domestic setting, the TCJA introduces a 20 percent deduction on so-called “qualified business income” earned through a sole proprietorship (including a wholly owned disregarded LLC), partnership, or S corporation. Among other requirements, income must be effectively connected with the conduct of a U.S. trade or business in order to qualify as QBI.
Among the more taxpayer-unfriendly changes, the TCJA adds a new-anti-deferral regime referred to as the “GILTI” regime. Under this regime, a U.S. shareholder of a controlled foreign corporation will have to include in gross income the CFC’s global intangible low-taxed income (“GILTI”) in a manner generally similar to inclusions of Subpart F income. In general, GILTI is computed as the income of the CFC (aggregated for all the CFCs owned by the U.S. shareholder) that is in excess of a 10 percent return on certain tangible property of the CFC. Importantly, GILTI does not include income effectively connected with a U.S. trade or business, Subpart F income, Subpart F income qualifying for the high-tax exception, or certain related-party payments.
Challenges and opportunities for digital nomads
What do these rule changes mean for the digital nomad entrepreneur? The answer depends on the specific circumstances of the individual, including perhaps most critically, the location of the entrepreneur’s business activities.
For the entrepreneur running a business outside the U.S., the most tax-advantageous legal structure under prior law was to operate the business through a non-U.S. corporation (assuming no employees or other tax nexus triggers within the United States). This structure allowed for the deferral of U.S. tax on active business income until profits were repatriated to the U.S., while at the same time reducing adverse self-employment tax implications. Under the new anti-deferral GILTI regime, this structure becomes much less advantageous, particularly in the case of service-based businesses with little tangible property, which generate profits that exceed the maximum foreign earned income exclusion amount.
With the GILTI rules in mind, digital nomads who are employed or have business activities outside the U.S. may need to explore structuring alternatives, including operating through a U.S. corporation, in order to take advantage of the new lower corporate tax rate, or operating through a U.S. corporation holding a foreign subsidiary, in order to take advantage of the new participation exemption. Entity classification elections (often referred to as “check the box” elections) to treat business entities as partnerships or disregarded entities may also prove tax effective depending on the circumstances. The most effective structure will most often hinge on the amount and type of income being generated by the digital nomad’s business.
For the entrepreneur running a business within the U.S., the tax calculus changes significantly due to the fact that the outbound anti-deferral regimes are less relevant. Further, the TCJA’s new 20 percent deduction on QBI should generally be available due to the fact the business is run within the United States. This may make a pass-through structure, such as running the business through an S corporation, a worthwhile structure to explore moving forward.
Given the complexities of the tax rules post-tax reform, tax professionals will be of great service to digital nomads in explaining how these rules affect them and their businesses. The new rules present a host of challenges and opportunities, and the emerging digital nomad community offers a fascinating test case for applying the new rules in a modern context.