One of the side effects of the large rise of Americans moving to the UK is also the considerable use of unique US structures. 

We have already written about the treatment of US LLCs in the UK and it is now time to say a few words about S Corporations (S Corp / S-Corp) or LLCs that elect to be taxed as S-Corps.

S-Corps are a unique vehicle that is only available to US citizens. It is a desirable structure when living in the US because it shields some of the income that people have from social security payments, leading, mostly, to a reduced overall tax rate. S-Corps are also an efficient vehicle for various deductions.

However, for people living in the UK or most other places, S-Corps (or LLC/SCorps) are not a recommended vehicle in our view, even for people under the FIG regime, for the reasons explained below.

Income from S-Corp - US perspective

S-Corp must pay their shareholder-employees a reasonable salary. A reasonable salary needs to be a sensible market compensation. Most S-Corp shareholder-employees pay themselves approximately 40% of the profits as a salary. Although this particular ratio is not defined anywhere, it is widely used. The IRS is cracking down on people trying to reduce the salaries below "reasonable".

Over and beyond the salary, the S-Corp can retain or distribute its profits. Distributed profits are not considered earned income and are therefore not subject to social security payments. They are, however, pass-through income, i.e. they are allocated to the owners regardless of whether they have been distributed or not. 

It is important to remember that whilst distributions are exempt from social security payments in the US, there is another side to the coin - since they are not earned income, they will not be benefiting from the Foreign Earned Income Exclusion and will thus be fully taxed in the US.

Income from S-Corp - the UK position

The salary

As we have seen, S-Corp owner-employees much pay themselves a salary. 

The double taxation treaty between the US and UK gives both countries taxation rights over salary income.

The default clause on salary income in the double taxation treaty sets out that salary is taxed at the country of residency unless the work is done in the other country. In other words, the default position is that work done from the UK is taxed in the UK regardless of where the employer is or where the clients are.

However, the saving clause gives the US taxation rights over all income by US citizens regardless of what other clauses say.

The bottom line is that both countries can tax the salary, but the UK has priority to tax first for work done in the UK, with the UK tax available as a deduction in the US.

Since work is done from the UK, even for a US employer and US client is sourced in UK both in accordance with the double taxation treaty and in accordance with UK domestic legislation. The income is therefore not foreign-sourced income and is not covered by the FIG regime.

Furthermore, S-Corp employment income should therefore be reported to HMRC as UK-sourced wages and tax should be paid in the UK first, claiming a credit on the US tax return. 

This position raises major practical issues. In the UK, the employer should withhold personal income tax, as well as national insurance contributions. In addition, the employer is subject to employer’s national insurance contributions in the UK.

As a result, the only compliant way for S-Corps to operate in the UK is to register with HMRC as a subsidiary, branch or a permanent establishment. Such registration should also be reported back in the U.S. to avoid withholding of said payments in the U.S. Such registrations are burdensome, complex and unusual.

The tax result for the individual is full UK tax, deductible as credit in the U.S. and a claim for social security exemption in the U.S. under the totalisation agreement.

That in itself is an undesirable outcome, but the problems don’t end there.

Most S-Corps are owned and operated at least partially by the members who are based in the UK. Since the members are now operating from the UK, there is a considerable risk that either the entire S-Corp would be classified as a domestic UK company or, in the event that some activity remains in the U.S., HMRC may seek to classify some of the income as belonging to the UK permanent establishment. In turn, HMRC would wish to charge corporation tax (currently between 19-25%) and attribute it to the S-Corps entire profits or those in the UK. S-Corps do not pay corporation tax in the U.S., but the UK will not respect the transparent classification and would seek to charge corporation tax in the UK, leading to untenable taxation.  

The distributions

It is unclear how distributions from an S-Corp to a UK tax resident should be classified.

It appears that the same analysis in relation to U.S. LLCs under Anson should apply, and such distributions should be classified as self-employment income if the shareholder has a proprietary right for the profits as they arise and the entity would be treated as opaque otherwise. As even LLCs that are classified as partnerships are treated normally as opaque, it is hard to think of a scenario that an S-Corp would not be treated as opaque for UK tax purposes.

As a result, the distribution could be treated as either a dividend (and taxed as such) or other income from a business.

This distinction would be primarily relevant to people under the FIG regime. Under said regime, if owners are able to satisfy that the S-Corp retained its nature as a US corporation (decisions made in the U.S., no material activity or income sourced in the UK), then the classification as a dividend would likely lead favourably to the income being considered exempt under the FIG rules.

However, if the income is to be classified as other profits from a business, such business needs to operate wholly outside the UK for the profits to be exempt, and this condition could likely only be satisfied if the UK-based owner holds an entirely passive position and does not receive a salary.

Summary

S-Corps with an active member based in the UK could lead to potentially disastrous outcome. The S-Corp would need to register in the UK to achieve compliance, suffer employment taxation and social security taxation in the UK, potentially suffer corporation taxes in the UK on the entity’s profits and face an uphill battle to convince the US tax authorities to apply credits.  

When would S-Corps be a good structure?

S-Corps could work well when they their owners are ENTIRELY passive and do not have any activity within the company. In such a case, their position would be equal to limited partners of an LLC taxed as a partnership, and the FIG regime should apply.