One of the side effects of the large rise of Americans moving to Portugal is also the considerable use of unique US structures.
We have already written about the treatment of US LLCs in Portugal 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 Portugal, S-Corps (or LLC/SCorps) are not a recommended vehicle in our view, even for people with NHR status, for 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. 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 Exclusions and will be fully taxed in the US.
Income from S-Corp - the Portugal position
As we have seen, S-Corp owner-employees much pay themselves a salary.
The double taxation treaty between the US and Portugal 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 Portugal is taxed in Portugal 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.
Many people mistakenly believe that the fact that the combined effect of the US's right to tax the salary, the effective taxation in the US that is deducted at source and the NHR regime that exempts foreign sourced employment income that is taxed at the source country leads to no taxation in Portugal.
This position may be on many tax returns but it is legally wrong.
Since work done from Portugal, even for a US employer and US client is sourced in Portugal both in accordance with the double taxation treaty and in accordance with Portuguese domestic legislation, the NHR exemption does not apply as it only applies to foreign-sourced income.
The outcome is reverting to the default position - Portugal has the first right of taxation.
S-Corp employment income should therefore be reported to the tax authorities in Portugal as Portuguese-sourced income and tax should be paid in Portugal first, claiming a refund on the US tax return, leading to a cash-flow problem.
However, the problems do not end there. Employment income in Portugal is also subject to social security contributions in Portugal. Social security contributions in Portugal are paid BOTH by the employee AND by the employer.
Therefore, employees in Portugal should be income tax and social security and their S-Corp employers should technically register with the Portuguese authorities and pay employers' social security.
The combined effect of doing things "by the book" would be a tax rate of the salary portion of approximately 54% under the NHR regime with no social security cap.
Distributions from an S-Corp that is genuinely a US entity would likely follow the rationale set out in processo 2360/2016 (covered here in relation to LLCs) and will be considered foreign-sourced capital income that is exempt from tax in Portugal under the NHR regime.
However, the risks of partnership LLCs apply to this income in an equivalent manner. Particularly, if the S-Corp is managed from Portugal, it could be considered a tax resident in Portugal and thus not benefiting from the exemption.
When would S-Corps be a good structure?
When an S-Corp is very profitable, e.g. can legitimately pay a relatively small salary and relatively high distributions, it can be a better structure than a standard LLC.
In such a specific scenario, the combined benefits on the US and the fact that it is slightly less likely that its status as a company will be questioned in Portugal, can give the S-Corp the edge.
However, these are rare occasions.
We believe that S-Corps are a ticking time bomb.
There are many people not following the correct treatment who are under enormous risk of future audits in Portugal going 4 years backwards.
for those who have any flexibility, we generally do not favour S-Corps and recommend to sacrifice the social security benefits in exchange for a much more straight forward structure.