As US-Israeli CPA working with US expats in Israel, I’m often asked by clients how they should report their US-earned income (from either salaries or self-employment) in Israel and whether this income is even taxable in Israel.

Question #1: If all the income is earned in Israel, why is it taxable? Don’t olim hadashim have a 10-year exemption from US-source income?

The answer to that question is simple: If the income was earned while you were physically working from Israel, it is considered Israeli-source income and therefore not entitled to the exemption. However, if worked part of the year outside of Israel, you can allocate that income as foreign-source income and it will not be taxable in Israel during the first 10 years since your aliyah. This can be specially helpful if travel to the US for a month or a few weeks and then return to Israel.

Question #2: For the portion of the income that is taxable in Israel, what is the most tax effective way to structure this income?

There are several ways to structure this income:

If you report this income as self-employed (without setting up an entity) you will be subject to Israeli income tax, US Social Security-Medicare, and Israeli Bituach Leumi. This can result in an effective tax of over 50 percent, so we never recommend this option. Likewise, if you are receiving a salary from a US company, the tax treatment is similar to that of self-employed except for the fact that your employer will pay half of your social security, still leaving a large tax bill .

For clients with moderate earned income levels, we often advice setting up an LLC and billing your employer/client through it. The advantage of this approach is that LLC income is not subject to Bituach Leumi in Israel. In addition, the Israeli Tax Authority will allow you to claim a foreign tax credit for the income tax you paid in the US, thus eliminating double taxation. Bottom line: only Israeli income tax (after crediting the US income tax paid) and social security will be due on this income, and you can avoid the complexity and costs of setting up an Israeli corporation. While planning this option, careful attention must be paid to the operating agreement of the LLC, as the Israeli Tax Authority can impose corporate tax rates on an LLC that is both controlled and managed from Israel. A qualified tax professional can help you prevent this tax by reviewing and modifying the operating agreement if required.

Taxpayers with higher earned income levels can reduce their effective tax rate by setting up an Israeli corporation and billing their US employer directly (or by using a US LLC as an intermediary). Under this option, taxpayer can claim an Israeli salary of up to 269,280 NIS annually and distribute the rest of the profits as a dividend. This option subjects taxpayers to Israeli income tax and Bituach Leumi on their salary (while avoiding social security taxes). Regarding the dividends, they are subject to an effective tax rate of 46.1 percent, which is lower than combined Israeli income tax-Bituach Leumi 50 percent or more tax rate that would otherwise be imposed if they report this income as a salary or as self-employment.

A hybrid option is to use an S-Corporation. The problem with S Corporations in Israel is that your salary from the S-Corp will be subject to both Social Security and Bituach Leumi. Regarding the S-Corp profits in excess of salaries, if the S-Corp is not controlled or managed from Israel, these profits can be exempt for 10 years. Before claiming the 10-year exemption on S-Corporation profits, an honest assessment by a qualified professional is required to determine whether the S-Corp meets these criteria both in substance and in form. Professional services companies have often been found not to meet these tests due to the personal nature of the service.

While using any of these tax structures, taxpayers can segregate their income earned from physically working outside of Israel during the first 10 years since their aliyah and exempt it from Israeli taxes.

Question #3: Do Traditional IRA contributions reduce my Israeli taxes?

The Israeli Tax Code does not exempt income deposited into a US IRA or other foreign deferred compensation plans. There are only limited cases in which such deposits can reduce your overall tax bill, and they are rare.

If you have any questions or require assistance, call us now for a free 15 minute consultation (972-55-6682243) or e-mail me at nathan@savranskypartners.com. We are licensed both in Israel and in the US and are a leading provider of tax and accounting services for both individuals and business with US-Israeli cross-border transactions. We are thrilled to assist you with the initial planning, set-up of your company/investment and preparation of tax returns in both countries.

The content of this article is intended to provide general information on the subject and does not constitute legal or tax advice. You should consult with a tax professional where appropriate.