An American taxpayer who is living overseas and engaged in work as an independent contractor or sole owner of an unincorporated business in a foreign country may easily be confused by the complexity of U.S. tax laws as they pertain to them. The main issue that expats must face is having to file taxes in the country where they work and reside and pay foreign taxes on income earned from their self-employment. What many fail to realize is that they also are still under an obligation to file U.S. expat tax returns.
What Are Self-Employed Taxes Assessed on American Expats?
This is one of the latest emails from one of our clients, an American living abroad: “I live in Rome and provide music lessons. I filed expat tax returns in Italy and paid overseas taxes. However, I didn’t know that I have to pay U.S. income and self-employed taxes. What should I do as an American expat?”
Here is an overview of the key expat tax requirements and self-employment taxes:
First – The tax laws in the United States state that U.S. citizen taxpayers and green card holders must be taxed on their worldwide income. That means that American expats are obligated to pay a U.S. income tax and any overseas taxes on their self-employed income.
Second – A self-employed American expat may also be required to pay their obligatory social security and Medicare taxes. Also referred to as FICA taxes, social security and Medicare taxes are determined per the Self Employed Contributions Act (SECA). The FICA tax rate is 15.3% of the assessed net self-employed income. In cases where there is an employer- employee relationship half of that amount, or 7.65% is typically paid by the employer while the employee pays the other half through their income. The FICA tax rate of 7.65% consists of two distinct parts; a social security tax rate of 6.2% on the initial $106,800 and the Medicare rate of 1.45%. A self-employed American expat should check treaty agreements between the U.S. and their foreign country of residence to calculate the amount of self-employment tax due. Additional guidance from a U.S. expat tax expert is needed to help determine the overseas tax and U.S. income tax due on an expats tax return.
Third – American expats are permitted to deduct certain business expenses to help minimize self-employed taxes and their U.S. income tax obligation. Original receipts and a detailed record of these deductions should be kept for a period of 3 years following the filing of the return as protection in the event of an IRS audit.
Fourth – A self-employed American living overseas is able to claim the Foreign Earned Income Exclusion (FEIE) if they can meet either the physical presence test or the bona fide residence test.
To Be Employed Versus Self-Employed (SE):
In general, there are distinct advantages for a foreign employed American expat over those who are self-employed.
An expats foreign unreimbursed expenses will be excluded from Schedule A when they are an employee, which will not affect the amount of the FEIE claim. A SE individuals Schedule C foreign expenses and applicable foreign self-employed adjustments on IRS Form 1040 line(s) 23-32 (including half of the SE tax and the SEHI deduction among other things) will reduce the amount of FEIE available dollar for dollar. This FEIE amount is set as follows for the indicated tax year: $101,300 for 2016, $100,800 for 2015, $99,200 for 2014, $97,600 for 2013, $95,100 for 2012, $92,900 for 2011 and $91,500 for 2010.
In addition, since a SE individual’s net SE income is subject to FICA taxes imposed by the U.S. – 6.2% on the initial $118,500 for tax year 2015 ($117,000 for 2014) plus Medicare (1.45%) taxes – they will be responsible for both the employer and employee contributions. This will add up to 15.3% of their net foreign earned income (6.2 + 1.45 = 7.65 x 2) paid towards FICA for all SE individuals reporting net income on Schedule C. This amount is always assessed if net income on Schedule C does arise as a SE individual’s FICA obligations are not affected by FEIE and HD. Foreign employed expats are not subject to U.S. employee FICA obligations, but rather will be subject to the social security payment requirements of the country in which they reside and work if any exist.
To reiterate, the IRS will always view the substance over legal form of an employee-employer or master-servant relationship, upholding the common law definition. IRS Revenue Ruling 87-41 declares that subject to a twenty point analysis, it may be possible for an individual to declare earnings on IRS Form 1040 as line 7 wages (in contrast to an independent contractor or SE individual on IRS Form 1040 Schedule C) and subject this wage income to only half of the SE tax using Form 8919. This form refers to uncollected Social Security and Medicare Tax on Wages, where an individual works for a U.S. based entity issuing them income declared on Form 1099-MISC, as box 7 – Non-employee compensation. If the individual is working for a foreign based company or corporation, then there will be no U.S. SE or FICA obligations to be met.
In cases where it is clear that the individual fails to meet the common law employee-employer definition, or it may be difficult to apply IRS Revenue Ruling 87-41 to avoid FICA SE taxes, than the employee could consider one of the following alternatives:
- Totalization, where the United States has reached a social security agreement with the foreign country of residence
- Going on the payroll of a foreign or third party business
- Having a client add them to their payroll
- Having a person who is non-related with ownership of a foreign entity pay them a wage
A fifth option is for the U.S. taxpayer SE individual conducting business abroad to do so directly through a foreign entity. This can help to avoid U.S. FICA SE taxes if they have not checked the box on Form 8832 (Entity Classification Election) to be treated as a one-member disregarded entity that automatically defaults to a Schedule C (Profit or Loss from a Business). So long as the foreign entity is an active business (no Sub Part F income-generally passive income), then the shareholder or owner corporate deferral reporting of both salary and dividends on a cash paid basis is recognized.
There is also a number of U.S. tax reporting requirements whenever a U.S. taxpayer directly or indirectly owns 10% or more of a foreign entity. Form(s) 5471 – Information Return of U.S. Persons with Respect to Certain Foreign Corporations, 8865 – Return of U.S. Persons with Respect to Certain Foreign Partnerships, and 8858 – Information Return of U.S. Persons with Respect to Certain Disregarded Entities – may be needed along with Form 926 – Return of a U.S. Transferor of Property to a Foreign Corporation. These are a collection of complex forms, with obscure instructions and the need to apply U.S. Generally Accepted Accounting Principles (G.A.A.P.) that can makes them difficult to comply with. In most cases a U.S. based CPA will not have all of the details necessary to meet compliance, necessitating a foreign accountant or the taxpayer to complete the forms.
Moving Expenses and Employed Versus Self-Employed (SE):
In the case of moving expenses, both employed and SE individuals may claim them, reducing the amount of the applicable FEIE dollar for dollar. Only moves that take the individual from the U.S. to a foreign county, or from one foreign country to another, are considered a foreign move and therefore eligible for the reduction in the FEIE.
Other Interesting Facts for American Expats Working Abroad:
FEIE, HE, and HD are elective exclusions and should not be used in cases where they trigger income inclusion. This occurs when Schedule C expenses outstrip income and these expenses are added back to create income.
Do you have more questions about US expat taxes?
A self-employed American expat needs to consult with an expatriate tax preparer in order to determine the right type of business structure, plus the amount due in foreign taxes, SE taxes and U.S expat tax paying obligations.
There are a wide range of U.S. tax requirements that citizens and green card holders living abroad must meet. This includes filing FBARs, FATCA, PFIC and an array of other overseas tax forms. In order to ensure complete compliance, it is in your best interest to contact one of our expert expat tax consultants before attempting to sort it all out yourself.