US tax laws can be confusing. There’s a lot of specifics, and the language surrounding these specifics is pretty complicated—particularly when it comes to the self-employment tax on US citizens abroad. So, how does all this actually work? For starters, unfortunately, you still have to pay US taxes on foreign income if you are a freelancer, independent contractor, digital nomad, or entrepreneur abroad. And yes, US tax laws apply no matter where in the world you live and perform the work.
The self-employment tax is a Social Security and Medicare tax on net self-employment income. You must pay this tax if your net self-employment earnings are at least USD$400 in a year. But don’t panic, we know the ways to ease the burden and legally minimize the self-employment tax on foreign income for Americans abroad.
Contact us if you want to receive a free email consultation. Or, keep reading for a few helpful tips and tricks that will help you navigate the murky waters of United States tax laws.
1. Filing requirements for self-employment taxes if you’re a US citizen abroad
You fall under a different filing threshold category if you are a self-employed US person who resides abroad. As we mentioned earlier, earning USD$400 in a year already triggers a filing requirement for a tax return. As the US is one of the two countries which practice citizen-based taxation, it’s necessary —and essential— to take care of US tax obligations even while living abroad.
Who does the IRS consider to be self-employed? If you belong to any of the following categories, you’re self-employed and need to file your taxes appropriately:
- A member in a LLC, depending on how the LLC elects to be treated for tax purposes
- Independent contractor
- Sole proprietor
- Partner in a business partnership
The self-employment tax rate is 15.3% of net earnings up to a base amount. The base amounts are US$128,400 in 2018 and US$132,900 in 2019. The rate consists of 2 parts: 12.4% goes toward Social Security (old age, survivors and disability insurance) and 2.9% covers Medicare hospital insurance). That means the Social Security portion applies only to the first $128,400 of your foreign self-employment income (for the 2018 tax year). And Medicare applies to any amount thereafter.
Additional Medicare tax: If you make more than the base amount limits, the excess of wage limits will be taxed at 2.9%. Depending on your income, you might be also subject to Additional Medicare Tax (AMT). The current rate is 0.9% and it applies to individuals who earn above a certain threshold, based on filing status.
The self-employed tax on US citizens abroad requires you to pay AMT if you earn more than the following amounts: $250,000 for married filing jointly and $200,000 for single filers. While Medicare Tax doesn’t have limits, a certain amount of your income will be subject to Social Security tax.
You do not take the Foreign Earned Income Exclusion into consideration when figuring net earnings.
2. What about Social Security tax for Americans residing abroad?
Americans abroad often need to pay Social Security tax regardless of where they work and live.
While residing abroad, many US expats have to contribute to their foreign country’s social insurance systems. It’s done to cover the benefits you might be receiving while living in a foreign place. This is where expats get taxed twice because they have to pay both US Social Security tax and to the current residence country.
But there’s an upside: To eliminate dual taxation of US citizens and GreenCard Holders living abroad, the US has Social Security Agreements with a number of countries. If you are employed by a foreign employer, including a foreign subsidiary of a US company, you won’t be subject to U.S. Social Security Tax in most cases.
Social Security Totalization Agreements
While there are income tax treaties with a large number of countries, they do not cover Social Security taxation in two countries on the same income. That’s why the US has separate Social Security Totalization Agreements with 29 countries:
- South and North America: Brazil, Chile, Uruguay, Canada
- Europe: Austria, Belgium, Czech Republic, Denmark, Finland, France, Germany, Greece, Hungary, Ireland, Italy, Luxembourg, Netherlands, Norway, Poland, Portugal, Slovak Republic, Slovenia, Spain, Sweden, Switzerland, United Kingdom
- Asia and Oceania: Australia, Japan, South Korea
Social Security Totalization Agreements (SSTA) with the above mentioned countries help prevent double Social Security Taxation. In this case, you are only subject to the host country SS tax. However, in some cases if you’re sent on a temporary assignment to one of these 29 countries, then you may qualify for an exception and pay FICA tax (Federal Insurance Contributions Act, the name of the law that created Social Security in the US) instead. The agreements indicate that if an individual is sent abroad on a contract or does not intend to stay overseas for more than 3 to 5 years, they will pay into Social Security of their home country.
Social Security tax fact: If you are working in a country that has an SSTA with the United States, then you are exempt from FICA tax. Generally, you can claim the foreign country’s Social Security tax as an addition to your foreign tax credit. But keep in mind that FTC offsets your US regular income tax liability and not your FICA taxes.
3. How to reduce self-employment tax on foreign income
Generally speaking, there are a few advantages for Americans abroad who are foreign employees over self-employed ones when it comes to US taxes. You may be subject to self-employment taxes if you are:
- A freelancer or independent contractor
- A sole proprietor
- A member of a general partnership
- A member of an LLC that is considered a disregarded entity for tax purposes
However, there are ways to minimize your tax burden triggered by self-employment tax laws. Can you avoid SE tax if you are self-employed working for a foreign company? You can’t avoid this entirely, but there are a few ways to save money on your tax bill in the long term.
Let’s break it all down.
LLCs vs S-Corporation
LLCs: A limited liability company (LLC) is not a separate tax entity. As a consequence, with an LLC, the income passes through to the owner, who has to pay 15.3% self-employment tax. As the owner who resides abroad, you can use the Foreign Earned Income Exclusion to minimize income tax but not self-employment tax.
The IRS considers single-owner LLCs as sole proprietorships for tax purposes. So you need to report all profits or losses of the LLCs on Schedule C. And then you attach it to the 1040 tax return. However, if you have profits in your company’s bank account at the end of the year, you will need to pay income tax on it.
Domestic LLCs are automatically considered to be disregarded entities. If you want the same election for a foreign LLC, you will need to file Form 8832 once and then another Form 8858 every year. In the cases where you decide not to have your LLC disregarded, you must file Form 5471, which is a lot more complicated.
S-Corp: As we already know, the self-employment tax on US citizens living abroad applies to earned income. If you form an S-Corporation and your clients pay not you directly but the S-corp instead, then it’s not earned income for you – yet. But you still should pay your personal bills, correct? For that you would need earned income. You can do the following: divide those payments and pay yourself a percentage as a “salary” and the balance as dividends. The “salary” portion will be subject to self-employment income as it is classified as “earned income”.
What happens to dividends? They aren’t taxed as self-employed income. Thus you have reduced your net earnings by whatever percentage you took as dividends.
Self-employment foreign income tax fact: There is a new Repatriation tax, which you may be subject to depending on the ownership in the company. It applies to US owners of foreign businesses.
4. Where to establish a foreign company?
If you are a nomad, moving from one country to another and you don’t stay in any one place long enough to establish an official tax residency, then this strategy might work for you. You can employ yourself in a foreign corporation. We recommend establishing one in a country with tax advantages and low operating costs. You can have a foreign corporation, which owns a US LLC and you use the latter one to sell your products. But this all depends on your particular business needs.
This option might cost a few thousand dollars to set up correctly and maintain. But there is a possibility it will be cheaper than paying foreign self-employment income taxes. Caribbean islands and particularly Belize is an easy country to incorporate and bank with no income tax. However, they lack the prestige of other popular jurisdictions. Hong Kong is a popular place to establish a company but it’s getting harder with FATCA regulations. HK doesn’t impose taxes on those with no HK income, but you have to qualify for this exception. The country of Georgia is also one of the options with their foreign-friendly jurisdiction.
If you decide to form a company in more business-friendly countries, i.e. the United Kingdom or Estonia, you probably won’t need an LLC. While these countries have a corporate income tax (around 20%), that only applies to corporate net profits. You can pay yourself nearly all the income of the business as a salary. In this case the corporate profit will be quite a small amount.
Keep in mind, the strategies we mentioned above only apply to businesses where you offer services. The US has a concept, which bans directing the income to another person than the one who performs the services. Since a corporation is a separate legal person, running the income through it won’t be in accordance with US tax law.
5. Deductions for ordinary and necessary expenses
One of the ways to save money on your tax bill is to take advantage of business expenses. We have already learned that Foreign Earned Income Exclusion can lower your income tax liability, but what about other available deductions?
The IRS allows you to deduct ordinary and necessary expenses—and it’s important to know the distinction.
Ordinary expenses are commonly used and accepted by your business industry standards. The expenses are frequent and ongoing—and critical to your trade to run the business. However, ordinary expenses should also be necessary in order to deduct them from your business taxes.
Necessary expenses are considered to be helpful and appropriate in running your business. Again, you cannot deduct necessary expenses if they are not ordinary expenses also.
Does it all sound too complicated for you? Well, here are a few examples that might help you understand what qualifies as ordinary and/or necessary expenses: advertising, supplies, rental of office space and equipment, taxes and licenses etc. You will need to use Schedule C to deduct these expenses. You will also need to pay SE tax before you can apply FEIE or FTC.
Summary of the self-employment tax on US citizens abroad
Being a US entrepreneur or freelancer while living abroad is a rewarding experience. Hoping that the IRS will not find out about your foreign self-employment income is a bad idea in general. The IRS will impose heavy fines if they catch you under-reporting self-employment income or not reporting it at all. Do you know that they can go back as many years as they want? Even past the 7 year statute of limitations.
While we described a few ways to reduce your self-employment tax liability, it’s extremely important to seek professional tax advice before you proceed with any of the above-mentioned strategies. There are some issues to consider beyond taxes and we strongly recommend consulting tax professionals.
At 1040 Abroad, we have tax experts who help Americans abroad to minimize their tax burden on a daily basis. Contact us now and schedule a free consultation to discuss the best solutions.