Americans who work abroad face a challenging job preparing their tax returns. So let’s happily ignore today’s income tax issue and focus instead on Social Security taxes.
Technically, I’m talking about the FICA tax: the tax you pay for your pension, survivor’s pension, disability insurance, and Medicare benefits. But for the sake of simplicity — to match the way ordinary people talk about these taxes — I’ll call these taxes “Social Security” taxes.
Let’s take a look at digital nomads. You are a U.S. citizen and own a business incorporated as a corporation and operates in the United States. You plan to travel abroad for a few years. During the trip, you will continue to work and receive a salary from your business.
Zeroing U.S. income tax on that salary is not difficult. But, first, make sure you qualify for the foreign income exclusion and that you can earn a salary of $108,700 (2021) entirely tax-free.
But social security taxes… This is something else entirely. The total tax payable on this $100,000 salary is $15,300:
$6,200 in Social Security taxes you paid as an employee;
$6,200 in Social Security taxes paid by your business as an employer;
$1,450 in Medicare taxes you paid as an employee; and
Medicare tax of $1,450 paid by your business as an employer.
What if you don’t want to pay $15,300 in Social Security and Medicare taxes? Or, what if you live in a country that has its own Social Security tax system and you don’t want to pay both your U.S. Social Security tax and your other country’s taxes?
Territorial Rules: Working in the United States
The critical concept is where the service is performed. Therefore, the identity and location of the employer are irrelevant. Likewise, the employee’s status (citizen, resident, non-resident, etc.) is irrelevant.
Exception: also working outside the U.S.
U.S. citizens or resident aliens who work outside the U.S. for an “American employer” must also pay U.S. Social Security taxes.
The term “American employer” is defined in IRC § 3121(h):
(h)American employerFor purposes of this chapter, the term “American employer” means an employer which is—
(1) the United States or any instrumentality thereof,
(2) an individual who is a resident of the United States,
(3) a partnership, if two-thirds or more of the partners are residents of the United States,
(4) a trust, if all of the trustees are residents of the United States, or
(5) a corporation organized under the laws of the United States or of any State.
As you can see, the following would be “American Employers”:
Individuals who are residents of the United States;
Partnership, if two-thirds or more of the partners are U.S. residents; or
A corporation organized under the laws of the United States or any state.
The critical point to remember is that if your employer is an “American Employer” when you work abroad, you are subject to U.S. Social Security taxes. However, if your employer is not an “American Employer,” and you work abroad, you are not required to pay U.S. Social Security taxes.
You own a U.S. business organized as a Wyoming LLC (a single-member disregarded entity). You decide to become a digital nomad. When you provide services while traveling abroad, you will continue to report the business income as self-employment income on Schedule C and pay Social Security tax (called Self-Employment tax) of 15.3%
Because you provide services to an “American Employer” you are required to pay U.S. Social Security taxes on your wages.
What if you don’t want to pay U.S. Social Security taxes while living a digital nomad lifestyle, traveling, and working abroad?
Be employed by a Foreign Employer and eliminate U.S. Social Security tax
Keep in mind that only foreign Americans who work for a U.S. employer are subject to U.S. Social Security taxes. The goal is clear: to avoid being employed by an “American employer.”
You own a U.S. business organized as a Wyoming LLC (a single-member disregarded entity). Then, you decide to become a digital nomad, traveling the world and working remotely anytime, anywhere.
You create a foreign corporation, and you sell the Wyoming LLC to that foreign corporation (to retain access to U.S. banking). The Wyoming LLC will still be a disregarded entity, but now it will be an extension of the foreign corporation and not of yourself. You are no longer self-employed. Instead, you are employed by… wait for it… keep on waiting for it… a foreign employer.
Since you work outside the U.S. and do not provide services to an “American employer,” you are not required to pay U.S. Social Security taxes on your wages.
Also, keep in mind that a considerable part of the tax savings will be consumed in the cost of the foreign company and the annual costs of bookkeeping and preparation of tax returns.
Setup and operating costs
Creating a foreign company costs money. Not a lot, but some money.
The cost of forming and running a foreign company may be less than the Social Security tax you will pay.
Accounting Costs (Form 5471)
However, owning a foreign company is very expensive when preparing U.S. income tax returns. The accounting costs of Form 5471 (PDF) and tax return preparation costs can easily consume the Social Security tax savings you expect to realize.
If you screw up your Form 5471, the IRS could hit you with a $10,000 fine.
How to reduce your accounting costs
You can reduce tax paperwork costs by eliminating the requirement to file Form 5471. Here’s a strategy to eliminate the horrible fees and complexities of Form 5471 and replace it with the less scary and cheaper Form 8858.
This can be done by using a check-the-box election and electing for the foreign corporation to be treated as a disregarded entity.
Find a Totalization Agreement
The other way is to find a totalization agreement. It’s just a fancy word to describe treaties that relate to social security. You would need to be an actual resident of a foreign country, not just any foreign country, but a country that has a totalization agreement with the United States.
If so, you will have to pay social security tax to one country and not the other. In most cases, that means that you will pay to your country of residence and you will be free from having to pay Social Security taxes to the US.
Think twice. Hire someone to help you (probably our company). Don’t incorporate a corporation until you’ve thought about the tax consequences.