One of the biggest misconceptions in business is the application of self-employment tax for business that operates overseas with owners who are U.S. Citizens or Legal Permanent Residents. Unfortunately, for the most part a self-employed individual who qualifies as a U.S. Citizen or Legal Permanent Resident is still going to be required to pay self-employment tax to the Internal Revenue Service, no matter where they reside.

Golding & Golding – International Business Tax Lawyers

In fact, while having passive income and other deductions from your business might reduce the general tax liability to zero (including the applicability of the Foreign Earned Income Exclusion for the self-employed 2555-S, it will often do little to reduce or eliminate your self-employment tax).

                                          

Self-Employment Tax – General 

When an individual works for a company as an employee, the employment tax responsibility is normally split between the employer and the employee. In other words, the employer pays 6.2% and the employee pay 6.2% (the employee’s 6.2% is an amount which is withheld from the employee’s paycheck). In addition, both the employer employee pay 1.45% Medicare tax, of which the employee’s portion is withheld from his or her paycheck.

When a person works for themselves, they generally have to pay both portions of the self-employment tax. In computing the tax return, the self-employed individual is able to deduct a portion of the employment tax paid by when computing the tax liability, but it does little to minimize the overall self-employment tax liability.

Example: Jeffrey owns his own company. He completes his schedule C which results in around $100,000 of income. As a result, in addition to his personal income tax liability, Jeff will also pay 15.3% in employment tax on 92.35% of his net earnings.

                                          

Self-Employment Tax – International Tax

The United States is one of the few countries that taxes individuals on their worldwide income. In other words, it does not matter where on the planet you reside – if you are aU.S. Citizen or Legal Permanent Resident you will be fully subject to IRS tax law. Thus, if you are operating a business overseas you are still required to file a US tax return (although foreign tax credit or foreign earned income exclusion may be available for your income tax). In other words, if you pay $20,000 in income tax overseas in your US tax liability would also be $20,000 (the foreign country has the same tax rate as the United States) you may be able to obtain a credit so that you do not have to pay the same tax twice.

Generally, this is not apply to self-employment tax.

                                 

The following in a summary provided by the IRS on “Self-Employment Tax for Businesses Abroad”:

If you are a self-employed U.S. citizen or resident, the rules for paying self-employment tax are generally the same whether you are living in the United States or abroad.

The self-employment tax is a social security and Medicare tax on net earnings from self-employment. You must pay self-employment tax if your net earnings from self-employment are at least $400.

For 2009, the maximum amount of net earnings from self-employment that is subject to the social security portion of the tax is $106,800. All net earnings are subject to the Medicare portion of the tax.

                                          

Self-Employment Tax & Nonresident Aliens

Nonresident aliens are not subject to self-employment tax. However, self-employment income you receive while you are a resident alien is subject to self-employment tax even if it was paid for services you performed as a nonresident alien.

Example: You are an author engaged in the business of writing books. You had several books published in a foreign country while you were a citizen and resident of that country. During 2009, you entered the United States as a resident alien. After becoming a U.S. resident, you continued to receive royalties from your foreign publisher. You report your income and expenses on the cash basis (you report income on your tax return when received and deduct expenses when paid).

Your 2009 self-employment income includes the royalties received after you became a U.S. resident, even though the books were published while you were a nonresident alien. This royalty income is subject to self-employment tax in 2009.

*This should provide you an example of the harshness of the Internal Revenue Service when it comes to self-employment tax. In the above referenced example, the fact of the matter is the individual authored the book while the individual was a nonresident and not subject to US self-employment tax. Thereafter, individual relocated to United States and had earnings of royalties from the book (which was authored and published overseas) and now through the mere fact that the author resides in the United States, his or her loyalties are subject to self-employment tax (generally, international tax treaties may have reduced tax rates for royalties but not self employment tax)

                                          

Effect of Foreign Earned Income Exclusion

You must take all of your self-employment income into account in figuring your net earnings from self-employment, even income that is exempt from income tax because of the foreign earned income exclusion.

Example: You are in business abroad as a consultant and qualify for the foreign earned income exclusion.  Your foreign earned income is $95,000, your business deductions total $27,000, and your net profit is $68,000.  You must pay self-employment tax on all of your net profit, including the amount you can exclude from income.

**This is another important issue to consider. Even if you are able to significantly reduce your net profits deductions overseas business, you still have to pay self-employment tax hundred net profit. As in the above example, individual is still required to pay self-employment tax on $68,000, even though if a person qualified the foreign earned income exclusion they would get to exclude that $68,000 from their personal income tax.

                                          

Income from U.S. Possessions

If you are a U.S. citizen or resident alien and you own and operate a business in Puerto Rico, Guam, the Commonwealth of the Northern Mariana Islands, American Samoa, or the U.S. Virgin Islands, you must pay tax on your net earnings from self-employment (if they are $400 or more) from those sources.  You must pay the self-employment tax whether or not the income is exempt from U.S. income taxes (or whether or not you must otherwise file a U.S. income tax return).  Attach Schedule SE (Form 1040) to your U.S. income tax return.

If you do not have to file Form 1040 with the United States and you are a resident of any of the U.S. possessions listed in the preceding paragraph, figure your self-employment tax on Form 1040-SS, U.S. Self-Employment Tax Return (Including the Additional Child Tax Credit for Bona Fide Residents of Puerto Rico).

                                          

Services for Foreign Government or International Organizations

For U.S. citizens, the income paid for services rendered to a foreign government or international organization is reportable as self-employment income on their U.S. federal income tax returns, and is subject to self-employment tax to the extent such services are performed within the United States.

                                          

 

International Social Security Agreements

The United States has entered into social security agreements with foreign countries to coordinate social security coverage and taxation of workers employed for part or all of their working careers in one of the countries.  These agreements are commonly referred to as Totalization Agreements.  Under these agreements, dual coverage and dual contributions (taxes) for the same work are eliminated.  The agreements generally make sure that social security taxes (including self-employment tax) are paid only to one country.

If your self-employment earnings should be exempt from foreign social security tax and subject only to U.S. self-employment tax, you should request a certificate of coverage from the U.S. Social Security Administration, Office of International Programs.  The certificate will establish your exemption from the foreign social security tax.  You can get more information about the Totalization Agreements on the Social Security Administration’s web site.

To establish that your self-employment income is subject only to foreign social security taxes and is exempt from U.S. self-employment tax, request a certificate of coverage from the appropriate agency of the foreign country.  If the foreign country will not issue the certificate, you should request a statement that your income is not covered by the U.S. social security system.  Request it from the U.S. Social Security Administration.  Attach a photocopy of either statement to your Form 1040 each year you are exempt from U.S. self-employment tax.  Also print “Exempt, see attached statement” on the line for self-employment tax.

See the “Self-Employment Tax” information in IRS Publication 54, Tax Guide for U.S. Citizens and Resident Aliens Abroad, for more detailed information about self-employment tax for U.S. citizens and residents abroad.

                                           

Self-Employment Tax on Foreign Earnings – Be Careful!

Many of our clients get tripped up on the idea that since they are working overseas there outside of the reach of the Internal Revenue Service; that is simply not the case. Whether you live in a foreign country that allows nonresidents to open up that accounts which are not generally tracked by the foreign country and/or reside in the country that does not tax certain types of income (especially if foreign threshold requirements are not met) is important that you stay compliant US tax law.

As a US citizen or legal permanent resident was still required to file a tax return meet the minimal earnings requirements – no matter where you reside and no matter whether that income is self-employment income of foreign earned income.

Golding & Golding, A PLC

We have successfully represented clients in more than 1,000 streamlined and voluntary disclosure submissions nationwide and in over 70-different countries.

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