The article intends to offer you a deeper understanding of the differences between taxation of self employment income and employee-earned income on the international level. It is not the purpose of this article to fully educate you on international tax laws and regulations, although it will provide you with enough information to accurately gauge whether or not your chosen tax professional is as aware as he/she should be to offer you the most competent tax preparation services available.
Traditional Employment versus Self Employment
Generally speaking, employees working overseas have quite a few advantages over those who are internationally self-employed.
The main benefit of being an international employee has to do with the FEIE (Foreign Earned Income Exclusion). Employees with unreimbursed expenses can exclude these amounts from schedule A without their FEIE claim being affected. Those who are self employed, on the other hand, are subject to a reduction of the FEIE amount on a dollar-for-dollar basis when expenses and self-employment (SE) adjustments are calculated on Schedule C. This also applies to moving expenses, regardless of employment status. If these expenses are claimed and they are deemed to be foreign expenses, they would result in the reduction of available FEIE. Persons moving back to the United States are not considered to have incurred foreign expenses.
One obligation of SE individuals which is not shared by employees is the responsibility of United States FICA taxes, which include Social Security and Medicare. The Social Security tax rate is 6.2% on a taxpayer’s initial $106,800, and the rate for Medicare is 1.45%. These rates are applied to both employers and employees, and international SE taxpayers may be required to pay both portions, making them liable for over 15% of taxation on their net SE income reported on Schedule C.
Taxpayers responsible for Self Employed Contributions Act (SECA) taxes cannot find relief in FEIE or various housing deductions, as SECA taxes are not subject to their rules. FICA taxes are only assessed, however, on income which is generated within the United States. Meanwhile SECA tax is due on Self-Employment income generated by an American citizen worldwide. There is, however, an exemption for certain countries (see http://www.taxesforexpats.com/expat-tax-advice/us-social-security-agreements.html)
There is a method by which an SE individual can avoid paying US FICA taxes, and that is through an FCC (Foreign Controlled Corporation). Simply acting as the responsible party of the FCC for generating income is not sufficient to avoid SE taxes, as all income is deemed to have come from you (the responsible party). If, however, the income of the FCC is parceled out to shareholders then the IRS no longer deems the income as that of the responsible party.
While this is a valid option to those who are self employed overseas and working with an FCC, but it’s important for you to be aware of the reporting requirements involved. If you directly or indirectly own at least 10% of an FCC you will be required to file multiple forms with various agencies all in place to prevent tax evasion and international money laundering. Some of these forms include 5471, 8858, and 8865, which all have to do with earnings and other financial information of US persons involved with foreign corporations or other partnerships. These forms are highly complex and the individual completing the forms needs to be educated on the GAAP (Generally Accepted Accounting Principles) outlined and mandated by the US.
Aside from the stringent reporting requirements, you may be negatively affected by your host country’s social security tax laws and regulations – which may make the option of parceling income out to shareholders a more expensive option.
As an alternative to working as an SE individual in conjunction with a foreign corporation or partnership, it may be more beneficial to you to have the entity hire you as an employee rather than an independent contractor. The IRS would view your employment as an employee-employer relationship and may allow you to file your earnings on Form 1040, rather than your having to file SE taxes with a Schedule C and being subject to 50% of the SE tax on your income denoted on Form 1099-MISC.
The aforementioned exclusions are claimed on a voluntary bases. There are situations in which these elections may result in exclusion income and should not be exercised. In these cases, you are better off filing a Schedule C and allowing your high level of expenses to offset your income – putting more money in your pocket and decreasing your tax liability.
I.J. Zemelman, EA is the founder of Taxes for Expats