Social Security Taxes: The Bane of the Existence of Self-employed U.S. Citizens Who Work Abroad – continued –
b. U.S. Citizens Working Abroad as Self-Employed Individuals
This section explores the self-employment taxes that face a U.S. citizen who works abroad as a self-employed individual. The self-employed U.S. citizen or resident faces self-employment taxes on all qualified earned income. In other words, the self-employed individual must always pay U.S. Social Security tax. Exclusions for foreign earned income under 26 U.S.C. 911, while reducing the amount of federal taxable income due, do not apply in calculating the self-employment tax.
Under 26 U.S.C. 1401, a self-employed individual must pay self-employment tax on his earned income, regardless of where that income was earned or by whom it was paid. In other words, no provision exists to limit this taxation based upon where the underlying income was earned or by whom it was paid.
Being self-employed, the individual will pay both halves of the tax – FICA tax and Medicare tax. However, the individual may deduct one-half of the tax in calculating his taxable income. In calculating federal income tax (not social security tax), the self-employed individual will benefit from the same foreign income exclusion and foreign income tax credit as the employer will.
Consider the following example. John is an American citizen who lives in New Jersey. He is a self-employed architect. John contracts to do work for a British firm that is building a hotel in China. The project is expected to last well over a year, with John working overseas the entire time. In exchange for his services, John will receive $ 90,000 (U.S.). The question is: how, and by whom, should John be taxed?
The first issue is whether John’s income represents foreign or domestic earnings? United States citizens and residents are subject to U.S. taxation on their worldwide income regardless of where it was earned. The Internal Revenue Code, however, allows a taxpayer to exclude certain foreign earned income if the requirements of 26 U.S.C. 911 are satisfied. Because the 2012 foreign earned income exclusion is $ 95,100, the first $ 95,100 of foreign earned income that qualifies under 26 U.S.C. 911 is excluded from taxation.
To satisfy the requirements of 26 U.S.C. 911, the taxpayer must (1) have foreign earned income; (2) meet either the Bona Fide Residence Test or the Physical Presence Test, and (3) have a tax home in the foreign country. John satisfies all three requirements. First, the income that John earned from this project satisfies the foreign earned income requirement. It is personal services income because it arose out of the active efforts of John. Income from performing personal services is earned income. In addition, the income is sourced where it is earned. Because the income was earned in China, as opposed to the United States, it is foreign source income. Therefore, the income is both earned income and foreign source income.
Second, John satisfies the physical presence test because the project is expected to last over a year, with John returning to the United States only for brief vacations. And third, John satisfies the tax home requirement because he maintains a home in China from which he works and from which all traveling expenses are deducted.
Therefore, the income earned from this project is eligible for the foreign earned income exclusion. What does that mean for John? It means that the first $ 95,100 of John’s salary is excluded from taxation. Because John earned $ 90,000, $ 5,100 less than the 2012 foreign earned income exclusion of $ 95,100, none of John’s income is subject to U.S. federal income taxation.
The next issue is more complicated. How should John be taxed for Social Security purposes? As a preliminary matter, John is not at risk for paying employment tax on the same income to both the Chinese government and the American government. Because John works in China, he would be taxed under whatever social insurance program exists in China. China does not have a social insurance program. Therefore, John does not have to pay social insurance taxes to the Chinese government.
However, John is not as lucky when it comes to having to pay social security taxes to the United States government. U.S. social security taxes are the bane of an American taxpayer’s existence. A very subtle distinction must be made between a U.S. citizen who works abroad for a foreign employer as an independent contractor and a U.S. citizen who works abroad for a foreign employer as an employee. While this distinction might appear to be trivial, the classification of a worker can result in drastic changes in the rate of tax paid by the taxpayer.
Under 26 U.S.C. 1401, a self-employed individual is subject to self-employment tax on his earned income, regardless of where it was earned or by whom it was paid. Thus, the fact that John earned his income while working overseas in China for a British company does not excuse him from paying social security taxes to the United States. By comparison, a U.S. citizen who works abroad for a foreign employer – not as an independent contractor but as an employee – is generally exempt from paying social security taxes and medicare taxes to the United States.
Because John is self-employed and because his income is classified as foreign earned income for self-employment purposes, John must pay U.S. self-employment taxes on all $ 90,000 of foreign earned income. The fact that all $ 90,000 of income is exempt from federal taxation under the foreign earned income exclusion does not alter this result. The only way to alter this result would be to reclassify John as an employee of the British company, instead of an independent contractor. In that case, he would be exempt from paying social security taxes to the United States.
Calculating the self-employment tax is the next step. The self-employment tax is a separate calculation from the federal income tax. Once calculated, it is added onto the federal income tax to be paid together when the individual tax return is filed. The foreign earned income exclusion has no impact on the self-employment tax in terms of reducing the amount of income subject to the self-employment tax. For John, this means that he must pay self-employment taxes on all $ 90,000 of foreign earned income, even though it was exempt from federal taxation under 26 U.S.C. 911.
Although the foreign earned income exclusion does not help John reduce the amount of income subject to self-employment taxation, he may still be entitled to a deduction. John may deduct one-half of the self-employment tax in calculating his federal taxable income.
Unfortunately for John, there is no federal taxable income from which to deduct the self-employment tax. That’s because the Chinese income was John’s only income and the foreign earned income exclusion eliminated all of that income, thus reducing John’s tax liability to zero. Therefore, the deduction of one-half of the self-employment tax will not affect John’s overall tax liability.