II. Social Security Taxes: The Bane of the Existence of Self-employed U.S. Citizens Who Work Abroad –
ii. Absence of a Totalization Agreement –
Now assume that the same facts exist in Japan, a country in which a social insurance program exists, but which does not have a totalization agreement with the United States. Because John works in Japan, he would be taxed under the Japanese social insurance program.
A critical issue confronting U.S. citizens and residents who work abroad is what to do in the event they are subject to social insurance taxes in the foreign country where they work but there is no totalization agreement between the United States and that country. In the absence of a totalization agreement, the self-employed individual might have to pay social insurance taxes to the foreign country and to the United States. If so, he would be paying social security tax on the same income to both countries, thus resulting in double taxation of his foreign earned income.
Here, John might have to pay social insurance taxes to the Japanese government and self-employment taxes to the United States government. What can John do to avoid the double tax bite of paying social insurance taxes and self-employment taxes on the same income to both countries?
Fortunately for John, a strong argument can be made that he should be entitled to a credit on the social insurance tax paid to Japan. As a preliminary matter, there is no statute or law that addresses how to handle foreign social security payments in the absence of a totalization agreement. The courts have also been silent on this issue.
Treasury Regulation 1.901-2(a)(1) is often cited as authorization for a tax credit or deduction. Under that regulation, for a foreign tax to be deductible against income, it must have the predominant character of an income tax as that term is understood under the Internal Revenue Code. In order for foreign social insurance tax to have the predominant character of an income tax in the U.S. sense, it must tax the net gain earned by the individual. In other words, if the foreign country taxes the gross income earned, without allowing a deduction for business expenses associated with that income, then the foreign tax will not be an income tax in the U.S. sense. Therefore, no foreign tax credit would be allowed to offset it.
All of this can be reduced to a simple rule. Under 26 U.S.C. 901, foreign self-employment tax will either be deductible or creditable against income or taxes paid to the United States if the foreign country taxes the net gain earned by the individual, allowing all business expenses to be deducted from self-employment earnings in reaching that gain.
This approach is rational from a fairness standpoint as well as from a public policy standpoint. It’s fair because it creates uniformity in the taxation of self-employment earnings regardless of the existence or the absence of a totalization agreement. For example, under a totalization agreement, the self-employed individual is excused from paying self-employment taxes to the United States if he is already paying it to the foreign country where the income is earned. This results in one level of tax on the earnings.
In the absence of a totalization agreement, self-employment/social insurance tax must be paid to both countries. However, if the foreign country taxes self-employment earnings on their net gain, then the foreign tax would be deductible or creditable against United States taxable income or income tax. Once again, that results in tax payments equal to only one level of tax being paid.
Another factor is the disparity in economic benefits derived if foreign self-employment tax is not deemed deductible or creditable against income paid to the United States. For example, under a totalization agreement, the self-employed individual qualifies for social security benefits in both countries while paying into only one country’s program – i.e., the country in which the services are being performed.
In the absence of a totalization agreement, the self-employed individual pays into both countries’ social security programs with the heightened risk of not being able to qualify for either. Therefore, from a public policy standpoint, it makes sense to allow a foreign tax credit to be taken.
Even if John is allowed a credit for the social insurance taxes paid to the Japanese government, he still has a serious problem. John may only take a credit on the social insurance tax paid to Japan to the extent that he has other U.S. tax against which to apply that credit. Recall that the foreign earned income exclusion reduced John’s taxable income to zero. Because no federal taxes are due, there is no other tax against which to apply the credit. Thus, the credit will be lost.
This draconian result is due to the instructions on Form 1040. According to those instructions, whenever the federal income tax is reduced to zero or below, zero (and not a negative number) must be entered on the form. Any additional taxes must then be added to that zero.
Because John’s federal income tax is zero, the foreign tax credit (for the Japanese social insurance tax) cannot reduce it to a negative number. Thus, the amount on form 1040 for federal tax less credits will remain at zero and the self-employment tax will be added on. This results in double taxation of the social insurance tax, regardless of whether or not it is creditable by law. Therefore, form 1040 prevents an actual crediting of the foreign tax against the U.S. self-employment tax.
Of course, if John had earned more than the amount allowed to be excluded under 26 U.S.C. 911, such as $ 96,000, then that additional $ 900 would be subject to U.S. federal income tax. In that case, John would be allowed to credit the social insurance taxes paid to Japan against the federal income taxes paid on $ 900 of earned income.