III. Recommendations to Assist Self-Employed U.S. Citizens Working Abroad Avoid or Reduce Self-Employment Taxes and Social Security Taxes –
Because self-employment taxes represent such a significant threat to the survival of U.S. citizens or residents doing business abroad, recommendations are needed to assist these individuals in avoiding self-employment taxation or reducing the amount of self-employment taxation paid. Can a U.S. citizen working abroad escape self-employment taxation? How about social security liability and medicare liability? If so, how? Is there a special exemption for overseas companies?
a. A Paradigm for Absolute Avoidance of Social Security Taxation: U.S. Citizens Working Abroad for a Foreign Company in a Foreign Country that has no Social Insurance Program
The paradigm for absolute avoidance of social security taxation contains a unique framework. And there is a good reason why. If successful, it would result in the wages of a U.S. citizen working abroad being completely tax free – free of federal income tax, free of social security tax (U.S. and foreign), and free of state income tax.
Before letting out a shout of joy, the global worker should know that the facts that give rise to tax free wages are extremely difficult, if not impossible, to replicate. Indeed, several obstacles must be overcome before a self-employed individual working abroad can enjoy tax free wages.
One such obstacle is the formation of a foreign entity. Thanks to the IRS, that obstacle alone is virtually insurmountable. Because of how impractical it is to form a foreign entity, this author explores alternative strategies for avoiding U.S. social security taxation.
Consider a variation of the example described above involving John. Instead of working as an independent contractor for the British firm that is building a hotel in China, John is an employee. All of the other facts remain the same. John is responsible for designing and building the hotel. The project is expected to last well over a year, with John working in China 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?
John is still exempt from federal income taxes for the same reasons discussed in the first example. The seminal issue is how should John be taxed for social security purposes? When a U.S. citizen works abroad for a foreign employer, he is generally not subject to social security or Medicare liability. Here, John was working abroad for a British company, not an American company. A British company is not considered an American employer for purposes of Section 3121(h) or Section 3306(j)(3). Therefore, John is exempt from paying U.S. social security taxes because the withholding requirements of the United States do not apply.
Although John can avoid U.S. social security taxation, must he still pay social insurance tax? If so, would John have to pay social insurance tax to England? After all, John is an employee of a British company. The answer is “no.” While England has its own social insurance program, the fact remains that an employee need only pay into the social insurance program of the country in which the income was earned. Here, the country in which John earned his income was China, not England. Because John did not earn a dime of income in England, he has no obligation to pay social insurance taxes to England.
However, John is still not off the hook for paying foreign social insurance taxes. Because he earned all of his income in China, John would be taxed under whatever social insurance program exists in China. Fortunately for John, China does not have a social insurance program. Therefore, John is exempt from paying social security/social insurance tax to all three countries.
But John’s good tax fortune doesn’t end with the avoidance of social security/social insurance tax. That is just the beginning. Like a rainbow forming against a clear blue sky is the foreign earned income exclusion that John qualified for. As such, none of his income is subject to U.S. federal income taxation.
When John’s social security exemption is combined with his foreign earned income exclusion, the result is extraordinary. His wages are completely tax free – free of federal income tax, free of social security tax (foreign or domestic), and free of state income tax.
With a result this favorable, one can bet that the IRS is only a heartbeat away from mounting a challenge. For example, the IRS may attempt to reclassify John’s working status as “self-employed” in order to collect FICA and Medicare tax from his income. As a preliminary matter, the IRS takes an active role in ensuring that workers are properly classified as employees or independent contractors. To that extent, the IRS may reclassify a worker’s status if it discovers that the worker was actually an independent contractor and not an employee.
If successful in reclassifying a worker as an independent contractor, that worker would then be subject to self-employment tax on his earned income. That’s because self-employed individuals must pay self-employment tax on their earned income, regardless of where it was earned or by whom it was paid. In John’s situation, an IRS victory means that he would be subject to U.S. self-employment tax on his earnings.
John is likely to survive this challenge. In Revenue Ruling 87-41, the IRS lists twenty factors that it considers in determining employment status. Upon reviewing these factors, it appears that John is an employee and not an independent contractor.