Recommendations to Assist Self-Employed U.S. Citizens Working Abroad Avoid or Reduce Self-Employment Taxes and Social Security Taxes – continued
b. Forming a Foreign Entity –
As described above, forming a foreign entity is essential to any plan that seeks to avoid domestic and foreign social security taxation. This section describes the obstacles that a self-employed individual from the United States must overcome to form a foreign entity. In doing so, it explains why certain definitions in the Federal Insurance Contribution Act (FICA) and the Federal Unemployment Tax Act (FUTA) make forming a foreign entity for U.S. citizens working abroad virtually impossible.
For half a century, efforts to avoid Social Security and Medicare taxation have centered on entity classification. The reason for this is obvious. Certain entities, such as foreign entities, are exempt from U.S. social security taxation. Thus, any U.S. citizen working abroad who was beleaguered by escalating U.S. employment taxes immediately turned their attention to forming a foreign entity.
Generally speaking, when a U.S. citizen works abroad for a foreign employer, he is not subject to Social Security or Medicare liability. However, the same is not true about U.S. citizens or residents working abroad for U.S. employers. Those individuals are subject to Social Security and Medicare taxation. In comparing these two rules, a very subtle point emerges. The nationality of the employer that a U.S. citizen works for determines whether he or she will be subject to U.S. social security taxation, not the type of work he does or where it was performed.
To understand why a U.S. citizen working abroad for a foreign employer is exempt from Social Security and Medicare liability, one need look no farther than three definitions in the Internal Revenue Code. Those definitions are “wages,” “employment,” and “American Employer.” These definitions are terms of art that the Internal Revenue Code defines with great precision and accuracy.
Under Section 3121(a) of the Code, “wages” are defined as all remuneration for employment, including the cash value of all remuneration (including benefits) paid in any medium other than cash.
“Employment” has two definitions, one of which is found in the Federal Insurance Contribution Act (FICA) and the other which is found in the Federal Unemployment Tax Act (FUTA). Both are nearly identical. Under the Federal Insurance Contribution Act, “employment” is defined as:
… any service, of whatever nature, performed by an employee for the person employing him, irrespective of the citizenship or residence of either, within the United States … and [any] service performed outside the United States by a United States citizen or resident as an employee of an American employer (as defined in section 3121(h)).
[Section 3121(b), emphasis added.]
Under the Federal Unemployment Tax Act, “employment” is defined as:
… any service, of whatever nature, performed by an employee for the person employing him, irrespective of the citizenship or residence of either, within the United States … and any service, of whatever nature, performed after 1971 outside the United States (except in a contiguous country with which the United States has an agreement relating to unemployment compensation) by a citizen of the United States as an employee of an American employer (as defined in section 3306(j)-(3)).
Just as “employment” has two definitions, so too does “American employer.” Both definitions are nearly identical. Under the FICA, “American employer” is defined as:
(1) the United States or an instrumentality thereof; (2) an individual who is a resident of the United States; (3) a partnership, two-thirds or more of the partners of which are United States residents; (4) a trust, if all of the trustees are residents of the United States; and (5) a corporation organized under the laws of the United States or of any State.
Under the FUTA, “American employer” is defined as:
(1) a United States resident; (2) a partnership, two-thirds or more of the partners of which are United States residents; (3) a trust, if all of the trustees are United States residents; and (4) a corporation organized under the laws of the United States or of any State.
Notably absent from the list of entities that fall within the definition of “American employer” are foreign entities. Thus, a foreign entity is not an “American employer” within the meaning of sections 3121(h) and 3306(j)(3). Because a foreign entity is not an “American employer,” services performed by an employee of a foreign entity are not included within the definition of “employment” for FICA and FUTA purposes. Therefore, remuneration paid to the employee of a foreign entity does not constitute “wages” for FICA and FUTA purposes.
In layman’s terms, this means that a U.S. citizen working abroad for a foreign employer is exempt from Social Security and Medicare liability. This leads to an inescapable conclusion: the most desirable option for a U.S. citizen doing business abroad is to form a foreign entity in which he is the sole shareholder and employee.
An example illustrates this point. John is an American citizen. He is hired by a Swiss company to build a ski lodge in Zermatt. The project is expected to last well over a year, with John working overseas the entire time.
How is John taxed for social security purposes? John is working abroad for a foreign company – here, a Swiss company – not an American company. A Swiss 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, he must still pay foreign social insurance tax to the Swiss government because Switzerland is the country in which John earned his income and Switzerland has a social insurance program. However, John need not despair because Switzerland is a country that prides itself as being a true tax haven. Thus, Swiss social insurance taxes are substantially less than social security taxes in the U.S.
If escaping U.S. social security taxation was as simple as forming a foreign entity, then why doesn’t every self-employed U.S. citizen doing business abroad (with half a brain) form a foreign entity? The problem is that it is much easier said than done. This cannot be any more apparent than in the case of an American businessperson who attempts to form a foreign partnership.
Under 3121(h) and 3306(j) of the IRC, the term “American employer” includes a partnership, if two-thirds or more of the partners are residents of the United States. This short definition has sweeping consequences. Implicitly, if a partnership is an “American employer” whenever two-thirds or more of its partners are U.S. residents, then a partnership can only be a “foreign employer” if more than one third of its partners are foreign residents.
This effectively precludes a U.S. businessperson from ever forming a foreign partnership that is exempt from U.S. self-employment and social security taxation. To do so, a U.S. businessperson would have to satisfy two conditions. First, he must have partners. And second, more than one third of those partners must be foreign residents.
Because a self-employed U.S. citizen is not likely to have any partners, let alone foreign partners, any attempt by a U.S. citizen to form a foreign partnership is likely to fail. And it will fail even if the partnership is incorporated in a foreign country and is governed by the laws of that country.
What about the U.S. citizen who forms a foreign entity other than a partnership, such as a corporation? Can that foreign entity avoid being classified as an “American employer” or is it destined to be classified as an “American employer” and suffer the same fate as a partnership – U.S. self-employment taxation? The answer to the former is “no” and to the latter is “yes.”
As a preliminary matter, most foreign entities are partnerships to begin with. But what about foreign corporations? Those countries that embrace the “corporation” as a business entity do so in name only. While foreign corporations possess some of the same characteristics as U.S. corporations, the fact remains that they are hybrid partnerships because a salient feature is that profits “pass through” to shareholders. Because pass through taxation is the trademark of a U.S. partnership, any foreign corporation that possesses that characteristic more closely resembles a U.S. partnership than a foreign corporation. Therefore, the foreign corporation will be reclassified as a U.S. partnership for purposes of U.S. self-employment and social security taxation.
However, if one-third or less of the partners are foreign, as would be the case if the partnership had only one partner and that partner was a U.S. citizen or resident, then the businessperson would have more to worry about than just the reclassification of the foreign corporation. And that is the classification of the partnership as an “American employer.” Therefore, sections 3121(h) and 3306(j)(3) are equivalent to the knock-out punch in a boxing match. They effectively preclude any U.S. citizen from forming a foreign entity that is not an “American employer” for purposes of U.S. self-employment and social security taxation.