Recommendations to Assist Self-Employed U.S. Citizens Working Abroad Avoid or Reduce Self-Employment Taxes and Social Security Taxes – continued
c. Forming a Foreign Affiliate of an American Employer
A more practical solution for the self-employed U.S. citizen seeking to avoid U.S. self-employment and social security taxation is to form a foreign affiliate of an American employer. The term “foreign affiliate” is defined in two sections of the IRC: 26 U.S.C. 3121(l)(6) and 26 U.S.C. 3121(l)(8). Under 26 U.S.C. 3121(l)(6), a foreign affiliate of an American employer is defined as any foreign entity in which an American employer has at least a 10% interest. This 10% interest is determined by a 10% ownership of the stock of a corporation or a 10% ownership of the profits of a non-incorporated entity.
Under 26 U.S.C. 3121(l)(8), “foreign affiliate” is defined as any foreign corporation in which the American employer owns – directly or indirectly – at least 10% of the voting stock. Thus, a second-tier or lower-tier foreign subsidiary may be covered by a FICA election, provided that the American employer indirectly owns at least 10% of the voting stock of the foreign company that is covered by the election.
How does being a foreign affiliate of an American employer allow a self-employed U.S. citizen to avoid U.S. self-employment and social security taxation? A foreign affiliate operating in a foreign nation is generally not subject to the tax laws of the United States. Therefore, it will be taxed like a foreign company, and any U.S. employees that work for the affiliate will not be subject to U.S. Social Security tax.
The value in forming a foreign affiliate lies in its flexibility. For example, just because the company is a foreign affiliate does not preclude an American employer from making a one-time, irrevocable election to be subject to U.S. Social Security tax. That election must be made under 26 U.S.C. 3121(l). Under the election, an American employer must pay the full FICA (both employee’s and employer’s share) on all U.S. citizens and resident aliens employed by the foreign affiliate.
For an employer trying to qualify her employees for Social Security benefits, this is a valuable election. For an employer trying to reduce her own expenses, this should clearly be avoided.