I. A Lesson for the Ages: If You Can’t Beat Them Join Them – continued
a. The C Corporation – An Entity to Avoid
The self-employed U.S. citizen or resident doing business abroad should think long and hard before forming a U.S. corporation in which he is the sole shareholder and employee. Before explaining why this is so, it is necessary to cover a fundamental concept of U.S. international taxation. United States citizens are taxed on their worldwide income regardless of its source – i.e., regardless of whether the income’s origin is foreign or domestic. Noncitizens, who are classified as resident aliens for income tax purposes, are also subject to U.S. income taxation on their worldwide income.
Much to the chagrin of U.S. citizens or residents working abroad for U.S. employers, the U.S. government does not exempt such individuals from social security taxation. That tax is withheld from their wages in the same manner as U.S. citizens working inside the United States.
As in the case of a U.S. citizen working in the United States, the employer’s portion of the social security tax is calculated based upon the employee’s wages. That portion is deductible as an expense by the company and is used to reduce taxable income.
Consider the hypothetical involving John, with a slight variation. John is hired by an American firm to design and build a hotel in London. The firm is a U.S. C corporation. John is an employee of the corporation. The project is expected to last over a year, with John working overseas the whole time. In exchange for his services, John will receive $ 90,000 (U.S.). For the reasons discussed above, John is still exempt from federal income taxes.
The seminal issue is how should John be taxed for social security purposes? As a preliminary matter, the firm is an “American employer” for purposes of Section 3121(h) or Section 3306(j)(3) because it is a corporation organized under the laws of the United States. Because John works overseas for an American employer and because American employers must withhold social security tax from any employee that works overseas so long as that employee is either a U.S. citizen or resident, the withholding requirements apply.
Therefore, it appears that John must pay U.S. social security taxes on all $ 90,000 of his income. A slight digression is in order here. Incredibly, John’s U.S. social security tax liability is based merely on the nationality of his employer and not upon the type of work he was doing or where he was doing it. If John worked for a foreign company, then his story would have a very different ending, at least as far as U.S. social security taxation is concerned.
Part and parcel of John’s social security taxation liability is whether England has its own social insurance program. If so, John must pay into that program because he is performing his services in England and an employee must pay social insurance taxes to the foreign country in which he works. Here, England has its own social insurance program. Does that mean that John must pay social insurance taxes to England and social security taxes 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.
Fortunately for John, a totalization agreement between the United States and England exists. The purpose of a totalization agreement is to provide relief from double social security taxation. It accomplishes that goal by ensuring that social security tax is only paid once on the same income – to one of the two countries.
Under the terms of the totalization agreement between the United States and England, John and his employer need only pay social security taxes to the United States government. In that way, they are covered under the United States social security system, not the U.K. social security system. The end result is that John’s wages are only subject to U.S. social security taxation.
Failure to satisfy the requirements of the foreign earned income exclusion illustrates how drastically John’s tax liability would increase. Assume that John does not meet the “qualified individual” requirement for the foreign earned income exclusion. Not only would John be subject to U.S. social security taxation, but he would also be subject to U.S. federal income taxation, New Jersey state taxation, and social security taxation.
The only thing worse than not qualifying for the foreign earned income exclusion would be not qualifying for the foreign earned income exclusion and being subject to both U.S. and foreign income taxation. Such a result is not as unlikely as it seems, especially since the United States has totalization agreements with only twenty-four of the world’s one hundred ninety-six countries (http://www.irs.gov/businesses/small/international/article/0,,id=105254,00.html) (http://geography.about.com/cs/countries/a/numbercountries.htm). Fortunately for John, the totalization agreement between the United States and England eliminates any risk that his foreign source income will be taxed twice.
What if the United States did not have a totalization agreement with England? Absent a totalization agreement, John’s tax liability would soar to unimaginable heights. Without question, this would be the stereotypical “doom’s day” scenario for a U.S. citizen working abroad. Not only would John’s income be subject to U.S. federal income taxation, New Jersey state taxation, and U.S. social security taxation, but it would also be subject to British income taxation and British social insurance taxation.
On the positive side, John would be allowed to take a foreign tax credit on the foreign income taxes paid to the British government. A key feature of the U.S. tax system is the foreign tax credit. The purpose of a foreign tax credit is to mitigate double taxation of foreign-source income. Under a credit system, the home country taxes the foreign income of its citizens and residents. However, it allows a credit for any foreign taxes paid on that income. The net result is that foreign income is taxed only once at the higher of the host country’s rate or the home country’s rate.
Practically speaking, all that’s happening here is that the home country is solving the double taxation problems of its citizens and residents by forfeiting all or part of its jurisdictional claim over their foreign-source income. In that way, the home country asserts secondary jurisdiction over the foreign income of its citizens and residents.
The foreign tax credit in this example would result in a dollar-for-dollar reduction of John’s U.S. federal income tax, subject to a few limitations. Unfortunately, as its name reveals, a foreign tax credit does nothing more than provide a credit. Unlike the foreign earned income exclusion, a foreign tax credit does not exclude income from taxable income. In other words, John must still pay state taxes, social security taxes, and taxes to the British government. Of course, John would only have to pay U.S. federal income taxes to the extent that the amount of federal income tax exceeded the allowable U.S. foreign tax credit.