US Social Security and Medicare taxes continue to apply to “wages” for services performed as an employee working outside of the United States if you are working for an “American employer”. Many Americans abroad are employees of a foreign employer and I will write a separate blog post about their situation. Many Americans abroad are self-employed and running their own business. For them, the “Self-Employment” tax comes into play, and it can get expensive. This is the focus of today’s blog post.
What is Self-Employment Tax?
The self-employment tax is a social security and Medicare tax based on net earnings from “self- employment”. We’ll review what it means to be “self-employed” later in this posting. The dollar threshold trigger for paying self-employment tax is quite low – you must pay self-employment tax if your net earnings from self-employment are at least US$400.
For 2021, the self-employment tax rate is 15.3% on the first US$142,800 worth of net income (up from $137,700 in 2020). That rate is the combination of 12.4% for Social Security (old age, survivors, and disability insurance) and 2.9% for Medicare. These rates reflect that if you are paying self-employment tax, you are paying both portions of Social Security and Medicare, that of the employer and the employee.
If you are a “self-employed” US citizen or US resident, the rules for paying self-employment tax are generally the same whether you are living in the United States or living and working overseas.
A “Totalization Agreement” entered into between the US and the foreign country where the individual is living and working, may prevent the individual from being subject to self-employment taxes in both countries. More on Totalization Agreements in an upcoming blog post.
Effect of Foreign Earned Income Exclusion (FEIE)
You must take all of your self-employment income into account in figuring your net earnings from self-employment, even income that is exempt from income tax because of the FEIE. Briefly, for those who may not be familiar with the FEIE, Americans working abroad may be eligible to exclude certain foreign earned income (wages, compensation for services) from US taxable income under the FEIE rules, and certain foreign housing costs paid by their employers. If one is self-employed, then instead of taking a housing exclusion, a housing deduction is taken which further reduces the amount of taxable income.
It often comes as a rude awakening, however, that the FEIE amount will not reduce self-employment income. While regular income tax will be reduced, the permissible exclusion for income earned abroad will not reduce self-employment tax. Here is an example:
You work in Dubai as a business consultant and qualify for the FEIE. Your foreign earned income is US$100,000, your business deductions total $27,000, leaving you with a net profit of $73,000. You must pay self-employment tax on all of your net profit ($73,000), even though you do not owe income tax because all of the foreign income is excluded based on the FEIE (assuming you properly file your tax return and claim the FEIE). Your self-employment tax would be US$11,169 (15.3% of $73,000).
All of my blog posts about the FEIE and foreign housing exclusions can be found here.
Who is Self-Employed?
Generally, you are “self-employed” if any of the following apply:
- You carry on a trade or business as a sole proprietor or an independent contractor.
- You are a member of a partnership that carries on a trade or business.
- You are otherwise in business for yourself (including a part-time business)
Employee or Independent Contractor?
The general rule of thumb is that an individual is not treated as “self-employed’ for US tax purposes if he is categorized as an “employee”. An individual is treated as an “employee” for federal employment tax purposes if the individual has the status of an “employee” under the usual common law rules that are applied in determining whether an employer-employee relationship exists. Guidelines for determining whether an employer-employee relationship is in place are found in three substantially similar sections of the Employment Tax Regulations. These are Sections 31.3121(d)-1(c) (FICA Regulations); 31.3306(i)-1 (FUTA Regulations); and 31.3401(c)-1 (Federal Income Tax Withholding Regulations).
Overall, these sections provide that an “employer-employee” relationship exists when the person or persons for whom the services are performed have the right to control and direct the individual who performs the services, not only as to the result to be accomplished by the work but also as to the details and means by which that result is to be accomplished. That is to say, an “employee” is subject to the will and control of the employer not only as to what shall be done, but as to how it shall be done. It is not necessary that the employer actually direct or control the manner in which the services are performed. The various Regulations mentioned previously, provide that it is sufficient if the employer has the right to do so.
The Internal Revenue Service (IRS) had published an aid to determining whether an individual is an “employee” under the common law rules. Revenue Ruling 87-21 analyzes twenty factors that have been identified as indicating whether sufficient “control” is present to establish an employer-employee relationship. The twenty factors focus on the degree of “control” over the worker and have been developed by examining cases and rulings that considered whether an individual should be treated as an employee.
While the IRS doesn’t use this precise 20-factor test anymore, the agency still uses the underlying principles to help in the classification whether one is an employee or independent contractor (self-employed). The twenty factors include such items as whether the worker is required to comply with instructions about when, where, and how to work; whether training is given to the worker (whether by an experienced employee; correspondence, attendance at meetings); whether the worker’s services are integrated into the business operations generally, as this indicates control by the owner of the business; whether the services must be rendered personally – if so, this indicates control as presumably the person for whom the services are performed is interested in the methods used to accomplish the work; whether the person for whom the services are performed hires, supervises, and pays assistants since this indicates control over the workers on the job; whether the worker is providing services on a full-time basis; whether he is provided with tools and a place to work as well as if he has set working hours.
The mere fact that the parties label their relationship as an “employer-employee” relationship will not be determinative. If, in substance, the worker is an independent contractor, he will be treated as such by the IRS and self-employment tax will be assessed. Obviously, this can get tricky when one is working overseas since the local employment laws and rules may have an impact on the situation. If there is any doubt as to your status, you should seek competent US taxation advice and I am here to help.
Paying Self-Employment Tax
If you are self-employed, you will likely have to pay quarterly Estimated Taxes. You can use these estimated tax payments to pay your self-employment tax. Refer to the Estimated Taxes page and Publication 505, Tax Withholding and Estimated Tax for more details on paying self-employment tax with Estimated taxes.
Circumventing Self-Employment Tax
One method that can be considered is the creation of a foreign entity, such as a foreign corporation and being hired by that entity to serve as its “employee”, generally with full salary being eligible for the FEIE and elimination of self-employment tax concerns . Whether this is a viable solution will require very careful consideration of many factors and professional tax advice should be sought. For starters, one must consider the US tax impact of owning a foreign corporation – one’s life can get very complicated when owning a foreign entity. Professional advice is required to make sure the structure is sound from a US tax perspective. This is an area in which I can help. My tax return preparer colleagues can make sure the tax and various foreign-related information returns are timely and properly prepared.
Posted October 7, 2021
All the US tax information you need, every week –
Just follow me on Twitter @VLJeker (listed in Forbes, Top 100 Must-Follow Tax Twitter Accounts 2017-2021).
Subscribe to Virginia – US Tax Talk to receive my weekly US tax blog posts in your inbox. My blog specializes in foreign and US international tax issues.
You can access my papers on the Social Science Research Network (SSRN) at https://ssrn.com/author=2779920