This week’s episode is about Social Security tax and self-employment tax, and it tells U.S. citizens and green card holders living and working outside the United States how to not pay those taxes.
Hacker News and Dynamite Circle people (I participate at both places and get frequent tax-related emails from people active in both of them, so this week’s episode is for you) understand that there are good reasons to form a corporation outside the United States in order to do business. Local laws, banking, and visa considerations are three good reasons. There are a ton of dumb reasons, too.
Consider the following scenario, which is useful for a U.S. person living and working abroad as a freelancer, independent contractor, or self-employed person. You may be a digital nomad, perhaps. But this idea will work for any self-employed person or business owner abroad.
Consider the one-person corporation. Here is what you do:
Your non-U.S. corporation goes out into the world and does business. It provides services to customers or sells products. You, as an employee, help make this happen.
The corporation’s customers pay the corporation for the services or products they receive. The corporation pays you a salary. The Circle of Life is complete.
There are two taxes you probably want to avoid: income tax and Social Security tax (or self-employment tax, which is the self-employed person’s equivalent to Social Security tax).
If you qualify for the Foreign Earned Income Exclusion and keep your salary below the appropriate level ($100,200 in 2015) you will not pay income tax on your salary. I am not going to talk about the Foreign Earned Income Exclusion. Go look at Form 2555 and the instructions to that form for more information.
The strategy will eliminate Social Security tax and self-employment tax from your life. Because of the quirks of tax law (and specifically how words are defined differently for tax purposes than they are in the real world), your employer (the foreign corporation) is not required to pay Social Security tax on the wages it pays you, and you (as an employee) are not required to pay Social Security tax, either. Since you are an employee (and not self-employed) you are not required to pay self-employment tax, either.
Don’t be dumb. Your future self may hate you.
I remember very well a call I received a few years ago from a gentleman who had carefully avoided the U.S. tax system for decades while living in Southeast Asia and the Pacific. In his mid-60s he realized that he had never made any contributions to the Social Security system in the United States, and therefore would not be receiving retirement benefits.
You think you are smart, cutting out Social Security tax or Self-Employment tax. You justify the action by saying you will save and invest the tax money and that will serve you well in retirement. Bzzzzp! Wrong. You won’t save the money.
Or you say the U.S. government will be broke by the time you retire and there will be no Social Security payments left for you. No, you are not as clairvoyant as you think.
There are no explanations, only excuses. You want to do this because your cash flow sucks right now and the only way you can make ends meet today is to take money from your future self.
You want to be rich? “Don’t pay Social Security tax” is not the way to do it. “Increase revenue” is the way you get rich. I have seen the future. Get off my lawn.
Social Security tax is imposed on “wages.” When an American citizen or green card holder works abroad for a foreign employer, the payment received for services rendered is not “wages” as defined for Social Security tax purposes.
Your foreign corporation is a foreign employer.
Therefore the compensation you receive for services rendered will not be “wages” for Social Security tax purposes. And as a result, no Social Security tax is imposed.
If you are bored, stop reading here. If you want the deep dive, continue reading.
Here is the deep dive into the technical reasons why this strategy eliminates Social Security tax. I will deal with self-employment tax after this.
Let’s start with the definition of “wages”. This has a tax jargon meaning for Social Security tax purposes:
For purposes of this chapter, the term “wages” means all remuneration for employment, including the cash value of all remuneration (including benefits) paid in any medium other than cash[.]1
We now need to look at the definition of “employment” for Social Security tax purposes.
There are three different definitions of “employment”, but the one that we care about is:
For purposes of this chapter, the term “employment” means any service, of whatever nature, performed … (B) outside the United States by a citizen or resident of the United States as an employee for an American employer[.]2
If you are a U.S. citizen or resident alien, and you are performing services outside the United States, and you are doing so as an employee of an “American employer”, then the wages you receive are “remuneration for employment” and are subjected to Social Security tax.
Conversely, if you are performing services as an employee for someone or something that is not an American employer, then what you are doing is not included in the definition of “employment”. If the money you get is not from “employment”, then the money you get is not “wages”. And if the money you get is not “wages”, there will be no Social Security tax imposed on it.
Let’s look at the definition of “American employer”.
There are five different types of employers identified as being “American”. One of them applies to our situation:
For purposes of this chapter, the term “American employer” means an employer which is … a corporation organized under the laws of the United States or of any State.3
A corporation that is organized under the laws of the United States or any State will be an American employer. Therefore, a corporation that is formed under the laws of a jurisdiction other than the United States or any State will not be an American employer.:
How do you know which laws were used to organize the corporation? Look at the Articles of Incorporation for the corporation. If you find the name of a country that is not the United States, you have a foreign corporation.
Yes, you pay for your own retirement benefits, or a part of those benefits, to be precise. The Social Security tax is paid by an employee on “wages” received:
In addition to other taxes, there is hereby imposed on the income of every individual a tax equal to the following percentages of the wages (as defined in section 3121(a)) received by him with respect to employment (as defined in section 3121(b))[.]5
The salary you draw from your foreign corporation does not meet the definition of “wages” since the money paid to you is not from “employment”. The money paid to you is not from “employment” because working for a foreign corporation is not “employment”.
Since the tax is a percentage of “wages” and there are no “wages”, the Social Security tax you pay as an employee will be zero. Zero multiplied by any percentage will be zero.
Employers pay Social Security tax, too. They contribute money to the Social Security system to fund retirement benefits for their employees:
In addition to other taxes, there is hereby imposed on every employer an excise tax, with respect to having individuals in his employ, equal to the following percentages of the wages (as defined in section 3121(a)) paid by him with respect to employment (as defined in section 3121(b)) … .6
Since “wages” are zero and “employment” does not exist, your foreign corporation is not required to pay Social Security tax on your salary.
I know. You just read something really weird. You work and get paid, but the payments you receive are not wages. You work as an employee for a corporation, but this activity is not employment. Up is down, night is day.
Welcome to tax law. 🙂
After you get over that bemusement, the conclusion still stands. You can conduct your business through a foreign corporation, pay yourself a salary, and be exempt from the Social Security tax system. No Social Security tax payments will be necessary.
For those of you living abroad and working as freelancers, you currently report your income and expense on Schedule C. That is where self-employed people report income on their income tax returns. Your net profit (Line 31) is carried over to Schedule SE, where you compute the self-employment tax you owe on that income.
The net profit from Schedule C is earned income, and can be exempted from income tax using the Foreign Earned Income Exclusion (Form 2555). The self-employment tax computed on Schedule SE cannot be exempted from tax using the Foreign Earned Income Exclusion, because the self-employment tax is not an income tax.
The self-employment tax is imposed on a special type of income – self-employment income:
In addition to other taxes, there shall be imposed for each taxable year, on the self-employment income of every individual, a tax equal to the following percent of the amount of the self-employment income for such taxable year[.]7
Self-employment tax is imposed on self-employment income. “Self-employment income” has a special meaning:
The term “self-employment income” means the net earnings from self-employment derived by an individual (other than a nonresident alien individual, except as provided by an agreement under section 233 of the Social Security Act) during any taxable year … .8
Oh, joy! Let’s go look at the definition of “net earnings from self-employment”, shall we?
Net earnings from self-employment is a defined term. Section 1402(a) says:
The term “net earnings from self-employment” means the gross income derived by an individual from any trade or business carried on by such individual, less the deductions allowed by this subtitle which are attributable to such trade or business … .9
Only an individual who derives money from conducting a trade or business can have net earnings from self-employment. If you are not conducting a trade or business, then you cannot have net earnings from self-employment. And if you do not have net earnings from self-employment, you do not have “self-employment income”. No self-employment tax.
If your corporation is conducting business and you are an employee of the corporation, then you (personally) are not engaged in a trade or business, so your income cannot be self-employment income subject to the self-employment tax.
Thus, by operating your business through a corporation (any corporation–foreign or domestic) you can eliminate the self-employment tax that is otherwise imposed on you, the independent contractor or freelancer conducting your business and making money. By using a foreign corporation, you also eliminate Social Security tax.
This strategy requires a corporation. Not a limited liability company, not a partnership. A corporation. Be sure that the entity you form is treated as a corporation for U.S. tax purposes. And it requires a foreign corporation. This strategy will not work if you use a U.S. corporation. Do not spend money forming a company until you know precisely what type of entity you need, and where it should be located.
Owning shares of stock of a foreign corporation is like juggling with ninja swords. Internal Revenue Service-issued ninja swords.
Your foreign corporation will either be a Controlled Foreign Corporation (Form 5471) or a Passive Foreign Investment Corporation (Form 8621).
You do not want a Passive Foreign Investment Corporation. Trust me. This means that you cannot accumulate a lot of passive assets in your corporation – that usually means cash for an active business. But with attention to detail and help from your friendly international tax enthusiast (Hi there!), you will be in the territory of filing Form 5471 and not Form 8621.
The next thing you want to ensure is that your corporation does not earn “Subpart F” income. This type of income is treated as taxable to you (as the shareholder of the foreign corporation) even if cash is not distributed to you. Surprisingly, even active businesses engaged in active business-like … uhhh … activities can generate this type of bad income.
Where you pay out the entire net profit of your foreign corporation to yourself as a salary, this is not a big deal. But if the corporation’s net profit is more than the salary you are paid, you will want to take care to avoid Subpart F income. Otherwise you will have to pay U.S. income tax on the extra profit that you thought belonged to the corporation and not to you. Again, you will want your friendly international tax buddy along for the ride to prevent accidental taxation of income.
Penalties are a problem. The IRS policy on late Form 5471s is to impose a $10,000 penalty up front, then force you to shovel snow uphill (both ways) in Hell in the summertime to get the penalty removed, and maybe that will happen (or maybe not). The IRS has even been known to throw a $10,000 penalty at people who file on time but do not fill in Form 5471 completely.
There are other forms to watch out for, too. Form 926 comes to mind. This is used when a U.S. person contributes capital to a foreign corporation.
I want to be clear. This strategy will work. But is it right for you, quite apart from the “Get off my lawn” advice? What is the cost/benefit of this strategy?
The added overhead of running a foreign corporation correctly for U.S. tax purposes is probably going to come close to the amount of self-employment tax you are paying. This expenditure makes sense when your profits are high, or if there are other reasons for setting up the foreign corporation structure so that you are incurring the U.S. tax paperwork requirements anyway.
You should be willing to absorb the risk of a $10,000 penalty or two for screwing up the tax filings. Minimize that risk by being (or hiring) the right kind of competent human. You might think that doing it yourself is cheaper. You’d be wrong. All those hours spent working on tax accounting are hours that you are not spending to create new customers.
So. If you are going to be out of pocket $10,000 every year, where would you like that money to go? Toward your eventual retirement benefits? Or to expensive tax talent and occasionally to the IRS as penalties?
I’m not saying this is a dumb idea. It isn’t. At some point your business must put on the Big Boy Pants, and multiple corporations are part of that stage of the business life cycle. What I am saying is that saving Social Security tax will not get you there, and if the only reason you are thinking about a foreign corporation is to save this tax, you’re not keeping your eye on the ball.
I will be attending the Tropical MBA Mastermind in Singapore. It is scheduled for February 20-23, 2015, and will be a speaker at the event.
I am paying my own way and get nothing from promoting the event. We will probably talk about this week’s topic and many other tax topics of interest to entrepreneurs and digital nomads.
If you meet the financial qualifications (basically, would you be an accredited investor for U.S. securities law purposes?), you should go. Attendance is capped at 30, and the last time I checked, they had 6 slots open.
The way I look at it, you could get your money’s worth from attending, just by hearing with one good idea.
It is definitely worth the jet lag for me.
Thanks for reading all the way to the end of this first edition of the Friday Edition. Topic suggestions and comments are welcome. Shoot me an email by hitting “Reply” and send me your thoughts.
Stay tuned for next week’s Friday Edition. And if you want a weekly dose of exit tax information, subscribe to the Expatriation Only mailing list, where every Tuesday I answer someone’s question (maybe yours?) about expatriation and the exit tax.