Check-the-Box Election and Self-Employment Tax

This topic came up by way of a question by email from a new member of our ​International Tax Law community​.

Background

Making the check-the-box election for a foreign operating business will make sense for many people. Certainly, it eliminates the dreaded Form 5471, and simplifies U.S. tax compliance.

But it may come with an added and unexpected tax cost: self-employment tax in the United States. If the American entrepreneur abroad is also paying employment taxes in the other country, that’s a net loss. Contributing to two countries’ Social Security systems is not the best idea in the world.

With that, let’s look at a simple situation that explores one of the edges of the check-the-box election: when a disregarded entity is (or is not) treated as a disregarded entity.

Facts

A foreign company is owned by Wife. Husband is an employee of the company.

The company is classified as a corporation for foreign country tax purposes and as a disregarded entity for U.S. tax purposes.

For foreign country tax purposes, both H and W are paid wages. They pay income tax and the foreign country equivalent of Social Security tax on the wages.

Questions

Must Wife pay U.S. self-employment tax on the foreign company's net income? (Yes).

Are Husband's wages subject to U.S. Social Security tax? (No).

Disregarded for everything, except some things

Start with the assumption that the foreign company is a disregarded entity.

For U.S. income tax purposes, Wife’s sole proprietorship because it is an entity disregarded from its owner. Reg. §§301.7701-2(a), 301.7701-2(c)(2)(i).

“Disregarded” status does not apply across the board. There are exceptions where the disregarded entity is treated as a corporation. Reg. §301.7701-2(a).

One exception is for employment tax purposes. Reg. §301.7701-2(c)(2)(iv)(B). “Employment tax” means Social Security, Medicare, and Federal Unemployment Tax on wages paid to employees.

Husband’s wages are exempt from U.S. Social Security

Let’s look at the Husband’s wages paid by the foreign company.

Social Security taxes are imposed on an employee’s “wages received with respect to employment.” IRC §3101(a), 3111(a).

“Employment” means, among other things, a U.S. citizen or resident alien working outside the United States for an “American employer.” IRC §3121(b)(B).

A foreign disregarded entity is treated as a corporation for employment tax purposes. Reg. §301.7701-2(c)(2)(iv)(B). And if the Internal Revenue Code treats the foreign entity as a corporation, it must be a foreign corporation—after all, it was organized under the laws of a foreign country.

A foreign corporation cannot be an “American employer.” Only a domestic corporation can be an American employer. IRC §3121(h)(5).

Husband’s wages were paid by a foreign corporation (not an American employer) for services performed outside the United States. This is not “employment” as that word is used in IRC §3121(b).

As a result, Husband’s wages from the foreign company owned by Wife are not “received by the individual with respect to employment (as defined in section 3121(b).” IRC §§3101(a), (b).

Thus, Social Security tax is not imposed on the employer or the employee.

Wife pays self-employment taxes

The exception for Social Security taxes (“treat a disregarded entity as a corporation”) does not apply to self-employment taxes imposed on a sole proprietor. This is self-evident from the fact that self-employment taxes are imposed by IRC §1401, while the employment taxes are imposed by IRC §§3101-3512.

It is also explicitly called out in Reg. §301.7701-2(c)(2)(iv)(C)(2).

Example in the Regulations

The Regulations have an example that is almost exactly on point (except for the fact that the disregarded entity, in our case, is foreign).

Reg. § 301.7701-2(c)(2)(iv)(D) gives the example of a single-member LLC (named LLCA in the example) that is classified as a disregarded entity. The sole member is A.

In part (iii) of the example, the effect of disregarded entity status on self-employment tax is addressed:

Double taxation

This obviously causes a double-taxation problem for Wife in my example. She is subject to the foreign country employment taxes (because she receives a salary) and to U.S. self-employment tax on her Form 1040.

​Totalization agreements​ can help. But there are not a lot of them, so maybe this solution is not available to prevent double imposition of employment taxes.