How to Not Pay U.S. Social Security Tax While Working Abroad

Americans who move abroad to work face a particularly difficult job in preparing tax returns. Let's cheerfully ignore income tax problems today, and instead look at Social Security taxes.Technically, I am talking about FICA¹ taxes: the taxes you pay to fund your old-age pension, survivor's pension, disability insurance, and Medicare benefits. But for simplicity's sake--and to match the way normal people talk about these taxes--I will refer to these taxes as "Social Security" taxes.Let's look at the semi-established digital nomad. You are a U.S. citizen who owns an operating U.S. business, formed as a corporation. You plan to move abroad and travel for a few years. While traveling, you will continue to work in your business and draw a salary from your business.It is not terribly difficult to zero out your U.S. income tax on that salary. Make sure you qualify for the foreign earned income exclusion and you can earn a salary of $101,300 (in 2017) completely free of U.S. tax.But Social Security tax. That's another thing entirely. The total tax payable on that $100,000 salary will be $15,300:

• Social Security tax of $6,200 paid by you, as the employee;²
• Social Security tax of $6,200 paid by your business, as the employer;³
• Medicare tax of $1,450 paid by you, as the employee;⁴ and
• Medicare tax of $1,450 paid by your business, as the employer.⁵

What if you would rather not pay $15,300 in total Social Security and Medicare taxes? Alternatively, what if you are living in a country that has its own social security tax system, and you would rather not have to pay U.S. Social Security tax and the other country's tax, too?

The Territorial Rule: Work in the USA

The basic concept for Social Security tax is territorial: if you work in the United States, you pay Social Security tax.⁶The key concept is where the services are performed. The identity and location of the employer is not relevant. The employee's status (citizen, resident, nonresident, etc.) is not relevant.

Exception: Work Outside the USA, Too

A U.S. citizen or resident alien who is working outside the United States for an "American employer" must pay U.S. Social Security tax, too.⁷An American employer is, among other things:

• An individual who is a U.S. resident;⁸
• a partnership, if two-thirds or more of the partners are residents of the United States;⁹ or
• a corporation organized under the laws of the United States or of any State.¹⁰

Key point to remember: if your employer is an "American employer" while you are working abroad, you pay U.S. Social Security tax. If your employer is not an "American employer", you do not pay U.S. Social Security tax.

ExampleYou own a U.S. business that is organized as a Delaware corporation. You decide to become a digital nomad. You will continue to draw a salary from your business while you perform services while traveling abroad.Because you are providing services for an "American employer" you will be required to pay U.S. Social Security tax on your wages.

Create a Foreign Employer to Eliminate U.S. Social Security Tax

What if you do not want to pay U.S. Social Security tax while you are living the digital nomad lifestyle, traveling and working abroad?¹¹Remember that U.S. Social Security tax is imposed on Americans abroad only if they are working for American employers. The strategy is simple: be employed by a company that is not an "American employer".

ExampleYou own a U.S. business that is organized as a Delaware corporation. You decide to become a digital nomad, traveling the world and working remotely as you go.Your Delaware corporation forms a foreign corporation as a wholly owned subsidiary. You work for that foreign corporation, and are paid a salary from that foreign corporation.Because you working outside the United States and are NOT providing services to an "American employer", you will be NOT required to pay U.S. Social Security tax on your wages.

Setup and Operating Costs

Creating a foreign corporation costs money. Not a lot, but some money.The cost to form and operate the foreign corporation is probably less than the amount of Social Security tax you will pay.

Accounting Costs (Form 5471)

However, owning a foreign corporation is exceedingly expensive when it comes to preparing U.S. income tax returns. The accounting costs and tax return preparation costs for Form 5471 (PDF) can easily chew up the Social Security tax savings you expect to achieve.And if you screw up the Form 5471, the IRS is likely to throw a $10,000 penalty at you.

How To Cut Your Accounting Costs

You can reduce the tax paperwork costs by eliminating the requirement for filing Form 5471. Here is a strategy that will eliminate the ghastly expense and complexity of Form 5471, and replace it with the less ghastly and less expensive Form 8858.

ExampleForm a foreign corporation as the wholly owned subsidiary of your Delaware corporation. You, the digital nomad, will work for that foreign corporation.Make a "check the box" election¹² (see Form 8832 (PDF)) to have the foreign corporation disregarded for U.S. tax purposes. This radically simplifies the accounting and tax work required to keep the IRS happy.Your Delaware corporation will file Form 8858 (PDF) to report that it owns a foreign disregarded entity. The work required for this form will be less than the work required for Form 5471, so it will be cheaper.

So far, all we have done is reduce your annual accounting and tax return preparation fees. This is a Very Good Thing, but now let's look at the Social Security tax situation.Even though the foreign corporation is now disregarded for U.S. tax purposes, it is still treated as a corporation for Social Security tax purposes.¹³Hey presto: you are employed by a foreign corporation and not by an "American employer". No U.S. social security tax.

Find a Totalization Agreement

"Totalization Agreement" is the bureaucrat's way of describing a treaty between the United States and another country that is limited to synchronizing the two countries' social security systems.The United States has a number of totalization agreements.As a general principle, these totalization agreements allow for short term exemptions (up to five years) from the resident country's Social Security system.

ExampleYou own a U.S. business that is organized as a Delaware corporation. You decide to become a digital nomad. You will continue to draw a salary from your business while you perform services while traveling abroad.Because you are providing services for an "American employer" you will be required to pay U.S. Social Security tax on your wages.However, you will be living in Spain for two years, working. Spain has a totalization agreement with the United States. If you do the paperwork correctly, you will be exempt from Spanish social security taxes, and will contribute solely to the U.S. social security system.

Totalization agreements are useful. They eliminate double-application of social security taxes, and they save you from making contributions to a country's social security system where you will never draw a retirement pension. You will, of course, continue to pay U.S. Social Security taxes, but I treat that as a feature, not a bug.Totalization agreements are not everywhere. If you can use one to your advantage, I think you should.