Foreign Earned Income Exclusion and Self-Employment Income

Self-employed people are enterprises engaged in commerce without using a business entity, like a corporation or limited liability company. Human-scale businesses can be large, and even be multinational enterprises: doing business within the grasp of multiple countries’ tax systems.

An American entrepreneur living and doing business abroad is by definition a multinational business: his country of residence and the United States both assert the right to tax him.

For purposes of demonstrating basic tax principles, let’s assume we have an American management consultant living and working in Dubai. No spy stuff, just commerce.

The Taxes

An American living and working abroad is fully taxable by the United States, simply because he is a U.S. citizen.

U.S. Income Tax and Countermeasures

American citizens living abroad calculate their income tax just like U.S. citizens living in the United States. However, American citizens abroad have two counter-measures not available to their domestic counterparts. These two countermeasure can reduce the amount of U.S. income tax payable:

• Foreign tax credit. Paying a dollar’s worth of income tax in a foreign country can reduce your U.S. income tax bill by a dollar.¹ Form 1116.
• Foreign earned income exclusion. For earned income (you work, you get paid) it is possible to exclude income entirely from being taxed in the United States. Up to a limit, that is. Again, certain terms and restrictions apply. Form 2555.

Self-Employment Tax and One Countermeasure

American citizens living and working abroad must pay self-employment tax. When you are an employee, you contribute to the Old Age Pension scheme run by the Social Security Administration by paying social security taxes. Your employer also pays these taxes on your behalf. But when you are self-employed, you are the employee and the employer. So you pay the same amount of tax, except this is called self-employment tax.

There is one countermeasure possible. You do not need to pay U.S. self-employment tax if you can qualify to eliminate it under a treaty between the United States and your country of residence. These treaties are called totalization agreements. Instead of contributing to the U.S. Social Security system (by paying self-employment tax) you contribute to your country of residence’s social security system by paying its equivalent tax.

Our Consultant in Dubai

Here, let’s look at the U.S. tax calculations for our American management consultant in Dubai. The United States does not have a totalization agreement with the United Arab Emirates, so we will ignore totalization agreements and just consider self-employment tax rules in their pure and unadorned form.

The United Arab Emirates does not have an income tax, so the only income tax countermeasure available to reduce U.S. income tax for our American Abroad is the foreign earned income exclusion.

Let’s see how all of the rules work together. Let's look at the interaction of

• Schedule C;
• Form 2555; and
• Schedule SE.

The Foreign Earned Income Exclusion and Form 2555 Generally

American citizens and green card holders must file tax returns and pay income tax, no matter where they live and where they work.

The foreign earned income exclusion² says that a certain amount of "foreign earned income" will not be taxed for Americans living and working abroad. The amount of "foreign earned income" that is not taxed is $104,100 for 2018³

"Earned income" is money you make by providing services to people. That includes the money a self-employed person receives for building websites, or doing management consulting. Earned income if "foreign" if, when you did the work, you were in a foreign country.⁴

There are some procedural requirements you must satisfy: you really truly live outside the United States, basically.⁵ Let's assume you have those requirements covered.

You claim this tax benefit by filling in Form 2555 and attaching it to your income tax return.

How Self-Employed People Report Business Income on Schedule C

A self-employed person reports income and business expenses on Schedule C attached to Form 1040.

Start with Line 1 ("Gross Receipts") which includes all of the money you received from doing business during the year. Make a few adjustments, and you have Gross Income on Line 7.

Then, deduct business expenses, do some simple subtraction, and you have Net Profit on Line 31. This is your business profit for the year.

Net Profit Gets Taxed Twice

Net Profit from self-employment gets taxed twice:

• You pay income tax on Net Profit.
• In addition, you take that your Net Profit amount from Line 31 of Schedule C, put it on Schedule SE and calculate self employment tax.

The calculations get a little complicated when applying the foreign earned income exclusion to self-employment income.

Net Profit from Self-Employment on Schedule C

Let's say the management consultant living in Dubai generates $150,000 of gross revenue (customers paid this much money) and had $50,000 of business expenses. Before taking into account the foreign earned income exclusion, his calculation of net profit on Schedule C looks approximately like this:

Foreign Earned Income Exclusion and Self-Employment Income

At first blush, this looks like a winner. The amount of foreign earned income is $104,100 for 2018. The American living in Dubai made $100,000 of net income from self-employment. That should mean zero income tax, right?

Wrong.

The foreign earned income exclusion applies to gross income. That is revenue before expenses. Net profit is income after expenses.

"At the election of a qualified individual . . . , there shall be excluded from the gross income of such individual, and exempt from taxation under this subtitle, for any taxable year . . . ."⁶

Well, you think. Not so bad. I deduct the maximum foreign earned income exclusion for 2018 from my gross income on Schedule C, and that will take me from profit to loss for the year:

You have excluded some of your gross income from taxation (as required by the Code), and then calculated your net profit. Net profit turned out to be a loss, so you pay zero income tax. Right?

Wrong.

If you have income that is taxed, you can take a deductions for the expenses incurred in earning that income. If the income is not taxed, you cannot take a deduction for the expenses incurred in earning that untaxed income.

"No deduction . . . shall be allowed to the extent the deduction . . . is properly allocable to or chargeable against amounts excluded from gross income under section 911(a)."⁷

You are excluding some of your gross income because you are claiming the foreign earned income exclusion. This means you must exclude from deductions a portion of the business expenses you had for the year. To figure out how much of the business expenses are not tax-deductible, you need to create a fraction:

Foreign Earned Income Exclusion Claimed / Gross Income

For our example, the amount is $104,100 divided by $150,000 = 0.694.

In our example, we have $50,000 of business expenses that are tax-deductible, before considering the foreign earned income exclusion. But 69.4% of those business expenses were incurred to generate gross income that is not taxed. That means $50,000 x 69.4% = $34,700 of business expenses are NOT tax deductible. That leaves $50,000 - $34,700 = $15,300 of business expenses that ARE deductible.

The result, then is a Schedule C calculation that looks like this:

The $30,600 of net profit carries over to Form 1040, Line 12, and from there it gets taxed along with your other income.

In summary, the effect of the foreign-earned income exclusion is to reduce your taxable income (net profit) from $100,000 to $30,600. A nearly 70% reduction in taxable income means your tax bill will be reduced by 70% as well.

Self-Employment Tax and the Foreign Earned Income Exclusion

You might reduce or eliminate your income tax liability with the foreign-earned income exclusion. You cannot, however, use the foreign-earned income exclusion to reduce your self-employment tax.

Self-employment tax is a percentage of "self-employment income."⁸

Self-employment income means "net earnings from self-employment derived by an individual".⁹

"Net earnings from self-employment" means gross income from self-employment minus allowable deductions.¹⁰ Critically for our purposes, however, gross income is not reduced by the amount of foreign earned income exclusion under IRC § 911.

"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, plus his distributive share (whether or not distributed) of income or loss described in section 702(a)(8) from any trade or business carried on by a partnership of which he is a member; except that in computing such gross income and deductions and such distributive share of partnership ordinary income or loss--

(11) the exclusion from gross income provided by section 911(a)(1) shall not apply."

Let's go back to our example. Our American management consultant has $150,000 of gross income (payments from customers for services rendered) and $50,000 of business expenses. Remember how we reduced gross income by the foreign earned income exclusion amount of $104,100, and we also reduced the amount of business expenses deducted in computing net profit?

For self-employment tax calculation purposes, we cannot reduce gross income by the foreign earned income exclusion amount. That means we also do not reduce the amount of business expenses. For self-employment tax, Line 31 will show $100,000 of net profit, which will be subjected to the self-employment tax:

The net profit of $100,000 for self-employment tax purposes on Line 31 will be passed through to Schedule SE, where it will be subjected to tax at 15.3%.¹¹

Meanwhile, the net profit on Line 31 is $30,600 for income tax purposes, which is passed through to Form 1040, Line 12, where it is included in gross income and will be subjected to income tax (after various adjustments, deductions, etc.).

Conclusion

The point of this little exercise is to show two things:

• The foreign earned income exclusion is not terribly efficient at eliminating income tax for American self-employed individual living and working abroad.
• Self-employment tax is unaffected by the foreign earned income exclusion.

The next step in tax planning for my hypothetical Dubai-based American management consultant is to consider other methods of doing business: through a U.S. S corporation, a foreign corporation, or a foreign corporation that elects to be disregarded for U.S. tax purposes. Each of these can have interesting effects: enhancing the effectiveness of the foreign earned income exclusion, and eliminating self-employment tax and Social Security tax.

That’s a topic for another time.