Social Security, Self-Employment Tax Eliminated
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:
- Form a corporation in any country outside the United States;
- (Optional but customary) Own all of the shares of the corporation;
- (Optional but customary) Be the sole officer and director of the corporation;
- Be an employee of the corporation (often the only employee);
- Do all of the work while you are outside the United States; and
- Have the corporation pay you a salary.
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.
Success Looks Like …
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).
Income 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.
Social Security/Self-Employment Tax
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.
Warning Shot/Pre-emptive Strike
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.
TL;DR: Why It Works
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.
Deep Dive: Why You Do Not Pay Social Security Tax
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.
“Wages” Defined
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.
“Employment” Defined
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”.
“American Employer” Defined
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.:
- If B, then A
- Not A
- Therefore not B 4
In English:
- If it is an American employer, then the corporation is organized under the laws of the United States or a State.
- Your corporation is not formed under the laws of the United States or a State.
- Therefore your (foreign) corporation is not 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.
Social Security Tax on Employees
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.
Social Security Tax on Employers
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.
Conclusion: No Social Security Tax
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.
No Self-Employment Tax
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.
Self-Employment 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 Income” Defined
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” Defined
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.
Foreign Corporation Only
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.
“Thar Be Dragons!” Exclaimed the Juggling Ninja
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.
Cost/Benefit?
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.
Singapore in February (Shameless Promotion)
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.
The End
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.
Thanks, Phil. 🙂
How is it supposed to work, if you live overseas (with the legal right to work) but your income is from the US…. does it still count towards the $100k limit you have towards tax exemption as an expat? And if it’s self-employment, what happens to that self-employment tax? You still have to pay that, in the US, even if you’re not living in the US, and you earn less than $100k?
What would happen if I gave up my citizenship (once I get foreign citizenship)? What tax would I have to pay on that same income from the US, if I’m not a US citizen and not living in the US?
I’ve also been researching places like Panama… where they don’t tax you on foreign earned income… I’m thinking of all possible combinations here and trying to figure out how they would work. Like, for example…
1. Being a US citizen with a US online income source, living in Panama.
2. Being a citizen of somewhere else, maybe an EU country, earning online income from the US, living in Panama.
I don’t know that I would earn enough to make it worth the trouble of starting a business for it, and I want to simplify my life anyway…. not add more responsibilities and paperwork… I’m glad to contribute what I can afford to good causes, to savings, to road-building or whatever… but I have a problem when nearly every year, the IRS wants pretty much exactly as much as I’ve been able to save, if not more, setting me back every single year and stealing my life from me as if my sole purpose in life is to earn money for their debt. I’m just trying to get my life back.
@Kendal,
If you are a U.S. citizen or U.S. permanent resident (i.e., you have a green card) you will be taxable on your worldwide income no matter what. There are things you can do that will:
Those processes involve setting up a foreign corporation to be used to run your business. It will cost you money and it will cost you some attention diverted away from your business. Whether the tax savings are worth it (attention in my opinion is more valuable than money) is up to you.
If you are an American living in another country, it is likely that one of two things is true. The first one is that you are there on a visa status that does not permit you to work (like a tourist visa) and the country will kick you out if they find you are running a business within their boundaries, even an online business. The second one is that you are entitled to work and should be paying tax.
There are some places where you can go and work for a while (legally) without trouble. But for the most part the digital nomad lifestyle depends on flying under the radar in the country of choice. This may make you uncomfortable. Or not.
In my experience, the Canadian system is particularly touchy about this. I fly back and forth to Canada a lot, and usually get questioned about my intentions regarding working while in Canada.
Thanks for this post! I hadn’t heard this information before, it’s definitely something to think about…. I’m wondering though if and how it might apply if you are a digital nomad, but you earn money from companies in the US, like for instance, Google Adsense? I’m trying to figure out how to arrange myself so that I’m not paying taxes in a country I don’t live in…
Thank you for writing this.
I receive a lot of questions about this from Americans and now I know where to refer them to.
And although I know the basics, I found a number of details that I was not aware of.
It is much simpler for the rest of the world. Just make sure that you are not resident of a high tax jurisdiction and the draconic reporting (and taxes, when done right) belongs to a thing of the past.
Julius
@Adam,
Thanks for the comment. I’m glad you liked the post.
Whoa! As a digital nomad CPA, I took a lot from this article…from all sorts of angles. Thanks for taking the time to create such a great and detailed post!
@Wesley,
Thanks for stopping by. It is indeed an honor to hear from you. 😀
I think this question of “What is Subpart F income?” for a digital nomad is an important one and I will blog about it or stick it in my Friday Edition email. The main thing that a digital nomad’s foreign corporation is trying to *avoid* is “Foreign Base Company Income”, which is a subset of Subpart F income. Everything else is probably trivial in size, so the taxation of it (or no taxation) won’t matter much.
Based on your description, I am still unsure of how and when something is defined as “Subpart F” income, can you please clarify that?
Thanks.
This is awesome! Thanks for laying it out, many have been looking for this info from a tax authority for awhille.
The main takeaway for me is: Yes, as a freelancer, you can avoid paying taxes by being an employee of your own foreign corporation, but the costs of doing so will likely approach the cost of your taxes. Those costs being: Filing US taxes correctly, Setting up the foreign corp, Filing foreign corp taxes correctly.
That said, what jurisdiction do you think would be most cost and time saving for a freelancer under $100,200/yr?
PS. Email me and I’ll fix your fonts as a thanks for this great post.
This comment was sent to us by Marina Hernandez from MHTax – Cross Border Tax Planning:
Or move to a country with a totalization agreement with the US… and free-lance away SE tax free. Problem solved. 🙂
I always enjoy your newsletters, even when they are written for those with hacker mentality, and especially appreciate that you always provide all the cites. So refreshing!
But seriously, let’s think for a minute about the average overseas American: by the time he forms the foreign corp., hires a service to do the payroll and keep the books according to local law, pays the extra corporate taxes (which can be quite hefty: combined gross proceeds tax and corporate income tax are not uncommon) and for the preparation of the local corporate returns and related stuff (expensive formalities abound in civil law countries!), incurs double taxation in the local country when paying dividends (unless he is smart enough to organize a foreign pass-through when that is possible), makes the inevitable local compliance mistake and pays the fine/s or a professional to get him out of the fine/s or both, pays a competent US preparer who will complete the 5471 correctly after converting the foreign books to US GAAP and without charging him an arm and a leg (look, I see a Unicorn!), how much is he really saving in current cash flow? Potential savings at the max SS salary would be around$18K gross. All this extra stuff costs how much? I haven’t even factored in the loss of social security benefits (which you mentioned) and of peace of mind as a result of the additional complexity he is now required to manage…..
Yep, that sounds like a great plan, would say:
a) The SSA (one fewer retiree or 2, if he has a spouse who would have received spousal SS benefits, yeah!)
b) Foreign corporate attorneys (cha ching!)
c) Foreign governments (cha ching!)
d) Foreign accountants and tax specialists (cha ching!)
e) US preparers (cha ching!)
f) Circular 230 professionals doing tax representation (cha ching!)
Maybe we should circle back to the idea of moving to a country with a totalization agreement instead………. Did you know that weather in Chile is really nice this time of the year? And they have beaches, and skiing and really good wine, and this really smart lady President who spoke at the Chamber of Commerce here in Philly on Tuesday (not to be confused with her pathetic neighbor to the east, ruler of my native country). Personally, I’m partial to Italy and Spain, though. I’m blaming my parents for that.
I give this idea a high risk rating with a significant chance of negative ROI. But I’m sure that for the hacker/internet dudes in those groups you mention it sounds pretty awesoooome! At least they have a better idea of what they might be getting into after reading your post (I hope)
Have fun in Singapore,
Marina