What is Self-Employment Tax?
The self-employment tax is a social security and Medicare tax based on net earnings from “self- employment”. We’ll review what it means to be “self-employed” later in this posting. The dollar threshold trigger for paying self-employment tax is quite low – you must pay self-employment tax if your net earnings from self-employment are at least US$400.
For self-employment income earned in 2013, the self-employment tax rate is 15.3% imposed on your net earnings. The rate consists of two parts: 12.4% for social security (old-age, survivors, and disability insurance) and 2.9% for Medicare (hospital insurance).
If you are a “self-employed” US citizen or US resident, the rules for paying self-employment tax are generally the same whether you are living in the United States or living and working overseas.
Effect of Foreign Earned Income Exclusion (FEIE)
You must take all of your self-employment income into account in figuring your net earnings from self-employment, even income that is exempt from income tax because of the FEIE. Briefly, for those who may not be familiar with the FEIE, Americans working abroad may be eligible to exclude certain foreign earned income (wages, compensation for services) from US taxable income under the rules governing the Foreign Earned Income Exclusion (FEIE), and certain foreign housing costs paid by their employers. If one is self-employed, then instead of taking a housing exclusion, a housing deduction is taken which further reduces the amount of taxable income. For self-employed persons, both the FEIE and the housing deduction will be calculated based on the individual’s net income as figured on Schedule C or Schedule F. Calculating the right amount of the exclusion depends on figuring one’s business income accurately.
The above-mentioned beneficial rules apply regardless of whether any foreign tax is paid on the foreign earned income or housing amounts. These tax benefits can be claimed, however, only if a US tax return is filed within certain time deadlines. More details can be found in my write-up here.
You work in Dubai as a business consultant and qualify for the FEIE. Your foreign earned income is $97,000, your business deductions total $27,000; your net earnings from self-employment is therefore $70,000. You must pay self-employment tax on all of your net earnings ($70,000) even though the full $70,000 would not be subject to US income tax since you can fully exclude the net earnings under the FEIE (assuming you properly file your tax return and claim the FEIE). Your self-employment tax would be $10,710 (15.3% of $70,000).
Who is Self-Employed?
The general rule of thumb is that an individual is not treated as “self-employed’ for US tax purposes if he is categorized as an “employee”. An individual is treated as an “employee” for federal employment tax purposes if the individual has the status of an “employee” under the usual common law rules that are applied in determining whether an employer-employee relationship exists. Guidelines for determining whether an employer-employee relationship is in place are found in three substantially similar sections of the Employment Tax Regulations. These are Sections 31.3121(d)-1(c) (FICA Regulations); 31.3306(i)-1 (FUTA Regulations); and 31.3401(c)-1 (Federal Income Tax Withholding Regulations).
Overall, these sections provide that an “employer-employee” relationship exists when the person or persons for whom the services are performed have the right to control and direct the individual who performs the services, not only as to the result to be accomplished by the work but also as to the details and means by which that result is to be accomplished. That is to say, an “employee” is subject to the will and control of the employer not only as to what shall be done, but as to how it shall be done. It is not necessary that the employer actually direct or control the manner in which the services are performed. The various Regulations mentioned previously, provide that it is sufficient if the employer has the right to do so.
The IRS has published an aid to determining whether an individual is an “employee” under the common law rules. It analyzes twenty factors that have been identified as indicating whether sufficient “control” is present to establish an employer-employee relationship. The twenty factors focus on the degree of “control” over the worker and have been developed by examining cases and rulings that considered whether an individual should be treated as an employee.
The twenty factors include such items as whether the worker is required to comply with instructions about when, where, and how to work; whether training is given to the worker (whether by an experienced employee; correspondence, attendance at meetings); whether the worker’s services are integrated into the business operations generally, as this indicates control by the owner of the business; whether the services must be rendered personally – if so, this indicates control as presumably the person for whom the services are performed is interested in the methods used to accomplish the work; whether the person for whom the services are performed hires, supervises, and pays assistants since this indicates control over the workers on the job; whether the worker is providing services on a full-time basis; whether he is provided with tools and a place to work as well as if he has set working hours.
The mere fact that the parties label their relationship as an “employer-employee” relationship will not be determinative. If, in substance, the worker is an independent contractor (self-employed), he will be treated as such by the IRS and self-employment tax will be assessed. Obviously, this can get tricky when one is working overseas since the local employment laws and rules may have an impact on the situation. If there is any doubt as to your status, you should seek competent US taxation advice.
Paying Self-Employment Tax
If you are self-employed, you will likely have to pay quarterly Estimated Taxes. You can use these estimated tax payments to pay your self-employment tax. Refer to the Estimated Taxes page and Publication 505, Tax Withholding and Estimated Tax for more details on paying self-employment tax with Estimated taxes.
Circumventing Self-Employment Tax
One method that can be considered is the creation of a foreign entity, such as a foreign corporation and being hired by that entity as an employee, generally with full salary being eligible for the FEIE and elimination of self-employment tax concerns . Whether this is a viable solution will require very careful consideration of many factors and professional tax advice should be sought. For starters, one must consider the US tax impact of owning a foreign corporation. Some initial guidance can be found in my tax blog posting here.
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