For many people, an essential part of the “American Dream” is being your own boss. Becoming a business owner or an entrepreneur has always been a quintessentially American value, and many of the wealthiest Americans today are people who began their own businesses from nothing.
However, in today’s global economy, one of the United States’ most popular exports is American citizens, who move to other countries and begin businesses abroad. It is unknown exactly what percentage of the estimated 9 million US expats worldwide are self-employed, but it is not insignificant.
Today, we are going to discuss the idea of expat business ownership from the perspective of the self-employed individual. We will deal with owners of foreign corporations in the near future. But first, let’s get a little bit of background on the whole idea of business ownership.
Business Ownership Structures
When a person begins a business, he or she needs to decide what legal structure the business will take. This decision will have far-reaching ramifications, from liability to taxation, and needs to be carefully considered. The three main options to consider are the sole proprietorship, the partnership, and the corporation. We will discuss them one at a time here.
Sole proprietorships
A sole proprietorship is the simplest form of business structure. The business is no more than an extension of the single owner. The owner of a sole proprietorship is responsible for any liabilities incurred by the business, and is taxed on the business’s profits at his or her personal rate. Sole proprietorships generally do not file their own tax returns, but they calculate their earnings on Schedule C (or Schedule F) which is attached to the owner’s Form 1040.
Partnerships
Partnerships are businesses that are owned by more than one person. Partnerships are similar to sole proprietorships in that the business’s liabilities are assigned to the owners (in proportion to their ownership percentages) and that the business’s profits are taxed at the partners’ individual rates. Partnership entities usually file Form 1065 as an information return, and they distribute a Schedule K-1 to each partner, detailing his or her share of the business’s earnings.
Corporations
Unlike proprietorships and partnerships, corporate entities are distinct legal entities from their owners (or shareholders). Liability is generally limited to the assets held by the corporation. Corporate earnings are usually taxed twice: Once at the corporate level (corporations usually file Form 1120) and again when the profits are distributed to the individual shareholders in the form of dividends.
Other structures
There are other structures that you will see occasionally, but these are usually treated as one of the above types of entities come tax time, so we will touch on them very briefly:
Subchapter S Corporations (S-Corps): S-Corps are hybrids between traditional corporations and partnerships. They are taxed as partnerships, file their taxes on Form 1120S, and distribute K-1s to their shareholders. S-Corps cannot have foreign ownership, so they are less common for US expats.
Limited Liability Companies or Partnerships (LLCs or LLPs): LLCs and LLPs are business structures that are recognized on the state level, not on the federal level. They are generally taxed as partnerships, but can elect to be taxed as a corporation or as a “disregarded entity” (i.e., a sole proprietorship) if they chose.
Paying US Tax as a Sole Proprietorship Outside the US
As mentioned earlier, a sole proprietorship usually calculates its income using Schedule C. If the business kept decent bookkeeping records, this part is fairly straightforward. Calculate the business’s revenue using Part I of the form (gross receipts, returns, and cost of goods sold), and itemize your expenses by category in Part II (expenses). Subtract the expenses from the revenue, and there is your net profit or loss, which gets put on Schedule 1 as a form of “additional income” on line 3. Business income is then added to the rest of your income in order to calculate your gross income for the year.
Sole proprietors are generally subject to two types of tax on their net income: Income tax and self-employment tax.
Income tax for businesses
Income tax for expat business owners generally follows the same rules as it does for wage earners. You can exclude the income for taxation using Form 2555, or use Foreign Tax Credits against your US tax bill using Form 1116. In short, income tax is usually not a concern for the majority of US expat business owners.
Self-Employment Tax
Self-employment tax, on the other hand, is a whole other matter. Before we go into the potential impacts of the self-employment tax regime on US expat business owners, let’s take a bit of a detour into the history of the tax, and why it is being levied on millions of Americans worldwide.
History of Social Security and Medicare
In 1935, Congress enacted the Social Security Act as part of President Franklin D. Roosevelt’s “New Deal” suite of domestic programs enacted in the wake of the Great Depression. The idea of the program was to provide a form of income to the elderly funded by payroll taxes on workers. The initial tax rate in 1937 was 2%, split between employees and employers. As you may have guessed, the rate has gone up quite a bit in the years since. Self-employed individuals were made to start contributing to the program as well beginning in 1951.
In 1965, the Social Security Act was amended as part of President Lyndon B. Johnson’s “Great Society” program. The amendments added two major social programs to the federal budget: Medicare (health insurance for the elderly) and Medicaid (matching funds to states who provided health coverage for the poor). Medicare was funded by adding an additional tax to the payroll taxes most Americans were already paying.
Payroll tax today
Nowadays, employment taxes are categorized into two types: Old-Age, Survivors, and Disability Insurance (OASDI—i.e., Social Security) and Hospital Insurance (HI—i.e., Medicare). Tax rates have pretty much held steady since 1990, and the same rates are paid by employees and employers:
Social Security/OASDI: 6.2% of income up to a cap which is adjusted yearly ($132,000 in 2019)
Medicare/HI: 1.45%--employees who earn more than $200,000 (or $250,000 for married couples filing jointly) pay an extra 0.9%
Self-employment tax today
Because a self-employed individual is both employee and employer, he or she is subject to both sides of social security tax, and rates are effectively doubled:
Social Security/OASDI: 12.4% of income up to the income cap.
Medicare/HI: 2.90%--business owners who earn more than $200,000 (or $250,000 for married couples filing jointly) pay an extra 0.9%
For those of you keeping score at home, that is a 15.3% (or 16.2%) tax that you get to pay for the privilege of owning your own business. Wage earners in other countries are not covered by Social Security, so they are not subject to this extra tax from the United States.
Self-Employment Tax for Expats
Here’s where you interrupt me: What about all of my foreign tax credits? What about the Foreign Earned Income Exclusion? And, I already pay hefty social insurance taxes to (Brazil/New Zealand/China/Israel/the UAE/etc.), why should I pay to the United States?
The answer to all of these questions rests on the fact that the rules regarding double taxation are only there to prevent double income taxation. Because Social Security is calculated separately from regular income tax, the exemptions usually available to expats do not apply.
Unless…
Totalization Agreements
Do you live in one of the following 28 countries?
Australia
Austria
Belgium
Brazil
Canada
Chile
Czechia
Denmark
Finland
France
Germany
Greece
Hungary
Ireland
Italy
Japan
Luxembourg
Netherlands
Norway
Poland
Portugal
Slovakia
South Korea
Spain
Sweden
Switzerland
United Kingdom
Uruguay
If yes, you can disregard everything I said in the previous section. The US has “totalization agreements” (tax treaties designed to eliminate double social security taxation) with each of the above-listed countries, so self-employed individuals living in those countries would not have to pay Social Security tax to the United States, even if they are self-employed.
Other Ways to Avoid Self-Employment Tax
Self-employment tax is only assessed on individuals with business income—US expats who own their own companies and pay themselves wages are exempt. However, a business owner who is considering this course of action needs to analyze the numbers carefully, because the costs of owning and maintaining a foreign corporate entity could sometimes be more than the amount of the self-employment tax (we will discuss some of the issues in a future post), so you should consult with an expert in your country regarding whether this would be worthwhile.
Need Help With Filing Your U.S. Taxes From Overseas?
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Article by Lewis Grunfeld, CPA
Lewis Grunfeld, CPA, is a renowned expert in international and U.S. expat taxation, with expertise spanning over ten years. He has successfully helped thousands of expats around the world navigate complex international U.S. tax regulations, and achieve significant tax savings. His work is driven by a strongly rooted passion for assisting the expat community through a wide range of tax situations, ensuring tailored solutions for each unique situation.