Self-Employed American Living Abroad: Do I Still Pay U.S. Self-Employment Tax?

Who owes self-employment tax

A U.S. citizen or resident with net earnings from self-employment of $400 or more generally owes self-employment tax, reported on Schedule SE, regardless of where the work is performed or where the individual lives. The rate is 15.3 percent on net earnings up to the Social Security wage base, and 2.9 percent Medicare tax above it, with an additional 0.9 percent Medicare tax on higher incomes. Half of the self-employment tax is deductible for income tax purposes.

Why the foreign earned income exclusion does not help

The foreign earned income exclusion removes qualifying foreign earnings from gross income for income tax. The Code specifically provides that the exclusion does not apply in computing net earnings from self-employment. A freelancer in Mexico City who excludes all of their consulting income for income tax purposes may therefore still owe self-employment tax on the full net profit. Foreign tax credits likewise offset income tax, not self-employment tax.

Totalization agreements

The United States has totalization agreements with about 30 countries, including Canada, the United Kingdom, most of Western Europe, Japan, Korea, Australia, and in Latin America, Chile, Brazil and Uruguay. These agreements generally assign social security coverage to one country to prevent double taxation. For self-employed individuals, many agreements assign coverage to the country of residence. An American self-employed resident of a totalization country who pays into that country's system can generally be exempt from U.S. self-employment tax.

The certificate of coverage

To claim the exemption, the taxpayer generally obtains a certificate of coverage from the foreign country's social security agency and attaches a statement — and in many cases a copy of the certificate — to the U.S. return. Without it, the IRS will generally expect self-employment tax to be paid.

Countries without an agreement

Americans self-employed in countries without a totalization agreement — including Mexico, Colombia, Argentina, Peru and the Dominican Republic, among others — may owe both U.S. self-employment tax and local social security contributions on the same income. Mexico and the United States signed an agreement in 2004, but it has not entered into force. In these countries, structure and planning become more important.

How structure changes the result

Self-employment tax applies to income from a trade or business carried on as a sole proprietor or through a partnership, including a single-member LLC that is disregarded. Wages paid by a foreign employer to a U.S. citizen abroad are generally not subject to U.S. Social Security tax unless the employer is an American employer or has entered into a voluntary agreement. Some self-employed Americans therefore operate through a foreign corporation and pay themselves a salary. That approach can remove self-employment tax, but it typically brings Form 5471 reporting, the controlled foreign corporation rules and GILTI into play, and the corporation must have genuine substance. It should be evaluated carefully rather than adopted by default.

Credits toward U.S. Social Security benefits

Paying self-employment tax builds credits toward U.S. Social Security benefits. Totalization agreements also allow credits earned in both countries to be combined in some circumstances to qualify for benefits. For some individuals, continued U.S. coverage has real value; the decision is not purely about minimizing current tax.

Common mistakes

• Assuming the foreign earned income exclusion eliminates all U.S. tax
• Claiming a totalization exemption without a certificate of coverage
• Forming a foreign corporation without addressing Form 5471 and GILTI
• Not making U.S. estimated tax payments on self-employment income
• Overlooking FBAR reporting on local business bank accounts

Sources and official references

• IRS — Self-employment tax for businesses abroad
• IRS — Totalization agreements
• Social Security Administration — U.S. international social security agreements
• IRS — Publication 54, Tax Guide for U.S. Citizens and Resident Aliens Abroad