Wages vs Self-Employed

The IRS and U.S. foreign nationals living and working abroad

Just because you are a U.S. citizens living and working abroad does not mean that you don’t have to report your yearly earnings to the IRS. However, if you pass two tests and qualify for the “foreign earned income exclusion,” you don’t owe any tax unless you made more than $87,500. That’s if your income was earned by working for someone else or within a corporate structure.

For those of us who own businesses (or provide a service) the IRS has a different set of rules for “self-employment income.” If you are self employed, then every dollar over $400 is taxable (and, of course, you must file). The good news is that if you qualify for the foreign earned income exclusion, you still don’t owe any INCOME tax, unless you make more than $87,500.

But now the bad news: Unlike wages earned outside the U.S., self-employment income outside the U.S. IS subject to Social Security and Medicare tax (total of 15.3 percent) on every dollar above $400. And, worse yet, the foreign earned income exclusion does NOT apply to Social Security and Medicare tax.
So, you have a little widget business and you netted $20,000. You do qualify for the foreign earned income exclusion, so you don’t owe any income tax. However, you do have to file AND send a check to the IRS for Social Security and Medicare taxes in the amount of $2,999. ($19,600.00 x 15.3 percent).
There are several ways to avoid this problem; one of the simpler methods is to form a corporation, have all checks made to the corporation, and have the corporation pay you as an employee. Now you are governed by the “wage” rule, not the “self-employed” rule.

I have had a person tell me that they didn’t feel that was “playing fair” – that everyone should pay their “fair share” (of taxes). My first inclination was to tell them that under the present tax structure, there isn’t any amount that I consider to be “fair.” I believe in a flat tax system or, better yet, a national sales tax. Instead, I referred them to a quote from Judge Learned Hand: “Anyone may arrange his affairs so that his taxes shall be as low as possible; he is not bound to choose that pattern which best pays the Treasury. There is not even a patriotic duty to increase one’s taxes. Over and over again the courts have said that there is nothing sinister in so arranging affairs as to keep taxes as low as possible.”

I also agree with Arthur Godfrey, who said: “I’m proud to pay taxes in the United States; the only thing is, I would be just as proud for half the money.”