Working overseas either as a contractor or an employee comes with both pros and cons. A US expat residing abroad can enjoy quite a lot of monetary as well as non-monetary benefits, especially compared with their stateside counterparts. But your taxes will be very different depending on whether you’re a contractor or an employee. Read the case studies below to find out how both situations—and your location—can affect how much you spend when paying expat taxes as a contractor or an employee.
The Definition of a Contractor and Employee
The primary difference between an employee and a contractor is that a worker is considered an employee when a business has the right to direct or control the work performed by the worker and the financial and business aspects of a worker’s job. Also, an employee is covered by several federal and state employment and labor laws, whereas a contractor is not covered by employment and labor laws. Notably, an employee of a US company receives a W-2 for salaries paid during the year, whereas, a contractor working in the US receives Form 1099-MISC to report the commissions or fees received.
Paying Expat Taxes as a Contractor: A Case Study
US expats will have to be compliant with the host country’s income tax (if applicable) and also US income tax because the US taxes all US citizens or Green Card holders (legal permanent residents) on worldwide income. Consider for this example: a US expat who contracts overseas and earns $60,000 of net self-employment income during the year. The contractor is a resident in Dubai from January 01 – July 31 of the tax year and in Singapore from August 01 – December 31 of the tax year. For the $35,000 ($60,000 x 7/12) earned while resident in Dubai, the contractor will be subject to no income tax in Dubai. Since the contractor is resident in Singapore for less than 183 days in the year, $25,000 ($60,000 x 5/12) earned while in Singapore, is subject to a 15% flat non-resident tax rate. Therefore, tax payable in the host country, i.e., Singapore, will be $3,750.
On the US tax return, an expat who has resided overseas for more than 330-days in any given 365-day period will be able to exclude the entire $60,000 of net self-employment income under Foreign Earned Income Exclusion (FEIE) under Section 911 of the Internal Revenue Code. However, the contractor’s net self-employment income, is subject to self-employment tax, i.e., 15.3% of ($60,000 X 92.35%) = $8,478. This is irrespective of the fact that the contractor was able to fully-exclude their earnings from income tax by claiming the FEIE. In this example, the contractor’s total tax liability for the year would be $3,750 of Singapore tax, plus $8,478 of US self-employment tax, for a total tax liability of $12,228, on $60,000 of net self-employment income.
Paying Expat Taxes as an Employee: A Case Study
Consider the same example as above for an individual who is an employee of a foreign employer. The salary earned overseas ($60,000) would not be subject to US social security and Medicare taxes, and $60,000 of foreign earned income would be fully excludable by claiming the FEIE. Therefore, the only taxes payable during the year would be tax in the country of residence, i.e., the Singaporean tax of $3,750.
Double Taxation as an Independent Contractor
Based on this example of contractor versus employee taxes, working as an independent contractor overseas is clearly different from being employed overseas. Generally speaking, while employed overseas by a foreign employer, wages are not subject to social security or Medicare taxes. Whereas income earned as an independent contractor, whether it is earned in the US or overseas, is considered to be self-employment income and is subject to self-employment taxes, i.e., social security and Medicare taxes on both the employer’s and the employee’s portion. In a sense, a self-employed individual or independent contractor would face double taxation on social security and Medicare wages. In contrast, an employee would be subject to this tax generally only when employed by a US employer who reports wages on a W-2.
Note that there is an exception to this rule. The totalization agreement also applies to an employee working for a US employer for a period of more than five years in a foreign country with whom the US has signed a totalization agreement, where social security tax only needs to be paid in the foreign country and not to the US, even though wages are reported on a Form W-2.
For independent contractors, there is a relief for one-half of the self-employment tax that can be claimed as an adjustment to taxes (an above-the-line deduction) to arrive at adjusted gross income (AGI). However, this adjustment only serves to reduce the income tax on the net self-employment income. The self-employment tax remains unaffected.
The Impact of Totalization Agreements
Continuing with the example above, consider a contractor residing in South Korea. In South Korea, an annual net self-employment income of $60,000 is taxed at an effective tax rate of around 15.5%, which will result an in income tax of $9,300. On the contractor’s US tax return, the entire self-employment income of $60,000 can be excluded from being taxed by virtue of the FEIE. Importantly, the contractor will not be subject to self-employment tax on their net-self employment income in the US as a result of a Totalization Agreement between the US and South Korea.
If they are considered to be self-employed (i.e., an independent contractor) and if they have an intention to reside in South Korea long-term, they can obtain a “certificate of coverage” in South Korea, which would exempt them from having to pay self-employment tax to the US. They should make sure to attach a copy of the “certificate of coverage” with their tax return for each year. However, they will still be subject to social security tax on net self-employment earnings in South Korea. But having a certificate of coverage would enable them to avoid paying social security tax in two tax jurisdictions.