If you plan on working abroad as an independent contractor, you will be subject to self-employment tax on your freelance income just as you would if you were self-employed in the US. To make sure you don’t overpay, read our guide on how to avoid self-employment tax while working abroad.
What Is US Self-Employment Tax?
Self-employment tax consists of Social Security (12.4%) and Medicare taxes (2.9%) and applies to your net self-employment income, even if that same income is entirely excluded from regular income tax under the Foreign Earned Income Exclusion (FEIE). When you work for a US employer, you pay half of the 15.3%, and your employer pays the other half. When you are self-employed, you are both the employee and employer and, thus, pay the full 15.3%.
How to Structure Your Business to Avoid Excess Self-Employment Tax
You may be able to minimize your self-employment tax burden depending on your business structure. As a freelancer, you may or may not have established an LLC (limited liability company) to conduct your business. A US LLC with a single owner is not treated as a separate entity for tax purposes. Instead, it is considered a “disregarded entity” – the income and expenses are reported on Schedule C of your tax return, and the net income is subject to self-employment tax.
However, you can elect for your LLC to be treated as a corporation (by filing Form 8832), then electing for your LLC to be treated as an S corporation (by filing Form 2553). You conduct your business through the S corporation, with clients paying the S corporation instead of you personally. An owner of an S corporation will have two types of income from the S corporation: salary and distributions. The salary portion will be subject to Social Security and Medicare tax (with half paid by the employer; here, the S corp) and half paid by the employee (you). However, the distribution portion will not be subject to Social Security and Medicare tax. While there may be a temptation to maximize the amount paid as distributions and minimize the amount paid as salary, be aware that S corporation owners must draw a “reasonable compensation” as salary or risk the ire of the IRS. Note that, while your S corporation salary is eligible for the foreign earned income exclusion, the distributions are not considered “earned income” and would not qualify for the exclusion.
Can I Avoid Self-Employment Tax with a Foreign LLC?
An alternative to establishing a US LLC that elects S corporation status is to establish a foreign LLC. For US tax purposes, a foreign LLC is not automatically treated as a disregarded entity – instead, it is considered by default a foreign corporation, unless another classification is elected. If you conduct your business through a foreign LLC, your salary paid by the foreign LLC would not be subject to US Social Security and Medicare Tax. And, it would be eligible for the FEIE. However, a foreign corporation would likely require the filing of Form 5471, which can be complicated, and any income that is not paid out as salary may be subject to a different tax (GILTI, or global, intangible low-taxed income).
Want to Minimize Self-Employment Tax? Plan Ahead
Suffice it to say, there is no magic bullet for how to avoid paying self-employment tax while working abroad. However, with careful planning, you may be able to minimize the burden. Whether using an S corporation or foreign LLC, it is crucial to maintain meticulous records of your business’ activity so that you can produce accurate financials at the end of the year. It is also critical to seek professional advice before proceeding with either of the structures described, as there are detailed requirements and other matters (both tax and not tax-related) to consider.
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