You live abroad or travel the world and work for yourself? Don’t overlook self-employment tax on foreign income!
A common misconception among expats and nomads is that the first roughly $100,000 of income is completely tax-free in the US under the Foreign Earned Income Exclusion (FEIE). This is however only partially true. The FEIE lets you exclude income from income tax. It does not get you out of paying self-employment tax on foreign income when working as a freelancer, independent contractor or sole proprietor abroad.
1. Taxes for the self-employed abroad
Generally, self-employed individuals pay income tax and self-employment tax (SE tax). If they qualify for the FEIE, they can exclude foreign earned income up to $107,600 in 2020 and $108,700 in 2021 from income tax. (Although the FEIE will be pro-rated depending on the business expenses.) But they still have to pay self-employment tax. Being self-employed, you must pay SE tax on your entire net profit, even the amount you can exclude from income tax.
The SE tax is a Social Security and Medicare tax for individuals who work for themselves. If you work for a company in the US as an employee, the Social Security and Medicare tax is automatically taken out of your monthly paycheck. As a freelancer, however, you are responsible yourself for calculating and paying it regularly.
The IRS considers you self-employed if you work for yourself, no matter if full-time or part-time. It also doesn’t matter if you are registered as a sole proprietor or not. Even when you have a US LLC, but did not elect to have it taxed as a corporation, you will have to pay SE tax, because the LLC income passes through to you as the owner.
The only way to avoid SE tax is to elect your LLC to be taxed as an S Corporation. Of course, an S Corp has different tax and reporting obligations. To know when to switch from an LLC to an S Corp to save on self-employment tax consult a knowledgeable accountant.
2. Low tax filing thresholds for self-employed
Some freelancers may think that they don’t earn enough to have to file a tax return. However, the $12,400 income threshold for filing (2021) does not apply to self-employed people.
The IRS requires that self-employed file a tax return if their annual net earnings are more than $400. In some cases, you even have to file if your earnings are below that if you meet certain requirements.
3. Self-employed vs employee
The main difference between income as an employee and income from self-employment is in how income tax works and how it is reported. An employee receives a W-2 form, whereas a contractor receives a 1099-NEC form. (This used to be a 1099-MISC form but the IRS recently changed it to 1099-NEC Non-Employee Compensation.)
The same kind of work, like programming, could generate two different types of income. A remote employee for a US company will receive a W-2. If he also does programming work for a different US company as a contractor, he should receive a 1099-NEC form for that work.
Make sure you understand if your company considers you an employee and provides a W-2, or if they treat you as a contractor and issue a 1099-NEC.
The differences between a contractor (1099) and an employee (W-2)
Here are three types of questions to distinguish between the two:
- Behavioral: Does the company control or have the right to control what the worker does and how the worker does his or her job?
If the answer is “yes,” s/he is likely a W2. If the worker is free to manage their own schedule and work process, they are more likely 1099.
- Financial: Does the employer control the business aspects of the worker’s job? This includes for example, how the worker is paid, whether expenses are reimbursed, and who provides tools or supplies.
If the company controls how the worker is paid and pays for expenses and supplies, s/he is likely a W2. If the worker has to send an invoice to get paid and/or cover their own expenses, they are more likely 1099.
- Type of relationship: Do you have a written employment contract (versus project or an independent contractor agreement) or employee-type benefits, e.g., health insurance, vacation pay? Will the working relationship continue for the foreseeable future if the work is done correctly and is the work performed a key aspect of the business?
If the company provides an employee with benefits and believes the employee is there for the long-term, s/he is likely a W2.
Only ONE of the questions has to be met for the employee to be considered a W2 employee.
4. Form 1099 for self-employment income
1099-MISC forms are a bit more complicated than a W-2. First of all, you may not receive a 1099-NECfor all the income you earned. And there may even be double-reporting.
You can’t rely on 1099-NEC forms alone to report your self-employment income for tax. Instead, you have to keep track of your self-employment income and all related expenses on your own.
1099-NEC forms only list your gross earnings. Unlike with W-2s, there are no taxes withheld on your behalf. Be aware that in some cases, for example with Airbnb, the amount on the 1099 Form may include commissions paid to the company that issued the form, instead of just your earnings net of that commission.
Keep in mind that 1099s sometimes contain errors. Always check them against your own records and request a corrected form if you find a mistake.
Who issues a 1099 Form?
- If you earn more than $600 as an independent contractor for a US company, then the company must issue a 1099-NEC form. (Just like with a W-2, a copy of the 1099 Form will be sent to the IRS.) But even if the company fails to give you a 1099, or you earn less than $600 per year with a single company, you still have to disclose the income.
- PayPal and other electronic payment processors will also send out a 1099 form, called 1099-K if you meet certain thresholds. According to PayPal, they issue a form 1099-K to sellers who exceed the IRS thresholds, i.e., when they receive over $20,000 in gross payment volume for the sale of goods or services AND receive over 200 separate payments in the same calendar year. (Some states require reporting at a lower threshold.) If you don’t receive a 1099 form from them, you need to use your own records to report the income.
- Many affiliate sites also issue 1099 forms. You can expect that every place that asks for your SSN or tax information, when signing up, could send you – and the IRS – a tax form.
When you receive a 1099-NEC form from a company you worked for and were paid electronically, for example via PayPal, there is a risk that the same payment is also included in a 1099-K from PayPal. You should compare all 1099-NEC and 1099-K forms carefully against your own records.
Even without a 1099 form, you must report your foreign self-employment income on your US tax return. We can help you with your US taxes.
5. Reporting self-employment income earned abroad
If you teach English online for a Chinese company while traveling outside the US, do web design or copywriting for international clients, are an independent fashion designer, etc., you will likely not receive any official tax document. That doesn’t mean that the income is not subject to the US self-employment tax.
To report your income, you can use any official or semi-official document or your own spreadsheet. You want to keep track not only of the income you made but also of your expenses and any tax you may have paid on that income.
If your payments come through PayPal, you can go into the history section and download the history from January 1 to December 31 of the tax year. You can do the same for bank accounts and other financial providers you use for receiving payments. This exercise will be much easier if you have separate accounts for your business. Mixing business and personal finances is never a good idea.
Also, be aware of any Social Security Totalization Agreements between the US and your residence country. In countries where they exist, you may end up paying to your host country’s government or to the US. This depends on a number of factors unique to each totalization agreement.
If you are in a country where you have to pay social security type taxes locally, you should get a “certificate of coverage” fully translated into English. This ensures the IRS does not ask for SE tax payment as well. Speak to an experienced accountant about your US tax return when working abroad.
6. Self-employment tax rate
The self-employment tax rate is 15.3% for the first $137,700 of net income (2020). For the 2021 tax year, the threshold is $142,800. On income above this level, you have to pay only 2.9% Medicare tax, but no further social security tax.
For self-employment tax, you cannot exclude any income you earn while abroad. You must pay self-employment tax on all of your net profit, including the amount excluded under the FEIE.
Let’s say you work self-employed abroad and qualify for the Foreign Earned Income Exclusion. Your foreign earned income is $80,000 and your business deductions total $20,000, so your net profit is $60,000. You don’t have to pay federal income tax because you can exclude all of your foreign income. But you have to pay the 15.3% self-employment tax on all $60,000 of your net profit.
7. Quarterly estimated payments
Since self-employed don’t have tax deducted from their monthly paycheck, they have to make estimated quarterly payments
Here’s how to calculate quarterly estimates quarterly:
1. Calculate your net earnings
Add up all (expected) income for the year and then subtract all business expenses to calculate your estimated net earnings.
Accounting software or at least a simple spreadsheet helps with keeping track of all income and expenses.
2. Estimate your taxes and pay quarterly estimated taxes
Take your estimated net earnings for the year, multiply it by 0.15 for the total self-employment tax, and then divide by 4 to get the quarterly payments.
If during the year you realize that you will likely make more than estimated, you need to adjust your quarterly payments. Of course, you should also adjust if you think you will make less than expected.
Once the year is over and you know your actual income and expenses, you can file your annual tax return and receive a refund if you overpaid.
Quarterly installment payments are due on April 15, June 15, September 15, and January 15.
8. Ways to avoid self-employment tax on foreign income
Simply hoping that the US might not know about your foreign self-employment income and therefore not reporting it is asking for trouble.
If you are caught not reporting or under-reporting your income to the IRS, it could be deemed fraudulent, and you could be fined heavily. When the IRS suspects fraud, they can go back as many years as they want, even past the 7-year statute of limitations. It’s important to make sure you report all income properly and accurately.
The only way to avoid having to pay self-employment tax is to form a business and elect to be taxed as an S Corp. Depending on your income level, the cost of forming and maintaining a legal business structure may be more than offset by the savings in self-employment tax. An experienced tax accountant can advise you.