Effect of the Foreign Earned Income Exclusion on the Self-Employment Tax on Business Activities Oversees

In this essay, I would like to explore the relationship between the self-employment tax and the tax exclusion of income earned by the U.S. businesses abroad.

The self-employment tax is a social security and Medicare tax on net earnings from self-employment. A self-employed U.S. citizen or resident must pay self-employment tax if his net earnings from self-employment are at least $400. In tax year 2009, the maximum amount of net earnings that is subject to the social security portion of the tax is $106,800, while all net earnings are subject to the Medicare portion of the tax.

Despite the commonly-held belief, in calculating his self-employment tax liability, a U.S. citizen or resident must take all of his self-employment income into account, even if this income is exempt from income tax because of the foreign earned income exclusion. For example, suppose A, a U.S. citizen, provides consulting services in a European country as part of his business activities. Under the independent contractor agreement, A is paid $120,000 for his services; A’s total business deductions are $50,000, and his net income is therefore $70,000. A can successfully exclude $70,000 from taxable gross income (the exclusion for year 2009 is up to $91,400). He, however, must pay the self-employment tax on all of his net profit, including those $70,000 that he excluded from taxable income.

Similar rule applies to U.S. citizens or residents alien who own and operate a business in the U.S. possessions (Puerto Rico, Guam, the Commonwealth of the Northern Mariana Islands, American Samoa, and the U.S. Virgin Islands). Self-employment tax must be paid on all of the self-employment income (as long as it is $400 or more) derived from such businesses, even if the income is exempt from the U.S. income taxes. Schedule SE (Form 1040) must be attached to the U.S. income tax return. If the owner of the business is a resident of any of the U.S. possessions and he does not have to file Form 1040, then the self-employment tax should be determined on Form 1040-SS. Residents of Puerto Rico may file the Spanish-language Form 1040-PR, Self-Employment Tax Form — Puerto Rico (Spanish Version).

While non-resident aliens generally are not subject to the self-employment tax, they still have to pay the tax on self-employment income received while they were resident aliens, even if such income was paid for services performed while they were non-resident aliens. For example, royalties received by a U.S. resident for the intellectual property created while this person was non-resident alien.

Finally, one must be aware that the United States has entered into social security agreements (also known as Totalization Agreements) with foreign countries to eliminate duel coverage and duel social security tax payments for the same work. Hence, the social security taxes (including the self-employment tax) are paid only to one country. If a person’s self-employment earnings should be exempt from foreign social security tax and subject only to U.S. self-employment tax, he should request a certificate of coverage from the U.S. Social Security Administration, Office of International Programs. The certificate will establish this person’s exemption from the foreign social security tax.

To establish that one’s self-employment income is subject only to foreign social security taxes and is exempt from U.S. self-employment tax, this person must request a certificate of coverage from the appropriate agency of the foreign country. If the foreign country will not issue the certificate, he should request from the U.S. Social Security Administration a statement that his income is not covered by the U.S. social security system.

Sales Tax Deduction for Vehicle Purchases

If you are considering whether to buy a new car, it is important to remember that, under the American Recovery and Reinvestment Act of 2009 (the “ARRA”), taxpayers may deduct state and local sales and excise taxes paid on the purchase of new passenger cars, light trucks, motor homes and motorcycles. The deduction is available on new vehicles purchased from February 17, 2009 through December 31, 2009. In states that don’t have a sales tax, the ARRA provides a deduction for other taxes or fees paid as long as these taxes and fees are assessed on the purchase of the vehicle and are based on the vehicle’s sales price or as a per unit fee. This deduction is available whether or not a taxpayer itemizes deductions on Schedule A.

The deduction is limited to the taxes and fees paid on up to $49,500 of the purchase price of an eligible vehicle. The deduction is reduced for joint filers with modified adjusted gross incomes (MAGI) between $250,000 and $260,000 and other taxpayers with MAGI between $125,000 and $135,000. Taxpayers with higher incomes do not qualify.

House passes the Tax Extenders Act of 2009

On December 9, 2009, the U.S. House of Representatives approved H.R. 4213, the “Tax Extenders Act of 2009.” The bill would extend for one more year more than forty tax provisions that are set to expire at the end of this year, including the research credit and a number of important tax breaks for individuals. In order to offset more than $30 billion in tax relief, the bill also requires stricter reporting on U.S.-held foreign assets by foreign financial institutions and U.S. citizens.

Three provisions draw particular attention. First, starting with tax year 2013, the foreign financial institutions, foreign trusts, and foreign corporations are required to obtain and provide information from each of their account holders to determine if any account is American-owned. Foreign financial institutions must also comply with verification procedures and to report any U.S. accounts maintained by the institution on an annual basis. Then, any foreign financial institution that complies with the new verification and reporting standards would be subject to a 30 percent tax on income from U.S. financial assets held by the foreign institution. Where the owner of the account is a foreign government, an international organization, a foreign central bank, or any other class identified by the Treasury Department as posing a low risk of tax evasion, the withholding tax would not apply. Notice, the H.R. 4213’s requirements only apply if the aggregate value of the accounts in the foreign institutions exceeds $10,000. Hence, the basic FBAR rule that the owners of foreign financial accounts with the aggregate value of below $10,000 do not need to report the accounts still applies.

Second, H.R. 4213 requires any U.S. taxpayer with a foreign financial asset exceeding $50,000 in value to report the asset with their tax return. The penalty for failure to report a foreign financial asset would be $10,000 and could possibly increase to as much as $50,000.

Third, additional annual reporting requirements (similar to other U.S. holders of foreign assets) are imposed on the shareholders of passive foreign investment companies and U.S. owners of foreign trusts. A U.S. taxpayer failing to report a foreign owned trust would pay the greater of $10,000 or 35 percent of the amount of the trust.

Finally, the Tax Extenders Act of 2009 increases the tax rate on so-called “carried interest” levied on investment partnerships by treating carried interest as normal income and taxing it at the standard income tax rate (currently 35 percent) rather than the capital gains rate (currently 15 percent). This measure would have a particular impact on most private equities and hedge funds (which operate as partnerships with a general partner managing the fund and contributing partners supplying the capital), because the managers of these funds generally receive two forms of compensation from the fund: a small percentage of the fund’s assets like a contributing partner, and a higher percentage of the fund’s annual earnings that only the fund’s manager receives (i.e. carried interest).

While most of the provisions of the H.R. 4213 are expected to pass the Senate, the “carried interest” provision might present a significant problem.

IRS Announces 2010 Standard Mileage Rates

The Internal Revenue Service today issued the 2010 optional standard mileage rates used to calculate the deductible costs of operating an automobile for business, charitable, medical or moving purposes. Beginning on Jan. 1, 2010, the standard mileage rates for the use of a car will be:

  • 50 cents per mile for business miles driven
  • 16.5 cents per mile driven for medical or moving purposes
  • 14 cents per mile driven in service of charitable organizations

Remember, you may not use the business standard mileage rate for a vehicle after using any depreciation method under the Modified Accelerated Cost Recovery System (MACRS) or after claiming a Section 179 deduction for that vehicle. In addition, you cannot use the business standard mileage rate for any vehicle used for hire or for more than four vehicles used simultaneously.

Also note that you always have the option of calculating the actual costs of using your vehicle rather than using the standard mileage rates.