If you’re an American expat searching for more autonomy in how you work and what you work on then transitioning to self-employment may be the natural next step. There are a few different ways you can achieve this – you can become an entrepreneur and start your own business, or you can work as an independent contractor or freelancer.
Either way, filing taxes overseas can be a bit more complicated. While Bright!Tax is always happy to do them for you, we also want to give you the tools to DIY. Here’s a rundown on the essentials.
Defining Self-employed, Freelance, and Independent Contractors
Self-employed individuals embody the term “be your own boss” and typically get to work the hours they choose and decide what they work on.
Freelancers usually work alone, can sometimes choose their hours, and take on multiple jobs with different clients but generally must follow the requests of their clients. A freelancer is similar to an independent contractor, except they tend to work on short-term projects and have multiple clients.
Independent contractors normally work longer term and predominantly with one company or client. In many cases, independent contractors, like consultants, provide expertise or services rather than specific products.
Regardless of how you define yourself, the IRS does not make the distinction when it comes to filing your expat taxes and groups together self-employed, independent contractors, and freelancers. In this article, we will guide you through filing self-employment taxes on foreign earned income
How the IRS defines self-employed
The IRS has three main criteria to determine if individuals providing services are employees or self-employed (independent contractors). These are called the common law rules and are used to provide evidence of the degree of control and independence you have in your position.
- Behavioral: Does the company control or have the right to control what the worker does and how the worker does his or her job?
- Financial: Are the business aspects of the worker’s job controlled by the payer? (these include things like how a worker is paid, whether expenses are reimbursed, who provides tools/supplies, etc.)
- Type of Relationship: Are there written contracts or employee-type benefits (i.e. pension plan, insurance, vacation pay, etc.)? Will the relationship continue and is the work performed a key aspect of the business?
The eventual conclusion incorporates many factors and is determined on a case-by-case basis. The lines can be easily blurred, while one factor may be indicative of an independent contractor and another factor of an employee.
Requirements for filing taxes overseas on self-employment income
The filing threshold on foreign income is much lower for self-employed expats. If you earn just $400 in a calendar year you must file a US tax return.
Income is classified by where it is earned, according to the IRS. So if you are living and working abroad, your income is considered foreign earned income. This is the case even if a US company is paying you.
Unlike a W2 employee whose employer withholds tax from their earnings, you will need to be on top of withholding taxes from your self-employment income.
The rate for self-employment taxes is 15.3%. Or in other words…
- 12.4% Social Security tax on up to $127,200 of your net earnings
- 2.9% Medicare tax on your entire net earnings.
Use Schedule SE (Form 1040) to calculate the tax due on net earnings from self-employment. The Social Security Administration also uses the information from Schedule SE to calculate your benefits under the social security program.
Reporting Self-employment income and expenses
Schedule C (Form 1040) reports income earned as a self-employed person either through a sole proprietorship or single-member LLC. In other words, you should use Schedule C to record your company’s (or your own) earnings and expenses. You can deduct the following expenses using Schedule C:
- – Advertising
- – Legal and financial services
- – Travel
- – Car expenses/transportation
- – Supplies
- – Rent, business space, and equipment
- – Taxes and licenses
- – Cost of goods sold
- – Food and entertainment
This list is not exhaustive! Any expense considered ordinary and necessary in the course of your business activities can also be deducted.
Estimated Tax Payments
Since self-employment income isn’t subject to withholdings, typically business owners pay taxes every quarter, estimating the amount they will owe throughout the year. You can use IRS form 1040-ES to calculate your estimated tax payments. It’s important to note that you should remain on top of these quarterly payments. Failing to do so or underpaying can result in penalties. Be sure you are paying the correct amount by getting in touch with an expat tax professional!
Location, Exemptions, Totalization Agreements, and Non-Resident Aliens
The country in which you reside makes a difference too since 24 countries have Totalization Agreements with the US. These serve the purpose of avoiding double taxation of income with respect to social security taxes. If you reside in one of these countries and have already made contributions to their social security system, the Totalization Agreement may determine that you are exempt from paying US self-employment/social security taxes.
If you pay into the Social Security system of a country that does not have a Totalization Agreement with the US, then you will have to pay US social security & Medicare taxes as a self-employed individual. It’s not all bad news though, with the accumulated credits you will qualify for social security benefits from both countries.
Effect of the Foreign Earned Income Exclusion
You must take all your self-employment income into account when calculating your net earnings from self-employment for purposes of calculating the self-employment tax, even if all, or a portion was excluded from income because of the foreign earned income exclusion.
If you own a business overseas and qualify for the foreign earned income exclusion you must pay self-employment tax on all your net profit, including any amount excluded from income.
The Foreign Bank Account Report (FBAR) is a key component of self-employment tax for expats. If you have $10,000 or more in your foreign bank accounts (combined) at any time during a given year, you will need to file an FBAR report. Missing this step is another common mistake that could create exposure to an unforgiving penalty.
Tapping into expertise when filing taxes overseas
Being your own boss can be rewarding beyond measure but with that comes a new level of responsibility. Your taxes are no exception! It’s imperative you understand your filing requirements and obligations both at home and in your host country. To ensure you minimize tax liability and avoid penalties, we recommend seeking professional expat tax advice.
Catching up if you’re behind
While catching up on US taxes from abroad as a self-employed taxpayer may mean paying a few years of overdue self-employment taxes, if you do so using the Streamlined Offshore Filing Procedure you may only have to file 3 years of tax returns, and catching up can be done without penalties.
If you have questions or need help filing, Bright!Tax is here to support!