It’s common knowledge in the realm of expat taxation that U.S. citizens residing abroad encounter a range of unique tax challenges and opportunities. This holds particularly true for self-employed expats, as their income may be subject not only to U.S. income taxes but also U.S. self-employment taxes, including social security taxes, depending on the circumstances.

In this blog post, we will delve into the fundamentals of the U.S. self-employment tax system, outline the key tax exemptions, and highlight practical considerations that self-employed expats should bear in mind to minimise their overall global tax burden.

Self-Employment and Social Security Taxes on Income for Expats

According to U.S. tax law, if you are self-employed and your net earnings from self-employment amount to $400 or more (a relatively low threshold), you are required to:

File Schedule SE

Pay self-employment tax, which encompasses Social Security taxes The IRS categorises individuals as self-employed if they own their own business or work as independent contractors. It’s important to note that self-employment tax differs from income tax. The self-employment tax rate stands at 15.3% of net earnings, consisting of a 12.4% Social Security tax and a 2.9% Medicare tax on net earnings.

For the tax year 2022, the Social Security portion applies to the first $147,000 of earnings, increasing to $160,200 in 2023. Additionally, an additional 0.9% Medicare tax may be applicable if your net earnings from self-employment exceed specific thresholds. It’s worth emphasising that even if you are self-employed abroad, you are still liable for U.S. self-employment taxes on foreign earned income that is exempt from income tax due to the foreign earned income exclusion.

The Role of Social Security Totalization Agreements

Social security totalisation agreements between the United States and numerous foreign countries can prevent individuals from being subject to self-employment taxes in both nations Totalisation agreements, akin to tax treaties, are designed to address social security and Medicare taxes rather than income taxes.

These agreements serve two primary purposes:

Eliminating issues of double social security taxation

Establishing provisions for protecting social security benefits for individuals potentially subject to two social security systems

In summary, if you are self-employed abroad or earn income abroad while paying social security taxes to another country that has a totalisation agreement with the United States, you are unlikely to be required to pay self-employment taxes to the U.S.

A comprehensive list of countries with totalisation agreements can be found here: https://www.ssa.gov/international/agreements_overview.html

Planning Strategies for Self-Employed Expats

The imposition of the self-employment tax, in addition to income tax, can have a significant or even devastating impact on a growing business. This is particularly true for those residing in countries without a totalization agreement, as it could result in individuals being subject to double self-employment taxation.

For this reason, tax planning is crucial to reduce self-employment taxes for expat citizens within the bounds permitted by U.S. and local tax systems. Effective planning often involves establishing a company structure, which, on one hand, can lower self-employment taxes but, on the other hand, may present various tax and reporting pitfalls for the uninformed.

Our recommended approach is to tailor a strategy based on your overall circumstances, including your country of residence and its tax regulations, as well as your present and projected financial situation, such as gross and net profits and income sources. By evaluating different company structures from a tax perspective, we can analyse and determine the optimal structure for you and your business.

Taxation processes can be confusing, but Xerxes Associates are here to assist.  Contact us via www.xerxesllp.com or fill out our contact form to discuss your expat tax situation with us.

In a positive development for the American expatriate community, the U.S. Supreme Court has delivered a ruling that favours taxpayers and limits the scope of FBAR (Foreign Bank Account Report) penalties. This decision not only significantly reduces the proposed penalties imposed on taxpayers but also establishes an important precedent for calculating FBAR penalties going forward.

Understanding FBAR Obligation and Penalties

The FBAR obligation arises when the total value of an individual’s foreign financial accounts exceeds $10,000 at any point during the calendar year. The FBAR, also known as FinCEN Form 114, must be filed electronically using the BSA E-Filing System, administered by the Financial Crimes Enforcement Network (FinCEN) under the U.S. Department of the Treasury.

Failure to file an FBAR due to negligence or a “non-willful” violation can result in a penalty of $10,000 per account, per year, unless reasonable cause can be established. Conversely, a “willful” failure to file can lead to civil penalties equal to the greater of $100,000 or 50% of the balance in each unreported account, and in certain circumstances, even criminal penalties may apply.

US Supreme Court’s Verdict on FBAR Penalties

In the case of Bittner v. United States (No. 21-1195, decided on February 28, 2023), the U.S. Supreme Court ruled that the $10,000 penalty for non-willful FBAR violations should be applied per form rather than per account. The decision was reached by a narrow majority of 5-4, overturning the previous ruling in favour of the IRS by the U.S. Court of Appeals for the Fifth Circuit. The Bittner case itself witnessed a substantial reduction in the penalties imposed, from $2.72 million to $50,000, due to the Supreme Court’s verdict.

Implications of the Supreme Court’s Decision

The Bittner decision provides much-needed clarity and sets a precedent for the IRS in applying penalties for non-willful FBAR violations. However, tax practitioners have expressed concerns that this ruling may prompt the IRS to more actively pursue and impose higher penalties for willful FBAR violations. It would have been beneficial if the Supreme Court had addressed the specific criteria for differentiating between willful and non-willful violations. In the beginning of the decision, the Court refrained from delving into this matter, stating, “What, if any, mens rea the government must prove to impose a ‘non-willful’ penalty is not before us.” Notably, lower courts have consistently adopted a broader interpretation of “willfulness” for civil FBAR violations, encompassing recklessness and willful blindness, rather than limiting it to intentional violations used in criminal cases.

Taxpayers can find solace in the fact that the burden of proof for civil FBAR penalties rests with the government. The government must establish liability for the civil FBAR penalty by a preponderance of evidence, meaning it must demonstrate that the event was more likely than not to have occurred.

Despite the favourable U.S. Supreme Court decision, taxpayers with foreign accounts should remain vigilant and ensure compliance with FBAR requirements to avoid penalties altogether. Being aware of and fulfilling FBAR obligations from the outset is crucial to preventing penalty issues.

Taxation processes can be confusing, but Xerxes Associates are here to assist.  Contact us via www.xerxesllp.com or fill out our contact form to discuss your expat tax situation with us.