If you’re a freelancer who works outside the United States there are some important rules you need to know when it comes to keeping on the right side of taxing authorities around the globe — and managing your own tax burden. To help you learn the language of foreign taxes and how it applies to your freelance business check out the tips below:
Welcome to the worldwide tax system. In general, your tax obligations in the United States are based on a global tax system. That is, you pay tax on all your income from any country or source. If you earn income in a foreign country, you may also owe tax to that country. This could lead to double taxation, but there are several tax provisions that can help you avoid this situation, including the foreign tax credit and deduction, the foreign-earned income exclusion, and the foreign housing cost exclusion. Here’s a summary of how you can use them to lower your freelance taxes while working with international clients.
The foreign tax credit and deduction
Taxes that you pay to a foreign country or to the United States on foreign-earned income can be claimed as either a credit or deduction. Usually, claiming the credit is a better option, but keep in mind that you can only claim the amount of U.S. tax that is proportionate to your foreign taxable income over your total worldwide taxable income.
The foreign earned income and foreign housing cost exclusions
If you are working as a freelancer in a foreign country for the long-term, the foreign-earned income exclusion may be a better alternative. It allows qualifying individuals to exclude from their gross income up to $105,900 in 2019 ($103,900 in 2018) of foreign earned income. You can also exclude certain non-employer-provided housing costs. The IRS considers the following when determining if a taxpayer qualifies for these deductions:
- The taxpayer’s intention.
- The length of stay in a foreign country.
- The nature and duration of employment.
- The establishment of a home in the foreign country, and
- The nature, extent and reasons for temporary absences from the foreign home.
You must provide appropriate documentation to substantiate eligibility for the foreign-earned income and housing exclusion such as travel dates and the type of work you have done and the locations in which you have worked.
Another important point is that you cannot take both the foreign-earned income and housing exclusions as well as the foreign tax credit. In addition, if you decide to use the foreign-earned income exclusion, you will not qualify for the earned income credit for that year.
How do you decide which is the better option? It may be a good idea to talk to a tax professional before you choose between the credit or exclusions described above. Key factors in the decision include the tax rate of the country in which you are earning income, and the length and certainty of your stay in a foreign country.
If for example your foreign-earned income is taxed at a higher foreign income tax rate than your U.S. income, it would be better to claim the foreign tax credit. However, if you revoke this election, you won’t be able to take it again for another five years unless the IRS grants you special permission.
You must also be aware of the “stacking rule” which stipulates that foreign-earned income that is excluded from your gross income is still included when determining the applicable tax rate for U.S. citizens living abroad. This is to ensure that U.S. citizens working abroad still pay the same U.S. tax rates as those who are living and working domestically.
Don’t forget about social security taxes. If you do work abroad it is also key to learn how your self-employment taxes will be affected. As a refresher, your self-employment tax incorporates social security payments and Medicare tax — which must be paid when net earnings from self-employment are at least $400 for the tax year. The maximum amount of your net earnings from self-employment that are subject to the social security portion of the tax is $132,900 in the 2019 tax year. You must pay the Medicare tax on all your net earnings.
The United States has totalization or social security agreements with many foreign countries. The intent of these agreements is to coordinate the social security coverage and taxation of workers who earn income in other countries to avoid dual coverage and dual contributions. The result is usually that social security taxes (including self-employment tax) are paid only to one country. The following are some important caveats for specific situations related to how self-employment tax should be calculated:
- If you are a nonresident alien (i.e. not a U.S. citizen) you are not subject to self-employment tax. However, any self-employment income you earn while you are a resident alien in another country is subject to self-employment tax. This applies even if the income was paid to you for services performed as a nonresident alien.
- If you take the foreign earned income exclusion you must also use all of your self-employment income when calculating your net earnings from self-employment.
- If you own and operate a freelance business in Puerto Rico, Guam, the Commonwealth of the Northern Mariana Islands, American Samoa, or the U.S. Virgin Islands, your net earnings from self-employment in excess of $400 or more is subject to the self-employment tax, whether or not the income is exempt from U.S. income taxes, and whether or not you are required to file a U.S. income tax return.
If you are a U.S. citizen and are paid for services you provide to a foreign government or to an international organization, this self-employment income must be reported on your U.S. federal income tax return. As such any income for services that are performed within the United States will be subject to self-employment tax.
Foreign bank and financial accounts mean another tax form. If you set up any kind of foreign bank accounts (or you have signing authority on any) with an aggregate balance of $10,000 or more, you will need to file a tax form with the Treasury Department on April 15 each year, disclosing the details of your foreign financial interests. This form is called a Report of Foreign Bank and Financial Accounts or FBAR. The penalties for failing to file this form can be steep, so be sure to do it if necessary.
Expanding your freelance business to include work in other countries can be very exciting and a great business strategy. Just be sure that you are aware of all the tax implications that doing so entails so that you don’t end up with any surprise tax obligations or any unwanted attention from the IRS.
Jonathan Medows is a New York City based CPA who specializes in taxes and business issues for freelancers and self-employed individuals across the country. He offers a free consultation to members of Freelancer’s Union* and a monthly email newsletter covering tax, accounting and business issues to freelancers on his website, http://www.cpaforfreelancers.com — which also features a new blog, how-to articles, and a comprehensive freelance tax guide.
*Jonathan is happy to provide an initial consultation to freelancers. To qualify for a free consultation you must be a member of the Freelancers Union and mention this article upon contacting him. Please note that this offer is not available March 1 through April 18 and covers a general conversation about tax responsibilities of a freelancer and potential deductions. These meetings do not include review of self-prepared documents, review of self-prepared tax returns, or the review of the work of other preparers. The free meeting does not include the preparation or review of quantitative calculations of any sort. He is happy to provide such services but would need to charge an hourly rate for his time.