Foreign Earned Income Exclusion And Other Tax Breaks

“Kathleen, regarding your response to a recent question from a reader, if this reader is a U.S. citizen and follows your advice, wouldn’t he still be liable for paying the 15.3% U.S. self-employment tax?

“Or does the non-U.S. company have to pay the employment tax? Maybe there is some loophole in the tax code whereby the U.S. citizen ends up not having to pay employment tax when he qualifies for the Foreign Earned Income Exclusion?”

— Dorothy G., United States

Correct. If you are working overseas for a non-U.S. company, you don’t pay Social Security…even if the non-U.S. company is your own.

If you are working for a U.S. company and being paid outside the U.S., you still can qualify for the Foreign Earned Income Exclusion, but you’ll have Social Security and Medicare charges withheld from your check (unless you are exempt for some other reason…for example, if you’re paying into another country’s social security system).

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“Kathleen, I am an American currently living in Germany but may relocate to Spain or Mexico in a few months. I receive, basically, four types of income: Social Security, two retirements, plus inherited royalties. I have little or no income from foreign sources. Can I take advantage of one or the other foreign residence provisions that allow me up to US$90,000 before paying taxes. Rarely do I exceed US$50,000 in total annual income.

“Must I pay tax on my U.S.-generated Social Security and other U.S. retirements, or are they included in the US$90,000?”

Phil G., Germany

When you reference earning up to US$90,000 tax-free as an American residing overseas, you’re thinking of the Foreign Earned Income Exclusion (FEIE). And, in fact, the amount of this exclusion for 2014 is US$99,200 per person.

However, retirement income does not qualify for this and is going to be taxable no matter what. It’ll either be taxable in the United States, or it will be taxable in the country you move to, depending whether or not a double-taxation treaty is in place and the specifics of the treaty.

The FEIE applies to earned income only. And, remember, it applies to U.S. tax on earned income. Depending on the country where you are living, you could owe taxes on that earned income locally. This is why, as an American abroad, you need two tax advisors—one in the States and one in the country where you’re residing.

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“Kathleen, I know that some income earned overseas can be excluded from my U.S. tax return, but what about an Internet business where income is derived from many different countries?

“In other words, if we move to Panama to run our business, is the income excluded regardless where it comes from, even if it comes from the United States?

“Thanks, and I love reading your dispatches.”

— Gary C., United States

As long as the income is earned doing work outside the United States and as long as you qualify for the Foreign Earned Income Exclusion (FEIE), through either bona fide residency or the “days test,” then, yes, all the revenue would be eligible for the FEIE, including the revenue generated from U.S. sources.

The thing to do would be to set up a non-U.S. company to own the Internet business and then to pay yourself a salary from that company not exceeding the allowable FEIE amount each year. This can be an effective (and legal) strategy for paying zero tax, depending on your country of residence.

 

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