Background
Making the check-the-box election for a foreign operating business will make sense for many people. Certainly, it eliminates the dreaded Form 5471, and simplifies U.S. tax compliance.
But it may come with an added and unexpected tax cost: self-employment tax in the United States. If the American entrepreneur abroad is also paying employment taxes in the other country, that’s a net loss. Contributing to two countries’ Social Security systems is not the best idea in the world.
With that, let’s look at a simple situation that explores one of the edges of the check-the-box election: when a disregarded entity is (or is not) treated as a disregarded entity.
Facts
A foreign company is owned by Wife. Husband is an employee of the company.
The company is classified as a corporation for foreign country tax purposes and as a disregarded entity for U.S. tax purposes.
For foreign country tax purposes, both H and W are paid wages. They pay income tax and the foreign country equivalent of Social Security tax on the wages.
Questions
Must Wife pay U.S. self-employment tax on the foreign company’s net income? (Yes).
Are Husband’s wages subject to U.S. Social Security tax? (No).
Disregarded for everything, except some things
Start with the assumption that the foreign company is a disregarded entity.
For U.S. income tax purposes, Wife’s sole proprietorship because it is an entity disregarded from its owner. Reg. §§301.7701-2(a), 301.7701-2(c)(2)(i).
“Disregarded” status does not apply across the board. There are exceptions where the disregarded entity is treated as a corporation. Reg. §301.7701-2(a).
One exception is for employment tax purposes. Reg. §301.7701-2(c)(2)(iv)(B). “Employment tax” means Social Security, Medicare, and Federal Unemployment Tax on wages paid to employees.
Husband’s wages are exempt from U.S. Social Security
Let’s look at the Husband’s wages paid by the foreign company.
Social Security taxes are imposed on an employee’s “wages received with respect to employment.” IRC §3101(a), 3111(a).
“Employment” means, among other things, a U.S. citizen or resident alien working outside the United States for an “American employer.” IRC §3121(b)(B).
A foreign disregarded entity is treated as a corporation for employment tax purposes. Reg. §301.7701-2(c)(2)(iv)(B). And if the Internal Revenue Code treats the foreign entity as a corporation, it must be a foreign corporation—after all, it was organized under the laws of a foreign country.
A foreign corporation cannot be an “American employer.” Only a domestic corporation can be an American employer. IRC §3121(h)(5).
Husband’s wages were paid by a foreign corporation (not an American employer) for services performed outside the United States. This is not “employment” as that word is used in IRC §3121(b).
As a result, Husband’s wages from the foreign company owned by Wife are not “received by the individual with respect to employment (as defined in section 3121(b).” IRC §§3101(a), (b).
Thus, Social Security tax is not imposed on the employer or the employee.
Wife pays self-employment taxes
The exception for Social Security taxes (“treat a disregarded entity as a corporation”) does not apply to self-employment taxes imposed on a sole proprietor. This is self-evident from the fact that self-employment taxes are imposed by IRC §1401, while the employment taxes are imposed by IRC §§3101-3512.
It is also explicitly called out in Reg. §301.7701-2(c)(2)(iv)(C)(2).
Paragraph (c)(2)(i) of this section applies to taxes imposed under subtitle A of the Code, including Chapter 2—Tax on Self-Employment Income. Thus, an entity that is treated in the same manner as a sole proprietorship under paragraph (a) of this section is not treated as a corporation for purposes of employing its owner; instead, the entity is disregarded as an entity separate from its owner for this purpose and is not the employer of its owner. The owner will be subject to self-employment tax on self-employment income with respect to the entity’s activities. * * * *
Example in the Regulations
The Regulations have an example that is almost exactly on point (except for the fact that the disregarded entity, in our case, is foreign).
Reg. § 301.7701-2(c)(2)(iv)(D) gives the example of a single-member LLC (named LLCA in the example) that is classified as a disregarded entity. The sole member is A.
In part (iii) of the example, the effect of disregarded entity status on self-employment tax is addressed:
(iii) A is self-employed for purposes of subtitle A, chapter 2, Tax on Self-Employment Income, of the Internal Revenue Code. Thus, A is subject to tax under section 1401 on A’s net earnings from self-employment with respect to LLCA’s activities. A is not an employee of LLCA for purposes of subtitle C of the Internal Revenue Code. Because LLCA is treated as a sole proprietorship of A for income tax purposes, A is entitled to deduct trade or business expenses paid or incurred with respect to activities carried on through LLCA, including the employer’s share of employment taxes imposed under sections 3111 and 3301, on A’s Form 1040, Schedule C, “Profit or Loss for Business (Sole Proprietorship).”
Double taxation
This obviously causes a double-taxation problem for Wife in my example. She is subject to the foreign country employment taxes (because she receives a salary) and to U.S. self-employment tax on her Form 1040.
Totalization agreements can help. But there are not a lot of them, so maybe this solution is not available to prevent double imposition of employment taxes.