This is a guest post written by Author and CPA Olivier Wagner of 1040abroad.com
May expatriates chose the Ecuadorian lifestyle, but there are some things Americans should know about when they are thinking about relocating to a country such as Ecuador. U.S. citizens and U.S. persons are taxed on their worldwide income regardless where they reside and here are some implications of moving to a foreign country such as Ecuador when it comes to Social Security.
What is Social Security?
It’s a government system that you and your employer make equal contributions to throughout your work history. It will provide you with benefits when you lose your job, pension when you retire, etc. Tax deposits are collected by the IRS and entrusted in the Social Security Trusts. There are two Social Security Trusts; the Federal Old-Age and Survivors Insurance Trust Fund and Federal Disability Insurance Trust Fund. You have to pay into to the system for at least 10 years in order to receive its benefits (about 40 quarters). The threshold above which the social security is not taxed anymore is $127,000 in 2017, which means that any amount above this threshold will not be taxed. The social benefits you will receive depend on the amount of income you’ve earned while you worked (the higher your wages, the higher contributions you have made). If a US company employs you, your employer will deduct the appropriate social security contribution amount from your wages on a W-2. However, if you are self-employed, you will have to pay the social security and Medicare yourself at a rate of 15.3%. It is also known as the self-employment tax.
Now, what happens if you move abroad?
The US government has thought of you and to secure your future benefits totalization agreements were signed. These are treaties with governments of other countries that aim to eliminate the double taxation and also account for the time you lived abroad and contributed to the other country’s social security system. If you move to a country that signed a totalization agreement with the government of the U.S., you would contribute into the local social security system and such contributions would count as if they had been made into the US system at time of retirement, you would not have to contribute into the US social security system, regardless of your employment status. However, if you work in Ecuador (or other country that did not signed a totalization agreement), the two systems would work independently.
If you work for a non-U.S. employer as an employee, you would not contribute to the U.S. Social Security system while just paying your dues to Ecuador, thus your wages will still be subject to Social Security Tax. Only wages paid on or after the effective date of the totalization agreement can be exempt from the US Social Security Tax. For IRS’ more detailed explanation of the consequences of Social Security tax abroad, click here.
If you work for an American company, your employer will withhold your share of your social security contribution to later deposit it in the Social Security Trust together with his equivalent contribution. It will be reported on your W-2 he would later provide you at the end of the year.
If you are self-employed and you live in Ecuador, you can exclude up to $101,300 of foreign earned income using the foreign earned income exclusion (FEIE), provided that you meet either the physical presence test or the bona fide residence test. Foreign earned income is an income earned in a foreign country. In order to meet the requirements of the physical presence test, you must spend 330 days out of the country for a consecutive 12-month period. The consecutive 12-month period does not have to be 12 calendar months, it could start on March 2016 to end of February 2017. While preparing your 2016 return, you prorate the amount you can exclude based on the ration of the time you spent abroad during the tax year to the 2016 tax year. The bona fide residence test is more complicated as you do not automatically establish a bone fide residence by simply living in a foreign country for a year. You need to be a resident of a foreign country for uninterrupted period of time that includes one tax year and only then the length and the nature of your job determines whether you qualify for the FEIE. However, the FEIE won’t save you from paying the self-employment tax. Self-employment tax is the equivalent of social security and Medicare for those who are self-employed. For more information about the self-employment tax, click here.
By being employed by a non-US corporation, you would not be subject to either social security tax or self-employment tax (social security is only due if working for an “American employer” as defined by IRC 3306(j)(3), which would not include a foreign corporation). IRC 3306(j)(3) doesn’t make a distinction based on the shareholders of such corporation.
How to avoid paying the self-employment tax?
Creating a foreign corporation is the most common way to eliminate the self-employment tax. The foreign corporation pays you all the income as wages that you can later exclude using the FEIE on your personal tax return. The disadvantage of using a foreign corporation is the complicated form 5471, but you’re not paying the self-employment tax anymore (form 5471 is similar to a corporate tax return – but since the US doesn’t have jurisdiction over a foreign corporation, it requires the US shareholder to attach it to his/her personal tax return instead). The form 5471 is very complicated and I would recommend contacting an accountant that specializes in the US international tax. Many of the domestic Enrolled Agents and CPAs do not have any experience dealing with these types of forms and the penalties for erroneous 5471 or a failure to file the form are hefty ($10,000).
It is important for you to consider all your available options. As many try to avoid paying the self-employment tax, it is worth to bear in mind that the Social Security is there to benefit you in the future. It is your choice whether you want to eliminate the self-employment tax (social security) and not be eligible to claim any benefits such as pension or investing in a private pension plan.
1040 Abroad is there for all your US tax compliance needs. By and for expatriates, Accidental Americans and digital nomads. Serving US citizens living outside the United States since 2012.