In our last post, we started going over the 20 most common tax forms that taxpayers with foreign income and assets typically use to report those assets and income to the IRS.
We have already covered the following forms: (If you missed our previous issue, you can download it using this link):
Today, we are going to cover the following tax forms:
#6 – Schedule SE – Self Employment Tax:
This form is used by taxpayers who run independent businesses alone, or in partnership with others. This includes sole proprietors, members of single member LLCs and partners in multi-partner LLCs or LLPs.
What is this form used for?
This form is used to calculate self-employment taxes. Self-employment taxes are not income taxes, they are social security taxes.
Why is this calculation needed?
It is needed because any persons conducting their own business are not just the business service provider to their customer or clients, they are also their own employer. They are both employee and employer.
As the employer of themselves, they are responsible for calculating and paying their own social security and Medicare tax. They are responsible for both the employer portion and the employee portion. Form 1040-SE is where those calculations are made.
Do Americans who are self employed abroad need to use this form?
Every taxpayer who is required to file Form 1040 as a US tax resident because they are living in the USA and providing services from the USA, are required to use this form if they have income from their business activity in excess of $400 per year. Just $400 per year of income triggers the requirement to use this form.
If the US taxpayers are living abroad and providing services from a foreign country, the USA has international social security agreements with 30 of those countries. If they live and are self-employed in one of those 30 countries, their income could very well be exempt from US self-employment tax, and subject to self-employment taxes in their country of residence instead.
What does an international social security treaty do?
One of the main goals of any tax treaty is the avoidance of double taxation. Social security agreements determine what country taxes a person for social security purposes when two different countries would otherwise have the right to tax that person.
The default rule in these agreements is that self-employment income is subject to social tax in the country in which the taxpayer is physically providing services, not in their country of citizenship or perhaps not even their country of normal residence.
Having said this, there is no 100% uniformity in the Totalization Agreements, which is another name by which international Social Security Agreements are known. Therefore, it’s important to check the Totalization Agreement that applies to you before reaching any conclusions about your social security tax obligations.
Where can you find copies of these Totalization Agreements?
In the Social Security Administration’s website. To link to the relevant section of the SSA’s website, click here.
What happens if you live in a country with which the USA does NOT have a Totalization Agreement?
In those cases, you will need to complete Form 1040-SE following the form instructions, calculate your self-employment tax and make the resulting payments.
Unfortunately, many times this will mean that you will be double taxed for social taxes, as it is likely that the foreign country where you are working and living will also require that you make contributions into their system, in addition to the requirement imposed by the USA.
# 7 – Schedule D – Capital Gains and Losses:
This form is used to report the gains and losses on capital assets that you sold during the year.
What is a capital asset?
The IRS says the following about capital assets:
Almost everything you own and use for personal or investment purposes is a capital asset. Examples include a home, personal-use items like household furnishings, and stocks or bonds held as investments.
When you sell a capital asset, the difference between the adjusted basis in the asset and the amount you realized from the sale is a capital gain or a capital loss. Generally, an asset’s basis is its cost to the owner, unless you received the asset as a gift or inheritance, in which case, special rules apply to determine the original cost to you apply. We will discuss cost basis of gifts and inheritances in a separate issue of CBP.
Capital gains and losses are considered long term when the asset that was sold was owned by you by at least one year plus one day. If you owned the asset for a year or less and then sold it, the gain or loss on the sale is short term.
The difference between short term and long-term matters because long term gains are taxed at reduced tax rates that are more favorable than the tax rates that apply to other types of income such as wages, interest and rents.
This is where I would like to issue a warning about a common mistake that I see in self prepared tax returns of US taxpayers with foreign financial investments:
Investment funds like mutual funds and exchange traded funds are treated as capital assets, if, and this is a big IF, they are registered in the USA.
When an investment fund is registered abroad, it is typically classified as a Passive Foreign Investment Company or PFIC, for short. The gains from sales of PFICS are generally not reported in Schedule D, and the dividends earned through PFICs are generally not reported on Schedule B, where dividends from US funds are reported.
In both cases, where the investment fund is foreign, Form 8621 is required to be used instead, so let’s talk a little bit about this form.
# 8 – Form 8621 – Information Return by a Shareholder of a Passive Foreign Investment Company or Qualified Electing Fund
Form 8621 is used to report income from PFICs, including dividend distributions and gains from sales of PFIC shares.
Form 8621 is NOT a simple form.
It is not supported by tax preparation software sold to individuals. To be candid, most professional tax preparation software do not fully support it either, and some don’t do it at all.
Heck, even many tax professionals have chosen to run away from this form, particularly if they don’t focus on international tax clients in their practice.
If you are required to file Form 8621, you will likely need the assistance of an international tax professional.
The instructions to this form are 15 pages long and below is how much time the IRS estimates you will need to complete one of these forms. Just one of these forms. Keep in mind that you are required to fill out one Form 8621 PER investment fund.
If, for example, you have 10 different foreign mutual funds in your foreign brokerage account, you will need to fill out 10 different 8621s. How much work will this be, per the IRS, per form by the way?
Recordkeeping: 16 hr., 58 min.
Learning about the law or the form: 11 hr., 24 min.
Preparing and sending the form to IRS: 20 hr., 34 min.
Does dedicating 203 hours and 40 minutes preparing these 10 forms sound fun to you? I didn’t think so!
By the way, there’s 168 hours in a week.
If you are curious about how to make better use of your 168 hours than by preparing 8 PFIC forms, you may want to check out this book.
Back to taxes:
Given the form’s complexity and the unlikelihood that you will decide to fill it out by hand on your own, we are not going to spend a lot of time going into the form details. We will limit ourselves to creating awareness that this form exists.
You are now aware of Form 8621.
What is the lesson you just learned?
If you have a foreign brokerage account that is invested in foreign funds, and those funds earn dividends (even if you reinvest those dividends) or you sell all or part of your fund holdings at a gain, then:
You may need to file Form 8621.
If you believe you need a refresher about PFICs, it’s a subject we talked about them a few months ago when we discussed about foreign pensions, because foreign pensions tend to be full of PFICs. A copy of that discussion can accessed through our blog, via this link.
I think I may have created too much awareness of the complexity of international tax reporting for one week, so I let you be for this week. We’ll resume our talk in seven days, with Schedule E and rental income.
Be safe and stay healthy!