If you’re a self-employed individual whose business is located in the United States, but you also work with clients in other countries (or are thinking about expanding to do so) there are some very important tax rules you need to follow. This includes U.S. federal tax laws, the tax laws in the state where your business has a nexus and the country where you are doing business. While the laws are pretty complex and vary from situation to situation, it’s smart to have a general overview of how they work to keep yourself out of any tax troubles and to make sure that doing freelance work in a given country is beneficial for you.
In general, your federal tax obligations in the United States are based on a global tax system. That is, you pay tax on all of your income from any country or source. The United States provides a foreign tax credit against United States taxes for any income tax properly paid to other countries as long as the effective rate of the tax paid to the other country is not greater than the effective United States income tax rate on that same income. If you have paid excess foreign tax, it is carried forward to future tax years.
When you do work for clients in other countries, you must be familiar with how they tax income—or risk having to pay some serious tax penalties or other legal repercussions for not paying taxes correctly. Most countries have some kind of income tax which is usually applied to the income that a U.S. company, citizen or resident receives from their business transactions there. The exception to this is when your income is not subject to tax because there is a tax treaty between the United States and the foreign country.
The purpose of a tax treaty is to help businesses and individuals avoid paying tax twice on their income, thereby encouraging international commerce. Fortunately for you and your freelance business, the United States has income tax treaties with many countries including with most European countries and other major trading partners such as Mexico, Canada, Japan, China, Australia, and the countries of the former Soviet Union.
Typically, a treaty excludes a U.S. resident or company from the other country’s income tax on their earnings from business transactions there as long as they do not have a “permanent establishment” (i.e. a permanent place of business or residence) there. As an individual freelancer and a U.S. resident, you are not generally subject to tax in a foreign country as long as you are not in the country for more than 183 days. After this point, you are considered to have a “significant presence” and would be subject to paying income tax. In addition to the income tax provisions, treaties also often include a reduced or zero rate of withholding on passive income such as loan interest, dividends, rent, and royalties paid.
When it comes to social security taxes, the United States has totalization agreements with many countries. This means that U.S. individuals working abroad pay social security tax only to the U.S. government. Some agreements include clauses where if individuals must pay social security tax to a foreign government, this amount will be credited to their U.S. social security account. As you can see, if you do work on site for a foreign client at any point, it is key to learn how your self-employment taxes will be affected as well as your income tax.
Periods where you work abroad for a few days or weeks are different than if you actually go abroad and set up your business in another country. In the latter case, the foreign earned income exclusion may apply.
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 by 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.
Our NYC CPA firm specializes in taxes for expats and taxes for U.S. citizens working abroad. Contact us for assistance.