A US citizen living outside the US still pays taxes on their worldwide income just as if they lived in the US. However, but they are allowed to exclude from their taxable income an amount (indexed for inflation) of foreign earned income. The Foreign Earned Income Exclusion (FEIE) amount for 2020 is $107,600.
As a self-employed person you are probably familiar with Schedule C, that extra form in your tax return that looks similar to your business’ profit and loss statement. But how familiar are you with the FEIE and the factors which reduce its effectiveness for self-employed taxpayers?
There are many rules regarding qualification for the exclusion which you can read about here <link> in our article on qualifying for the FEIE. In this article we will look at how the exclusion is calculated for self-employed persons.
Let’s examine this through the example of Jen, a self-employed consultant.
For 2020 Jen earned $200,000 in gross business income and had business expenses of $100,000, therefore, her net business income was $100,000 ($200,000-$100,000). Great, you think, given the 2020 designated exclusion amount of $107,600, Jen has no taxes to pay. She simply excludes the $100,000 of net Schedule C business income. Unfortunately, it’s not that simple.
The first consideration is Self-Employment tax. This is levied on net self-employment income and requires the self-employed person to pay both the employer’s share and the employee’s share of the Social Security and Medicare taxes. Based on IRS designation numbers, this is 15.3% on 92.35% of the first $132,900 of income and 2.9% on income in excess of that amount. For Jen, the self-employment tax on the net $100,000 would be $14,130 ($100,000 x 92.35% x 15.3%).
Unfortunately, this isn’t the end of the issue. Next, we need to apportion some of our expenses to the income we are trying to exclude.
Even though self-employed taxpayers are required to pay self-employment tax they are permitted to deduct the ‘employer’ share of the self-employment tax (which is one half the self-employment tax). In the case of Jen, that would be $7,065 which is half of $14,130. Therefore, Jen’s total ‘allocable deductions’ is $107,065 (the business expenses $100,000 and one half of the self-employment tax $7,065).
Since we want to exclude $107,600 from the $200,000 of income, we must allocate some of the deductions of $107,065 to the income we wish to exclude. We do this by multiplying the deduction by the ‘exclusion ratio’. To calculate the ‘exclusion ratio’ the FEIE amount of $107,600 is divided by the gross income amount $200,000 ($107,600/$200,000) = 0.538. Thus, for Jen $107,065 multiplied by 0.538 equals $57,601. This is the amount which is allocated to the excluded income. To determine the amount of the FEIE which remains to be excluded from net profit we deduct this amount of $57,601 the exclusion amount ($107,600) leaving an allowed FEIE amount of $49,999.
Therefore, the net income after the allowed FEIE is $50,001 ($100,000 net profit minus $49,999).
Of course, Jen is entitled to the same deductions and credits on this remaining income as every other self-employed taxpayer. Jen will receive the standard deduction of $12,400 (for a single person). As Jen is a self-employed consultant, she qualifies for the Qualified Business Income Deduction ($10,961 in her case), and she can deduct one half of the self-employment tax $7,065. That leaves taxable income of $19,575. From the tax tables, we can calculate that the income tax payable of $19,575 is $2,152.
So we’ve calculated that Jen a self-employed person who qualifies for the Foreign Earned Income Exclusion has a tax liability of $16,282 (self-employment tax of $14,130 and tax of $2,152) even though her net profit from her self-employment is less than the FEIE amount of $107,600.
Here the same information in a table format:
1. Foreign Earned Income Exclusion limit (from the IRS)
2. Standard Deduction (from the IRS)
3. Gross income (from the example)
4. Expenses (from the example)
5. Net income (subtract item 4 from item 3)
6. Self-Employment Tax ‘SE Tax’ (calculation omitted)
Business Expenses from Schedule C (net income, item 5)
SE Tax Expense (one half the SE Tax, item 6 divided by 2)
7. Total Allocable Deductions
8. Foreign Earned Income Exclusion (item 1)
9. Total Foreign Earned Income (Gross income, item 3)
10. Exclusion Ratio (item 8 divided by item 9)
11. Deductions Allocable to Excluded Income (Multiply item 7 by item 10)
12. Foreign Earned Income Exclusion (item 1)
13. Deductions allowed in figuring AGI (item 11)
14. Net Allowed FEIE Amount
15. Net Sch C income (item 5)
16. Net Allowed FEIE Amount (item 14)
17. Income after Net Allowed FEIE (item 15 minus item 16)
18. Standard Deduction (item 2)
19. QBI Deduction (calculation omitted)
20. One half SE Tax adjustment (item 6 divided by 2)
21. Taxable Income (item 17 minus items 18, 19, and 20)
22. Income Tax (from tables calculation omitted)
23. SE Tax (item 6)
24. Total Tax (item 22 plus item 23)
This is a simplified example ignoring additional possible deduction such as self-employed health care costs, moving expenses, foreign housing expenses, and foreign taxes.
The main takeaway for the self-employed claiming foreign earned income exclusion is that your business expenses, which reduce your taxable income, also reduce the amount of foreign income you are allowed to exclude.
If you’d like to discuss your personal situation, please feel free to contact us.