While trotting the globe to visit foreign countries is an invaluable experience, it’s important to remember that your income will be taxed regardless of where you are traveling. U.S. citizens and residents are subject to U.S. income taxation on their taxable income on a worldwide basis, one of the few remaining industrialized countries with this ‘worldwide’ tax system.
But wait! If you are living and working in Guam, the Commonwealth of the Northern Mariana Islands (CNMI), American Samoa, the U.S. Virgin Islands, or Puerto Rico you may be one of the few exceptions to this rule. Bona fide residents of these beautiful locations pay no U.S. income tax on income sourced from these U.S. possessions or territories.
Jose M. Curet v. Commissioner
This doesn’t mean your entirely free of U.S. taxes as a recently decided U.S. Tax Court Memorandum reminds us in Jose M. Curet v. Commissioner (T.C. Memo. 2016-138). In this case, Mr. Curet lived and worked as a self-employed consulting engineer in Puerto Rico. He properly filed and paid all Puerto Rican taxes. In a subsequent year, Mr. Curet received a notice of deficiency from the Internal Revenue Service stating he did not pay U.S. self-employment tax on his earnings.
Mr. Curet argued that he was not subject to any U.S. tax because he was a resident of Puerto Rico and all his earnings were sources to this U.S. territory. The court disagreed and said that while he was exempt from U.S. income tax, the Internal Revenue Code clearly states he is still subject to self-employment tax.
What exactly is the U.S. Self-Employment Tax?
Under U.S. rules, the self-employment tax is a substitute payroll tax for those who are not employees. As you know, payroll taxes automatically deduct income tax, FICA, and Social Security from employee paychecks. Since the self-employed do not receive paychecks, they must self-assess these taxes to pay their share of FICA and social security.
Like U.S. based employees, employees in Puerto Rico also have payroll taxes taken out of their paychecks since they are eligible for social security benefits. As a result, all residents and workers in Puerto Rico pay no U.S. income tax but employees and the self-employed do pay the social security tax.
It is important to note that this rule on self-employment tax also applies beyond Puerto Rico. A common error is when a citizen is working outside the U.S. as self-employed. Even if you qualify for the foreign earned income exclusion which exempts foreign income from U.S. income tax, the full amount of self-employment income is still subject to self-employment tax.
The lesson here is that if you are a U.S. citizen or resident, the U.S. self-employment tax is mandatory no matter where you are, even if you are exempt from U.S. income tax.