Taxation is far from being the most exciting part of your freelancing business. As a matter of fact, it is a very dull, boring, time-consuming, frustrating and expensive part of your life.
And if you think that’s bad, consider this: taxes also have the power to prevent you from achieving your life goals.
As a freelancer, you work hard to establish your reputation, staying on top of your profession with the latest developments, devoting countless hours to your clients. You do everything you can to create value for your clients and grow your business.
Unfortunately, that’s not enough. Because unless you find a way to keep all your hard earned gains for yourself without getting in trouble with the taxman, all your efforts will be in vain.
That is why you need to be tax conscious, to take every tax saving you are legally entitled to. Remember: every penny you keep in your pocket is money available to invest in your business; while every dollar you pay in taxes is money not available to cover expenses or future investment.
This is particularly dramatic if you are a freelancer from the United States (including Puerto Rico) living and working abroad, due to the way the U.S. taxes its citizens.
If you are a U.S. citizen or resident alien, your worldwide income is subject to U.S. income taxes, regardless of where you live. The common belief that you do not have to pay federal taxes because you moved out of the U.S. is simply not true.
For example, let’s assume that you are a freelancer living and working in Spain. As a consequence of U.S. worldwide taxability, you are still liable to the Internal Revenue Service for taxes based on that income generated while living in Spain; on top of any taxes imposed by the Spanish government.
This situation (known as “double taxation”) creates a major challenge for any freelancer living and working abroad. How can the freelancer offer competitive prices if his or her income will be subject to tax by two different countries?
Fortunately, the U.S. Internal Revenue Code provides mechanisms to either alleviate or eliminate the negative financial impact created by double taxation. The most important of these tax advantages are the:
- Foreign Earned Income Exclusion
- Foreign Earned Housing Exclusion
- Foreign Tax Credit
This article will discuss the “Foreign Earned Income Exclusion,” leaving the “Foreign Earned Housing Exclusion” and the “Foreign Tax Credit” for future publications.
The “Foreign Earned Income Exclusion” is a tax saving within the U.S. tax code that allows taxpayers who meet certain criteria to exclude from their taxable income up to $101,300 for tax years beginning in 2016.
Does this mean that if you qualify for this tax break you will not have pay income taxes to the IRS on $101,300 of your income for the year 2016? Yes. If you qualify for this tax saving opportunity, you will not have to pay federal income taxes on $101,300 of your income; in other words, $101,300 income tax free. And now, the most important part, how to qualify for this tax privilege.
There are two ways to qualify for the tax exemption: The “Bona Fide Residence Test” and The “Physical Presence Test.”
The “Bona Fide Residence Test”
To qualify for the Bona Fide Residence Test, you (the taxpayer) are required to maintain a “tax home” for the entire year outside the U.S. Your “tax home” is your main residence, the place you actually call home.
You do not need to purchase the property. You can rent a house or an apartment, but this place has to be your main residence and it has to be located in a foreign country. You also have to become a resident of the foreign country for an entire year, beginning on Jan. 1st and ending on Dec. 31st.
Obviously, most taxpayers will not qualify for the “Foreign Earned Income Exclusion” on the first year, since it requires the taxpayer to move abroad on Jan. 1st. Therefore, most taxpayers qualify under the “Bona Fide Residence Test” during the second year and forward. For the first year, taxpayers typically qualify under the “Physical Presence Test,” discussed below.
The “Physical Presence Test”
The “Physical Presence Test” is the second way to qualify for the Foreign Earned Income Exclusion. It requires the taxpayer to live outside the U.S. for 330 days during any period of 12 consecutive months.
This is how most taxpayers will qualify for the exclusion during the first year, since it does not require the taxpayer to move outside the U.S. on Jan. 1st. This test does not require the taxpayer to become a resident of any country in particular (other than the U.S.); it only requires the taxpayer to remain outside the U.S. for 330 days during a 12 consecutive month period. And now, let’s discuss the fine print: what the extension does not cover.
What the Extension does NOT cover
First, the “Foreign Earned Income Exclusion” is a tax saving for federal income taxes only; it does not apply to state income taxes. If you live in states with no income taxes, such as Florida, you will not pay state income taxes regardless of the “Foreign Earned Income Exclusion,” because Florida does not have a state income tax.
However, if you are in a state that taxes natural persons (not corporate entities) who are considered domiciled in the state, regardless if they live outside the state or out of the U.S., you might have to pay state income taxes on your foreign earnings. This determination is done on a state-by-state basis. Therefore, you will have to consult a tax professional with experience within your particular state of origin.
Second, the “Foreign Earned Income Exclusion” is a tax saving for federal income taxes; it does not apply other taxes, such as the “Self-Employment Tax.”
If you are self-employed (as most freelancers are) you are required to pay “Self-Employment Taxes” on top of Federal income taxes. “Self-Employment Tax” is considered a payroll tax (Medicare and Social Security, also known as FICA), not an income tax, therefore, it is not covered by the “Foreign Earned Income Exclusion.”
This means that even if you qualify for the “Foreign Earned Income Exclusion,” you still will have to pay “Self-Employment Taxes” to the IRS, unless you are covered by the Social Security Program of another country, a subject that is way beyond the scope of this article.
Third, the “Foreign Earned Income Exclusion” is a tax saving for income that is earned. Earned income is generally income that is generated by way of labor, such as salaries or professional services.
The “Foreign Earned Income Exclusion” does not cover income such as dividends and interests. Therefore, even if you qualify for the “Foreign Earned Income Exclusion” on your freelancing income, if you have unearned income (like revenues from rental property) you might be liable to pay the IRS taxes on your rental income.
Fourth, the “Foreign Earned Income Exclusion” is an exclusion of income from the U.S. system of taxation. It has nothing to do with taxes imposed by the country where you become resident.
Please — and I cannot emphasize this more — consult a competent tax advisor who has experience in tax matters of your country of residence. Tax penalties from countries other than the U.S. can be very severe. This is definitely not a subject to be taken lightly.
A final thought
The “Foreign Earned Income Exclusion” is a great tax advantage available for freelancers living and working abroad. However, qualifying for the exclusion does not relieve the taxpayer from their filing obligations with the IRS.
As a matter of fact, you are required to file a tax return with the IRS to claim the “Foreign Earned Income Exclusion.” If you do not file with the IRS, even if you qualify for the “Foreign Earned Income Exclusion” and owe zero taxes, as a penalty, the IRS can disallow the “Foreign Earned Income Exclusion” for up to five years. This means that as a penalty for not filing, you will have to pay taxes on your foreign earned income.
As you can see, being a successful freelancer requires more than being good at your trade. It involves many other aspects of your business, like keeping your earnings safe, by being in compliance with the different taxing authorities of your particular reality.
Remember: “What you know makes you money; what you ignore costs you money.” Always be on the lookout to get all the tax savings you are entitled to; while at the same time always be in compliance with the regulatory environment where you operate.
AUTHOR’S NOTE: This article is for information purposes only and does not constitute legal tax advice from the author. It is only intended to make the reader aware of certain tax advantages contained within the U.S. Internal Revenue Code available to U.S. freelancers living outside the United States. The article applies to U.S. federal taxes ONLY; it does NOT apply to state or local taxes, or to taxes levied by the current home country of the freelancer living abroad. Please consult a licensed CPA or tax attorney before considering the information contained within this article to your particular tax situation.