Totalization Agreements Explained: Self-Employed US Citizens

Self employed people face a myriad of challenges going out of their own and building a business. One such challenge that can get overlooked is US taxes.

When a US person is employed by a US company, the company is required to withhold both income tax and social taxes on behalf of the employee. For the social taxes (Social Security and Medicare), the employer pays half and then takes the other half from you and pays it over directly. If you aren't paying attention, you may not even notice that you pay socials taxes on your wages.

What is The Self Employment Tax?

As a self employed person, there are no withholdings. Income taxes and social taxes are your responsibility and that can sneak up on you come tax time if you are not prepared. The Social Security (or FICA) and Medicare tax piece is called "self employment tax" in this case. The total self employment tax is made up as follows...

• FICA = 12.4% (limited to $168,600 of earned income)
• Medicare = 2.9% (no limit)
• Total = 15.3%

You do get a deduction for half of your self employment tax (i.e., to create parity with the employee situation where the employer pays half) but this is real money and not something to overlook.

So how does this impact a US citizen living abroad and earning self-employment income. That person is likely subject to a similar social tax in the local country which can cause a problem. This is where Totalization Agreements come into play and that is the subject of this article.

Client situation

Let's take a look at a typical U.S. expat tax scenario where totalization comes into play.

Here we have a U.S. Citizen who in Year 1 lives in the U.S. and has a Sole Proprietorship doing business consulting. Then, in Year 2 they become a tax resident of Spain and continue running their business remotely from Spain.

What we know

The US operates on a citizenship based taxation model. So our taxpayer is going to need to file a US tax return and report his self employment income to the US. Since he is also a tax resident in Spain, he is going to be subject to income tax in the local country as well.

The US tax code and treaties (if necessary) make it pretty clear how to deal with this double taxation of income. The US allows foreign tax credits and/or a foreign earned income exclusion which our taxpayer can take advantage of.

Unfortunately, that does not solve our self employment tax problem. Neither the foreign earned income exclusion nor the foreign tax credit can be used to offset US self employment tax. So if he is also paying Spanish social taxes (called "Regimen Especial de Trabajadores Autonomo" or "RETA") on that same income then we have a double tax problem.

The role of Totalization agreements

A totalization agreement is an international agreement that can prevent dual social security taxation and helps coordinate benefits between two countries. It also enables workers who split their careers between two countries to combine contributions for eligibility in social security benefits, avoiding gaps in coverage.

Here we are focusing on the double tax side of the totalization agreement.

First, you have to make sure there actually is an agreement with the country of residence. There are 31 countries in total where the US has agreements. Notable, most of Latin America is excluded with the exception of Brazil and Chile. Also, New Zealand is not on the list.

So if you are dealing with a country where there is no Totalization Agreement, then the double tax is real. In that case you would look to other restructuring options to see about making the earnings more tax efficient.

But in our case, with Spain, there is a Totalization Agreement. The SSA website provides a link to the agreement which lays out the procedures for utilization.

Step-by-Step: Using a Totalization Agreement to Save Taxes

1. Ensure there is an agreement with the resident country

2. Get a certificate of coverage

This requires that you write a letter to the resident country asking for their documentation that you are covered under their system. The will send a letter back (a certificate of coverage) which is your proof to the IRS that you can be exempt from US self employment tax.

3. Attach the certificate of coverage to your US Federal tax return.

There may be times where you don’t have the certificate of coverage in hand in time for the tax return due date. In that case, my suggestion and what I do is to include a statement in the return which documents the intention to utilize the specific Totalization Agreement and still exempt the self employment tax.

Concurrently, go ahead and request the Certificate of Coverage so that if the IRS were to inquire about it you would already have it or at least the wheels are in process.

Conclusion

The Totalization Agreement is a handy tool for avoiding double taxation on self employment income. Where there is not an agreement in place, more extension tax planning and structuring may be necessary.

As with all things tax, following the procedures correctly is critical in actually applying the benefits of this provision in practice. But if done correctly, it can save you real money so make sure to keep this one in your toolbox.