Dateline: Bogota, Colombia
Since the American Civil War, US citizens living abroad have had to deal with citizenship-based taxation. Whereas every other country in the world uses residential, territorial or even zero tax systems to determine taxable income, US citizens are obligated to keep up on their taxes no matter where their money comes from…
… and no matter where they live.
While this makes reducing your tax burden by going offshore more complicated for Americans, it doesn’t negate the benefit of doing so. It just means that more attention needs to be paid to how and where you do business.
Unfortunately for some, many forget to pay attention to the very underappreciated payroll tax. Just like income taxes, payroll taxes also follow you everywhere you go.
When people think about reducing or limiting their tax burden by going offshore, income tax is what their minds immediately go to. Many people get caught up thinking about federal income taxes, state income taxes, and even city income taxes. The problem with this thinking is that it doesn’t encapsulate the whole picture.
The reality is that most US citizens are paying more in payroll tax when they break out the tax calculator than they do in income tax.
This may not be entirely true for you if you’re one of the many six- or seven-figure entrepreneurs who visit our site, but cutting down on the amount that payroll taxes take out of your income is still a very important part of your tax strategy. Any reduction in your tax burden will allow you to invest more in your business.
For US citizens living and doing business overseas, there can be a lot of confusion on the subject of taxes. In other articles, we’ve covered how complicated the tax situation can be, but there are a couple of simple things that you can do to lower your payroll tax obligations while offshore.
In this article, we’ll cover how payroll taxes affect business owners and freelancers as well as a few ways that you can legally avoid payroll tax by changing how you do business, where you do business, and who you work with.
Nomad Taxes 101
For the first-time nomad, figuring out your taxes now that you’ve physically left the United States may seem a bit overwhelming. Let’s say you’re a freelance web developer who’s decided to leave the US to reduce your tax burden and cost of living. The last thing you want to do is jump into a new country where you’ll end up paying more taxes than you were paying in the US.
While you will generally be treated best as a tourist in most countries around the world, there are all kinds of hidden taxes that might not be apparent when you start looking into places to go. Before you make the jump, make sure to research the different potential taxes that you may have to pay abroad. You should also review the rules of tax residency for the countries that you will visit to ensure that you do not fall into the nomad tax trap.
Now, let’s say that you choose to go to Malaysia and start in Kuala Lumpur before exploring other countries in the region. After doing your research, it makes the most sense for your tax situation and the lifestyle you want to live. You pack up your life, move out there, and begin enjoying the food, culture, and people.
You’ve been out there for a while, having a very successful year, when it comes time to pay taxes.
The first thing that you need to take into account while working overseas is the Foreign Earned Income Exclusion. Because you’ve taken the steps to go where you’re treated best and live the lifestyle you want outside of the United States, you can use this tax benefit to exclude just over $100,000 a year from your taxable income.
This is a pretty attractive thing for many people. If your yearly income is less than the amount covered in the FEIE, you can eliminate your entire federal income tax, your state tax (in all but four states), and city income tax. All of it just goes away.
If not, it still leaves a decent dent in your tax bill.
However, this doesn’t entirely solve your tax problem. Even if you are self-employed overseas, you still have to worry about payroll taxes that go to fund Social Security and Medicare — two services that, if you’re living overseas, you probably won’t be using.
The amount you’ll lose will vary depending on your income, but it sits somewhere around 15%.
For many people, that 15% is going to be a very significant chunk. Even if you were able to exclude over $100,000 of your income from income tax through the FEIE, ~$15,000 still goes away in taxes thanks to the payroll tax.
Suffice it to say that just getting out of the country and qualifying for the Foreign Earned Income Exclusion won’t eliminate your entire tax burden. You still have to worry about payroll taxes.
The Payroll Tax Benefits of a Foreign Company
If you are a US citizen, what you need is a foreign company. You can set up a foreign company and then hire yourself and be paid as an employee of that foreign company.
If you are a freelancer, there are special rules that determine whether your foreign company really is a company in the eyes of the IRS, but once you get that set up, you’ll be shielded (at the very least, in part) from payroll tax.
The reason behind this is very simple: foreign companies do not pay payroll taxes to the US for their employees, even if their employees are US citizens.
So, if you want to be totally tax free as a US citizen, you not only need the Foreign Earned Income Exclusion, you also need a foreign company. Without it, you’ll still be stuck in the US tax net when it comes to payroll taxes.
With the recent Trump tax reform, some people doubted how substantial your tax savings could still be with a foreign company. It’s true that the old strategies don’t work the same way they used to, but that doesn’t mean that all the benefits have been lost.
The point of the foreign company is — if nothing else — to save yourself from the payroll tax.
If you are interested in creating your own offshore company, there are a few questions you’ll need to consider to determine how this strategy will benefit your tax situation. Check them out in this article to see if you’re ready to move offshore.
If it works in your particular situation, incorporating your business offshore will open you up to numerous benefits beyond taxation, including asset protection, investment opportunities, second residency, and even second citizenship.
There are countries around the world that take a much more friendly approach to corporate taxation than the US does in an effort to attract business owners. They need the money and are willing to do whatever they can to boost their economy.
There’s a great deal of research that needs to go into setting up an offshore company as it is just one of many moving parts in a holistic offshore plan. But, the good news is that this key player in your offshore strategy will also enable you to reduce or even eliminate your payroll tax burden.
The Payroll Tax Benefits of Hiring Offshore
While offshoring your business can help you eliminate payroll taxes, if you’re doing business in the US, this particular strategy will not be an option for you. In this case, instead of setting up a foreign company, you can reduce your payroll taxes by hiring foreign employees.
By doing your hiring outside of the US, you can cut down the amount that you have to give up to payroll taxes. As a business owner, you aren’t required to pay for the benefits associated with the payroll tax for foreign employees because only US citizens can benefit from Medicare and Social Security.
Now, most people focus on the fact that hiring foreign talent allows you to cut costs upfront. Lower wages means more savings for you. And this is certainly true.
I used to run a swimming pool business in the US. At the time, I was really getting into hiring out some of the office work through Upwork (Elance back in the old days). This was when Tim Ferris’s book “The 4-Hour Workweek” was really popular. I felt like it was worth a shot, so I tried out some of his ideas on my swimming pool business.
When it came time to sell my business, more than a couple of my potential buyers laughed when I told them I had a guy from Bangladesh posting ads on Craigslist for $1.50 an hour. Nobody else was doing it. They were all paying US workers or doing their advertising themselves.
Obviously, paying $1.50 an hour over even minimum wage at that time was saving me money, but there was the tax benefit as well. When it came to paying my payroll taxes, I didn’t have to include the guy doing all of my advertising.
If I had brought someone in, even part-time, to handle my social media for me, I would have had to pay their Social Security tax, Medicare tax, unemployment tax, and all the different state and federal taxes on top of their hourly wages.
All of those additional taxes can add up to an extra 10% or 12% of their salary.
When most people think about hiring offshore, they think of getting the work done and paying much less for it. But even if you go looking for high-end help with wages that rival what you would be paying in the US, there are still huge savings.
Hiring “offshore” can significantly reduce your payroll tax burden, even if you’re not ready or you are unable to offshore your business.
How to Hire Quality Offshore Work
Now, the immediate problem with hiring offshore is that, if you do it wrong, you’ll be spending the money you could have saved trying to find quality work. If you’re a digital nomad looking into building a business, who you hire is a very important decision.
Many people worry when going offshore that they won’t be able to find quality work or that they’ll have to deal with cultural and language barriers. These can be problems, but they can be minimized with the right research and thought.
The reality of the situation is that there are several places around the world with a surplus of educated labor looking for work wherever they can find it. In China, for example, recent college graduates are entering a workforce that is already densely packed with other educated graduates that often have several degrees.
Fierce competition and English fluency make them great picks for business owners looking to offshore their labor. I have had great success in hiring and building a team with talent from Eastern Europe. If you look in the right places, you can find great employees that match the pace and style of your business.
Having a variety of different perspectives helps my business even if I’m not paying them any less than I would be paying someone in the US.
That doesn’t mean it won’t take some work to find the right employees. You’ll need to understand the kind of personality you work best with and look in the right places. But when you start looking, the right answers might surprise you.
Many US citizens don’t consider payroll taxes as a part of the equation when they build out their offshore strategy. It’s a very underappreciated part of the tax system and definitely something that you want to keep in mind as a US citizen looking to better your situation.
If you go offshore and take advantage of the Foreign Earned Income Exclusion, you will certainly reduce your income taxes. That just shouldn’t be the end of your efforts.
If you’re a freelancer or a digital nomad, you may benefit by setting up your own foreign company. Doing so will help you get the tax breaks you need to live more of the life you desire.
If you’re already a business owner, going offshore can be a real benefit to your corporate and personal tax strategies as well.
While there are benefits to taking everything offshore, it isn’t possible in every case. When it isn’t, start diving into the pool of foreign labor. You’ll be able to find quality work that satisfies the needs of your business. You’ll find new perspectives, ideas, and even markets for your business that could help you move forward.
You’ll often find all of this without the same high wages you’d find at home. But that’s just the cherry on the top when you compare it to legally and effectively reducing your payroll tax obligations.