In an International Practice Unit (IPU), the IRS has explained the self-employment tax obligations of U.S. citizens and resident aliens who are self-employed in U.S. territories and have net self-employment income of $400 or more. (An IPU provides IRS staff with explanations of tax concepts.)
The self-employment tax is made up of Social Security and Medicare tax on net earnings from self-employment.
Who is covered?
Self-employed persons include:
- Sole proprietors, including independent contractors and sole members of limited liability companies (LLCs) that are disregarded for federal income tax purposes and are members of qualified joint ventures,
- Partners in a partnership, including members of a multimember LLC that has elected to be treated as a partnership for federal tax purposes, and
- Those who are engaged in business in a capacity other than as an employee.
An individual doesn’t have to carry on regular full-time business activities to be self-employed. Individuals can also be deemed to be self-employed if they have part-time businesses in addition to regular jobs, work on the side as independent contractors, or operate seasonal businesses.
Included in taxable self-employment income are:
- Gross income from a trade or business minus the allowable deductions attributed to that enterprise,
- A general partner’s distributive share (whether or not distributed) of income or loss from any trade or business carried on by a partnership, excluding rental, dividends, interest and capital gain or loss, and
- Payments received by a partner in a partnership for services rendered to the entity (such as guaranteed payments).
U.S. territories and Social Security
U.S. territories, including American Samoa, the Commonwealth of the Northern Mariana Islands, Guam, Puerto Rico and the U.S. Virgin Islands, have separate, autonomous income tax systems, but they don’t have their own separate systems for Social Security. The IRS is responsible for ensuring that self-employed individuals who live and work in U.S. territories comply with the requirements for paying self-employment tax.
Bona fide residents of U.S. territories are considered U.S. residents for purposes of the self-employment tax. They generally must pay both Social Security and Medicare to the United States. They must pay self-employment tax even if their self-employment income is excluded from gross income for U.S. income tax purposes and regardless of whether a U.S. income tax return is required to be filed.
Specific points regarding U.S. territories
The IRS guidance makes a number of specific points about the self-employment tax obligations of self-employed U.S. citizens and residents in Puerto Rico:
- That territory is a community property jurisdiction. If an individual and his or her spouse wholly own an unincorporated business as community property and only one spouse participates in the business, the income from the business is considered self-employment income of that spouse. If both spouses participate, the income and deductions are allocated to each spouse based on their respective distributive shares.
- While net self-employment income is generally computed the same way for territory income tax purposes as it is for U.S. self-employment tax purposes, some operating expenses that may be deductible on returns filed with Puerto Rico’s tax agency may not be allowed in computing net income for U.S. self-employment tax purposes. For instance, while the Puerto Rico tax return may allow the deduction of one half of self-employment tax, self-employed health insurance, and contributions to qualified pension plans as business operating expenses on Form 1040, these aren’t deductible when computing net self-employment income on Schedule C or F of the U.S. Form 1040.
Contact your tax advisor to help ensure you understand all the implications of the self-employment tax if you reside in a U.S. territory.
For a no-obligation discussion on the possible impact and steps you should take now, contact Lien Le, the head of our International Tax practice.