by Jane A. Bruno
author of
The Expat's Guide to U.S. Taxes (Hands on Help for Americans Overseas)

If you are an American citizen living overseas and running your own business, you face many challenges. Not only are you trying to make a profit with sales of your product or service, but your host country may have a myriad of rules and regulations regarding the operation of your business. In addition, as an American, you are taxed on your worldwide income so each year you must report your net profit on a US tax return and pay any taxes that are due.

The purpose of this article is to discuss some of the complexities of the tax rules applied to small businesses operating overseas. It assumes your business is operated as a sole proprietorship and that you file a Schedule C, Profit or Loss from Business. The information given here should not be relied on if you have a partnership or a corporation.

As a starting point, you should realize that income earned in a small business will qualify for the foreign earned income exclusion, (assuming the other requirements are met). This means that you can exclude up to $70,000 of foreign earned income from US tax each year if your tax home is in a foreign country and you are either a bona fide resident or meet the physical presence test. You are also entitled to take a foreign housing deduction, which in some cases may allow you to exclude more than $70,000 of income from US tax.

Preparation of Schedule C and Form 2555— When you have a small business, preparation of your US tax return requires more than as just reporting your income on Form 2555, Foreign Earned Income, and taking the appropriate exclusion. This is because of the tax interaction of foreign earned income and deductible business expenses. To the extent that income is reduced by expenses, such income is not eligible for the earned income exclusion.

To illustrate, let’s look at the following example:
Let’s suppose you are self-employed in a foreign country and qualify as a bona fide resident. Your income was $120,000, but you had expenses of $60,000. In preparing your tax return, you will first fill-out Schedule C without regard to your overseas status. This means you will report $120,000 of income and $60,000 of expenses, leaving you a net profit of $60,000 which is reported on Form 1040.

You then prepare Form 2555, reporting the full $120,000 of gross income and excluding $70,000 of it. The next step is to calculate what percentage of your income was excluded. This is $70,000/$120,000 or 58% of $120,000. Since you excluded 58% of income, you also have to exclude 58% of expenses or $34,800 ($60,000 X .58) This will have the effect of reducing the amount of income you can exclude on Form 2555 to $35,200 ($70,000 -$34,800).

The last step is to transfer the calculations from Schedule C and Form 2555 to Form 1040. You will show net income from Schedule C as $60,000 on Form 1040 and net excluded income from Form 2555 as $35,200 on Form 1040. The difference of these two, or $24,800, will be taxable income.

Self Employment Tax—It may come as an unpleasant surprise to many ex-pats that the foreign earned income exclusion does not apply to the self-employment tax. This means that if you have your own business overseas or are an independent contractor, you are required to pay self-employment tax on your net earnings. For 1996, the Social Security portion of the tax is on net earnings of $400 or more (up to $62,700). All net earnings are subject to the Medicare portion. In order to calculate this tax, you will need to prepare Schedule SE, Self Employment Tax.

Jane A. Bruno is an attorney with a Master's in Tax Law from George Washington University. She has extensive experience with tax issues related to living overseas, having lived in several countries in Europe and Africa over the past 12 years. A former IRS employee, she has worked as a tax consultant/preparer in such diverse places as Germany, South Africa and the Commonwealth of Virgina. She recently published:

The Expat's Guide to U.S. Taxes (Hands on Help for Americans Overseas)
by Jane A. Bruno

This self-help book presents in simple and concise form the complicated U.S. tax laws that impact on Americans living overseas. It covers a wide range of topics, starting with the most common tax situations for Americans living overseas and ending with an appendix of tax forms and other important tax information. Numerous examples are used to clarify difficult points and tax saving tips are given where appropriate.