2025-08-07
This post discusses some of the US tax rules that apply to self-employed US citizens living abroad. However, this post only focuses on sole proprietorships where the individual does not operate through a US or foreign entity.
Separate from owing US income taxes, self-employed US citizens generally must also pay a 15.3% self-employment tax on their self-employment income.[1] US self-employment taxes, along with other FICA taxes, fund US social security.
Self-employment income generally includes income derived from a trade or business carried on by an individual.[2] If a US citizen is deriving income from a trade or business (inside or outside the US), that individual generally must complete Schedule C (Profit or Loss From Business) and Schedule SE (Self-Employment Tax).
Many foreign countries impose their own social security taxes on self-employed individuals. Thus, without some sort of relief, US citizens living outside the US would often be subject to double social security taxes.
Although one of the purposes of US income tax treaties is to avoid double taxation, US income tax treaties apply to income taxes and not to social security taxes.[3] However, Congress has authorized the President to enter into social security agreements (often referred to as "totalization agreements") with foreign countries.[4] One of the purposes of the totalization agreements is to avoid double taxation with respect to social security taxes. The Social Security Administration website shows that the US currently has 26 totalization agreements in force.[5]
Totalization agreements generally provide that individuals permanently or indefinitely resident in a country only pay social security taxes to that country.[6] Thus, US citizens living in foreign countries that have totalization agreements with the US can generally avoid US self-employment tax.
The instructions to Schedule SE state that you should obtain a statement (often referred to as a "certificate of coverage") from the appropriate agency of the foreign country verifying that your self-employment income is subject to social security coverage in that country. The instructions then state to attach a copy of the statement to Form 1040 and enter "Exempt, see attached statement" on Schedule 2.[7] In practice, many individuals do not obtain or attach the statement to their tax return. Most tax return preparation programs allow taxpayers to simply check a box indicating that they are exempt from US self-employment tax.
If a self-employed US citizen is located in a country that does not have a totalization agreement with the US, the individual will be subject to both US self-employment tax and foreign social security taxes. However, in this case foreign social security taxes can typically be claimed as foreign tax credits against US income tax.[8] If the foreign country has a totalization agreement with the US, then no foreign tax credits are allowed for the foreign social security taxes.[9]
A US person that operates a foreign branch needs to file Form 8858.[10] The instructions to Form 8858 state that the term "foreign branch" is defined in Treas. Reg. §1.367(a)-6T(g),[11] but also includes a foreign qualified business unit ("QBU"), as defined in Treas. Reg. §1.989(a)-1(b)(2)(ii).
Treas. Reg. §1.367(a)-6T(g) provides in part:
[T]he term foreign branch means an integral business operation carried on by a U.S. person outside the United States. Whether the activities of a U.S. person outside the United States constitute a foreign branch operation must be determined under all the facts and circumstances. * * * Activities outside the United States shall be deemed to constitute a foreign branch * * * if the activities constitute a permanent establishment under the terms of a treaty between the United States and the country in which the activities are carried out. * * *
A self-employed individual in a foreign country, in most cases, would seem to have an integral business operation carried on outside the US. The activities of a self-employed individual would also typically constitute a permanent establishment (if a treaty exists). Therefore, most self-employed individuals in foreign countries likely have a foreign branch under Treas. Reg. §1.367(a)-6T(g).
Treas. Reg. §1.989(a)-1(b)(2)(ii) provides in part:
Activities of * * * [an] individual qualify as a QBU if (A) The activities constitute a trade or business; and (B) A separate set of books and records is maintained with respect to the activities.
To have a QBU, not only must the activities constitute a trade or business, but a separate set of books and records must be maintained with respect to those activities. The separate set of books and records requirement is unclear to me. Some individuals may not have formal accounting books and records for their foreign trade or business. If the individual does not have formal (paper or electronic) accounting ledgers, does that mean the individual is not maintaining a separate set of books and records with respect to their business activities?[12] What if the individual tracks business income / expenses separate from personal income / expenses? Does that trigger the separate books and records requirement? I am not sure whether an individual can avoid QBU status by failing to maintain formal accounting records for their foreign business.
The definition of foreign branch for purposes of Form 8858 includes either a foreign branch defined in Treas. Reg. §1.367(a)-6T(g) or a foreign QBU defined in Treas. Reg. §1.989(a)-1(b)(2)(ii). Most self-employed US citizens residing outside the US would meet the definition of foreign branch defined in Treas. Reg. §1.367(a)-6T(g). Consequently, most self-employed individuals residing outside the US would need to annually file Form 8858.
The instructions to Form 8858 refer to a $10,000 penalty for failing to file Form 8858 when required to file. This $10,000 penalty does not apply to sole proprietorships of individuals.
When discussing the $10,000 penalty, the instructions refer to Code §6038(a). The reporting requirements under Code §6038(a) only apply to foreign corporations and foreign partnerships.[13]
The US owners of controlled foreign corporations ("CFCs") and controlled foreign partnerships ("CFPs") may be required to file Form 5471 or Form 8865. The CFCs or CFPs may own foreign disregarded entities. The US owners of the CFCs or CFPs are required to include Form 8858 with their US tax returns for the lower-tier foreign disregarded entities. Form 8858 for a lower-tier foreign disregarded entity can be thought of as component part of the parent Form 5471 or Form 8865. If the US owner of the CFC or CFP does not include a Form 8858 for the lower-tier foreign disregarded entity, then the Form 5471 or Form 8865 may be considered incomplete. A substantially incomplete Form 5471 or Form 8865 can trigger a $10,000 penalty under Code §6038(b).
The CFC and CFP rules in Code §6038(a) do not apply to an individual with a foreign sole proprietorship. Consequently, the potential for the $10,000 penalty in Code §6038(b) does not apply to an individual with a foreign sole proprietorship.
US tax law generally limits the foreign tax credit to the US tax on foreign income.[14] However, the limitation applies separately to several categories of foreign income.[15] These categories are often called "baskets", and include the GILTI basket (soon to be the net CFC tested income, or "NCTI", basket), the foreign branch basket, the passive basket, the general basket, and the income resourced by treaty basket.[16]
An individual can have income in the foreign branch basket only if the individual has a QBU in one or more foreign countries.[17] As described above, activities of an individual qualify as a QBU if the activities constitute a trade or business[18] and a separate set of books and records is maintained with respect to the activities.[19]
While not entirely clear, in my view most self-employed US citizens residing in foreign countries likely have QBUs in those foreign countries. Consequently, if I were preparing a US tax return for a foreign-resident self-employed US citizen, I would likely include the foreign self-employment income in the foreign branch basket. If the self-employed income did not go in the foreign branch basket, it would go in the general basket.
For US citizens, the US dollar is their functional currency.[20] However, if the individual has a QBU, the functional currency of the QBU is the currency of the economic environment in which a significant part of the QBU's activities is conducted.[21]
If a self-employed US citizen abroad has a QBU, most or all of the QBU's activities will typically be conducted in the foreign currency issued by the foreign country where the US citizen is resident. For example, a self-employed US citizen resident in the United Kingdom with a QBU in the United Kingdom likely has most or all of his/her business assets, liabilities, income, and expenses incurred in pounds. Thus, the QBU would have the pound as its functional currency.
Having a QBU with a functional currency other than the US dollar is both a blessing and a curse. It is a blessing because the day-to-day transactions within the QBU do not trigger currency exchange gains or losses.[22] Instead, currency exchange gains or losses are generally only triggered when funds or assets are distributed out of the QBU.[23]
If a self-employed US citizen abroad did not have a QBU (perhaps because no separate set of books and records was maintained), then many business-related transactions in foreign currency would trigger currency exchange gains or losses. Even the simple payment of an expense using a foreign currency would trigger an exchange gain or loss.[24] Although there is a de minimis exception to recognizing currency exchange gains or losses for personal transactions,[25] no de minimis exception exists for business transactions. Thus, having a QBU with a foreign functional currency avoids the need to compute currency exchange gains or losses on routine transactions.
The curse aspect of having a QBU with a functional currency other than the US dollar is that the regulations computing when and how much of a currency exchange gain or loss should be recognized are some of the most complex regulations issued by the Treasury Department.[26]
Even just determining the status of the current regulations is a challenge. Proposed regulations were issued under Code §987 in 1991.[27] New proposed regulations were issued in 2006.[28] The 2006 proposed regulations were finalized, with substantial modifications, in 2016.[29] Additional proposed and temporary regulations were also issued in 2016, with some of the 2016 proposed regulations being finalized in 2019.[30] In 2023, additional proposed regulations were issued that were finalized in December 2024.[31] All the while, the effective date for the final Code §987 regulations has been getting pushed out.[32] The latest incantation is that the final regulations will apply starting in 2025,[33] unless the Trump administration decides otherwise.
If a self-employed US citizen living outside the US qualifies for the foreign earned income exclusion and elects to claim the exclusion on Form 2555,[34] then the individual can exclude up to $130,000[35] from his or her gross income.
Consistent with the format on Schedule C, self-employed individuals have both gross business income and related business expenses. The $130,000 exclusion applies to gross income and not to net income. For example, if a self-employed US citizen abroad has gross business income of $260,000 and related expenses of $160,000, the net business income would be $100,000. The individual could exclude $130,000 of the $260,000 gross income (50% of gross income in this case), and 50% of the expenses ($80,000) would be disallowed.[36] Thus, $50,000 of the net income ($130,000 - $80,000) could be excluded, and $50,000 of the net income would be taxable. Foreign income taxes on the excluded income also cannot be claimed as foreign tax credits.[37]
A self-employed US citizen living abroad has some complex rules to contend with. The individual may be subject to double social security taxation unless a totalization agreement exists. Form 8858 is likely required to be filed each year. The self-employment income may go in the foreign branch basket. Currency gain or loss calculations are likely complicated, regardless of whether the individual is claiming they have a QBU or not. If the individual is claiming the foreign earned income exclusion, the exclusion amount applies to the gross business income.
Code §1401(a) and (b), and Code §1402(b) (defining self-employment income). All section references are to the Internal Revenue Code of 1986, as amended (the "Code") and the regulations promulgated thereunder. ↑
Code §1402(a) (defining net earnings from self-employment). ↑
For example, Article 2, paragraph 3 of the UK-US Income Tax Treaty states: "The existing taxes to which this [treaty] shall apply are: (a) in the case of the United States (i) the Federal income taxes imposed by the Internal Revenue Code (but excluding social security taxes) * * *." ↑
Code §1401(c). ↑
https://www.ssa.gov/international/status.html (visited on August 4, 2025). The 26 countries include: Australia, Austria, Chile, Czech Republic, Denmark, Finland, France, Germany, Greece, Hungary, Iceland, Ireland, Japan, Korea (South), Luxembourg, Netherlands, Norway, Poland, Portugal, Slovak Republic, Slovenia, Spain, Sweden, Switzerland, United Kingdom, Uruguay. ↑
For example, Article 6 of the Austria totalization agreement provides in part: "persons who are * * * self-employed within the territory of one [country] shall * * * be subject to the laws of only that [country] * * *." ↑
Rev. Proc. 84-54 also states that the certificate of coverage must be attached to the individual's tax return. ↑
Rev. Rul. 68-411 (Canada, before the existence of the totalization agreement with Canada), Rev. Rul. 69-338 (Venezuela), PLR 8129013 (Saudi Arabia). ↑
Section 317(b)(4) of the Social Security Amendments of 1977. See also Rev. Rul. 79-291 (no foreign tax credit for Italian social security taxes after entering into a totalization agreement), Rev. Rul. 80-94 (same for Germany), and Rev. Rul. 81-39 (same for Switzerland). ↑
See Category 1 Filer in the instructions to Form 8858. ↑
The instructions refer to a foreign branch as an "FB". ↑
Treas. Reg. §1.989(a)-1(d)(1) ("[A] separate set of books and records shall include books of original entry and ledger accounts, both general and subsidiary, or similar records."). ↑
Code §6038(e)(1) ("The term ‘foreign business entity' means a foreign corporation and a foreign partnership."). ↑
Code §904(a). ↑
Code §904(d). ↑
Code §904(d)(1) and (d)(6). ↑
Code §904(d)(2)(J) and Treas. Reg. §1.904-4(f)(3)(vii). ↑
The term "trade or business" for QBU purposes also includes for profit activities for which deductions would be allowable under Code §212. Treas. Reg. §1.989(a)-1(c). This could include, for example, a foreign rental property. ↑
Treas. Reg. §1.989(a)-1(b)(2)(ii). ↑
Treas. Reg. §1.985-1(b)(1)(i). ↑
Treas. Reg. §1.985-1(c)(1). ↑
Treas. Reg. §1.987-3(b)(1). ↑
Treas. Reg. §1.987-5(a). A distribution out of a QBU to its owner is generally referred to as a remittance. ↑
Code §988. Under general US tax principles, foreign currencies are considered property. When the foreign currency is disposed of (e.g., through paying an expense), the disposition triggers, or crystalizes, a currency exchange gain or loss. ↑
Code §988(e). ↑
Treas. Reg. §1.987-1 through 15. ↑
REG-208270-86, 71 FR 52876 (page visited August 5, 2025). The 1991 proposed regulations seemed fair for most taxpayers and were reasonably easy to understand. ↑
REG-208270-86, 71 FR 52876 (page visited August 5, 2025). ↑
T.D. 10016 (page visited August 5, 2025). ↑
Notice 2017-57, Notice 2018-57, Notice 2020-73, Notice 2021-59, and Notice 2022-34. ↑
Treas. Reg. §1.987-15. ↑
Code §911. ↑
This amount is annually adjusted for inflation. The $130,000 is for 2025. See Rev. Proc. 2024-40. ↑
Code §911(d)(6) and Treas. Reg. §1.911-6(a). See also Rev. Rul. 75-86. ↑
Code §911(d)(6) and Treas. Reg. §1.911-6(a) and (c). ↑