# FEIE for self-employed sole proprietor - tricky questions



## freedomseeker

I am a self-employed US citizen who satisfies the physical presence test. 
I am very confused by form 2555 instructions concerning deductions allocable to excluded income. Specifically, line 44 instructions on that form require one to deduct a portion of business expenses claimed on Schedule C from eligible FEIE amount, based on the specific ratio which uses GROSS Schedule C amount earned through self-employment abroad. Much to my surprise, following these instructions will disallow most of the FEIE I would otherwise be eligible for, since my net Schedule C earnings are only a small portion of gross Schedule C receipts. For example, if my gross self-employment receipts for 2011 are 200,000 USD but 50% of this is deducted as various legitimate business expenses on Schedule C, resulting in net profits of 100,000 USD, following form 2555 instructions disallows 50% of total FEIE I was hoping I could claim. Another 10% of FEIE will be wiped out by the 30 days I spent on trips to USA during the year. 
It seems that if I am correct in my understanding of the IRS rules, even though I am eligible to claim FEIE, I will not derive too much tax benefit from doing so and most of the FEIE amount I thought I could claim will need to be significantly reduced due to too many Schedule C expenses. If I am wrong and have misunderstood these instructions, I would be extremely grateful for an explanation. 
And if I am correct in my understanding of IRS rules, it would then seem that the only way out of this conundrum is incorporating and hiring yourself with W-2 salary, since corporation business expenses can be deducted without affecting the FEIE that the corporation owner can apply to his salary assuming this salary is equal to net corporation profit. Correct?


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## Bevdeforges

You may be misreading the instructions. I only took a quick scan of the 2555 instructions, but for line 44, they are talking about Schedule C deductions that you take in order to determine AGI.

If you're working overseas and you're self-employed, the Schedule C normally is how you determine what your "earned income" is - and that's the amount that is subject to the FEIE. But I did notice that for line 44, they specifically instruct you to check Pub. 54 to see how to determine which deductions do and don't apply to "excluded income." Make sure you check Pub 54 before you conclude that the FEIE won't do you much good. 
Cheers,
Bev


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## freedomseeker

Thank you for your response, Bev. I really wish you were right as it truly feels unfair that your legitimate business expenses such as rent, wages you pay to others, the cost of your supplies, etc., cannot be simply fully deducted for the purposes of arriving at net income eligible for FEIE, dollar for dollar.
However, I read publication 54 and I am afraid the examples they give suggest that only a portion of your business expenses can be effectively deducted:

Example 2.
You are a U.S. citizen, have a tax home in Spain, and meet the physical presence test. You are self-employed and personal services produce the business income. Your gross income was $111,300, business expenses $63,900, and net income (profit) $47,400. You choose the foreign earned income exclusion and exclude $92,900 of your gross income. Since your excluded income is 83.47% of your total income, 83.47% of your business expenses are not deductible. Report your total income and expenses on Schedule C (Form 1040). On Form 2555 you will show the following:

Line 20a, $111,300, gross income,
Lines 42 and 43, $92,900, foreign earned income exclusion, and
Line 44, $53,337 (83.47% × $63,900) business expenses attributable to the exclusion.

Then you need to deduct line 44 from allowed FEIE, in this example $92,900 - $53.337 = $38.663 - only about 40% of FEIE is allowed to be claimed here.


I can't wrap my head around this - it sounds like the lower is your profit margin, the larger is the portion of the FEIE that you can never claim - as long as you are self employed, that is. I couldn't find any similar draconian rules that would apply to bona fide employees. Hence my idea for incorporating and hiring myself as the only way to truly take advantage of FEIE - that is, if you have any business expenses and do not want them to decrease the FEIE you can claim as per IRS rules.


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## Bevdeforges

OK, it kind of depends on how your business is structured (and where it is located). Here in France, for example, you have to at least "register" your business to have it recognized (for social insurances, taxes, etc.). That business registration seems to be adequate to characterize the net profits (determined according to US tax rules) as your income or "salary" for FEIE purposes.

Depending on where you are tax resident, you may want to look into what forms of business registration are available to you. 
Cheers,
Bev


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## freedomseeker

*clarifying*

Just to clarify, when you say OK, does it mean you agree with my understanding of IRS rules in determining eligible FEIE for self-employed and that to be able to claim 100% of amount eligible for exclusion (based on net company profit of course), one needs to organize a legal form of business that is NOT sole proprietorship (in other words, that is NOT taxed as flow-through entity)? 
I am thinking of opening a regular C corporation in New York and paying myself an annual W-2 salary, deducting only Social Security on the first $95.000 for as long as I satisfy physical presence test - as complicated as it is, this seems so much easier than any other option such as opening a corporation offshore (the taxes and other reporting requirements in that case would become downright scary). Plus, I am not a legal resident in any foreign country, merely physically absent from US (spending time in several different countries without becoming a tax resident in any of them).


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## japandude

Freedomseeker,

I have just done some research on this, and to my surprise, what I would call "sales" is considered as earned income in a sole proprietorship! Your solution (incorporating) also occurred to me too as the only way to be able to rightfully claim expenses.

Here is another solution that may or may not work in your case.
If you are married, you can file a joint return with your spouse even if she (or he) is a nonresident alien. That way, you can claim the FEIE x 2. If you add in housing expenses, that should be enough to get you out of paying tax (barely).

What do you think?
Any other ideas?
I just keep thinking -- it's SALES, not EARNED INCOME!

JapanDude


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## Bevdeforges

Be careful with that approach. You normally can only file jointly with a non-resident alien spouse if he or she has lived in the US at some point during the year. The NRA spouse will also need a social security number or ITIN and will need to be a partner or otherwise participating in the business.
Cheers,
Bev


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## japandude

You may be right, but in checking the section "Nonresident Alien Spouse Treated as a Resident" in IRS Publication 54, I cannot find verification of your points. I don't want to be nit-picky, but since I am thinking of doing this myself, I want to be sure that I am doing it the right way.


*Must live in the U.S. at some point during year?
Based on my interpretation of this section, it says that one spouse must be a U.S. citizen or resident alien. There is no mention of the nonresident alien living in the U.S. In fact, the nonresident alien is "electing" to be treated as a resident alien, and so it *seems* that there is no such restriction.

*ITIN or SS number required
Yes, I found this -- exactly as you said. Still, if you apply now, there is probably enough time to get an ITIN, especially with the filing extension available to all FEIE (assuming that you owe no tax -- for which the extension does not apply).

*Need to be a partner or participating in the business?
I cannot find any mention of this.

The other strategy of establishing a company looks good, but Form 5471 also looks intimidating, and the penalties are severe.


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## Bevdeforges

Go back and re-read the section on filing jointly with a NRA spouse. I'm pretty sure it says pretty clearly in there that if you do so, you cannot claim any tax treaty benefits, which includes the FEIE. (Pub 54, p. 6, third column, the last couple of paragraphs just before the example.)
Cheers,
Bev


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## japandude

It says "This means that neither of you can claim under
any tax treaty not to be a U.S. resident for a tax
year for which the choice is in effect."

I see. It looks like you are right.
Thanks. It looks like I will have to have a CPA look at my situation. I will let you know what he or she says is the "best solution" to this dilemma.

Thanks!


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## japandude

I have done some more research, and here are some other possibilities for reducing tax on foreign income. I am not an accountant, and so please take these suggestions and run them through your accountant to see if they are feasible.

-Moving expenses: Since moving expenses can be claimed in full if you qualify, there is no need to classify moving expenses as a business expense. Claim them to get the full 100%.
-Housing deduction: If you live in Russia, there is a very high deduction for Russia and some other major cities. Moreover, you can not only include rent, but also utilities and other expenses, and so this can really help.
-Foreign tax credit: You can take a foreign tax credit for the tax amount that the FEIE does not cover. If you are in a country with a high tax rate, this might be significant.

Other ideas?


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## Bevdeforges

> I am thinking of opening a regular C corporation in New York and paying myself an annual W-2 salary, deducting only Social Security on the first $95.000 for as long as I satisfy physical presence test - as complicated as it is, this seems so much easier than any other option such as opening a corporation offshore (the taxes and other reporting requirements in that case would become downright scary). Plus, I am not a legal resident in any foreign country, merely physically absent from US (spending time in several different countries without becoming a tax resident in any of them).


Sorry, I hadn't read through this part very carefully. In the long run, I think this option may be your best bet. Your corporation may be subject to taxes on its earnings (federal or state), but by paying yourself a salary you'll simplify your personal income tax situation by quite a bit.

You should consider getting yourself a good accountant or EA to handle the corporate side of things (and maybe even the payroll), but it should pay off on the tax side.
Cheers,
Bev


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## freedomseeker

I can confirm that my original suspicions were correct - after several consultations it is clear that I am forced to open a corporation, otherwise I cannot claim business expenses (and I have pretty low margins making most of FEIE not excludable). 
Can anybody point me in the right direction on how to open a C corporation from abroad? Especially, how to arrange everything to be able to run it remotely, considering all the paperwork, filings, FEIE payroll, etc., that will need to be done.


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