Is U.S. Self-Employment Tax Prorated in a Split Year?

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I moved from USA to Germany in May 2019. I joined KSK and starting paying German social security in August 2019. We plan to live here long-term. I have a 5-year renewable residency permit through my EU spouse; my business is registered as a GbR. I'm self-employed. Now I'm doing my 2019 tax return in USA.  

If I get a German certificate of social security coverage (D/USA 101-A) that only covers the second part of the year, do I pay a prorated self-employment tax in the USA to cover the first part of the year?  How do I indicate all this on my 1040?  If I was covered the entire year in Germany, I understand I could simply write "exempt" and attach the 101-A.  My concern is the effect of the split year.

I moved in May 2019, but my social security payments/coverage did not start until August. Will the 101-A only show coverage starting in August? How would this effect prorating of US self-employment tax?  

 

 

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You pose an interesting question that I am surprised to realize I have never had to answer before.

 

Yours is not so much a question of "How much" as "how?".

 

I assume that whatever business you were in in the USA in 2019 was the same business you were in in Germany.  The only change involved a removal of the situs/seat/domicile of your business from the USA to Germany. 

 

The tax consequences of that change can be roughly summarized as follows:

 

1.  Your US income (self-employed and other) prior to the commencement of your German residence in May 2019 is directly (income and Self-Employment) taxable only by the US but that income must be reported on your 2019 German income tax return for purposes of Progressionsvorbehalt.

 

2.  Your German income (self-employed and other) after commencement of your German residence in May 2019 is directly taxable by BOTH the US and Germany but, the SE business income is eligible for a (prorata) FEI exclusion and/or foreign tax credit on your US return and, as you correctly noted, you may also exclude that SE business income from US SE taxes.

 

So far, so good.  The next question is how do you show this on your US return?

 

After some thought I would suggest to you the following:

 

1.   You absolutely must prepare two Schedules C, one for your US business and one for your German business.  (NB:  if your business activity continued after your arrival in May, the date of your "coverage" under the German system began the day of your arrival and commencement date of residence, not in August when you registered your GbR and/or started paying into the KSK. The fact of payment to KSK is of no relevance to "coverage".)  Since you are a probably a "cash-basis" taxpayer, keep it simple:  cash in and cash out Jan-May on the USA Sched. C and the same for May-Dec on the DE Sched. C.

 

2.   You now are faced with a quandry:

 

      You have to file Schedule SE to report your net SE income on the USA Sched C and compute your SE taxes on that form.

      Ordinarily, Sched SE would require you to aggregate all your sources of net SE income so as to compute the SE tax but, in your case, only one of those two sources (Sched C USA) is subject to tax.

 

      There are two possible solutions; neither is foolproof but neither is fatal either:

 

      Solution 1:    File 2 Schedule SEs one for each Sched. C.  The SE for Sched. C USA shows the computation of SE tax and the SE for Schedule C DE shows a zero and a reference declaring "Treaty Exempt per IRC §1401(c). Certificate of Coverage attached."

 

       Solution 2:   File 1 Schedule SE.  Show only the income from Sched. C on Line 3.

                           On Line 2 of Sched. SE show the same amount but in the space (fortunately generous) above that number overprint the form as follows:

     

                         Total of both Schedule Cs:                       XXXX

                         Less "Treaty Exempt" Sched C DE:    -   xxxx

                                             

 

Both solutions have their advantages and disadvantages but both have a crucial element in common:  They include the figures from BOTH Schedule C's on at least 1 Schedule SE and account for the exclusion of one of them from the SE tax base.

 

The IRS and most commercial software will automatically carry all Schedule C net income to a single SE for each filer.  If you include 2 Sched. SEs per solution 1, the SE with the Sched. C DE may get ignored and the other will be deemed to have a "computational math error" that may cause the IRS computer to spit out a "notice of adjustment".  On the other hand, 2 Sched. SE's may be more attention-getting than the more subtle approach of Solution 2.

 

If, on the other hand you use the single SE (Solution 2), the computations will at least be in one place on a single form SE where the IRS will theoretically be looking for it and hopefully one of its carbon-based units will actually see it and override their computer.  But if they don't then you may get the same "notice of adjustment".

 

In either case the likelyhood that what you have will actually be "seen" by a real live human being is enhanced by the IRS requirement that returns that claim the treaty exemption and include the certificate of coverage must be paper-filed.

 

There are, of course, technical challenges to both approaches:

 

Solution 1 requires you to crank out 2 Schedule SE's for a single taxpayer.  Your software may not cooperate and you'll have to download a .pdf from the IRS website.

 

Your return preparation software is not going to cooperate with Solution 2 either.  You will have to put the "bottom line" entries on Lines 2 & 3, print it out and then scan it to .pdf and electronically add the info in the space above the bottom line figure on Line 2 or just do the same with pen & ink on the paper printout.

 

 

Quite frankly, I cannot tell you which approach is more likely to save you the hassle of having to respond to an IRS adjustment notice.  (You will not, of course, let the IRS computerized notice bully you into paying more than you owe in SE taxes unless, of course, you don't mind unnecessarily adding a little bit of value to your future US Social Security retirement check.)

 

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Thanks so much for the detailed and expert response, Straightpoop!  I really appreciate you taking the time. There is a wrinkle: instead of being a sole proprietor (Schedule C), I conduct all business through an LLC partnership. It's registered in New York; all the clients are American, both before and after the move. The business is registered under the same name, as a GbR, in Berlin.  My wife and I are 50/50 partners; we file a 1065 and issue K-1s.  There is a box in the K-1 for "foreign transactions."  So sorry, I should have explained all this before; I was trying to keep my question simple, but of course taxes aren't simple!  The Schedule C workflow is really good info for other freelancers who find this thread.  If I could bother you again ... 

- How should I fill out the K-1s and the Schedule SE to reflect the treaty exempt income?  

- When writing to Deutsche Rentenversicherung for the 101-As for my wife and myself, do we need to include proof of when we moved to Germany in May (i.e. copy of Anmeldung)?  Otherwise how will they know when we moved?

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8 hours ago, SteveHarris said:

The Schedule C workflow is really good info for other freelancers who find this thread.  If I could bother you again ... 

- How should I fill out the K-1s and the Schedule SE to reflect the treaty exempt income?  

- When writing to Deutsche Rentenversicherung for the 101-As for my wife and myself, do we need to include proof of when we moved to Germany in May (i.e. copy of Anmeldung)?  Otherwise how will they know when we moved?

 

In my reply above just substitute "K-1 Form 1065" for "Sched. C USA" and "K-1 Form 8865" for "Sched. C DE".  Just like a Sched. C, the only thing on the K-1s that indicate the foreign source of the income will be the address of the respective partnership.

 

I doubt the DR will doubt your word on your application since it's no sweat off their back one way or the other. But, in the unlikely event they do, just send them something official looking from the Einwohnermeldeamt or something from the KSK showing your registration.

 

PS

 

Would you care to share your reasons for organizing your business as an LLC/GbR with all the associated compliance costs instead of simply as a sole proprietorship?

 

 

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Thanks so much!  I will give this a try and update with results.  My wife and I work together, so the LLC/GbR makes sense for us. The steuerberater I was working with in DE said his fees would be cheaper if we conducted biz 100% as a GbR, instead of separate freelancer businesses for myself and my wife; we also have ongoing royalty and licensing agreements that are set up through the partnership, so that would be yet a third element he would have to deal with.  

 

That said, the total steuerberater bill this year was almost 2000 euros. For our first year in Germany, we really wanted the professional support; he has provided some of that, but overall I have found the experience to be less than great. (For example, I caught him making a mistake accounting for our investment income, which he acknowledged. Also he had a problem with his email server and didn't answer my emails for 3 months.)  He said it would be cheaper for 2020 since the template has been created.  I actually am strongly considering doing the 2020 return myself using wundertax with the 2019 return as a reference.  Our business this year took a huge hit because of covid, so taxes will be minimal in any case.


 

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