Many people dream of founding their own businesses, no longer having to report to senior management, swiping a time card, or working their tails off so someone else can reap the rewards.
However, working as a business owner or freelancer comes with its fair share of challenges, from marketing and customer acquisition to peak and slow periods and dealings with the local tax authorities.
Freelancing in Israel requires interaction with three distinct tax authorities: Income Tax, Value-added Tax (VAT), and Israel’s National Social Security Agency.
Income Tax - Income Tax is the authority that taxes the income you earn from your business. Namely, you must pay taxes on your income and deduct any expenses recognized for tax purposes. In many cases (generally every two months throughout the course of the year), a periodic tax advance is paid. At the end of the year, annual income tax returns are filed, and all of your profits are reported. Your annual tax obligations are then calculated, and adjustments to the payment requirements are made accordingly. In addition, you are required to file a Declaration of Capital with the Income Tax authorities every few years, in which you declare all of your assets and liabilities in Israel and abroad.
Value-added Tax (VAT) - Many small business owners in Israel fall under the category of “Osek Patur,” meaning that they’re exempt from paying VAT. For these business owners, dealings with the VAT authority is minimal at best: a one-time meeting to open an account and a requirement to report income at the end of each year, before the following year’s month of January comes to a close. This, in order to ensure that the business did not earn more than is allowed under their VAT-exempt status. That being said, those who fall under the “Osek Murshe” category must regularly interact with the VAT authority, as it serves as a funnel for the transferring of tax shekels from the taxpayer to the state. An “Osek Murshe” charges its customers VAT and then pays that VAT to the state (once a month/every other month, depending on how high the periods returns are), while deducting the VAT paid on business-related expenses.
Israel’s National Social Security Agency - Every resident of the State of Israel is required to pay National Insurance and Health Tax. When opening your business in Israel, you must open a freelancer account at the National Insurance Institute, in addition to those accounts opened at Income Tax and VAT. The rate of National Insurance you will have to pay depends on your classification as a freelancer (“A freelancer who meets the criteria,” or “a freelancer who does not meet the criteria”), as well as how much profit you earn. Your payments to the National Insurance Institute will be made on a monthly basis. Here too, your account will be settled and payments will be recalculated, once your annual returns are filed with the Income Tax authority.
When establishing and growing your business, it is extremely important that you regularly reassess your expected tax requirements, so as to ensure that the payments you make match your actual tax requirements and provide safe and satisfactory coverage in the event of a workplace accident, childbirth, etc. It is recommended that you secure the services of an expert accountant that specialties in freelancer taxation for exactly this purpose.
Until now, we’ve discussed your obligations vis-a-vis Israel’s tax authorities.
But what happens if you’re also a US citizen?
American citizens are required to report their income, regardless of where they live, or where it is generated across the globe. Namely, a US citizen working as a freelancer in Israel, will file US tax returns that include their profits from their freelance business in Israel.
Does this mean that American freelancers in Israel are required to pay taxes in Israel and the United States?
Yes and no.
As in Israel, when talking about freelancer taxation in the US, we are referring to multiple types of taxes: Income Tax and Self-employment Tax.
Regarding Income Tax - since the business in question and the income it generates is located in Israel, the State of Israel gets to tax its income first. While your US tax returns will include a calculation of your US Income Tax as pertaining to your Israel-based business’ income, this tax will be off-set against the income tax paid in Israel on those same profits.
Self-employment (SE) Tax is an entirely different ballgame.
SE Tax is, in essence, a social tax comprising Social Security and Medicare Tax, which are comparable to Israel’s National Insurance and Health Tax. Your business’ income is taxed at a rate of 15.3%, where half of the tax is deductible, so that just over 14% of your income will reach the taxman’s door. That’s not a negligible amount.
So, what’s the problem? Can’t you deduct your National Insurance and Health Tax payments made in Israel against your SE Tax requirements?
No, you cannot.
While there is a treaty to prevent double (Income Tax) taxation between Israel and the US, no such agreement exists for social taxes. This means that you cannot deduct social taxes paid to the State of Israel against those paid in the US. The bottom line: freelancers in Israel who are also US citizens end up paying Income Tax, National Insurance and Health Tax in Israel, as well as SE Tax in the US.
When must you pay?
The American tax authorities, IRS and Social Security Administration, don’t want to wait for you to file your annual tax returns before receiving the tax dollars it's owed. As such, freelancers are required to pay quarterly advances throughout the year.
But it’s not all doom and gloom. Remember, SE Tax is, after all, a social tax paid to the Social Security Administration, which is in charge of paying pensions to retirees. So long as you pay your taxes for a sufficient period of time (roughly 40 quarters or 10 years), you will be eligible to receive a Social Security stipend upon retirement.
It is recommended that you secure the services of a professional that specializes in US taxation in order to correctly and optimally calculate your tax requirements, taking all permitted deductions into account. This way, you can ensure your taxes are paid right and on time, so you can avoid having to pay fines and interest.