Tom,
Your best bet is to discuss this with you CPA and your local TAX office (state and IRS). They are the experts and will minimize your future liability. Your past practices are an issue, but maybe you can start from scratch with the governing group, using your desires as the platform for your questions.

Minimally you need to complete a 1099 type IRS form to show that you paid out money to a "consultant". Hiring the person may not be the best plan. Keeping them as a consultant may be better for both of you. That's my opinion anyway.

Jeff S.
LCS. Inc.

Well, I'm no labour law expert, but what I do know, is the US Government has no authority to tax non-US citizens. The IRS and US laws only apply to US citizens and residents (Green card, Work Visa, etc....) in the US proper.

That I know for sure. A citizen of another country is liable for taxes in the country he resides in typically.

---

Robert Dubicki

It was almost a foreign concept that someone would actually stay in their own country and work for a US company

Where does it say ... that the programmer is a US citizen living in Japan?

If he's a Japanese national, the IRS has no say.

---

Robert Dubicki

I don't see what is so complicated about this if he is a foreign national. This is an arm's length relationship in the purchase of services (which are no different to products/goods).

A service expense, is a service expense IMO. Not much different if you bought office supplies for your company from Canada. Or when Microsoft pays Tata for offshore programming, its a service expense.

Its only when there is some employee/employer relationship going on - which there does not seem to be at this point - where things get complicated.

---

Robert Dubicki

[FONT=Verdana]Okay. Here's what the OP said

I want to start doing things more cleanly and I have incorporated a nevada LLC. How can I pay him? What could his status be? Do I have to pay taxes? Does he have to pay taxes? I plan on hiring him full time eventually and I need to know what is the best way to do this.

Does anyone *know* the answer to this related question:

For a US employer and a US worker, there are various guidelines and rules that say "if the work fits these rules, then even if the parties would like to call it a vendor relationship, the worker is a de facto employee and employment taxes and regulations apply."

Presumably something similar is true for, say, a Canadian employer and a Canadian worker.

But what if the employer is in one country and the worker in another? If I engage Bob Dubicki, pay him a set amount every week, train him, provide his tools, set his working hours, expect him to work exclusively for me, and supervise his methods, does that create an employer-employee relationship? What makes it so? US law? Canadian law? California law?

Again, I could speculate -- I'm looking for someone who knows.

Google does not seem to be much help either. Lots of coverage for the situation in which a US company sends a US citizen to work elsewhere.

I think two reasons for the lack of information are (1) the relative newness of this sort of situation and (2) the fact that typically a larger organization would hire Japanese residents through a Japanese subsidiary, which would have the effect of eliminating any ambiguity.

I did see one site which tended to confirm our guess that no employment taxes would be due. There was apparently a fairly common tax shelter scam in which a foreign service company would offer to hire a US company's workers and thereby escape employment taxes. Money would flow from the US company to the foreign company as a B2B transaction, and then from the foreign company to the US workers untaxed because of the "overseas" aspect of the employment. The IRS ruled that the substance of the arrangement was tax avoidance and that the workers were still effectively employed by the US company. But the strong implication was that at least for workers in the US with a foreign employer, there would be no payroll taxes, assuming the arrangement were legitimate and not a tax dodge. Of course, the workers would still owe US and state income and self-employment taxes, just like they would on any income.

My *guess* regarding the OP's question is that the Japanese government has no authority to impose rules or taxes on the US employer, and the US government has no authority to impose rules or taxes on the Japanese employee.

Sounds like we just went full circle to the first response. Good summarization Charles and I hope Tom works through this comfortably.

Jeff

My reading of the tax treaty is that all it covers is (1) if there is "international" work performed, which country gets to collect the income tax; and (2) avoiding at least some double taxation.

I still think that neither country has the ability to tell the OP that the programmer in Japan is a de facto employee and subject to employment taxes (i.e. FICA, unemployment, state disability, etc.).

I don't think there is any question about the topic covered by the tax treaty: the programmer owes Japanese income tax, and not US income tax.

So I think

1. The OP is not in any trouble for what he has been doing. As Lisa says, he should come out from under the table and take a business expense tax deduction for the work done in Japan. (But I'm not a tax lawyer -- your mileage may vary.)
   
2. The OP could hire the programmer as a regular employee, but I see little advantage and many disadvantages in doing so. Using a third party such as a Japanese "employee leasing firm" or personal corporation might preserve the advantage while obviating some of the disadvantages.
   
3. Going forward, the OP should formalize the relationship with a contract that spells out everyone's expectations.