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I am trying to do my daughter's taxes. She earned income on a cruise ship in international waters. Her W2 shows her income and federal tax withheld, but no social security or medicare withheld. I called the American company that employed her to ask why and was told to consult a tax attorney. Supposedly, because the income was earned in international waters, she does not owe any federal or state taxes, social security or medicare on this income.

Where did you get the "supposedly"? That statement doesn't jibe with the withheld Federal income tax or my understanding of the law.

No state tax was reported or withheld.

This is probably correct. An employer is required to withhold state income tax only if it operates in that state. Some out-of-state employers do withhold in these situations, but generally they're not required to. Taking care of state income tax through estimated tax payments is the employee's responsibility in such a case.

I asked why they withheld any federal tax and was told that they were required to withhold those taxes.

Yup. Because your daughter is a U.S. citizen, her worldwide income is taxable for Federal income tax. This, coupled with the fact that she was working for an American company, would account for the mandatory Federal income tax withholding.

I called the IRS and was told that she owed federal taxes, and her portion of social security and medicare. Because she was given a W2 instead of a 1098, she was not considered self-employed (which she was not).

Does anyone know any regulations that would support her not paying federal taxes, social security and medicare? She is an American citizen and the employment lasted 6 months.


It looks to me like Section 3121(b) of the Code is the answer. It reads in pertinent part:

Employment

For purposes of this chapter, the term 'employment' means any service, of whatever nature, performed (A) by an employee for the person employing him, irrespective of the citizenship or residence of either, (i) within the United States, or (ii) on or in connection with an American vessel or American aircraft under a contract of service which is entered into within the United States or during the performance of which and while the employee is employed on the vessel or aircraft it touches at a port in the United States, if the employee is employed on and in connection with such vessel or aircraft when outside the United States....


You mention that the company is an American company, but you don't mention the flag of the vessel. The way I read 3121(b) is that if it's a foreign-flag vessel (I can't think of a cruise ship that isn't), her earnings are exempt from Social Security and Medicare. Thus, zero in those boxes on the W-2 for both wages and tax withheld. I think the IRS gave you bad advice, perhaps based on the assumption that it's an American vessel since you stated that it's an American company.

Whether she owes state income tax will depend on your state's rules. Check the instructions for the income tax return. If she were a resident of Kansas, she would be deemed to remain a resident of Kansas, and owe Kansas income tax, for the period she was on the ship. However, each state has its own rules about residency.

This all makes sense to me, but feel free to follow up if something got mangled.

Phil Marti
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