More on this topic from yesterday.
The more I look at this, the more I wonder where the IRS coming from on the matter. I am hoping to get some commentary back from someone knowledgeable about the Earned Income Credit (Section 32 of the code), specifically the definition in the code of “earned income”. This is:
(2) Earned income
(A) The term “earned income” means—
(i) wages, salaries, tips, and other employee compensation, but only if such amounts are includible in gross income for the taxable year, plus
(ii) the amount of the taxpayer’s net earnings from self-employment for the taxable year (within the meaning of section 1402 (a)), but such net earnings shall be determined with regard to the deduction allowed to the taxpayer by section 164 (f).
(Notice how I bolded “includible in gross income”. That’s very important and I’ll come back to it in a bit.)
The definition then follows up with a few caveats:
(B) For purposes of subparagraph (A)—
(i) the earned income of an individual shall be computed without regard to any community property laws,
(ii) no amount received as a pension or annuity shall be taken into account,
(iii) no amount to which section 871 (a) applies (relating to income of nonresident alien individuals not connected with United States business) shall be taken into account,
(iv) no amount received for services provided by an individual while the individual is an inmate at a penal institution shall be taken into account,
(v) no amount described in subparagraph (A) received for service performed in work activities as defined in paragraph (4) or (7) of section 407(d) of the Social Security Act to which the taxpayer is assigned under any State program under part A of title IV of such Act shall be taken into account, but only to the extent such amount is subsidized under such State program, and
(vi) a taxpayer may elect to treat amounts excluded from gross income by reason of section 112 as earned income.
None of these six mentions anything about “foreign earned income”, Section 911 (Foreign Earned Income Exclusion, or Section 901 (Foreign Tax Credit).
Interestingly, Section 112, which has to do with combat zone pay, is noted in (vi). Combat zone pay is something is by definition not gross income (notice I bold this again), so is not includible in gross income.
Now, what is “gross income”? It is defined in Internal Revenue Code, Section 61. Here is a handy Cornell LII link, too.
It is “all income from whatever source derived”. The exceptions Section 61 are: “except as otherwise provided in this subtitle.” That subtitle would be Subtitle A, “Income Taxes”. So there are things that are not taxed, for income tax purposes, because Congress has defined them as “not gross income”. Otherwise, the income is includible as gross income.
Congress has specifically compiled in Part III, of Subchapter B, of Chapter 1, the kinds of income that are not gross income. Again, not includible as gross income. You can Firefox search the thing up and down Part III, nowhere does it say foreign earned income is not includible in gross income.
It looks like quibbling, but it isn’t. There are hundreds of American citizens overseas–maybe thousands–who think that “up to $80,000 of earnings overseas is exempt from tax!” So they never report the income. Well, no, that’s wrong. You are eligible under certain rules to exclude (now for 2009) up to $91,400 of foreign earned income from tax. It is includible in your gross income. But you can file a schedule each year to elect to exclude it. You can’t exclude it unless it is first includible. It’s not exempt—it’s excludible. Because it is first includible.
I think where the problem arises is that in Section 911, as I’m saying, the taxpayer can elect to exclude foreign earned income from gross income. Again, by law, it is includible in gross income, but you can take it out.
And I think someone at the Service interpreted this as “if you can exclude, or have excluded it, then it’s not includible in gross income”. As if the Earned Income Credit only considered earned income that was included in your gross income, and the definition above actually read “but only if such amounts are included in gross income for the taxable year.”
The EIC language is actually a negation. The definition was trying to capture all the earned income for purposes of calculating the Earned Income Credit, but allowing that certain kinds of earned income (that kind in that list on Part III) aren’t part of the calculation. The definition wasn’t dealing with foreign earned income at all—which is why the prohibition for FEIE users is in another part of the statute.
What the IRS is doing now is an interpretation I just don’t think is consistent with history. You have always had to report your foreign earned income, as includible in gross income, (no exemption provided under that Part III, above). And at that point the Section 32 definition is definitive. The fact that you can elect to pull the income out of gross income does not mean it isn’t includible.
[Update: If you get a hold of this Commerce Clearing House book, “2009 Tax Legislation: American Recovery and Reinvestment Act of 2009 (Law, Explanation and Analysis)”, they make it clear that the definition being used for this credit is the same definition that was used for the 2008 “recovery credit” rebate checks:
“The MWPC shares several similarities with the Code Sec. 6428 recovery credit, which most taxpayers received in the form of rebates up to $600 (plus $300 for each qualifying child) during 2008. The definition of earned income is the same; the definition of eligible individuals is the same except for the income and tax thresholds that applied to the recovery credit; the treatment of the credit for purposes of eligibility to participate in other government programs is the same; and the provisions governing U.S. possessions are the same.”
Well, last year the IRS was sending out recovery rebate checks to people here in Japan—even if they didn’t have a tax liability back home—because they had “earned income” on the 1040. I happened to have a tax liability in ’07, but I know of other, general, cases where Americans do did not got anyway. What changed?]