Making Work Pay credit and the Foreign Earned Income Exclusion (FEIE), Part 3. When you put it out on the net (for an answer), don’t be surprised what you get!

People, I put the question out as to why the American IRS was now prohibiting the new Making Work Pay credit to overseas Americans, even though the Bush Administration IRS sent out the same-style rebate checks based on “earned income”. Specifically, I used the Bogleheads BBS—once again violating my rule about posting on BBS’s that are unregulated as to who can post what.

You can read the exchange here.

I did get one response, from a poster “FoolishJumper”. As is typical when you get post out into the ether, the post was hostile and non-responsive.

To review, the question I am working on is: where did Congress say that the new Making Work Pay credit is not allowed against foreign earned income (income that Americans earn overseas)? The new credit, at Section 36A, adopts the definition of “earned income” in Section 32 (concerning the Earned Income Credit, a different credit to your taxes).

The definition is in Section 32(c)(2). Please remember that location.

What the Bogleheads poster did, was respond that anything in Section 32 was relevent to the new credit. Not simply that Congress adopted the definition in Section 32(c)(2). So I was told that the prohibition for Foreign Earned Income takers (Section 32(c)(1)(C) was also something that Congress included in the new credit.

And, again, my question is: Where? Where did Congress say that foreign earned income exclusion takers NOT get the benefit of the Making Work Pay credit because their income is foreign income? I just want to know where. If they adopted the Section 32(c)(1)(C) prohibition as well, I just want to know where.

I am sure that the folks at Commerce Clearing House would also be interested, because they also seem to be under the impression that foreign earned income earners are eligible for the new credit. Again, peruse what Commerce Clearing House had to say, here. The foreign earned income matter is not even a question. (Because whoever was in charge at the IRS got it right in 2008, and wrong in 2009.)

I am a big fan of Obama, and bigger as the weeks go on. But I think somebody screwed up at the IRS when they produced the instructions for the new credit, and the new form.

I just want to know why foreign earned income is no longer “includible” in earned income, and why it doesn’t support the Making Work Pay credit. The credit is refundable; it can’t have only been meant for people who had a liability to begin with . . .

[Update: It gets worse, actually. That Earned Income Credit definition? (Section 32(c)(2)(A)) It has two parts. (“Parts” in the normal sense of the word. Technically, I think these are two clauses of subparagraph A.)

The first part says about the earned income from wages, salaries, etc. But then the taxpayer must add “net earnings from self-employment” (as defined in Section 1402).

Now, the Foreign Earned Income Exclusion is an exclusion from income tax, but not the self-employment tax. This is the 15.3% that you are required to pay, on amounts more than $400 and up to $106,800, of self employment income. An American taxpayer overseas, unless otherwise exempted by totalization treaty, is required to pay this tax.

So, you can have a taxpayer overseas with $30,000 of earned income and $200 $500 of self-employment income. The whole $30,200 $30,500 is excludible using the Foreign Earned Income exclusion. But for purposes of the Section 32(c)(2) definition, even if you knock out the $30,000 as somehow not “earned income” includible in gross (small Roman ” i ” ), you must add back the $200 $500 “net self-employment income” in (small Roman ” ii “).

The $200 $500 is excludible from the income tax, but it is self-employment income (whether subject to tax or not, or whether someone at IRS decides it’s “includible” in gross income or not for purposes of the income tax.)

The $200 $500 should support a Making Work Pay credit of $12.40. $31. But nowhere in the Schedule M set-up is there a way for you to calculate it, because the Schedule has no place to add back your self-employment income.]

For reference, here is that Section 32 definition again:

(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).

[Update: The MWP credit adopts the definition in Section 32(c)(2), as I’ve been saying, but the one caveat is that it doesn’t include the part of net self-employment income that isn’t subject to tax. That would be the amount below $400. So there is special language to that effect in Section 36A(d)(2):

‘‘(2) EARNED INCOME.—The term ‘earned income’ has the meaning given such term by section 32(c)(2), except that such term shall not include net earnings from self-employment which are not taken into account in computing taxable income.

“Net earnings from self-employment” are taken into account regardless of whether you take FEIE or no, because SE tax is part of taxable income. But the Making Work Pay definition does pull a part of the self-employment earnings out anyway–the amount if you only had less than $400 self-employment earnings. [Update: No. I had this wrong. The thing being pulled out is the parsonage allowance.]

Why? I think it’s because the idea of the credit is to make the first $6,451 (effectively) of earned income free of any old-age pension tax ($6,451 times 6.2% OASDI is the maximum $400 of the MWP credit for a single person.) If you have side income from self-employment of, say, $200, which was my example originally above, there is no SE tax. No SE tax until you have $400 or more of self-employment income in the year. (A different $400 than the number we are talking about with MWP credit. It’s coincidence they’re the same.)

But Americans working overseas must pay SE tax on their self-employment income regardless of whether they take the FEIE or not. The FEIE only excludes earned income for the income tax, not the SE tax! So yes, you can earn the up-to-$400 and avoid it; and, yes, you can avoid it by treat–if you are in a country with a totalization treaty that says you only make old-age pension contributions to one country, (and you obtain the proper exemption form like “J/USA-6” in Japan). But otherwise, you must pay tax. It is part of your taxable income.

And again, there’s nowhere on the Schedule M to figure any of this, is there?]