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?]

6 thoughts on “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!

  1. >even though the Bush Administration IRS sent out the same-style rebate checks based on “earned income”

    If I recall correctly, (and this is referring to what I think it is referring to) those “rebate checks” only went out if you sent the government a cheque for taxes the previous tax year. In effect, you ended up giving the government an interest free loan for 1 year.

  2. There were two parts to the ’08 rebate, (which is codified at Section 6428(a) and (b): one, “(a)”, involved people who had had a tax liability in 2007 (or would have one in 2008 for which they could offset the rebate check against it). And the other one involved people (“b”) who had “earned income” as defined by, you guessed it, the Earned Income Credit definition in Section 32(c)(2). They needed at least $3,000 of this qualifying income in order to get a maximum $300.

    Here is a handy technical explanation.

  3. I think the one I was thinking of was a rebate from 2001-2002. Not sure if it was based on the same thing or not. You might not even have had to file for the rebate, they may have just given the money back to you. (My memory of this is a bit hazy, sorry.)

    1. Ah, the 2001 stimulus tax credit is one of my favorites as a math guy. Here is the best online discussion, by the Congressional Research Office in 2008:

      Link to MIT archive of Congressional Research Service report on the 2001 RRTC

      In short, it was not a rebate, even though it had aspects of one. It was money that was meant to create a “10% bracket” for the tax year 2001, which by then was half-over for the normal filer. They wanted money quickly in the hands of the public, without changing the withholding tables in July. Read the link for more on the “whys” of that.

      What Congress did was look to 2000 tax paid, and if there was enough to create a credit (say, you needed to have had a certain amount of income to have paid $300, you got the $300 as an RRTC (Rate Reduction Tax Credit — rebate was not part of those “r’s”). As you said, the IRS just sent one a check if one had filed.

      People who didn’t meet the formula were given a second crack at it on the 2001 tax return, in early 2002. If they made enough income in 2001 to be in, or clear, where the 10% bracket would be (it was first $6,000 taxable), they got a credit towards the 15% bracket of 5%. BUT if someone already got RRTC, there was no seconds. And people who got only part of the check based on 2000, got to try and make up the difference.

      So the legend became that it wasn’t really a rebate (true), and the government made you “pay it back” (false).

  4. Interestingly if you have a US citizen, who is married with no kids, working overseas with nominal income – say around 15,000. It would make sense NOT to take the Foreign earned income exclusion as none of the income is taxable anyway – right? Thereby generating $800 of making work pay credit – or am I missing something here?

    1. I agree, although, as I’ve written, I think the IRS is wrong on those Schedule M instructions, and the mistake goes back to the late Bush Administration’s interpretation of the 2008 economic recovery rebate.

      What the IRS has been saying, is that if a 2555 is present, the earned income won’t qualify. You are right that if a family takes the $11,400 standard deduction (or some Schedule A deduction instead), plus has two personal exemptions of $3650 ($7300 total), there is $18,700 that is not subject to tax no matter the people are. And since they did not elect to exclude through the Foreign Earned Income Exclusion, no 2555 is present and they should qualify as long as $6500 or so of that $18,700 was earned income.

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