Schedule M screwing Americans abroad (Part 6).

Back last February and March, I did a lot of blogging about something called Schedule M, which is part of the American Internal Revenue Service’s 1040 tax form.

Schedule M is a new form, and it’s meant to calculate a refundable tax credit called the Making Work Pay Credit. This was the main tax break in Barack Obama’s 2009 stimulus package, and a tax break that nobody quite understood. Its complexity really cost Obama and the Democrats a lot of political points. They gave a break to tens of millions of taxpayers, but very few even realized it.

The Making Work Pay Credit is designed to give you a tax break that equals up to the first $6,451 of social security tax that a single taxpayer pays towards old age pension and disability. This is referred to as OASDI, and the rate is 6.2%. The number $6,451 doesn’t come from out of the blue. If you notice, $6,451 multiplied by 6.2% and rounded is $400.

For joint filers (husband and wife), the credit is maximum $800.

To focus the tax break on the middle class, the Making Work Pay Credit phases out at higher incomes. Congress uses something we call in accounting jargon “MAGI” (pronounced Maggie like the Mick Jagger Rod Stewart song). It’s Modified Adjusted Gross Income. I think MAGIs were a 1980’s invention; at least, that’s when they became popular as part of tax legislation. The purpose of MAGI is to make the taxpayer add back deductions to Gross Income, that are otherwise allowed for other tax reasons. Sorry to confuse you; “Maggie” is an important gal in the story.

The MAGI for the Making Work Pay Credit is $75,000 for single people and $150,000 for joint filers.

Now, I do something that is really unusual as everyday people go: I actually read tax legislation. I do this for enjoyment. And, I like to think I come to understand what the tax law has to say.

Sure, there’s commentary on tax legislation. There’s IRS publications–those are nice, too. That’s light reading for when you want a break. Sometimes, they really clarify what Congress is passing in those humongous bills. But the actual legislation, the conference reports–things like that–that’s where the action is.

Accuse me of being a geek. Nolo contendere.

From here, the story is going to get a little dry and boring, but you are invited to keep right along with me.

Living abroad in Japan for five and a half years, I have become intimately familiar with Section 911 of the Internal Revenue Code. It provides for something called the Foreign Earned Income Exclusion (FEIE), which, in years when I qualify, lets me exclude up to $91,400 or so of my earned income from U.S. taxes. This tax break has existed about as long as there has been the modern income tax in America (1913–about 100 years ago). I think the original FEIE was in the 1920’s.

There are a handful of people in America who think FEIE is like cheating. But no. No. I pay taxes to Japan. If you don’t pay taxes to Japan and you don’t pay taxes to America, and they’re due in one or the other, then that’s cheating. But if you get an exclusion because you’re out of America and you’re in someone else’s taxing jurisdiction, there is nothing wrong.

Occasionally, an a**hole in the Senate, (usually the Senate), will get upset about Section 911, the Foreign Earned Income Exclusion, and try to kill it. This goes on every couple of Congresses, and they actually were successful in the late 1970’s. They replaced Section 911 with a Section 913. Section 913 was a nightmare, and I leave the discussion of it for some other time. Long story short, Section 911 came back in the first big tax act in the first Reagan Administration, the one in 1981.

It has survived 30 years, although it’s always on the radar for people who want to gut it.

The important thing to know is that that up to $91,400 exclusion is not an exemption. It doesn’t mean that your foreign earned income is not taxable or not includible in your gross income. It simply means that you can take out your foreign earned income when you calculate your AGI (Adjusted Gross Income. We don’t call this “Aggie” for some reason, even though MAGI is “Maggie”. Probably because there are no songs to an Aggie.)

You can bet that [for] every tax proposal that comes out in bill form, I do the Adobe or Firefox search for the term “Section 911”. Once I leave Japan, well, maybe this won’t be the first thing.

When the Making Work Pay legislation came out as part of the stimulus bill in early 2009, I checked to see how it was calculated. And yay! Just my luck, it was a credit based on earned income, not one based on how much social security tax you paid. Americans living abroad have earned income. Therefore, unless they are MAGIed out of a benefit, they should get the Making Work Pay Credit. That’s the law as Congress passed it.

The original 2009 tax year software from Intuit’s Turbotax also had the calculation correct, as to what Congress had passed. So when I did the rough draft of my ’09 tax return, it showed the $400.

But then, the IRS released the final version of the 2009 Schedule M. This is the form by which you claim the credit. The drafter of the form decided that foreign earned income was not earned income that is includible in your gross income. For the life of me, I have to wonder where that notion came from, and I can only conclude that the slow rot of the Bush Administration has diluted the abilities of the people who serve us as civil servants in government.

So now, what a mess. We have this IRS form out there that’s telling people their foreign earned income isn’t part of gross income anymore. There are indeed things, like employer-paid health care, that are indeed defined as not part of gross income. But nowhere in the whole body of Congressional tax enactments do you ever find a clause that says that foreign earned income is not part of your gross income. (Good luck searching; you won’t find it.)

So I try to figure out how this twist came about. I go back to Section 36A of the code, which is where the stimulus law put it, and I read the definition of earned income:

(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. For purposes of the preceding sentence, any amount excluded from gross income by reason of section 112 shall be treated as earned income which is taken into account in computing taxable income for the taxable year.

So the quest for the definition of earned income takes us to Section 32 of the tax code, which happens to be the Earned Income Credit. This is a grant of money to low-and-moderate wage earners. It originated in proposals for an income support payment called the Negative Income Tax–in the Nixon Administration, a Republican one, actually! It finally made it into law as the Earned Income Credit (EIC) in 1975 under President Ford, (another Republican). Since the 1970’s, it has been expanded and tweaked here and there.

Here is the Earned Income Credit’s definition of earned income, in its entirety:

(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).

(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.

If you did more than just scroll down (and I don’t blame you), you notice there’s nothing about foreign earned income or Section 911 in that part of the tax law. You cannot take the Earned Income Credit if you claim Section 911. But that’s because another part of Earned Income Credit section specifically says you can’t. It has nothing to do with the definition of earned income.

So talking around the internet commentary (which is mostly me talking to other people who hit on the issue), the focus of this puzzle has been one just one clause, this one:

wages, salaries, tips, and other employee compensation, but only if such amounts are includible in gross income for the taxable year

I have always believed that the “but only” portion goes to things that are nontaxable employee compensation; meaning: things like employee benefits that you are not taxed on, and do not appear on the 1040 as income. But not foreign earned income. That is includible. Want examples? Things like these:

(1) elective deferrals under a cash or deferred arrangement or section 403(b) annuity (sec. 402(g));

(2) employer contributions for nontaxable fringe benefits, including contributions for accident and health insurance (sec. 106), dependent care (sec. 129), adoption assistance (sec. 137), educational assistance (sec. 127), and miscellaneous fringe benefits (sec. 132);

(3) salary reduction contributions under a cafeteria plan (sec. 125);

(4) meals and lodging provided for the convenience of the employer (sec. 119),

and

(5) housing allowance or rental value of a parsonage for the clergy (sec. 107).

All of these tax breaks are not “includible in gross income”.
This is what the clause in the definition is referring to. These things. The reason that clause is there is to protect Earned Income Credit claimers from being dinged by their other enumerated benefits. It is not there because of foreign earned income.

Well, this all just generated a lot of back-and-forth, with me being in the position of internet tax crank or gadfly. You know, like I’m there saying Ohio didn’t really ratify the 16th amendment and so the whole tax code is bunk or something. It just gets me really down and reminds me of how weak the statutory interpretation skills are in this world today. I have the battle scars of those battles, for sure.

I know my reading of that clause is right, so I finally troubled myself to go back and figure out where the statutory language came from. Thank you Professor Abreu of Temple Law, who was an icon at this when I was there.

The Foreign Earned Income prohibition for EIC is old. In fact, it goes back to 1981, when Section 911 was restored. Look at the V-Lex database for the credit and search Section 911. You want to focus on Public Law 97-34, which was the big Reagan tax law in 1981. (Pub. L. 97-34). When the 97th Congress restored Section 911, they made sure it wasn’t a free ride for six-figure expats to also pick up a few thousand as low-income-assistance tax credit.

This makes sense. So the Earned Income Credit has always been closed to people who can take up to the $91,400 off their earned income. This is old news, and it’s been that way for 30 years.

But why the clause about

wages, salaries, tips, and other employee compensation, but only if such amounts are includible in gross income for the taxable year

?

Why is that there? To make doubly certain those rascally foreign income excluders get the point?

No.

The language is there, as I thought so, as part of a later modification to the bill, having nothing to do with foreign earned income. It’s from the 2001 Bush tax law, the one everyone’s fighting about this week.

The 2001 law is called EGTRRA in the jargon. [It stands for Economic Growth and Tax Relief Reconciliation Act. Why can’t they just say Revenue Act of 20**, like in the old days?] Through the magic of the internet, you can actually see the House-Senate conference report as a PDF file, here.

Here is where the “but only” clause got its start:

Page 19 of the Conference Report. Congress added it in 2001. Why? Because of foreign earned income? No.

Page 144:

Prior to the EGTRRA of 2001, earned income for purposes of EIC included a lot of the fringe benefits that employers provide as nontaxable compensation to employees. Congress wanted to change that. Page 146 and on:

Congress adopted the Senate amendment, which was meant to protect nontaxable employee benefits from reducing or eliminating a filer’s Earned Income Credit. The “but only” clause had nothing to do with foreign earned income, which was already handled by another part of the EIC statute in 1981.

So, if you come this far, you see why I am disappointed in Schedule M and whoever drafted it. The language they seem to be relying on is really meant for some entirely different situation. A lot of people have now gotten burned because of this. This was, “hey those expats overseas shouldn’t get this! They don’t deserve it!” Since the amount (maximum $400 or $800) is big, but small too, no one is going to fight for it.

I don’t give tax advice out over the internet, but my recommendation to people is to ask the IRS to calculate the Schedule M. I’ve known situations where people do it themselves, and the IRS dings them if they follow the instructions. I’ve known situations where people filed and got, and where they filed and didn’t get. So I don’t think the IRS knows what they’re doing with that form. I don’t think the drafter knew what “includible in gross income” meant, as Congress defined it for a situation that had nothing to do with a rebate/credit being sent to taxpayers abroad.

Now, the Service has a precedent where they’ve said foreign earned income is not part of your gross income. Nice, I guess, if the goal is make the code even more confusing. I think it just weakens the tax code compliance even more with regard to Americans abroad than it already is.

I am looking forward to seeing that 2010 Schedule M.