Filing an American 1040 form for foreign earned income, even if it’s excluded income.

I have spent part of the weekend back on Schedule M and a dialog with Devin of Class5tax.com. He had been researching the Making Work Pay credit and came across my writings.

As I have been laying it out, I feel that foreign earned income is always “includible in your gross income”. It’s simply that you get the (up to) $91,400 exclusion. It is includible and excludable. I agree that it is not part of adjusted gross income.

In my last post, I think I fairly well also showed that the statutory language that the Schedule M drafter used to deny people, filing from abroad, the Making Work Pay Credit had nothing to do with whether you exclude your foreign earned income. The language was actually there to clarify the Earned Income Credit (EIC) rules regarding “other compensation”. Before 2001, the definition for “earned income” in the EIC made it difficult to calculate, and quite often bumped filers out of eligibility due to things like pension contributions and other employer-provided benefits.

So the new definition was put there to make EIC easier to determine. It had nothing to do with foreign earned income, only now, thanks to Schedule M, it appears to have.

To wrap up for now, let’s just think a bit about what this novel reading of includible foreign earned income means:

Before, when the rule was clear that foreign earned income is includible in your gross income, it made sense that you have to file a return if you have foreign earned income. It was part of your gross income. That is to say, includible in your gross income. Now the IRS is saying it’s not.

So do you even have to file a return?

Well, the clear rule before was “YES!”. And even what the Service has written in the filing rules of Publication 501 says, “YES!”

U.S. Citizens or Resident Aliens Living Abroad

For purposes of determining whether you must file a return, you must include in your gross income all of the income you earned or received abroad, including any income you can exclude under the foreign earned income exclusion. For more information on special tax rules that may apply to you, see Publication 54, Tax Guide for U.S. Citizens and Resident Aliens Abroad.

So before, again, it was clear: foreign earned income was includible in gross income, regardless of whether later you could exclude it. It makes perfect sense to define it that way, too, since it is the government (and not you) that ultimately determines whether you can exclude the foreign earned income: there is a test on Form 2555. So you have to declare it as gross income.

If it were not includible, the filing rules would simply say that up to $91,400 of your gross income is exempt from tax and should not be considered in whether you must file. (They don’t.) That’s how most of the Americans abroad seem to treat the filing requirement, anyway; and it’s totally illegal!

Only now, the Service is saying in another part of the filing regulations that you should treat your (under) $91,400 of foreign earned income as not part of gross income and therefore exempt from tax! Huh?

Any non-filer abroad who gets a notice from the Service should point Schedule M out. To me, you’re still totally in the wrong, but the IRS is being inconsistent in whether the money is supposed to start out as part of your gross, or no.

[Update: Plus, can anybody really tell me why foreign earned self-employment income is being treated differently than foreign earned income?]