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?]

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

  1. I am a US tax practitioner based in Frankfurt, Germany. I read with interest and agree with your analysis of IRC 36A and its incorporation by reference of the definition of earned income found in IRC 32(c)(2) with the exception of net self-employment income that is not includable – for any reason, apparently – in taxable income.

    Applying the classic rule of statutory construction that “expressio unius est exclusion alteris” the express exception for self-employment income not included in taxable income adds great weight to your argument that the Congress did not intend to deny FEI eligible wage earners the MWP credit whether those wages ultimately showed up in taxable income or not.

    The fact that they took pains to expressly exclude self-employment income from the definition of qualifying income is to my mind the final nail in the IRS’s coffin. They cannot pretend that the Congress wasn’t thinking about it or had some other idea about the meaning of “gross income” when it is quite clear that they were thinking about it and assumed no other definition of GI other than the long-established one.

    That still leaves us with the question: Why? Why exclude the self-employed FEI excluder? And: if you’re going to exclude the SE FEI excluder why not also exclude the SE non-excluder who by dint of the foreign tax credit has no regular tax liability?

    My best guess: the Congress wasn’t thinking about Americans residing abroad. This is not surprising. It is a constituency with little or no profile or political clout and often gets overlooked when laws are being written – especially the slapdash sort of legislation that is issued in times of economic crisis when the Congress is in full pander mode.

    Thanks for the time you took to analyze this. Some of my employed clients can and will fight their MWP denial notices but it looks like the self-employed types will have to concede.

    Regards,

    John Nolan

    1. John, thanks for your message. My own reading of the SE clause is that it’s meant to exclude the Parsonage Allowance (Section 107), not foreign-earned SE income. After all, IRC Section 1402 specifically says that, in defining net earnings from self-employment, “the exclusion from gross income provided by section 911 (a)(1) shall not apply.”

      To me, this is another piece of evidence that foreign earned income is always meant to be includible in gross income, and that the people who have twisted the wording were those at the Service who wanted to cram the test for MWPC into the same calculation sheet that filers use for the Child Tax Credit and Additional Child Tax Credit. There, FEI is backed out because it would create a windfall for Form 2555 filers. But with Making Work Pay, the credit was meant to be fully refundable for taxpayers who weren’t MAGIed out.

  2. Dear Tax Specialists

    I will attempt to keep this short. We applied for the first time home buyer tax credit after purchasing our first home in the United States. We do own a home in the UK and it was our principle residence within the 3 year period (from when we purchased our home in the US).

    According to the IRS Q&A Website, owning a principle residence within the previous 3 years in another country does not disqualify you from the First Time Home Buyers Tax Credit – see 7th question from the bottom:

    http://www.irs.gov/newsroom/article/0,,id=206291,00.html

    Well, after 12 months of waiting, we received a letter from the IRS stating our claim had been denied, stating:

    “Per IRC 36 you can not have ownership interest in a principle residence during the past 3 year period.”

    I have searched IRC 36 but am not able to find any mention of owning a principle residence in another country.

    Does anyone have any further documentation or information pertaining to this situation? The IRS Q&A Website shows that we are allowed to claim the credit and some other sources seem to indicate this also. but we would need to find the conclusive written law that states this.

    Please help!

    Kind regards

    Richard

  3. I know you haven’t been in Japan long enough to have gotten used to what it was like before, and if you have no U.S. income it wouldn’t affect you anyway, but in 2006 the tax calculation rules changed for 2555 filers. Instead of simply using the tax table on the taxable income like everyone else, the IRS started requiring a special worksheet for calculating your tax if you are filing 2555/2555EZ (this year that worksheet is on page 36 of the instructions). If your income is all foreign or all U.S., it has no impact, but our income is about half and half, and that worksheet kills us! (And the bad exchange rate right now makes it even worse.) It says you have to look up what the tax would be on the sum of the U.S. and foreign income, then look up what the tax would be on only the foreign income, and subtract. It forces the U.S. income to be taxed in a much higher tax bracket than if you only had the U.S. income. When I discovered it, I called the IRS from Japan, because I was some combination of baffled and hopping mad. The answer I got was that it was due to some new law which had a name that sounded like it was intended to reduce taxes, not increase them (I don’t remember the name now). Do you or anyone else know anything about the origin of that evil worksheet? I searched the internet but found nothing. I’m wondering if it also, like this Schedule M issue, is a good law’s implementation gone bad. If your foreign earned income can be excluded, why should its existence change the rate at which you are taxed on the rest? Sounds like a way around international double taxation agreements to me…

    1. The answer I got was that it was due to some new law which had a name that sounded like it was intended to reduce taxes, not increase them (I don’t remember the name now). Do you or anyone else know anything about the origin of that evil worksheet?

      Sure, OsakaWebbie, I know exactly what the law was: it was the Tax Reduction Act of 2005, passed by a Republican Congress using that “reconciliation” process that bypasses Senate filibuster rules. It was passed sometime in the middle of the night one day in May 2006 (even though the act says “2005”.)

      It retroactively raised taxes on Americans working overseas that year (hence, “2005”–neat trick,eh?); and, like you said, it made it where you have to include all of your income to determine your tax bracket.

      I never realized it could also impact those taxpayers who aren’t U.S. citizens or PRs, and that have income from two or three different countries. My flash guess is that it hits you with the higher marginal US tax bracket, and if you’re lucky you just get hit by Uncle Sammy and not those other countries, too.

      The main Senator agitating for the change was Republican Charles Grassley of Iowa. He has never lived outside the country, and relatively few Iowans ever do.

      You can Google search the Tax Reduction Act of 2005 and Section 911 (Foreign Earned Income Exclusion). I am sure there is plenty of commentary about this out.

    2. If necessary, you can use Form 1116 for a tax credit to help alleviate some of the tax you would have to pay for being in the higher tax bracket.

  4. I never realized it could also impact those taxpayers who aren’t U.S. citizens or PRs…

    My husband and I are U.S. citizens living in Japan, just like you – I’m not sure how you got a different impression. [Hoofin’s Note: I think I misunderstood your earlier comment and put that notion out there.] But we came here in 1996, so I got used to the 2555 making it like the salary didn’t exist on the U.S. side.

    With your help and a little more clever googling, I finally found it on the internet – the actual name is “Tax Increase Prevention and Reconciliation Act of 2005” (TIPRA), and I remember thinking when I first heard it from the IRS guy, “Tax increase prevention???” Reading the Wikipedia article now, I see that it does a long list of things, many of which might indeed help various people (especially longer term), but the little phrase that impacted us was, “However, the Act also includes a ‘stacking provision’ that requires the FEIE to be excluded against the lowest tax brackets first.”

    @chuckers: That doesn’t help – you can’t include the same foreign income on both 2555 and 1116, and the income causing the problem in our case is earned income from a single source (salary). I’ve tried it both ways, and the 2555 is better for us.

  5. @chuckers: That doesn’t help – you can’t include the same foreign income on both 2555 and 1116, and the income causing the problem in our case is earned income from a single source (salary). I’ve tried it both ways, and the 2555 is better for us.

    You should still be able knock off some of the tax bill by claiming the credit for taxes paid in Japan which would be higher than those paid in the US, right? If your Japanese income is enough to actually push you into a higher tax bracket (assuming you aren’t borderline to begin with) it ought to be compensating by being able to claim the taxes paid on it.

    You *are* claiming that US based income on your Japanese taxes, aren’t you?

    1. Let me just say a couple of points:

      Yes it’s TIPRA, and I called it the Tax Reduction Act. It was a comment on the fly while I was busy at something else this morning. I blogged about TIPRA back around when it was enacted, here. That was June 14, 2006. I know that it messed up my Roth conversion strategy for that year (since the conversion would have been paid at the lower rates). That was a nice little benny that people had had since Roths came to be in 1998 (if they were not of too high an income), so it’s no surprise the Republicans went after things like that when they did their mid-year switcheroo.

      OsakaWebbie is also correct that you can’t claim the Foreign Earned Income Exclusion and the Foreign Tax Credit for the excluded income. The idea of FEIE is that it takes earned income out of adjusted gross because you are under someone else’s tax regime. The 1116 (Foreign Tax Credit) form only helps you if you have fully excluded your FEIE, and your Foreign Housing Allowance, and still have earned income subject to US tax. I had a year like that, too, beck when the accounting profession was a little less hardscrabble.

      The simple fact is that the stacking provision is unfair in situations that there are lower rates versus America. In places like the Netherlands or Sweden, it’s not a big deal.

      Watch, the next thing Congress is going to go after is eliminating Foreign Earned Income Exclusion (the 2555), and forcing everyone to use Foreign Tax Credit (the 1116). In countries that do not rely on “Section 901 creditable” taxes—such as consumption tax—you would get no relief. Additionally, if your Japanese income taxes are lower than what Uncle Sam would charge, you would be expected to make up the difference!

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