Q #1: Starting in 2015, if you are filing form 2555 or 2555-EZ you cannot claim additional child tax credit. Can anyone tell me who has to file these forms? I don’t remember filing either of them in previous years.
Although if someone heard that beginning in 2015, a filer of IRS Form 2555 or 2555-EZ does preclude one from claiming the ACTC (Additional Child Tax Credit), they have been informed correctly, I think it is important to explain both the purpose of Form 2555 and 2555-EZ, as well as the difference between the regular Child Tax Credit, and the ACTC.
The Child Tax Credit entitles a Taxpayer to a credit against taxes of up to $1,000 per child who is a US Citizen, and less than 17 years old at the end of the tax year. In order to be eligible for the credit, the Taxpayer must report earned income, but once the Taxpayer’s income reaches higher levels, the credit slowly phases out. These income levels at which phase out begins vary according to the Taxpayer’s filing status – Single, Married Filing Joint (MFJ), Married Filing Single (MFS), or Head of Household (HOH). Eventually, if a Taxpayer’s income is too high, then the credit is completely phased out.
Whatever amount of Credit a Taxpayer is calculated for a Taxpayer reduces that Taxpayer’s tax liability for the year dollar for dollar. Normally, a Taxpayer’s credit cannot be greater than the Taxpayer’s tax. For example, if the Taxpayer’s tax is calculated at $1,000, and, then the total credits also cannot exceed $1,000, unless that credit was for payments the Taxpayer made to the IRS, usually through employer withholding from salary, or through estimated tax payments. So if someone’s tax is $1,000, and their child tax credit would be $2,000 because the filer does not have high income, and has two qualifying children, the filer’s credit would normally be limited to $1,000. The reason for this is that most tax credits are known as non-refundable.
However, the Child Tax Credit has a special component which is refundable, and that is the ACTC. With this component, a Taxpayer could even have $0 tax, but the Taxpayer could still potentially receive a refund from the IRS for up to $1,000 per child qualifying for the ACTC. It’s like getting free money from the government just for fulfilling one’s legal obligation of filing a tax return.
Many US Taxpayers living in Israel have, over the years, traditionally combined Child Tax Credits with either Foreign Tax Credits or Foreign Earned Income Exclusion, or both, to minimize their US tax obligation, and in many cases, to annually maximize an IRS refund.
When one takes a Foreign Earned Income Exclusion, this Taxpayer files Form 2555 or, sometimes, could qualify to file the simpler Form 2555-EZ. This allows the US Citizen residing in a foreign country, and earning income from work in that country as an employee, or from self-employment, to exclude that income from gross income, provided that certain other conditions are met. The income still gets reported, but then, using Form 2555 or 2555-EZ, it then gets subtracted back out from gross income.
While this procedure works for many Taxpayers, it has for many years posed problems when one is trying to take advantage of the Child Tax Credit. As mentioned earlier, one must show earned income when claiming a child tax credit. So filers with status of Single, MFS, or HOH who exclude income are ultimately not showing any earned income as part of their gross income, and can lose even their regular, refundable, child tax credits. The same problem holds for filers with MFJ status, if both the husband and the wife exclude income with Form 2555 or 2555-EZ.
The new twist for 2015 is that Congress added a new rule specifically stating that if there is any Form 2555 or 2555-EZ on the tax return, then the filer cannot qualify for the ACTC.
In the past, filers who otherwise wouldn’t qualify for the regular Child Tax Credit would, instead of excluding income with 2555 or 2555-EZ, take foreign tax credits (FTC’s) against the US tax for taxes paid to Israel using Form 1116. FTC’s allow the filer to avoid, or at least mitigate double taxation on the same income from 2 or more questions. However, by using the FTC, the taxpayer still shows earned income, and qualifies for the Child Tax Credit.
Also, in the past, MFJ filers would often exclude one of the couple’s income, while taking the FTC on the spouse’s income to make sure that the Taxpayer would qualify for the ACTC. Beginning in 2015, that is no longer possible. To now qualify for the ACTC, the Taxpayer needs to make sure that both Taxpayer and Spouse use the FTC for both of their incomes from work.
It may be that your ACTC is reduced by taking FTC’s on both the income of the Taxpayer and the Spouse, compared to what it would have been before this rule was put in place. If this is the case, speak to your CPA and see if you might be able to bring your refund back up by considering whether you are considering all taxes that might be creditable. You will need to speak to your US CPA about this to see if you can bring your IRS refund back up.
Another strategy that CPA’s consider to maximize the ACTC of a married couple is to file the husband’s and wife’s tax returns separately, each with an MFS filing status. When doing this, the CPA then taking the 2555 on one of the returns, and having the other spouse claim the children and not taking the 2555. This very often results in obtaining larger IRS refunds that would otherwise be available when filing one tax return with MFJ filing status for the married couple, with the new law effective beginning with the 2015 tax year.
This, however, is a strategy to consider, but not necessarily implement, as it may not work for every taxpayer’s facts and circumstances. There is a potential downside, which is that this strategy can cause a tradeoff effect. The potential tradeoff is that the taxpayer might obtain a larger IRS refund, but then be required to pay the difference for additional tax preparation fees. The CPA might need to charge a higher bill for the time to prepare two separate tax returns for the couple, instead of one joint tax return, and the time to analyze whether one joint or two separate tax returns is better, since this strategy does not help every taxpayer. Therefore, the taxpayer should speak to their CPA to determine whether it is worth it to test whether this strategy works for them.
Have your US CPA consider whether you took a foreign tax credit for all taxes paid to Israel that qualify, whether you qualify for other non-refundable credits such as the Dependent Care Credit, which could help you to maximize your eligibility for the ACTC.
Q #2: Which Israeli forms do I need to calculate for the US foreign earned income exclusion? Thank you!
If you are a sachir (company employee) you will need your Tofes 106 from each of your employers, as well as those of your spouse. If you are an atzmai (self-employed), then you will need your Profit and Loss statement from your Israeli accountant. You will also need to make sure you are using the correct foreign exchange rate to convert the income from NIS to USD.
