institutions because such institutions and schools may be in the best financial position to provide such benefits.

Although the nondiscrimination rules for qualified tuition reductions require that the benefits not discriminate in favor of highly compensated employees, these rules may not adequately prevent the award of these benefits in favor of the more highly compensated, depending upon how a "reasonable classification" of employees is defined.108 Moreover, the nondiscrimination rules do not address the limited scope of the provision to benefit only employees of certain educational organizations.

By comparison to qualified tuition reductions, other provisions under present law provide tax benefits for education to a much broader segment of taxpayers. If the proposal were adopted, current beneficiaries of qualified tuition reductions would be entitled to claim benefits under any of these provisions if they are otherwise eligible.

Qualified tuition reductions are sometimes viewed as a means to promote loyalty on the part of employees of educational organizations. For example, under present law, such organizations may subsidize in a tax-free manner the education of an employee's dependents at the same institution where the employee works. But this rationale may not fully justify the present-law rules for qualified tuition reductions because these rules also permit a tax-free subsidy even if the employee's dependent is educated at any other qualifying institution.

The proposal simplifies the law and removes a potential source of noncompliance. For example, repeal of the provision eliminates the need to determine the appropriate classification of employees for purposes of applying the nondiscrimination requirement. Repeal also eliminates the potential confusion of distinguishing between a tax-free tuition reduction received by a student and taxable compensation received by such student for teaching, research, or other services.

108 Reasonable classification is a concept that also applies with respect to the nondiscrimination rules applicable to qualified retirement plans. The IRS has noted that the reasonable classification rule applies differently to qualified tuition reductions than to qualified retirement plans. See, e.g., Priv. Ltr. Ruls. 200137041 (June 20, 2001) and 9710022 (December 6, 1996).

D. Deny Refundable Child Credit When Section 911 Exclusion is Elected

(sec. 24) Present Law

Child credit

17.109

In general

An individual may claim a $1,000 tax credit for each qualifying child under the age of

110

The child tax credit is phased-out for individuals with income over certain thresholds. Specifically, the otherwise allowable child tax credit is reduced by $50 for each $1,000 (or fraction thereof) of modified adjusted gross income over $75,000 for single individuals or heads of households, $110,000 for married individuals filing joint returns, and $55,000 for married individuals filing separate returns. The length of the phase-out range depends on the number of qualifying children. For example, the phase-out range for a single individual with one qualifying child is between $75,000 and $95,000 of modified adjusted gross income. The phaseout range for a single individual with two qualifying children is between $75,000 and $115,000. The amount of the tax credit and the phase-out ranges are not adjusted annually for

inflation.

Refundability

For 2005, the child credit is refundable to the extent of 15 percent of the taxpayer's earned income in excess of $10,900.111 Families with three or more children are allowed a

109 Sec. 24. The credit reverts to $500 in taxable years beginning after December 31, 2010, under the sunset provision of EGTRRA. A qualifying child is determined by reference to the uniform definition of qualifying child enacted by Congress in 2004, effective for taxable years beginning after December 31, 2004. Secs. 21(b)(1)(A) and 152(a)(1) (as amended by The Working Families Tax Relief Act of 2004, Pub. L. No. 108-311, secs. 201 and 203). In general, a qualifying child means, with respect to a taxpayer for a taxable year, an individual who: (1) is a son, daughter, stepson, stepdaughter, adopted child, eligible foster child, brother, sister, stepbrother, or stepsister of the taxpayer, or a descendant of any such individual; (2) shares the same principal place of abode as the taxpayer for more than half the taxable year; (3) meets certain age requirements or is permanently and totally disabled; and (4) has not provided over one half of his or her own support during the year. Sec. 152(c) (as amended by the Act).

110

Modified adjusted gross income is the taxpayer's total gross income plus certain amounts excluded from gross income (e.g., excluded income of U.S. citizens or residents living abroad (sec. 911); residents of American Samoa and the Northern Mariana Islands (sec. 931); and residents of Puerto Rico (sec. 933)).

refundable credit for the amount by which the taxpayer's social security taxes exceed the taxpayer's earned income credit, if that amount is greater than the refundable credit based on the taxpayer's earned income in excess of $10,900 (for 2005). The refundable portion of the child credit does not constitute income and is not treated as resources for purposes of determining eligibility or the amount or nature of benefits or assistance under any Federal program or any State or local program financed with Federal funds. For taxable years beginning after December 31, 2010, the sunset provision of EGTRRA applies to the rule allowing refundable child credits based on earned income in excess of the threshold.

The definition of "earned income" for purposes of the refundable child credit generally follows that for the earned income credit, which includes (1) wages, salaries, tips and other employee compensation to the extent includible in gross income, plus (2) net earnings from selfemployment. For purposes of the refundable child credit, earned income also must be taken into account in computing taxable income in order to be considered earned income for calculating the refundable child credit.

Earned income credit

In general

112

Low and moderate-income workers may be eligible for the refundable earned income credit (“EIC”). Eligibility for the EIC is based on earned income, adjusted gross income, investment income, filing status, and immigration and work status in the United States. The amount of the EIC is based on the presence and number of qualifying children in the worker's family, as well as on adjusted gross income and earned income.

The earned income credit generally equals a specified percentage of wages up to a maximum dollar amount. The maximum amount applies over a certain income range and then diminishes to zero over a specified phaseout range. For taxpayers with earned income (or adjusted gross income (“AGI"), if greater) in excess of the beginning of the phaseout range, the maximum EIC amount is reduced by the phaseout rate multiplied by the amount of earned income (or AGI, if greater) in excess of the beginning of the phaseout range. For taxpayers with earned income (or AGI, if greater) in excess of the end of the phaseout range, no credit is allowed.

An individual is not eligible for the EIC if the aggregate amount of disqualified income of the taxpayer for the taxable year exceeds $2,700 (for 2005). This threshold is indexed. Disqualified income is the sum of: (1) interest (taxable and tax exempt); (2) dividends; (3) net rent and royalty income (if greater than zero); (4) capital gains net income; and (5) net passive income (if greater than zero) that is not self-employment income.

The EIC is a refundable credit, meaning that if the amount of the credit exceeds the taxpayer's Federal income tax liability, the excess is payable to the taxpayer as a direct transfer payment. Under an advance payment system, eligible taxpayers may elect to receive the credit

112 Sec. 32.

in their paychecks, rather than waiting to claim a refund on their tax return filed by April 15 of the following year.

Section 911

An individual electing to exclude foreign earned income under the provisions of section 911 is not eligible for the EIC.

Foreign earned income exclusion (section 911)

In general

U.S. citizens generally are subject to U.S. income tax on all their income, whether derived in the United States or elsewhere. U.S. citizens living abroad may be eligible to elect to exclude from their income for U.S. tax purposes certain foreign earned income and foreign housing costs, in which case no residual U.S. tax is imposed to the extent of such exclusion. In order to qualify for these exclusions, an individual must be either: (1) a U.S. citizen who is a bona fide resident of a foreign country for an uninterrupted period that includes an entire taxable year; or (2) a U.S. citizen or resident present overseas for 330 days out of any 12-consecutivemonth period. In addition, the taxpayer must have his or her tax home in a foreign country.

114

Exclusion for compensation

The foreign earned income exclusion generally applies to income earned from sources outside the United States as compensation for personal services rendered by the taxpayer. The maximum exclusion amount for foreign earned income is $80,000 per taxable year for 2005 and thereafter. For taxable years beginning after 2007, the maximum exclusion amount is indexed for inflation.

Reasons for Change

Present law permits certain high-income taxpayers to receive the refundable child credit, which is intended for low-income taxpayers.

Description of Proposal

The proposal denies a refundable child credit to anyone claiming the section 911 exclusion.

113

114

Sec. 911.

Only U.S. citizens may qualify under the bona fide residence test. However, resident aliens of the United States who are citizens of foreign countries that have a treaty with the United States may qualify for section 911 exclusions under the bona fide residence test by application of a nondiscrimination provision.

Effective Date

The proposal is effective with respect to taxable years beginning after the date of

enactment.

Discussion

The refundable child credit is generally intended to apply to working families of sufficiently low economic income. Under present law, however, because earned income must be included in gross income in order to be considered earned income for purposes of the EIC and the refundable child credit, taxpayers working abroad and claiming an exclusion under section 911 are potentially eligible for a refundable child credit if their income is sufficiently high. Specifically, the refundable credit becomes payable for taxpayers working abroad, and electing the section 911 exclusion, once the taxpayer's earned income exceeds $90,900 (section 911 exclusion of $80,000 plus the refundable child credit earned income threshold of $10,900 for 2005).

Example 1.-A married U.S. taxpayer with two children who lives and works in a foreign country with $100,000 of foreign earned income has gross income of only $20,000 as a result of the $80,000 foreign earned income (section 911) exclusion. The taxpayer is potentially eligible for up to $2,000 of child credits as a result of having two eligible children. Because the phaseout of the child credit starts at $110,000 of modified AGI for a married taxpayer filing jointly, the child credit is not reduced by the phaseout.115 As a result of other provisions of U.S. tax law such as the personal exemptions and the standard deduction which collectively exceed $20,000,116 taxpayer has no taxable income and thus no U.S. income tax liability to apply the $2,000 credit towards. However, because the refundable child credit is based on only the portion of earned income that is included in taxable income, the taxpayer is eligible for a refundable credit of up to 15 percent of the amount by which such income (in this case $20,000) exceeds $10,900, or $9,100, for a refundable credit of $1,365 (15 percent of $9,100). Since the taxpayer was eligible for up to $2,000 in child credits, the taxpayer is able to claim the full refundable amount of $1,365.117

Example 2.-The facts are the same as example 1 except that the taxpayer has $60,000 of foreign earned income, or $40,000 less income than the taxpayer of example 1. The taxpayer thus has no gross income for U.S. tax purposes as a result of the $80,000 foreign earned income (section 911) exclusion. The taxpayer is potentially eligible for up to $2,000 of child credits as a

115

The phaseout of the child credit applies regardless of whether the child credit is used to offset regular tax liability or is a refundable child credit.

116

The taxpayer would have two personal exemptions and two dependent exemptions at $3,200 each for a total of $12,800, and a standard deduction of $10,000, for total exemptions and deductions of $22,800.

117

If the taxpayer had only one child, the calculation for the refundable credit would still yield a potentially refundable credit of $1,365, but the actual refundable credit would have been limited to $1,000 as that is the maximum credit allowable for a taxpayer with one child.