I am in the military stationed in England and have been since 2008. My wife started working for a local fitness center in April 2008. When I claim her foreign income ( around $1038 for 2011) I lose out on the EIC ($3800). This doesn't seem right, or fair. How can I claim her income and not lose out on the EIC? Can I claim her income as self-employment? I have searched all over the internet but have found nothing on a situation like this. Any help would be appreciated. Cheers.

“ My wife started working for a local fitness center in April 2008. When I claim her foreign income ( around $1038 for 2011) I lose out on the EIC ($3800). This doesn't seem right, or fair. “---->US citizens and resident aliens are taxed on their worldwide income, whether the person lives inside or outside of the US. However, qualifying U.S. citizens and resident aliens who live and work abroad may be able to exclude from their income all or part of their foreign salary or wages, or amounts received as compensation for their personal services. In addition, they may also qualify to exclude or deduct certain foreign housing costs.
“How can I claim her income and not lose out on the EIC?”----->I do not think so, however, you can claim foreing tax credit on her income tax paid to UK;aAs your spouse earns taxable income in UK , then she needs to pay tax on it to UK then she can claim her foreign tax credit on her tax that she paid to UK on her US return, federal and state return by filing form 1116 and reporting the credit on 1040 line 47(you need to report the amount on Form 1116 line 30 to 1040 line 47) or itemizes it on Sch A of 1040 line 8. However, you still need to report her UK income on your joint return as part of your gross income(earn ed income).
“Can I claim her income as self-employment?”------>I guess it depends; the IRS reminds taxpayers to follow appropriate guidelines when determining whether an activity is a business or a hobby, an activity not engaged in for profit. In general, taxpayers may deduct ordinary and necessary expenses for conducting a trade or business. An ordinary expense is an expense that is common and accepted in the taxpayer’s trade or business. A necessary expense is one that is appropriate for the business. Generally, an activity qualifies as a business if it is carried on with the reasonable expectation of earning a profit. You must include on your tax return hobby income. Tax deductions for expenses related to hobby income are limited to the amount of hobby income you report on your tax return, and can be taken as tax deductions only if you itemize your tax deductions on Form 1040, Sch A. The tax deductions are subject to the 2% AGI floor. You cannot deduct a net loss on your tax return. However, if it is business income, then you need to report it on Sch C of 1040 as long as the amount on line 29/31 is $400 or exceeds $400 and also need to file Sch SE to pay SECA tax as long as the amount on Sch SE lin e4 is $400 or exceeds $400. The 2010 Tax Relief Act reduced the self-employment tax by 2% for self-employment income earned in calendar year 2011. The self-employment tax rate for self-employment income earned in calendar year 2011 is 13.3%, NOT 15.3% (10.4% for Social Security and 2.9% for Medicare). The Temporary Payroll Tax Cut Continuation Act of 2011 extended the self-employment tax reduction of 2% for calendar year 2012 so the rates for 2011 remain in effect for 2012. For self-employment income earned in 2010, the self-employment tax rate is 15.3%. The rate consists of two parts: 12.4% for social security (old-age, survivors, and disability insurance) and 2.9% for Medicare (hospital insurance).ALSO, If you are filing as a sole proprietor and a self-employed individual, you generally have to make estimated tax payments if you expect to owe tax of $1,000 or more when you file your return;however, you do not have to pay estimated tax for the current year if you had no tax liability for the prior year ;you were a U.S. citizen or resident for the whole year ;your prior tax year covered a 12 month period .

After reading my original post, I realize I made an error. My wife started working here in April 2011 not 2008. We moved here in October 2008.
I understand that we will be taxed on worldwide income. I am just wondering why we lose out on the $3800 EIC when my wife makes $1000 worth of foreign income.
As far as the foreign income tax exclusion goes... she doesn't pay British tax because she doesn't make enough to be taxed. She is self employed, it just happens that the business that has contracted with her is a foreign entity.
She is a fitness instructor. She doesn't work to make money, rather she works to be able to afford the certifications and to keep fit. When it is all said and done, after deducting the cost of certifications, equipment etc, she ends up with around $500 at the end of the year.
I guess my question is this. Since she is paid in foreign currency, is she required to claim it as foreign income, or can we legally claim it as self employment?

“I understand that we will be taxed on worldwide income. “---->Correct. You need to pay tax to UK taxing authority on your UK income and by filing Form 1116, you can claim it on your US return, federal and state return.
“I am just wondering why we lose out on the $3800 EIC when my wife makes $1000 worth of foreign income.”---->I guess it depends on the situation; as you said, as long as your wife’s UK income increases your earned income level over a certain level then you are not eligible for EIC. For example, $13,660 ($18,740 for married filing jointly) if you do not have a QC.
Please visit the Website here for more information: http://www.irs.gov/pub/irs-pdf/p596.pdf
“As far as the foreign income tax exclusion goes... she doesn't pay British tax because she doesn't make enough to be taxed. She is self employed, it just happens that the business that has contracted with her is a foreign entity.”--->I guess so; then she doesn’t need to file form 1116 as she doesn’t pay tax to UK so she has nothing to claim on her US return(s). I also guess she doesn’t need to pay her quarterly estimated taxes to the IRS. As you can see, estimated tax is the method used to pay tax on income that is not subject to withholding. This includes income from self-employment, interest, dividends, alimony, rent, gains from the sale of assets, prizes and awards. You also may have to pay estimated tax if the amount of income tax being withheld from your salary, pension, or other income is not enough. If you are filing as a sole proprietor and/or a self-employed individual, you generally have to make estimated tax payments if you expect to owe tax of $1,000 or more when you file your return.However, you do not have to pay estimated tax for the current year if you had no tax liability for the prior year ;you were a U.S. citizen or resident for the whole year ;your prior tax year covered a 12 month period.But as long as her net earning from her selfe employment is $400 or exceeds $400 then she needs to file her Sch C(as long ass the amoun ton Sch C line 29/31 ids $400 or exceeds $400), also, as long as the amount on Sch SE of 1040 line 4 is $400 or exceeds $400, then she MUST pay self employment tax; SECA tax is a tax consisting of Social Security and Medicare taxes primarily for individuals who work for themselves. It is similar to the Social Security and Medicare taxes withheld from the pay of most wage earners; The 2010 Tax Relief Act reduced the self-employment tax by 2% for self-employment income earned in calendar year 2011. The self-employment tax rate for self-employment income earned in calendar year 2011 is 13.3% , NOT 15.3%(10.4% for Social Security and 2.9% for Medicare). The Temporary Payroll Tax Cut Continuation Act of 2011 extended the self-employment tax reduction of 2% for calendar year 2012 so the rates for 2011 remain in effect for 2012. For self-employment income earned in 2010, the self-employment tax rate is 15.3%. The rate consists of two parts: 12.4% for social security (old-age, survivors, and disability insurance) and 2.9% for Medicare (hospital insurance).
“She is a fitness instructor. She doesn't work to make money, rather she works to be able to afford the certifications and to keep fit. When it is all said and done, after deducting the cost of certifications, equipment etc, she ends up with around $500 at the end of the year. “---->The IRS reminds taxpayers to follow appropriate guidelines when determining whether an activity is a business or a hobby, an activity not engaged in for profit. In general, taxpayers may deduct ordinary and necessary expenses for conducting a trade or business. An ordinary expense is an expense that is common and accepted in the taxpayer’s trade or business. A necessary expense is one that is appropriate for the business. Generally, an activity qualifies as a business if it is carried on with the reasonable expectation of earning a profit. The IRS presumes that an activity is carried on for profit if it makes a profit during at least three of the last five tax years, including the current year.If an activity is not for profit, losses from that activity may not be used to offset other income. An activity produces a loss when related expenses exceed income. So, if yoru wife’s income is hobby income, then she doesn’t need to file Sch C /Sch SE but needs to report her income on 1040 line 21 , other income. Deductions for hobby activities are claimed as itemized deductions on Schedule A (Form 1040). These deductions must be taken in the order:1st order; deductions that a taxpayer may take for personal as well as business activities, such as home mortgage interest and taxes, may be taken in full.2nd oreder:deductions that don’t result in an adjustment to basis, such as advertising, insurance premiums and wages, may be taken next, to the extent gross income for the activity is more than the deductions from the first category.3rd oreder:business deductions that reduce the basis of property, such as depreciation and amortization, are taken last, but only to the extent gross income for the activity is more than the deductions taken in the first two categories
“I guess my question is this. Since she is paid in foreign currency, is she required to claim it as foreign income,. . .”---->Whether she is paid in British Sterling or Euro, it is her foreign income that is taxable to the IRS as her world wide income, UK source income.
“or can we legally claim it as self employment?”---->As described above; it depends on the situation to determine if your wife’s income is hobby or self employment income.