Are short term capital gains considered earned income?

Question

I'm trying to figure out the implications of my income situation on my eligibility for the Earned Income Tax Credit. My understanding is:

• that short-term capital gains are taxed at the same rate as "ordinary income".
• that long-term capital gains are definitely not considered earned income.

However, I don't know what the overlap between "ordinary income" and "earned income" is. I know that short-term capital gains are still different from other forms of income explicitly defined as "earned income" (e.g. wages, salary, etc.) because you report it on form 8949. However, it's not explicitly excluded from the definition of earned income found here or here, but it isn't necessarily included in the general definition either. Can short-term capital gains be considered earned income?

The specific case I'm interested in is that of a "trader" as defined by the IRS. For traders, gains are reported as short-term capital gains so don't incur self-employment taxes. However, "trading" is still considered a business under their definition and allows for e.g. business expenses to be written off. If this business is generating income but the income is short-term capital income in nature, then is it considered both short-term capital gains and earned income?

Answer 1

Capital gains are not earned income. Short term capital gains are taxed at the same rate as earned income, but it doesn't magically convert passive income into active. Earned income is defined in IRC Sec 32(c)(2):

(2) Earned income

(A) The term “earned income” means—

• (i) wages, salaries, tips, and other employee compensation, but only if such amounts are includible in gross income for the taxable year, plus
• (ii)> the amount of the taxpayer’s net earnings from self-employment for the taxable year (within the meaning of section 1402(a)), but such net earnings shall be determined with regard to the deduction allowed to the taxpayer by section 164(f).

Traders report their income on Schedule C instead of form 8949, and then you do treat it as business (self-employment) income (but then you lose the capital gains benefits of long-term capital gains rates, unless you follow the rules carefully). You can then deduct expenses (news subscriptions, home office, communication costs, etc).

However you still cannot qualify the income you get as a trader for EITC anyway, since your income would still not be considered "earned" for the purposes of SE tax. See IRS Pub. 596 and the worksheet referenced.