If you’re a U.S. citizen, green card holder (permanent resident), or a resident alien (meaning you’ve lived in the U.S. for a good chunk of the year), the U.S. government taxes your income no matter where in the world you earn it. This can lead to a tricky situation where both the U.S. and another country tax the same income – ouch, that’s double taxation!
When you earn money in another country, that country usually taxes it. The U.S. also wants its share, which is where the Foreign Tax Credit (FTC) comes in.
The Foreign Tax Credit, offered by the IRS, is there to ease the burden of double taxation. It’s a valuable tax break for those with income from abroad.
The Foreign Tax Credit: What Is It and Why Does It Matter?
The FTC lets you reduce your U.S. tax bill by the amount of income tax you’ve already paid to a foreign government. It’s a direct, dollar-for-dollar reduction. Important nuances, for example, your US tax burden is equal or higher than tax imposed by foreign jurisdiction and you were physically working in that foreign location for the double-taxed income.
Two Ways to Handle Foreign Taxes (and Why One is Usually Better)
You generally have two choices when dealing with foreign taxes: taking a credit or claiming a deduction. The credit is almost always the better option for optimizing value.
- Foreign Tax Credit (FTC): This directly lowers the amount of U.S. tax you owe. If you paid $1,000 in foreign taxes, your U.S. tax bill could shrink by up to $1,000.
- Foreign Tax Deduction: This lowers your overall taxable income. If you paid $1,000 in foreign taxes, you’d deduct that amount from your income. The actual tax savings is only a portion of that as opposed to a dollar- to dollar benefit.
In most cases, the FTC provides a much bigger tax cut than a deduction.
What Taxes Qualify for the Credit? Four Key Requirements
Not every tax you pay to a foreign government is eligible for the FTC. The tax has to meet these requirements:
1. It Has to Be a Tax: The payment must be something you’re required to pay to a foreign government.
2. It Has to Be an Income Tax: This one’s important. The tax must be on your income, not on things like sales, property, or value-added tax (VAT).
3. The Tax Must Be Paid or Accrued: If you’re an individual taxpayer who uses the cash method, the tax has to be paid during the tax year in question.
4. The Tax Must Be on You: You have to be the person legally responsible for the foreign tax. Taxes taken out of your paycheck usually meet this requirement.
Limiting the Credit: How It Works
The FTC has limits. You can’t use foreign taxes to lower your U.S. tax on income you earned in the U.S. The IRS makes sure of this through the FTC Limitation, which stops the credit from being higher than your U.S. tax bill on your foreign income.
Treaties can sometimes allow US sourced income to be treated as foreign income in situations where the foreign government taxes the US income without offering any tax relief.
Without a tax treaty, you could end up paying double taxes (though the Foreign Earned Income Exclusion, or FEIE, might help).
Special Cases: Itinerant Workers
If you work in many countries throughout the year, calculating the FTC can be tricky
The Problem of Sourcing and Allocating Income
For U.S. tax purposes, the money you earn (like wages if you are employed, or income if you are self-employed) is tied to where you physically worked for determining source of income. As an itinerant worker, here’s what you need to do:
- Track your time: Keep detailed logs of your travels and work to know how many days you spent working in each country, including the U.S.
- Allocate income: Divide your total income and deductible expenses based on where you worked. This is key to figuring out your foreign income for the FTC limitation.
For example, imagine you make $200,000 a year and work 50 days in the U.K., 50 days in France, and 140 days in the U.S. For FTC purposes, your foreign income is only what you earned during those 100 days of foreign work. However, if the U.K. and France withhold taxes based on a different calculation, figuring out the credit becomes complex. It’s also important to confirm that the source country is imposing tax burden based on number of days worked in a said country.
Be Aware that the IRS is paying closer attention to how highly mobile workers allocate their time/days to make sure foreign income isn’t overstated just to boost the FTC limitation.
What to Do If You Paid Too Much Foreign Tax
The U.S. tax code offers a way to handle excess tax, which is common when the foreign country’s tax rate is higher than the U.S. rate.
- Carryback: You can generally move the excess foreign tax back one year.
- Carryforward: If you still have unused excess tax, you can carry it forward for up to ten years.
This carryover is helpful because you can use those high foreign taxes in years when the foreign tax rate is lower or when you owe more U.S. tax on foreign income.
Income Baskets: Why They Matter
To prevent manipulation, foreign income and taxes are grouped into categories, or Baskets. You have to figure out the FTC limitation separately for each basket.
The main basket is General Category Income (wages, business income, royalties). Others include:
- Passive Category Income: Includes interest, dividends, annuities, royalties, and capital gains not from active business operations.
- Foreign Branch Income: Income from a foreign branch of a U.S. business (for tax years starting after 2017).
These baskets prevent people from combining high-taxed income with low-taxed income to unfairly increase their FTC limit.
How to Claim the FTC: The Forms You’ll Need
To claim the FTC correctly, use these forms:
- Form 1116, Foreign Tax Credit (Individual, Estate, or Trust): Use this to calculate the FTC limitation for each income category and the final credit amount.
- Schedule 3 (Form 1040): Transfer the credit amount from Form 1116 to this schedule to lower your overall tax bill.
A Simpler Option
Some taxpayers don’t have to file Form 1116 if their total foreign taxes are $300 or less ($600 if married filing jointly) AND all their foreign income is Passive Category Income.
FTC vs. Foreign Earned Income Exclusion (FEIE): Which Should You Choose?
If you live and work abroad, you have another tax break choice: the Foreign Earned Income Exclusion (FEIE), claimed using Form 2555. It’s important to decide which one to use, as you usually can’t use both on the same income.
FEIE: Lets you exclude some of your foreign income from U.S. tax. This is best when you pay little or no foreign income tax (like in places with no income tax, such as Dubai).
FTC: Lowers your U.S. tax on your foreign income. This is usually best when you pay a lot of foreign income tax, especially in countries with higher tax rates than the U.S.
You can also use both methods to avoid double taxation as long as you are not claiming the benefits on the same income. This can be particularly helpful if you still need to reduce your US State income tax liability.
Frequently Asked Questions (FAQ) on Form 1116 & Foreign Tax Credits
1. What is the Foreign Tax Credit (FTC) and How Does it Prevent Double Taxation?
2. Form 1116 vs. FEIE (Form 2555): Which Option Is Better for Expats?
3. How Does the Foreign Tax Credit Limitation Work and How Is it Calculated on Form 1116?
4. Can I Carry Forward or Carry Back Unused Foreign Tax Credits?
5. Which Types of Foreign Taxes Qualify for the Credit on Form 1116?
6. Do I Need a Separate Form 1116 for Every Foreign Country or Income Type?
7. How Do I Report Foreign Taxes Paid in a Foreign Currency on Form 1116?
8. Who is Required to File Form 1116 (The $300/$600 Exception)?
9. How Does the FTC Apply to Capital Gains and Foreign Investment Income?
10. What Happens if I Get a Refund for Foreign Taxes Previously Claimed on Form 1116?
Disclaimer: while we aim to spark your interest and keep things entertaining, please treat everything shared here as food for thought rather than a rulebook for life. Since we don’t have a crystal ball and your situation is as unique as a fingerprint, we cannot guarantee accuracy or specific results, nor should you rely on this as professional advice. Please take these insights with a grain of salt, do your own homework, and always consult a qualified expert before making any big moves—because what works for one person might not work for all!
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