In our expanding global economy, more individuals and businesses find themselves engaged in international transactions, leading to an increase in foreign tax obligations. For tax preparers, understanding the intricacies of the tax code is crucial, and the foreign tax credit becomes a vital tool in managing the tax implications of income earned abroad. In this comprehensive guide, we will explore the foreign tax credit, its limitations, the process of filling out Form 1116, and how to calculate this credit accurately.
What is the Foreign Tax Credit?
The foreign tax credit is a provision in the U.S. tax code designed to alleviate the burden of double taxation on income earned in foreign jurisdictions. Essentially, it allows taxpayers to offset their U.S. tax liability by the amount of income tax paid to a foreign government on foreign-sourced income. The goal is to prevent taxpayers from being taxed on the same income by both the United States and the foreign country where the income was generated.
This credit is applicable to a variety of income types, including wages, self-employment income, dividends, interest, and rental income. It’s important for tax preparers to recognize that the Foreign Tax Credit is elective, meaning taxpayers can choose whether to take the credit or opt for other options like a deduction or the Foreign Earned Income Exclusion (FEIE) if they qualify.
Foreign Tax Credit limitations
While the foreign tax credit offers significant advantages, it comes with limitations that tax preparers must carefully navigate to ensure accurate and compliant filings.
Source of income
The income must be from a foreign source to qualify for the credit. If your client lived in another country but earned money from U.S. sources, this income wouldn’t be eligible for the credit.
Type of foreign taxes
Not all foreign taxes are eligible for the credit. In general, the taxes must be foreign income taxes or similar taxes that take the place of income tax. In most cases, foreign property taxes cannot be applied toward the credit, but they may qualify as a foreign tax deduction.
The Foreign Tax Credit limit
The credit’s limit is calculated by multiplying the total U.S. tax liability by a fraction where the numerator of the fraction is your client’s taxable income only from foreign sources and the denominator is their total taxable income from both the U.S. and foreign sources. You’ll make this calculation on Form 1116 (discussed below).
There are certain exceptions to this limitation that allow someone to claim a larger credit without using Form 1116:
- Their only foreign source gross income for the tax year is passive income (See “Separate Limit Income” in Publication 514 for a definition of passive income.)
- Their qualified foreign taxes for the tax year are not more than $300 ($600 if filing a joint return).
- All gross foreign income and foreign taxes are reported to the taxpayer on a payee statement like Form 1099-DIV or 1099-INT.
Choosing this election may make sense if it significantly increases your client’s credit amount, but if they choose it, they won’t be able to carryforward or carryback any unused foreign tax credit from the current year.
Threshold for high tax kickout:
If the foreign tax rate on a specific item of income exceeds 250% of the U.S. tax rate on the same income, the excess foreign taxes paid are not eligible for the foreign tax credit. This provision is designed to keep the amount of the credit similar to the amount of U.S. taxes that would be imposed on the income.
Foreign Tax Credit carryovers
If your client qualifies for a foreign tax credit that exceeds their U.S. tax liability for the year, they can carryover the excess credit for other tax years, up to 10 years in the future or one year prior.
The Foreign Tax Credit vs. Deduction
The IRS allows taxpayers to choose between taking the foreign tax credit or deducting the foreign taxes from their taxable income. In most cases, taking the credit is the more beneficial choice. Your clients cannot take both the credit and the deduction for the same income, and they cannot split their foreign income taxes, choosing the credit for some and the deduction for others. They must choose the credit or deduction for all their foreign income each year.
Note: Other types of foreign taxes, such as property taxes, can still be deducted from taxable income even if your client is taking the foreign income tax credit.
Foreign Tax Credit vs. Foreign Earned Income Exclusion
The Foreign Earned Income Exclusion is only available to U.S. taxpayers whose tax home is in a foreign country, such as U.S. expatriates. So, if your client lives in the U.S. but makes money from foreign sources, they would not qualify for the FEIE.
This provision allows taxpayers to exclude foreign earned income from their taxable U.S. federal income, up to a limit of $120,000. In some cases, it may be more beneficial than the foreign tax credit. For example, if your clients have an income below the $120,000 limit, they could eliminate any taxable income. Or, if they pay relatively little in foreign taxes, their foreign tax credit would be minimal as well.
On the other hand, the foreign tax credit is often the better choice for high-income taxpayers. Additionally, there is no carryover for the FEIE, and if a taxpayer completely eliminates all of their earned income using the FEIE, they may not be able to claim certain credits such as the Child Tax Credit or make contributions to IRA accounts. If your client qualifies for the FEIE, you’ll need to weigh the two options carefully, considering not only their tax liability for the current year but also the possibility of foreign tax credit carryover in future years and other financial considerations like their ability to contribute to IRAs.
How to fill out Form 1116: Foreign Tax Credit
Calculating your client’s foreign tax credit starts with Form 1116, which provides a detailed breakdown of the taxpayer’s foreign tax obligations and how they translate into credits against U.S. tax liability.
Selecting category of income
Before you get to Part I, you’ll check one of seven boxes to specify the category of income, such as from general sources, passive income, or foreign branch income. Even if your client has multiple types of foreign income, you must check only one box per form. You’ll fill out a separate Form 1116 for each type of income.
Part I: Taxable Income and Loss from Sources Outside the U.S.
In this section, you’ll list the countries the income was sourced from and the gross amounts of income.
Part II: Foreign Taxes Paid or Accrued:
Here, you’ll document the foreign taxes paid or accrued during the tax year. You may choose to report taxes paid or taxes accrued, but you must be consistent. For example, if your client accrued foreign taxes in 2022 that they paid in 2023, they would only report them if they were using the paid method. Similarly, if they accrued taxes at the end of 2023 that they had not yet paid, they could only report them if they were choosing to report accrued taxes.
Of course, foreign taxes are paid in a currency different from the U.S. dollar, so you’ll need to determine the average exchange rate on the date the foreign taxes were paid or accrued to convert the figures into U.S. dollars.
Part III: Figuring the Credit
Here, you’ll calculate the foreign tax credit using the credit limitation formula to determine the maximum allowable foreign tax credit (i.e. multiply their total U.S. total by a fraction where the numerator of the fraction is your client’s taxable income only from foreign sources and the denominator is their total taxable income from both the U.S. and foreign sources). This section also accounts for any high-tax kickouts or carryover from previous years’ foreign tax credits.
Part IV: Summary of Credits from Separate Part IIIs
If your client had multiple categories of foreign income and therefore multiple 1116 forms, in this section you will combine the figures from Part III of each different form to get your final total foreign tax credit.
On the surface, the foreign tax credit is a relatively simple dollar-for-dollar reduction in U.S. taxes based on any foreign taxes paid during the year. In reality, the credit can get tricky to calculate depending on the categories of your clients’ foreign income and the type of taxes they paid. If you’re unsure how to navigate your client’s foreign tax credit calculations, we recommend reading IRS Publication 514, Instructions for Form 1116, and the IRS’s Foreign Tax Credit Compliance Tips.
Tax professionals who take the time to master the intricacies of the Foreign Tax Credit, Foreign Earned Income Exclusion, and other foreign income tax laws will find that they are better positioned to attract clients with foreign income – and earn high rates for this specialized service.