What is Form 1116 and who needs to file it?
When talking about US taxes and taxation of US citizens who live abroad, you may have heard of Foreign Tax Credit and the possibility to offset the US tax owing by using the taxes paid to another country. That way you can narrow the tax owing down to zero!
Most of the US international tax experts prefer claiming Foreign Tax Credit (Form 1116) on client’s U.S. tax return rather than preparing form 2555 (Foreign Earned Income Exclusion), since it is more beneficial. Read further to learn why FTC is a better way to save money on your US expat taxes.
Here are 5 quick facts about IRS Form 1116 and US tax returns:
- You claim Foreign Tax Credit on your US expat taxes by filing Form 1116
- You attach this form to a Form 1040, your individual US tax return
- The credit reduces your US tax liability on expat income dollar for dollar
- You cannot take Foreign Tax Credit against income which you have previously excluded by the Foreign Earned Income Exclusion
- And you can’t receive a refund of foreign taxes paid through your US tax return
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How to claim the Foreign Tax Credit by filing Form 1116
Do you want to take advantage of the Foreign Tax Credit and file Form 1116 on your next US tax return? First, you need to know about the requirements. To be eligible to use the Foreign Tax Credit, one must meet ALL 4 specified standards:
- The tax must be actual foreign tax liability and legally derived
- The tax must be imposed on you
- You must have paid or accrued the tax, and
- The tax must be an income tax, or Tax in Lieu of Income Tax
Following Foreign Taxes That Do Not Qualify:
- Taxes refundable to you
- Taxes subsided you or someone related to you
- Taxes you could have avoided paying as they are not required by law
- Withheld foreign taxes on dividends for foreign stocks and they don’t meet required minimum holding periods
- Withheld foreign taxes on gains and income from other foreign properties that don’t meet required minimum holding periods
You can claim these taxes as itemized deduction even if you already claimed foreign tax credits for qualifying taxes.
Tax Tip 1: Remember that you need to convert all of the paid foreign taxes to US dollars. The IRS prefers that you convert each transaction at the foreign exchange rate at the date of the transaction. However, if you choose to claim foreign income taxes on an accrual basis, you will have to use the annual average foreign exchange rate.
The eligible taxes include only passive category income and general category income. Passive category income includes dividends, interest, rents and royalties. Capital gains that are not considered as an active conduct of a trade or business also falls under Passive income. General category income may include wages, salary, and overseas allowances. The latter category also includes income earned in the active conduct of a trade or business.
There are other limitations on certain foreign taxes that you can not claim as foreign tax credit. For example, the Foreign Tax Credit doesn’t apply against any tax paid to North Korea, Iran, Sudan or Syria.
You can easily calculate the amount of FTC limitation:
- Divide Foreign Sourced Taxable Income by Total Taxable Income Before Exemptions
- Multiply it by Total US tax and you will have the final amount of Foreign Sourced US Tax.
Advantages of Foreign Tax Credit and general rules
Are you ready to claim the Foreign Tax Credit on your U.S. expat tax return? You need to know that FTC cannot exceed the amount of US tax that you pay on foreign sourced income. Let’s look at the Form 1116 example and how US expat can benefit from it.
U.S. expats have to remember following information before deciding to claim Foreign Tax Credit:
- You can choose credit or a deduction to take the amount of any qualified foreign taxes paid during the year.
- If you choose the deductions, you must itemize them on Form 1040, Schedule A.
- If you choose the Foreign Tax Credit, you need to complete IRS Form 1116 and attach it to your 1040 or 1040NR Form.
- Every year you have to choose either Foreign Tax Credit or Itemized Deductions for all foreign taxes paid or accrued.
Tax Tip 2: Taking advantage of Carryback and carryover of Unused Foreign Tax Credit. First, you decided to claim Foreign Tax Credit on Form 1116 but you can’t apply credit against the full amount of qualified foreign income taxes that you paid or they accrued in the year. In this case, you can carry back for one year and/or carryover for 10 years the unused foreign income tax.
Instructions to file Form 1116 guide you to complete just one form if you have only one type of income. Every taxpayer who is using Foreign Tax Credit has to choose how they regard their income: on a cash basis or an accrual basis. Why is there such a requirement? IRS can use these accounting methods to track the timing of your income for tax purposes.
Tax Tip 3: If you are using Foreign Earned Income Exclusion and then decided to revoke it, you can’t use it again for another 5 years. But if you use the Foreign Tax credit, you can revert to the FEIE.
Tax Tip 4: You can use a refundable Child Tax Credit together with Foreign Tax Credit but not with Foreign Earned Income Exclusion.
Let’s take a look at Form 1116 example: how to claim Foreign Tax Credit
Amy is an American living in Canada. She had $140,000 of employment income and $4000 of income in dividends. With that income, Amy has, with the standard deduction that’s $12,000 for single filers in 2018, the tax would be $25,970. As she has paid $29,602 tax for her wages and $722 tax for the dividend income. Note: The amounts are shown in United States Dollars. Since the income comes from two different sources (General and Passive income), Amy has to file two Forms 1116. You cannot combine multiple categories of income and make the calculations using only one Form.
Start by choosing the appropriate income category, (in case of the wages the box “general category income” will be checked, the same method will be used later for “passive category income”) and populating the taxpayer’s country of residence on the line H (in Amy’s case the country will be “Canada”).
Next step: you will complete Part I of the form 1116. Here you need to report the income and name of the foreign country. Columns A, B, and C stand for multiple countries in which a taxpayer could earn income (in our first form 1116, we will have only Canadian sourced wages under column A, as general income. You will need to do the same thing for the second form 1116).
From line 2 to line 5, the gross income from all sources is being reduced with deductions that relate to that foreign income (i.e. standard deduction which is $12,000 in the tax year 2018, for single taxpayers, or itemized deductions, if any). Deductions and losses related to exempt or excluded income such as Foreign Earned Income Exclusion cannot be reported here. Line 3f explains the proportion of General Income with the Total Income, so we could know the amount of standard deduction which is attributable to General Income. The same method will be used when computing the numbers for Passive Income, in our second form 1116. Line 3g represents the amount of standard deduction which is attributable to the specific income (In Amy’s case, she will have $11,666 of her standard deduction tied to her general income, while the rest will be tied to the passive income).
Part II will look the same as with the previous form. The amount of taxes paid for this category of income is the only difference here.
The taxes may be accrued or paid, depending on your accounting method. One important thing is that if you choose the “accrued” box for the accrued taxes, you will have to credit foreign taxes in the year they accrue in all future returns. The date usually falls at the end of the calendar year, but there are some exceptions here, like with the Dual status returns, where the date is used as the last calendar day the taxpayer is considered as a US citizen (the day of renunciation). More about this topic you can find here (hyperlink or sth else, for the renunciation article).
The tax paid/accrued is reported under line A since the income in Amy’s case comes only from one foreign country. Line At will be the place where the amount of foreign taxes is reported, as we have the amounts that are already converted in USD. The method is the same for the Passive Category income.
Now it’s time to figure out Amy’s Foreign Tax Credit. Part III of form 1116 represents the computation of information that’s reported in previous parts of the form. From line 9 to line 20 there is information about taxes paid/accrued which have been transferred from Part II.
- Line 10 indicates potential carryback of carryovers from prior years which we mentioned in Tax Tip 2, but in Amy’s case, there aren’t any.
- Line 12 will indicate the reduction in foreign taxes which usually occurs when the Foreign Earned Income Exclusion is claimed along with the Foreign Tax Credit.
- Line 15 reflects the calculation from Part II, line 7, while line 18 shows the taxable income calculated but dividing standard deduction from gross income of all sources.
- Line 20 represents the taxes imposed for both general and passive income, while line 22 shows a portion of US tax for General Category income.
Part IV represents the information about the separate parts III, like we have the situation with Amy (We are preparing two forms 1116, and therefore two different computations in Part III of the forms). The amount of tax credit that has been utilized to offset US tax owing is divided by the sourcing: taxes from general and taxes from passive income.
The same method is used when preparing Form 1116 for some other category income (In Amy’s situation, Passive Category Income). In the following pictures, we’ll show the computations of the Passive income.
Part II will look the same as with the previous form. The only difference will be the amount of taxes paid for this category of income.
Part III and Part IV will reflect the computation of the passive income, with the ratio of passive income/standard deduction, which is significantly lower comparing to general income/standard deduction ratio. The portion of US taxes imposed on passive income will be allocated accordingly.
Since the foreign taxes paid on passive income has covered the entire portion of US taxes imposed on passive income, Part IV of the Form 1116 will be empty.
Since the Foreign taxes paid on General income were higher than the imposed tax on the 1040 tax return, an excess of the credit will be considered as the amount eligible for a carryover, about which we wrote earlier in this article. If necessary, that amount (US$ 4,354) can be utilized to offset the tax owing in the following tax year(s).
In Amy’s case, utilizing Foreign Tax Credit over the Foreign Earned Income Exclusion is a better decision, since the FEIE would cover only the first $104,100 of the earnings, while the passive income will be taxed regularly.