Learn what foreign tax credit you should be aware of if you're a U.S. citizen living abroad and how to report foreign income with Form 1116.
The IRS requires U.S. Citizens and U.S. Resident Aliens, both those who have a U.S. Green Card and those who meet the substantial presence test, to report and pay taxes on their worldwide income. That said, there are certain implications involved that taxpayers should be aware of. Let's take a deeper dive to see what those are.
Options for avoiding double taxation
To avoid double taxation on Americans living abroad, the IRS gives them a choice:
- Deduct their foreign taxes on Schedule A, like other common deductions.
- Use Form 1116 to claim the Foreign Tax Credit (FTC) and subtract the taxes they paid to another country from whatever they owe the IRS.
- Use Form 2555 to claim the Foreign Earned-Income Exclusion (FEIE), which allows those who qualify to exclude some or all of their foreign-earned income from their U.S. taxes.
In most cases, choosing the FTC will reduce your U.S. tax liability the most.
Foreign tax credit eligibility
Taxes paid to other countries qualify for the FTC when:
- You paid the tax on your income to a local or provincial government.
- You were legally obligated to pay the tax
- You have already paid or accrued the tax.
- You did not gain from paying the tax.
There are also some taxes that cannot be included in the FTC:
- Taxes on income excluded from your U.S. gross income (If you do not include wages earned in another country as part of your U.S. income, you cannot claim a credit for foreign taxes paid on those wages)
- Taxes paid to a sanctioned country
- Sales tax, value-added tax, real estate taxes, or luxury taxes paid to a foreign government
- Taxes on foreign mineral, oil, and gas income
- Taxes from international boycott operations
- Taxes related to a foreign tax splitting event
- Social Security taxes paid or accrued to a foreign country with which the U.S. has a Social Security agreement
Overview of Form 1116
If you have only one type of foreign income, you complete just one Form 1116. All Form 1116 filers must choose how they regard their income: on an accrual basis or a cash basis.
- If you record income when you earn it rather than when you get paid, you use the accrual method.
- If you record income when you receive it, you use the cash method. Most individuals use the cash method.
You should convert all amounts you report on Form 1116 to U.S. dollars, except where otherwise specified. The conversion rate you use should be the rate in effect on the day you paid the foreign taxes or the date they were withheld. If you choose the accrual method, you generally use the average exchange rate in effect during that tax year.
The instructions for Form 1116 walk you through each line item and include worksheets. You provide detailed information using each of the form's four sections:
- Part 1 to calculate taxable income from one to three countries
- Part 2 to list taxes paid in both the foreign currency and their U.S. dollar equivalent
- Part 3 to figure the FTC for the income category
- Part 4 to total all credits from all income categories
If your credit is larger than your U.S. tax obligation, you can use the leftover amount to reduce your taxes in the future. It's also important to note that if a foreign tax redetermination (recalculation to your benefit) occurs, you are required to file a Form 1040-X to notify the IRS of the change. If you do not notify the IRS, you could be fined for failure to notify.
Reporting foreign income with Form 1116
After classifying your foreign income by category, you must complete a separate form for each of the seven types of income you may have:
- Section 951A category income: A global intangible low-taxed income (GILTI) made by U.S. shareholders of certain controlled foreign corporations but doesn't include passive category income.
- Foreign branch category income: This involves business profits made by U.S. persons from one or more qualified business units (QBUs) in one or more foreign countries but doesn't include passive category income.
- Passive category income: Includes income from interest, dividends, royalties, and annuities.
- General category income: Includes your wages, salary, and any highly taxed passive income. Income becomes "highly taxed" for IRS purposes when the foreign country's tax rate is higher than the U.S. rate.
- Section 901(j) countries: Countries the U.S. has sanctioned for repeatedly providing support for acts of international terrorism, countries with which the U.S. doesn't conduct diplomatic relations, or countries whose governments aren't recognized by the U.S. You must report earnings from any of them.
- Resourced by treaty: Certain income resourced by treaty relates to tax treaties the U.S. has with other countries. Complete Form 1116 for this category if the country in which you worked has a special agreement with the U.S. about how it taxes your income as a foreigner. Under "resourced by treaty" agreements, all your income — including any money you made in the U.S. — counts as income from the treaty country when figuring out the taxes you owe.
- Lump-sum distributions: These include income you received from a foreign-sourced pension plan.
Foreign tax credit without Form 1116
Situations exist that allow you to claim the FTC without filing Form 1116, if the income concerned meets the qualifying definition.
- If all your foreign-taxed income was 1099-reported passive income, such as interest and dividends, you don't need to file Form 1116, provided that any dividends came from stock you owned for at least 16 days.
- Single filers who paid $300 or less in foreign taxes, and married joint filers who paid $600 or less, can omit filing Form 1116. But using the form enables you to carry forward any unused credit balance to future tax years; without filing Form 1116, you give up this carryover tax break.
- If your income came from a U.S. territory such as American Samoa, Puerto Rico, Guam, or the U.S. Virgin Islands, special rules govern how you use Form 1116 for the FTC.
When you use TurboTax to prepare your taxes, we'll ask you straightforward questions about your foreign income, determine how much of it is deductible (or available as a credit), and fill in all the right forms for you.
COVID-19 pandemic implications for foreign tax credit
While there haven't been any COVID-19 related changes to Form 1116, taxpayers using Form 2555 to claim the FEIE can qualify for a waiver of the bona fide residence or physical presence test for 2020 or 2021 by meeting one of these requirements:
- Due to the pandemic, you were required to leave the People's Republic of China (excluding the Special Administrative regions of Hong Kong and Macau) on or after December 1, 2020 through July 15, 2021.
- Due to the pandemic, you were required to leave another foreign country on or after February 1, 2021 through July 15, 2021.
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