While at first glance the Foreign Earned Income Exclusion might seem like the most alluring option, using Form 1116 to claim a Foreign Tax Credit can actually save some expats more money. In addition, US expats can even receive tax credits for use in the future.
Here we explore what IRS Form 1116 is and how expats can benefit from it.
What is IRS Form 1116 and the Foreign Tax Credit?
IRS Form 1116 is used to claim the Foreign Tax Credit. The IRS gives tax credits to US taxpayers who have already paid a tax on the income to another country.
By using this dollar-for-dollar credit, US expats can avoid or limit double taxation on their income.
When can the Foreign Tax Credit be used?
The Foreign Tax Credit (FTC) can be used when income is sourced and taxed outside the US. Most expats that work and pay high income taxes in another country use the Foreign Tax Credit to offset US income tax.
However, the FTC is not limited to foreign income tax on salaries. This makes Form 1116 not only valuable for expats but for any US taxpayer who pays foreign tax. For example, you may be able to claim a foreign tax credit if you have passive income abroad while living in the US.
Another situation is if you are only abroad on a short-term work assignment but you don’t relocate there. The income is still foreign-sourced, and a Foreign Tax Credit could be applied.
On the other hand, the Foreign Tax Credit cannot be used for income that you already excluded from taxes through the Foreign Earned Income Exclusion (FEIE). This means you cannot first use the FEIE to exclude your income and then apply a Foreign Tax Credit for the same income. No double-dipping.
Foreign Tax Credit and Foreign Earned Income Exclusion
The Foreign Earned Income Exclusion (FEIE) and the Foreign Tax Credit (FTC) are both big tax savings opportunities for expats. (Read more about the FEIE.)
For income below the FEIE limit, expats should consult with their tax accountant to decide if using the FEIE or the FTC is better in their specific situation.
Expats should be careful when choosing whether to use the FEIE, the Foreign Tax Credit, or both. Poor planning can cause issues for future tax filings.
Specifically, if you use the FEIE, and the next year you are still eligible for FEIE, but you decide not to use the FEIE and only use the FTC, then you revoke your right to use the FEIE for five years. This can only be reversed through written permission from the IRS.
Even expats that use the FEIE to exclude their foreign income from US income tax might still be able to use the Foreign Tax Credit for any income that exceeds the FEIE limits.
The FTC would then be prorated, meaning that they can only apply a tax credit for foreign tax paid on the unexcluded income.
Do I have to file Form 1116?
Form 1116 is optional, but often very advantageous. There is no penalty for failing to submit. The primary “con” for not filing is the potential loss of beneficial tax credits.
This form is frequently used by expats who are living and working abroad. However, as mentioned earlier, individuals living in the US can also benefit.
US citizens or residents that fall into one of these categories may be eligible for the FTC:
- Individual who earned income in a foreign country and paid taxes on that income to the foreign government.
- Mutual fund shareholder who paid taxes for the mutual fund to a foreign government.
- Owner of an S corporation that claimed credits on taxes paid to a foreign government.
- Owner of a trust or estate in a foreign country that paid foreign taxes.
Due date for filing Form 1116
The standard due date for Form 1116 is April 15 along with your personal tax returns.
To give expats extra time to file their foreign taxes, the IRS gives an automatic extension to June 15. If you still need extra time to file you can request to extend the deadline to October 15.
Foreign Tax Credit for general versus passive income
Keep in mind that you can receive foreign tax credits for different types of income. The most common are general income and passive income. In addition, there are other specific categories for foreign tax credits, for example resourced by treaty, which refers to tax treaties between the US and other countries. Consult with an experienced expat tax accountant to see which ones apply to you.
General income includes your salary if you work for an employer or self-employment income. Passive income includes income from dividends, interest, and real estate.
The IRS does have one important rule for these two different types of income. You can only credit one type of income tax to a tax for the same type of income.
In other words, only foreign credits for general income can be applied to your US tax liability for general income. Likewise, foreign credits for passive income can only be applied to US taxes for passive income. This means you cannot use a foreign tax credit for tax you paid on salary to offset US tax due on capital gains.
Foreign Tax Credit Carryovers and Carrybacks
If you pay more taxes to a foreign government than you would have paid to the US government, the IRS will let you keep the extra tax credits that you did not use.
However, foreign tax credits cannot be used to receive a refund from the IRS. They can only be used to bring your tax liability to zero.
If you do have extra foreign tax credits you can keep them for up to 10 years. You can carry them over and apply them to future taxes.
For example, Sam is living and working in Spain. Last year, he earned $100,000 in Spain and paid the Spanish government $35,000 in income tax. Sam earned no income in the US. His US income tax liability would have been $17,000.
When Sam files his US taxes, he uses Form 1116 to claim a credit for the tax he paid in Spain. The IRS will give him a dollar-for-dollar credit for the $35,000 taxes he paid to the Spanish government. Since his Spanish taxes exceed the US tax, Sam owes no income tax to the IRS. In addition, he has an unused tax credit of $18,000 that carries forward into future years.
The carryforward is especially useful for expats who move from a high tax to a low or no-tax country. For example, an expat worked many years in Japan and accumulated unused foreign tax credits. We helped him apply those credits later when he worked a few years in a low tax country like Singapore.
Should I use Form 1116 Foreign Tax Credit or the Foreign Earned Income Exclusion?
Whether the Foreign Tax Credit (Form 1116) or the Foreign Earned Income Exclusion (Form 2555) is optimal depends on each individual situation.
There are a variety of factors that our accountants take into consideration when evaluating the best tax strategy for you. Factors such as where you live, your plans for the future, family size, and retirement plans can all have an impact on what tax strategy you should use.
To ensure you have a plan that works for the long-term, you can set up a consultation with one of our accountants.
Getting help with expat taxes
When it comes to optimizing your taxes as an expat it is important to make sure that you take advantage of every opportunity available to you.
Filing taxes as an American abroad is a lot different than when living in the US. Most US-based tax accountants are not familiar with specific tax breaks available to expats. A tax accountant specialized in expat taxes can help you file everything correctly.
Unfortunately, our accountants have seen a variety of previous returns filed by other accountants, which miss out on key refunds or deductions. They have even seen Form 1116 done incorrectly, which can result in penalties.
Properly planning how to use FTC and the FEIE, accurately prorating foreign tax, and making sure your accountant is aware of taxes that you pay abroad are all frequent issues. Fortunately, in many cases, we are able to amend the previous returns and lessen the damage.
To make sure that your taxes are planned for and filed correctly, set up a consultation with one of our accountants.