What is foreign tax credit?
To avoid double taxation on the same income, U.S. taxpayers can use the foreign tax credit as a valuable tool. A U.S. citizen or resident may be obligated to pay income tax in the foreign country where they work if they earn income abroad. Those who pay foreign taxes can claim a credit from the IRS, which reduces their U.S. tax liability by the amount they pay.
Several steps are necessary to calculate the foreign tax credit. Here's a simplified outline:
- Determine the foreign taxes paid or accrued on income that falls under U.S. tax. Income, war profits, and excess profits taxes are only eligible.
- Your taxable income from foreign sources forms the numerator, as well as your total taxable income from both U.S. and foreign sources.
- Fill out Form 1116, Foreign Tax Credit, to report foreign taxes that qualify and calculate the credit. The purpose of this form is to determine the amount of credit you can claim.
- Include the calculated foreign tax credit when filling out your Form 1040, U.S. Filing an income tax return for an individual.
- If the foreign income tax credit is not fully utilized in the current year, it can be carried forward for ten years.
- To obtain specific guidance on tax treaties and special rules that may apply, it's essential to consult IRS publications or a tax professional.
Here's an example of how to calculate the foreign tax credit on income from overseas:
For 325 days this year, Scott, a U.S. citizen, was residing in France. For services rendered this year, Scott was compensated with $215,000. Let's assume that the exclusion for income earned in foreign countries is $126,500. What is the percentage of foreign-earnings that Scott needs to include in gross income?
The amount of foreign-earned income Scott must include in his gross income is based on the amount he receives for his services, except for the foreign-earned income exclusion. Scott's inability to meet the residency or presence requirements resulted in proration of :
($126,500 / 365 * 325) = $112,367 - $215,000 =$102,363 foreign tax credit is allowed to Scott.
