Foreign Tax Credit & Form 1116: What Taxpayers Should Know
By Mahoney
United States citizens and resident aliens are required to report their worldwide income on their U.S. federal tax returns every year. The foreign tax credit is a tax benefit for U.S. taxpayers that helps offset income taxes paid to foreign countries. The credit allows taxpayers to reduce their U.S. tax liability and avoid double taxation on the same income that is subject to taxation in foreign countries.
Who Qualifies for the Foreign Tax Credit?
Not all taxes paid to a foreign government can be claimed as a credit to reduce U.S. federal income tax. Here are some of the requirements to qualify for the foreign tax credit:
- The tax must be imposed by a foreign country or U.S. possession
- The tax must have been paid or accrued to a foreign country or U.S. possession
- The taxpayer must be a U.S. citizen or resident alien
- The taxpayer must have a legal obligation to pay the foreign income taxes
The foreign taxes paid must be on income derived from foreign sources. Income from U.S. sources, even if it is received while residing in a foreign country, does not qualify for the foreign tax credit.
Filing Form 1116: Foreign Tax Credit
Form 1116 is the federal tax form that individuals, estates or trusts use* to calculate and claim the foreign tax credit. The form can be complex, and it is important to follow the instructions provided by the IRS. Here is a summarized guide for the key steps to complete Form 1116:
- Identify the income categories: Taxpayers are required to split up their foreign income into specific categories, such as passive income, general income, foreign branch income, etc. A separate Form 1116 will need to be completed for each category of income.
- Complete Part I of Form 1116: This part of Form 1116 requires taxpayers to calculate their taxable income from sources outside of the United States. There are several columns on this part of the form. If the taxpayer has foreign income attributable to more than one country, a separate column must be used for each country. After the net foreign source taxable income is calculated, this amount is then carried to part III of Form 1116.
- Complete Part II of Form 1116: This part of Form 1116 asks the taxpayer to report the amount of foreign taxes that were paid or accrued in the current year. The total foreign taxes paid or accrued is then carried to part III of Form 1116.
- Complete Part III of Form 1116: This part of Form 1116 computes the amount of credit eligible to be claimed on the taxpayer’s return. To calculate the credit, the total foreign taxes paid during the tax year is compared to the foreign tax credit limitation. The limitation is computed as follows:
Finally, the foreign tax credit is claimed by taking the lesser of the foreign taxes paid during the year or the limitation as calculated above.
*Corporations eligible to claim a foreign tax credit file Form 1118.
Is the Foreign Tax Credit Refundable?
No, the foreign tax credit is a non-refundable credit. It can only reduce a taxpayer’s liability to zero. Any excess credit amount that is unused in a given tax year can be carried back one tax year and/or carried forward 10 tax years.
For additional tax considerations or to find a qualified tax consultant, please reach out to Travis Koester, CPA, Senior Associate, or contact Mahoney’s Tax Solutions Team. Let us know if we can help in any way.
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