If a taxpayer meets the definition of a U.S. Person the U.S. will require them to report their worldwide income and assess tax on said income regardless of the physical location of the taxpayer in the world. However, the IRS offers several mechanisms to the taxpayer to either reduce or eliminate any double taxation that might occur as a result of the taxpayer living outside of the United States. Today we will talk about two of these tools, the foreign tax credit and the foreign earned income exclusion.
The Foreign Tax Credit and Foreign Earned income Exclusion
Foreign Tax Credit (FTC)
The FTC (Form 1116 for individuals, Form 1118 for corporations) allows a taxpayer to claim any foreign taxes that were either paid or accrued to a foreign country or U.S. possession as a credit (or itemized deduction) if the foreign income is also subject to taxes in the U.S.
Generally speaking it is in the taxpayers interest to take the credit which will reduce their tax liability on a dollar for dollar basis. The deduction will only reduce the income which is subject to U.S. tax.
If you choose to exclude foreign earned income or foreign housing costs, you cannot take a foreign tax credit for taxes on the income you are allowed to exclude. If you try and take the credit on income already excluded, both choices may be considered revoked.
Foreign taxes taken as a credit in excess of U.S. tax assessed can be carried back one year and forward up to ten to offset any future U.S. taxes owed on foreign income.
Exception Election to Not File Form 1116 to Report the FTC
Generally form 1116 must be filed along with the tax return in order to claim the foreign tax credit. However certain circumstances allow the taxpayer to claim the FTC without filing form 1116. These are:
- If the foreign income is reported on a slip, such as a 1099-DIV or 1099-INT.
- If the total foreign taxes paid are $300 or less for single filers or $600 or less if filing married filing jointly.
- If the only gross taxable income from a foreign source is passive (this includes investment income, interest income, dividends, annuities, rent, and royalties)
The Foreign Earned Income Exclusion (FEIE)
If the taxpayer meets certain requirements while living and working abroad they may be able to exclude from income an amount of foreign earned income. This amount is adjusted for inflation every year.
|Foreign Earned Income Exclusion Amounts|
To claim the foreign earned income exclusion, the foreign housing exclusion, or the foreign housing deduction, you must have foreign earned income, your tax home must be in a foreign country, you must meet either the Bona Fide Residence or Physical Presence Test, and you must make a valid election. It’s also important to note that you can receive the income anywhere, including the U.S., as long as you were in a foreign country when you performed the services that gave rise to the income. If you are self-employed, foreign earned income includes professional fees for personal services you rendered in a foreign country.
Foreign Tax Home?
You must have a foreign tax home to claim the foreign earned income exclusion:
- Regardless of where you maintain your family home, your tax home is the general area of your main place of business, employment, or post of duty.
- Your tax home is the place where you are permanently or indefinitely engaged to work as an employee or self-employed individual. If you do not have a regular or main place of business because of the nature of your work, your tax home may be the place where you regularly live.
- If you have neither a regular or main place of business nor a place where you regularly live, you are considered an itinerant and your tax home is wherever you work.
Bona Fide Residence Test
You meet the bona fide residence test if you are a bona fide resident of a foreign country or countries for an uninterrupted period that includes an entire tax year. You do not automatically acquire bona fide resident status merely by living in a foreign country or countries for one year. The length of your stay and the nature of your job are only two of the factors to consider in determining whether you meet the bona fide residence test.
In addition to the time requirement, there a numerous factors you need to consider when determining whether or not you qualify as a bona fide resident of a foreign country:
- What is your intent?
- Have you established a home in the foreign country?
- To what extent have you assimilated into the life and society of the foreign country?
- Are you physically present in the foreign country other than brief, temporary visits to the U.S. or elsewhere?
- What is the nature, extent and reasons for any temporary absences?
Physical Presence Test
You can also qualify by meeting the physical presence test.
You meet the physical presence test if you are physically present in a foreign country or countries 330 full days during a period of 12 consecutive months. You do not have to be in a foreign country only for employment purposes. Unlike the bona fide residence test, this test does not depend on the kind of residence you establish, your intentions about returning, or the nature and purpose of your stay abroad.
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Any tax advice herein is based on the facts provided to us and on our interpretation of tax legislation as it reads at the time the advice is provided. Tax law is subject to continual change, at times on a retroactive basis and may result in incremental taxes, interest or penalties. We are not responsible for updating our advice for changes in law or interpretation after the date the advice is provided. Every tax situation is different. We are not responsible for the tax implications to any individual or entity that may act on this advice.