IRS Form 1116 Explained
Americans who are working abroad can save money on taxes by claiming the foreign tax credit using IRS Form 1116, Foreign Tax Credit.
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Key Takeaways:
- IRS Form 1116, Foreign Tax Credit, is an IRS form that individuals, estates, and trusts can file to claim dollar-for-dollar tax credits on foreign taxes paid.
- To qualify for the foreign tax credit, the taxpayer must have been legally obligated to pay the foreign tax and have actually paid the foreign tax, and the tax must have been a legal foreign tax liability and be an income tax or a tax instead of an income tax.
- The seven types of foreign earned income that apply to the foreign tax credit using IRS Form 1116 include Section 951A category income, foreign branch category income, passive category income, general category income, Section 901 (j) income, certain income re-sourced by treaty, and lump-sum distributions.
- Expatriates can avoid double taxation on foreign earned income by either deducting the foreign taxes paid as a regular Schedule A deduction when filing their income tax return, by claiming the Foreign Tax Credit using IRS Form 1116, or by claiming the Foreign Earned-Income Exclusion using IRS Form 2555.
What Is IRS Form 1116?
IRS Form 1116, Foreign Tax Credit, is a tax form used by individuals, estates, or trusts to claim tax credits for foreign taxes paid.
This means that expats working in a foreign country are able to claim tax breaks that help them avoid double taxation, where they would have to pay taxes both in the U.S. and in the country they are working in.
Foreign Tax Credit Qualifications
There are certain factors that must be met for taxpayers to be able to claim the foreign tax credit, including details about the taxpayer and the types of foreign income being reported.
Who Is Eligible To File IRS Form 1116?
Only certain individuals, estates, or trusts are eligible to claim the federal tax credit by filing IRS Form 1116. Here are the requirements:
- They were legally obligated to pay a foreign tax
- They paid a foreign tax
- The tax was a legal foreign tax liability
- The foreign tax was an income tax or a tax instead of an income tax
Types Of Income For Tax Form 1116
Taxpayers using IRS Form 1116 to claim the foreign tax credit must complete a separate form for each of the different types of income they have that qualify for the tax credit. There are seven types of foreign income that may qualify for the foreign tax credit:
- Section 951A category income
- Foreign branch category income
- Passive category income
- General category income
- Section 901 (j) income
- Certain income re-sourced by treaty
- Lump-sum distributions
Foreign Tax Credit Limitations
There are certain taxes that do not qualify for the foreign tax credit, such as:
- Taxes included in the foreign earned income exclusion
- Real estate tax, sales tax, value-added tax, or luxury tax paid to a foreign government
- Taxes used to support international terrorism that were paid to a foreign country
- Taxes for people controlling foreign corporations
- Partnerships or S-corporations who do not complete the tax filing for required tax returns
- Taxes that only qualify for itemized deductions
- Social Security taxes that were paid to a foreign country that has a social security agreement with the U.S.
- International boycott operations taxes
- Taxes on foreign gas, oil, and mineral income
- Taxes that are related to a foreign tax splitting event
Frequently Asked Questions
When Is IRS Form 1116 Not Needed To Claim The Foreign Tax Credit?
There are certain situations in which taxpayers can claim the foreign tax credit without filing 1116. In order to qualify for this situation, the foreign income must meet the following requirements:
- All of the foreign-taxed income was passive investment income reported in the 1099 form, such as interest, royalties, annuities, rents, and dividends, as long as the dividends came from stock that was owned for 16 days or more.
- The “foreign-earned income” was earned in a U.S. territory, such as Puerto Rico, the U.S. Virgin Islands, Guam, or American Samoa, in which special FTC rules apply.
- The foreign tax paid was less than $300 for single filers or less than $600 for married joint filers. However, failing to file IRS Form 1116 omits the ability to carry forward any unused credit amount to future tax years.
How To Avoid Double Taxation As An American Worker Overseas
As an expat working abroad, there are a few options offered by the IRS to help them lower their tax liability.
The first option is for them to treat their foreign tax payments as regular deductions when they file their Schedule A federal income tax return.
Another option is for the taxpayer to specifically claim the Foreign Tax Credit using IRS Form 1116, deducting the foreign taxes paid to another country from their U.S. tax payment.
Additionally, certain taxpayers may qualify to claim the Foreign Earned-Income Exclusion (FEIE) using IRS Form 2555, which allows eligible individuals to exclude a portion or potentially all of their foreign-earned income from their U.S. tax return.
Foreign Tax Credit Vs. Foreign Earned-Income Exclusion
Taxpayers who work in a foreign country may have looked into the tax breaks available for expatriates and realized there are different types of schedules and forms, such as the Foreign Tax Credit that is claimed using IRS Form 1116 and the Foreign Earned-Income Credit that is claimed using IRS Form 2555. While both of these tax exemptions work to prevent expats from double taxation on the income they have earned in a foreign country, the FTC is a dollar-for-dollar credit that can be claimed on the taxes they already paid to the foreign country, whereas the FEIE is a tax deduction that subtracts the tax-exempt foreign income from their annual tax liability.
There are several factors expats should consider when deciding whether to claim the FTC or the FEIE to help them save the most money on foreign taxes, including:
- Their income source
- Their income type
- Their housing expenses
- Their basic living expenses
- Their plans for the future living and working in a foreign country
- The local tax laws in their current country of residence
IRS Form 1116 is used to report taxable income, capital gain, and losses, and calculate the foreign tax credit for the income category, but this activity can be difficult to configure without the help of a tax professional with experience in filing taxes for an individual, trade, or business that operates in a foreign country.
Do you have any other lingering questions about tax credits, tax-deductible payments, or how to make the most of tax breaks when you file your taxes? If so, schedule your free consultation with the tax experts at Ideal Tax for guidance throughout the entire process so you can save money this tax season.
Luis serves as the Director of Operations for Ideal Tax, overseeing a multifaceted team including case management, tax professionals, document specialists, customer support, training, and development.
