The Foreign Tax Credit and Earned Income Exclusion

The United States operates on a “worldwide” taxation system. Essentially, this means that U.S. citizens and green card holders are bound by law to pay taxes on all of their income in the United States, regardless of where that money was earned. In many cases, those earnings are also subject to taxation in the host country as well. Without any remedy, this would result in double taxation and the citizen’s tax liability would skyrocket.

Fortunately, U.S. Tax Law provides two provisions to help avoid double taxation and allow the earner to keep more of their income. These include the Foreign Tax Credit and the Foreign Earned Income Exclusion. We will explain the basics of both in this blog. As always, tax matters are complex and it is always wise to consult an experienced professional. You may always contact Armel Tax for a free consultation.

The Foreign Tax Credit

The Foreign Tax Credit is available to the U.S. Taxpayer as a way of crediting back some of the taxes paid to a foreign government. Often, the credit is applied against gains received from owning a foreign stock or mutual fund. Taxpayers have two ways of claiming the Foreign Tax Credit. First, they can file the Foreign Tax Credit form known as form 1116. This is the most common way of claiming this credit. Second, a taxpayer can choose to claim the credit without form 1116 and on a regular 1040 but specific criteria must exist in order for this to occur. They are as follows:

All foreign-source income is “passive category income;” this basically means that the only income received from a foreign source consisted of interest and dividends.

All of the taxes paid on the income were reported on a qualified payee statement, such as a 1099-INT, 1099-DIV, or Schedule K-1.

The total applicable foreign taxes are not more than $300.

It is important to understand that by claiming the Foreign Tax Credit on the 1040 means than the taxpayer cannot carry over any of the foreign income taxes to another year.

Foreign Earned Income Exclusion

The other option is the Foreign Earned Income Exclusion. Generally, if the tax in the host country is higher than the U.S. rate, the taxpayer would benefit more from taking the credit rather than the exclusion. In most cases though, the exclusion is going to be more beneficial. The exclusion allows qualifying tax payers to avoid tax on up to $97,600 (in 2013) of foreign earned income. Please note that the amount of the exclusion is adjusted for inflation.

Additionally, the exclusion is per individual. Married taxpayers can each exclude up to the maximum amount every year. It should also be noted that whether you choose to take the credit or the exclusion, that choice is binding for the current year and all subsequent years unless it is revoked. Revocation can be made by attaching a statement to the 1040 specifying that one or more previous choices are being revoked. Like the credit, the exclusion is only available to those who meet 3 criterion:

The taxpayer must have a tax home in a foreign country.

The taxpayer must have foreign earned income (passive income such as dividends or interest do not count)

The taxpayer must meet the bona fide resident or physical presence test.

We will elaborate on the confusing terms used above in next month’s blog. If you have any questions, please contact Armel Tax for your free consultation anytime!