US taxpayers (including citizens, green card holders, and US business owners) face unique challenges when living abroad: paying taxes both to the country you reside in and to the United States. Two of the most helpful starting points when researching provisions designed to alleviate the risk of double taxation include the Foreign Earned Income Exclusion (FEIE) and the Foreign Tax Credit (FTC).
The FTC is claimed using IRS Form 1116, and reduces a US taxpayer’s US tax liability based on the taxes they’ve paid to a foreign country. (1) Below, we cover what the Foreign Tax Credit is, how it works, who qualifies, and the steps to claim it.
What is the Foreign Tax Credit?
The Foreign Tax Credit (FTC) is a tax benefit designed to prevent double taxation for US taxpayers who earn income abroad.
It allows you to offset your US tax liability with the foreign taxes you’ve already paid on the same income. For example, if you are self-employed in France and pay French income taxes, you can use the Foreign Tax Credit to reduce or eliminate the US taxes you owe on that income.
As mentioned in the introduction, the FTC is one of two primary ways to address double taxation, the other being the Foreign Earned Income Exclusion (FEIE).
Comparing the FTC and the FEIE
While the FEIE excludes a portion of your foreign-earned income from US taxation without regard to the foreign taxes, the FTC focuses on giving credit for foreign taxes paid.
In many cases, expats use a combination of both strategies to optimize their tax situation.
Generally, the FTC results in the most tax savings for a US taxpayer residing in a high-tax jurisdiction like Singapore, Canada, and most of Europe.
In low-tax countries, the FEIE may be the better option.
Who Qualifies for the Foreign Tax Credit?
You may qualify for the FTC if:
- You Are a US Taxpayer: This includes US citizens, permanent residents, and certain nonresident aliens who file a US tax return.
- You Paid or Accrued Foreign Taxes: The taxes must have been legally owed to a foreign government.
- The Foreign Taxes Are Eligible: Only income taxes or taxes paid in lieu of income taxes (e.g., certain withholding taxes) qualify. Property taxes, value-added taxes (VAT), and sales taxes are not eligible.
- The Income is Taxable in the US: The income for which you’re claiming the credit must be included in your US gross income. Essentially, you cannot claim the credit on income that is excluded from US tax – no double-dipping!
If these criteria apply, you’re generally eligible to claim the Foreign Tax Credit.
How the Foreign Tax Credit Works
The Foreign Tax Credit allows you to reduce your US tax liability dollar-for-dollar for foreign taxes paid, up to a specific limit. The IRS uses a formula to calculate the maximum allowable credit:
FTC Limit = (Foreign Source Income / Total Worldwide Income) x US Tax Liability
This formula ensures that the credit is proportional to the amount of foreign income relative to your total income. If your foreign taxes exceed the FTC limit, you may carry the excess forward for up to 10 years or back to the previous year.
foreign tax credit Example
Foreign source income: $50,000
Total worldwide income: $100,000
US tax liability: $20,000
FTC Limit = ($50,000 / $100,000) x $20,000 = $10,000
If you paid $12,000 in foreign taxes, you can claim a credit for $10,000 this year and carry forward the remaining $2,000.
How to Claim the Foreign Tax Credit
To claim the FTC, you must file IRS Form 1116 along with your federal tax return. Here’s a step-by-step overview: (2)
- Determine Eligibility: Ensure your foreign taxes and income meet the criteria for the credit.
- Complete Form 1116:
Part I: Report your foreign income and calculate the foreign taxes paid or accrued.
Part II: Determine your FTC limit using the formula we just reviewed (also provided on the form).
Part III: Calculate the credit you can claim and determine any carryback or carryforward amounts. - Attach Form 1116 to Your Tax Return: Include it with your Form 1040 and any other required schedules.
- Retain Supporting Documentation: Keep records of foreign tax payments, such as receipts, tax returns, or employer statements.
When to Use Form 1116
While Form 1116 is generally required to claim the Foreign Tax Credit, there is an exception for taxpayers with $300 or less ($600 for married filing jointly) in foreign taxes paid. In this case, you can claim the FTC directly on Form 1040 without completing Form 1116.
Benefits of the Foreign Tax Credit
The Foreign Tax Credit offers several advantages for US taxpayers living outside the US:
Prevents Double Taxation
By reducing or eliminating US taxes on income already taxed abroad, the FTC ensures you’re not taxed twice on the same income.
Maximizes Tax Savings
For many expats, the FTC provides greater savings than the Foreign Earned Income Exclusion, particularly if their foreign income exceeds the FEIE limit ($126,500 for 2024, $130,000 for 2025).
Note that in complex situations, both provisions may be applied to offset the greatest amount of your US tax liability, but it’s best to consult a US CPA experienced in crafting and executing these types of strategies.
Flexibility with Carryovers
The ability to carry forward unused credits allows taxpayers to optimize their tax liability over multiple years.
This is particularly beneficial if:
- the US recognizes income as taxable in one year, but your local country recognizes that income in a later year (i.e., a mismatch of timing)
- your tax situation changes significantly, putting you in a lower tax bracket
- you move to a country with a lower or different tax bracket; or
- the US recognizes income as taxable in one year, but your local country recognizes that income in a later year (i.e., a mismatch of timing).
Common Challenges with the Foreign Tax Credit
Despite its benefits, claiming the FTC can be complex. Here are some potential challenges:
- Tedious To File: Form 1116 is time-consuming to complete and can feel intimidating to non-tax-savvy people who are simply seeking compliance and relief from double taxation.
- Currency Conversion: Foreign taxes paid must be converted into US dollars. This is typically done by using the exchange rate on the date of payment.
- Timing Differences: The FTC can be claimed based on taxes paid or accrued, but timing differences between US and foreign tax systems may complicate calculations.
- Dual Taxation Agreements: Tax treaties between the US and foreign countries may affect eligibility or calculations for the FTC.
- Recordkeeping Requirements: Detailed documentation is necessary to support your claim, which can be burdensome for taxpayers with multiple income sources or accounts.
- Tedious To File: Form 1116 is time-consuming to complete and can feel intimidating to non-tax-savvy people who are simply seeking compliance and relief from double taxation.
Wrapping Up
The Foreign Tax Credit (FTC) is an important tool for US taxpayers to reduce the burden of double taxation and optimize their tax situation.
By understanding the rules, eligibility criteria, and process for claiming the FTC using IRS Form 1116, you can ensure compliance and minimize your US tax liability. However, given the potential for confusion or complex filing situations, consulting a tax professional is recommended to ensure compliance and the strategic application of the provision, particularly if your filing situation is complex.
References
The Foreign Tax Credit is a powerful tool that all US taxpayers living abroad should be aware of.
