It is important to understand the differences between Form 1116 Foreign Tax Credit and Form 2555 Foreign Earned Income as depending on your particular facts and circumstances one could yield a greater tax benefit for foreign earned income and foreign paid taxes.
Generally, the foreign tax credit is a basic credit that reduces a taxpayer’s U.S. income tax liability based on the foreign income taxes that have been paid during the tax year. To qualify, the tax must be a legal and actual foreign tax liability that is imposed on the taxpayer, that has been paid or accrued and it must be an income tax. In most cases, where the taxes of the foreign country are higher than in the United States, the taxpayer will not have a U.S. tax liability. If a taxpayer has unused foreign tax credit left over, that amount can be carried forward and may be applied in subsequent years. However, it is important to note that taxpayers are not able to obtain a foreign tax credit for taxes which were avoidable or that were refundable. For example, Ireland has taxes on interest income on accounts held by foreign owners; however, Irish citizens are exempt from this tax, even if they live abroad. If an Irish citizen is charged this tax, he or she may have it refunded upon proving citizenship status; since this would be a refundable tax for an Irish citizen, Irish citizens may not claim the foreign tax credit on it if they end up paying the tax.
The foreign earned income exclusion allows a qualifying taxpayer to completely exclude income they earned overseas. To qualify, a taxpayer must meet either:
- The Tax Home Test. To meet this test, the taxpayer’s tax home must be in a foreign country. A tax home is where the taxpayer’s regular or principal place of business, employment, or post of duty is, regardless of where their family residence is. If a taxpayer does not have a regular or principal place of business, then this is determined by their regular place of abode (place where they regularly live).
- The Bona Fide Residence or Physical Presence Test. To meet the bona fide residence test, a taxpayer must be a resident of a foreign country and intend to remain a resident of that country. Simply being a resident in a foreign country for a duration of time while intending to return to the United States does not qualify as being a bona fide resident of that foreign country. To meet the physical presence test, one must be physically present in a foreign country or countries for 330 full days during any period of 12 consecutive months.
For 2015, $100,800 was the maximum foreign earned income exclusion amount. This exclusion only applies to earned income; passive income cannot be excluded via the foreign earned income exclusion. Passive income is income from items such as interest, dividends, or rental properties, essentially, income where the taxpayer is not materially involved in earning that income. If you already excluded income under the foreign earned income exclusion, you cannot take a foreign tax credit for the taxes paid on that income. You can, however, still take the foreign tax credit on any amount of tax paid on earned income that is above the exclusion limit, as well as on foreign tax paid on passive income.
Certain situations necessitate choosing to take the foreign earned income exclusion or foreign tax credit over the other. Taxpayers should consult their tax advisors to learn which would be most beneficial for their unique situations.