By: Terri L. Marakos, CPA
With the expansion of the global economy, the involvement of taxpayers in foreign activities has become commonplace. Even not-so-sophisticated investors often hold the securities of companies with foreign activities and that pay foreign taxes in their brokerage accounts. Individuals work earning wages in a foreign country and have foreign taxes withheld from these wages. Do these individuals know how to recoup the foreign tax paid in these scenarios? According to the IRS, each year you can choose to take the amount of any foreign taxes paid or accrued during the year either as a foreign tax credit or as an itemized deduction. Of course, this raises the question of how you choose whether to take a credit or a deduction.
In order to determine this, you will need to calculate your tax both ways, claiming the credit and claiming the deduction. Then fill out your return the way that benefits you the most. If the foreign tax credit is being claimed, you generally must complete Form 1116, Foreign Tax Credit and attach it to your U.S. tax return. If the foreign taxes are being claimed as an itemized deduction, then you must complete and include Schedule A (Form 1040), Itemized Deductions as part of your tax return.
As a general rule, you must choose to take either a credit or a deduction for all qualified foreign taxes. If you choose to take a credit for qualified foreign taxes, you must take the credit for all of them. You cannot deduct any of them. Conversely, if you choose to deduct qualified foreign taxes, you must deduct all of them. You cannot take a credit for any of them.
The foreign tax credit is intended to relieve you of a double tax burden when your foreign source income is taxed by both the United States and the foreign country.
The foreign tax credit can only reduce U.S. taxes on foreign source income; it cannot reduce U.S. taxes on U.S. source income.
It is generally better to take the credit for qualified foreign taxes than to deduct them as an itemized deduction for the following reasons:
- A credit reduces your actual U.S. income tax on a dollar-for-dollar basis, while a deduction reduces only your income subject to tax;
- You can choose to take the foreign tax credit even if you do not itemize your deductions. You then are allowed the standard deduction in addition to the credit; and
- If you choose to take the foreign tax credit and the taxes paid or accrued exceed the credit limit for the tax year, you may be able to carry over or carry back the excess to another tax year.
The majority of individual taxpayers are on the cash basis of accounting and accordingly can choose to take the credit either in the year the tax is paid or the year the tax is accrued.
Naturally, a global economy yields increasing foreign activities by U.S. taxpayers. In turn, there are many U.S. taxpayers who speak English as a second language. We at Capaldi Reynolds & Pelosi, PA are fortunate to staff members who are fluent in a variety of languages such as Bulgarian, Greek, Gujarati, Hindi, Mandarin, Polish, Russian, Spanish, Taiwanese, Ukrainian, and Vietnamese. If you need foreign tax assistance, we would be happy to make available our tax expertise and to do so in any of these languages.
When engaging in foreign activities, it is important to understand compliance requirements and to minimize the related tax and penalty implications. Similar to the aforementioned foreign activities, ownership of offshore assets may also have a series of compliance requirements and tax implications for the unwary. If you engage in foreign activities, we would recommend you read the complementary article on international taxation in this publication by Patrick McCormick OVDP or Streamlined: Choosing an Offshore Disclosure Program.