Tax Deductions:

Choosing Credit or Deduction for Income Earned Overseas

The purpose of the foreign tax credit is to prevent income that is earned in a foreign country from being taxed twice. Once by the country it was generated in and again by the United States government. If you paid or accrued foreign taxes to a foreign country on income that was generated from a foreign source and are subject to US tax on the same income, you may be able to take either a credit or an itemized deduction for those taxes.

The difference between taking the amount as a deduction or as a credit is rather simple. If you choose to take the amount as a deduction on your tax return, the foreign income taxes paid will reduce your US taxable income. This means that the amount of income you will have to pay taxes on will be lessened before your tax rate is applied. If you choose to take the credit, the foreign income taxes paid will reduce your US tax liability. This means that the amount of tax that is calculated that you owe will be reduced by the amount of foreign taxes paid. To choose the deduction, you must itemize deductions on Schedule A, Form 1040. To choose the foreign tax credit, you generally must complete Form 1116, Foreign Tax Credit, and attach it to your Form 1040. However, if you meet the following requirements, you will not need to abide by any limit when it comes to claiming a foreign tax credit and do not need to file Form 1116:

  • You are an individual
  • Your only gross income from foreign sources for the tax year is passive income that is reported to you on a payee statement such as Form 1099-DIV or 1099-INT
  • Your qualified foreign taxes for the tax year are not more than $300 if filing as single or $600 if filing as joint
  • You elect this procedure for the tax year

If you choose to take a deduction for qualified foreign taxes, you must take deductions for all foreign taxes. The same applies to choosing a credit. You may only choose one method, credit or deduction, each year and apply that method to all of your qualified foreign taxes. The only exception to this rule is if you choose to use the credit method but a certain foreign tax is not allowed to be taken as a credit. In this case, you may use all other taxes on a credit basis and use the deduction method for the taxes that are not allowed to be taken as a credit. Taxes that are not allowed to be taken as a credit are as follows:

  • You participated in an international boycott
  • You paid taxes to a country whereby the US does not allow a credit to be taken because that country provides support for international terrorism or the US does not recognize or have diplomatic relations with their government
  • You paid withholding tax on dividends from foreign corporations whose stock you did not hold for the required period of time

It is usually more advantageous to you to choose to take a credit over a deduction. This is because:

  • A credit reduces your actual US 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 and instead choose to take the standard deduction, then you are allowed both the standard deduction and the foreign tax credit
  • If you choose to take a credit for the foreign taxes paid and the taxes paid exceed the limit for the tax year, you can carry over or carry back the excess to another tax year