Foreign Tax Credit or Foreign Earned Income Exclusion: Choosing Between Forms 1116 and 2555

US citizens and resident aliens living abroad are generally subject to US federal income tax on their worldwide income. Where employment or self employment income is earned overseas, two provisions commonly become relevant: the Foreign Tax Credit under IRC §901 and the Foreign Earned Income Exclusion under IRC §911.

The two provisions address foreign earnings differently. The Foreign Tax Credit provides relief for qualifying foreign income taxes paid or accrued. The Foreign Earned Income Exclusion removes qualifying foreign earned income from the US income tax base, subject to an annual limit.

In many cases either approach can eliminate the immediate US income tax liability. The fact that the current year result is the same does not mean that the two positions are equivalent.

Foreign Tax Credit: Form 1116

Individuals generally claim the Foreign Tax Credit on Form 1116.

A credit may be available for qualifying foreign income taxes paid or accrued on foreign source income, subject to the limitations in IRC §904. Broadly, the limitation prevents the credit from exceeding the US tax attributable to the relevant foreign source income.

The FTC is not confined to employment income. Foreign taxes are allocated among the applicable income categories, or “baskets,” and the limitation is calculated separately for each category.

Where allowable foreign taxes exceed the current year limitation, excess credits can generally be carried back one year and forward ten years.

For US taxpayers resident in comparatively high tax jurisdictions, this can make the FTC particularly relevant. The foreign tax liability may be sufficient not only to eliminate US tax on the same income in the current year but also to generate FTC carryovers with potential value in subsequent years.

Foreign Earned Income Exclusion: Form 2555

The Foreign Earned Income Exclusion is claimed on Form 2555.

IRC §911 permits a qualifying individual to exclude foreign earned income up to the statutory annual limit. Unlike the FTC, entitlement to the exclusion does not depend on foreign income tax having been paid.

The taxpayer must have a foreign tax home and satisfy either the bona fide residence test or the physical presence test.

The exclusion is limited to foreign earned income. It does not provide a general exclusion for foreign investment income, capital gains or other passive income.

There is also no carryforward of an unused exclusion. An individual who earns less than the annual limit does not preserve the unused balance for a subsequent year.

A UK example

Assume a US citizen resident and working in the UK earns $100,000 and pays $25,000 of qualifying UK income tax. Assume, for illustration, that the US federal income tax attributable to the income before double tax relief is $18,000.

Using the FTC, up to $18,000 of qualifying UK tax could potentially offset the US liability, subject to the Form 1116 limitation. The remaining foreign tax may constitute an excess credit available under the carryback and carryforward provisions.

If the individual also qualifies under IRC §911 and the earnings fall within the applicable FEIE limit, Form 2555 could potentially produce the same immediate result: no US federal income tax on those earnings.

The difference is what happens to the foreign tax.

Under the FTC approach, the income remains within the US tax computation and relief is provided by crediting qualifying UK tax. Excess credits may therefore have future value.

Under the FEIE approach, qualifying income is excluded. Foreign taxes attributable to the excluded income cannot also be claimed as a Foreign Tax Credit, and there is no corresponding carryforward of unused FEIE.

For a taxpayer who expects to remain in the UK or another higher tax jurisdiction, that distinction can be material.

The position in a low or zero tax jurisdiction

The analysis changes where little or no foreign income tax is imposed.

Assume the same US citizen earns $100,000 while resident and working in a jurisdiction with no personal income tax.

There may be no Foreign Tax Credit available because no qualifying foreign income tax has been paid or accrued.

The FEIE does not have that requirement. Provided the taxpayer satisfies the requirements of IRC §911, qualifying foreign earned income may be excluded notwithstanding the absence of foreign income tax.

The relative usefulness of Forms 1116 and 2555 can therefore differ substantially depending on the tax regime of the country in which the individual works.

Using the FTC and FEIE together

The provisions are not necessarily mutually exclusive.

A taxpayer may use the FEIE for qualifying foreign earned income and claim Foreign Tax Credits in relation to other foreign source income where the requirements are satisfied.

There is, however, no double benefit. IRC §911(d)(6) prevents a credit or deduction for foreign taxes allocable to income excluded under §911.

This becomes relevant where earnings exceed the FEIE limit, where an individual has both earned and investment income, or where income and foreign taxes fall into different FTC categories.

Self employment income

The FEIE applies to qualifying foreign earned income from self employment for income tax purposes, but it does not eliminate US self employment tax.

A US person operating a business overseas may therefore have income excluded under §911 while remaining liable for self employment tax.

Where the United States has a Social Security totalization agreement with the country concerned, that agreement may alter which country's Social Security system applies. This is a separate analysis from eligibility for the FEIE or FTC.

Changing from FEIE to FTC

The decision can also affect later years.

A taxpayer who has elected the FEIE and subsequently revokes the election is generally unable to make another §911 election for the following five tax years without IRS consent.

By contrast, excess Foreign Tax Credits may remain available within the statutory carryback and carryforward periods.

This matters where an individual's circumstances are likely to change. A taxpayer may move between high and low tax jurisdictions, receive a significant increase in compensation, develop investment income or cease to satisfy the requirements of §911.

Which approach should be used?

There is no presumption that Form 2555 should be used simply because an individual lives overseas.

For taxpayers in higher tax jurisdictions, Form 1116 can be preferable where foreign taxes are sufficient to offset the US liability and excess credits can be preserved. For taxpayers in low or zero tax jurisdictions, Form 2555 may provide relief where there is insufficient foreign tax to support an FTC claim.

In other cases, a combination of the two provisions may be appropriate.

The comparison should therefore be made across the taxpayer's overall position, including the source and character of income, foreign tax paid, FTC limitations and carryovers, eligibility under §911, expected future earnings and likely country of residence.

A zero US tax liability under both methods in the current year does not, by itself, make the choice between them irrelevant.

Disclaimer:
Content published by us is provided for informational purposes only and reflects research, industry analysis, and our professional perspective. It does not constitute legal, tax, or accounting advice. Regulations vary by jurisdiction, and individual circumstances differ. Readers should seek advice from a qualified professional before making decisions that could affect their business.
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