Understanding Foreign Tax Credits and the Foreign Earned Income Exclusion

 

Generally Americans abroad will choose between taxing a foreign tax credit on income (where it is possible) and taking the Foreign Earned income exclusion on wage and salary income.

The Foreign Tax Credit – Form 1116 – No Foreign Residence Required

Like everything else with U.S. tax law:

1. The idea is simple.

2. The application is not necessarily as simple.

All of this is communicated on IRS Form 1116.

The above tweet references an article Portugal based tax preparer Roger Adams. It is an excellent article.

Lest the article be lost, you will find it here:

foreigntaxcreditadams

The Foreign Earned Income Exclusion – Form 2555 – Foreign Residence Required

The above tweet references an article by William Perez who does a nice job of explaining how the FEIE works.

The article includes:

People who live and work outside the United States may be able to exclude all or part of their foreign-source wages and self-employment income from the federal income tax through a provision called the foreign earned income exclusion. To qualify for the foreign earned income exclusion, a person needs to:

Work and reside outside the United States, and
Meet either the Bona Fide Resident or Physical Presence tests.

Persons who qualify are eligible to exclude up to $100,800 in foreign earned income annually, depending on the year. The amount of the foreign earned income exclusion changes each year. Here’s the maximum allowable exclusions for tax years 1998 through 2015.

Should you take a Foreign Tax Credit or Exclude the income from taxation using the Foreign Earned Income Exclusion?

Like everything else it depends. But in general, I recommend the Foreign Tax Credit for the following reaons:

1. A Foreign tax credit is a credit against taxes owing and excess credits can be carried forward for future use! This could be of use if you are thinking of selling a principal residence which is taxable as a capital gain in the U.S. but NOT in Canada!

2. n general (because of the ability to carry excess credits forward, a credit will be more valuable than an exclusion from income. That said, it is also subject to more work.

3. The Foreign Earned Income Exclusion will not result in possible future tax advantages. It is easier to administer. In addtion,  income that is NOT subject to the exclusion (for example investment income) will be taxed at a higher marginal rate than it might otherwise be – this provision is referred to as the “Stacking Rule”.

Tax geeks can learn more about the “Stacking Rule” be reading the article referenced in the following tweet.

 

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