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How does the foreign tax credit work?

A lot has been written about the Report of Foreign Bank and Financial Accounts (FBAR) disclosure requirements. The Internal Revenue Service has placed a lot of emphasis on offshore tax compliance. As more people realize they need to report foreign financial accounts, the number of these FBARs filed last year reached 1,163,229.

You may not have reported a foreign account or income in the past, because you thought paying tax on it in the foreign country was enough. But the U.S. taxes worldwide income. You may be able to avoid double taxation, however, by using the foreign tax credit.

Foreign taxes

In general, the taxes you pay to a foreign country will either qualify for a deduction or a credit on your U.S. tax return.

A tax deduction reduces your overall taxable income and is entered on Schedule A as an itemized deduction. Tax credits provide a dollar-for-dollar reduction. An example illustrates the difference. For a taxpayer in the 25 percent bracket, a $200 deduction reduces a tax bill by $50. A credit on the other hand offers a $200 reduction in tax liability.

Claiming a foreign tax credit

You can claim the credit on Form 1116. While a foreign tax credit is often the best choice, there are numerous limitations.

The amount of the credit is the lesser of the foreign tax paid or the U.S. tax liability. If Swiss income tax was $400, but the U.S. tax liability on the same income was $250, the foreign tax credit would be limited to $250. While avoiding double taxation, you do pay the highest tax rate.

Beware that the laws related to foreign tax credit are complex and can open you to tax litigation. Here are a few of the issues:

  • Apportionment rules apply - interest expenses, for example, are apportioned based on the source of the income
  • Failure to notify the IRS of a foreign tax redetermination could lead to a penalty
  • Foreign tax credits cannot be claimed for taxes on income that is excluded from your U.S. gross income.

If you are being audited on foreign tax credit issues or failed to file an FBAR for a number of years, seek the assistance of a tax attorney to limit your tax liability.

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