U.S. Foreign Income & Reporting Services
Reporting the Foreign Tax Credit – Form 1116
Income received by U.S. taxpayers from foreign bank accounts, foreign investments, or through work performed abroad are becoming increasingly mainstream. This is a result of the globalized economy, where investors and workers alike, have found value putting their time and money into other parts of the world. Similar to the United States, most countries require tax be paid on the value created within their borders. Without a firm understanding of international tax law, the threat of double-taxation is a realistic concern.
Generally, foreign income is either classified as passive income or active income. These two income categories have separate tax treatment but the FTC (Foreign Tax Credit) can applied to both income types. For example, foreign bank accounts and foreign investments usually generate passive income. Typically, this includes interest, dividends, or capital gains paid to an investor or the owner of an asset (i.e. cash deposit). When passive income is received from a foreign source, the country it came from will likely require tax be withheld or paid by the recipient. This treatment is common of most countries, including the United States, that arguably leads the world in developing tax rules for international trade. Since U.S. taxpayers must report and pay tax on their worldwide income, relief from the double-taxation burden is important. For passive income, the FTC is a strong option.
The income paid to an employee, contractor, or business owner for services provided in a foreign country is active income. Similar to passive income, these activities also qualify for relief under the FTC but other options exist as well. When weighing the benefits of FTC versus other options, it’s wise to consider not only what’s most advantageous today but in the future as well.
Requesting the Foreign Earned Income Exclusion – Form 2555
When a U.S. taxpayer qualifies under a residency test, whereby their tax home is considered to be in a foreign country, they may qualify for the Foreign Earned Income Exclusion (FEIE) by submitting Form 2555. FEIE affects only what is earned by an employee, contractor, or proprietor doing business outside the United States. Similar to FTC, the burden of double-taxation can be avoided with FEIE. However, a taxpayer must choose between the FTC and FEIE. When FEIE is chosen, a long-term commitment has been made, given the IRS does not allow taxpayers to switch back-and-forth between the FTC and the FEIE without submitting a formal request.
The residency test requirement can be achieved by spending at least 330 days in a foreign country or countries (Physical Presence Test) or by establishing bona fide residence in a foreign country (Bona Fide Residence Test). Both residency tests share a number of important nuances that may confuse taxpayers as they match their situation with what’s required by law. It’s highly recommended a taxpayer confirms they meet the residency test with help of an experience tax professional.
In practice, every taxpayer should evaluate their current year FEIE eligibility, while simultaneously considering their tax picture in future years. By weighing the pros and cons of the FTC versus FEIE on a case-by-case basis, while estimating the long-term impact, could avoid additional reporting or paying excess income tax in one or multiple years.