Do US Citizens Have To Pay Taxes On Foreign Income?
All citizens, both living and working in the United States or abroad, must file a tax return with the Internal Revenue Service and pay their taxes. They have to report their worldwide income, including their profit from their businesses outside their area.
In fact, the U.S. is the only country that requires every citizen to shoulder their taxes based on their global income. This is very different from the other countries that only tax if they are residents of that country or the income is sourced there directly.
But don’t worry, there’s still a way to help lower your tax bill. Read further to learn more about the foreign tax credit, how it works and how to claim one.
What Is Foreign Tax Credit?
Foreign Tax Credit refers to the U.S.’s total tax credit for the income tax that an individual paid in another country. It is set on a dollar to dollar basis to ensure that the amount has the same value as both countries.
Taxpayers can deduct the foreign income tax they have paid and claim these amounts as a tax credit. It aims for U.S. citizens to avoid double taxation in the process.
For instance, an ex-pat lives in the U.K. He works for a renowned British company that pays an equivalent of $100,000 of U.K. income tax relative to their salary. Upon filing their U.S. federal tax return, they have the right to claim $100,000 of U.S. tax credits.
Those individuals who pay more foreign income tax than the corresponding U.S. income tax may receive higher tax credits. They may use these up to 10 tax years. This may also apply to future incomes or even shoulder the liabilities in the previous tax years.
How To Qualify For Foreign Tax Credit?
It does not mean that you get to enjoy these foreign tax credits once you live and work outside the U.S. There are various basic requirements you have to meet to qualify.
Here’s a short checklist for your guidance:
- The tax should have been imposed by a foreign country and was not optional.
- It comes from the income that was taxed by the foreign government.
- The declared tax has been paid in full and without any backlogs.
- The income was not a popular exclusion.
Besides that, you should also be aware that only selected types of foreign taxes qualify to receive a foreign tax credit. They should land under the following:
- Commissions and bonuses
- Gambling winnings
- Professional fees
- Selected fellowships and scholarships
- Pensions, annuities, and social security benefits
- Self-employment or business profit
Outside this list, various types of taxes do not qualify. Examples of these are the following:
- Specific taxes coming from foreign oil or foreign gas income
- Foreign income tax stemming from foreign mineral income
- Taxes that came from multination boycott initiatives
- Taxes on individuals who control and power play on partnerships or corporations that are not complying with tax-filing responsibilities
- Social security taxes which are either paid or accrued to a foreign country due to its entry in the Totalization Agreements with the US (e.g., Canada, Luxembourg, Australia, Germany, France, Sweden, Spain, and Switzerland)
- Foreign earned income exclusion
How To Claim Your Credit
The primary step for claiming the foreign tax credit is to complete and file the IRS Form 1116. Make sure that your tax return goes with this.
The IRS Form 1116 refers to a two-page document where you have to place all the information and figures necessary to develop your final US tax credits value. Keep in mind that you have to fill this up using both USD and foreign currency.
You also have to reveal what type of income these taxes were paid on. Make sure to include the corresponding expenses and foreign deductions that you have encountered as well.
Another alternative to claiming the full credit amount is through your Form 1040. You may receive the foreign taxes placed on this document without having to calculate the various intricacies if you can satisfy the following conditions:
- All income and foreign tax paid are reported on your Schedule K-1, Form 1099-DIV, and Form 1099-INT.
- Every gross income recorded came from interests and dividends only.
- You held the bonds or stocks on which your interest and dividends came from for at least 16 days.
- The total of your individual foreign tax is less than $300 or $600 if you are filing together as a married couple.
- You exclude income from businesses and sources in Puerto Rico by not filling up and submitting Form 4563.
- All the paid foreign taxes were not eligible for either a reduced tax rate or refund due to a tax treaty, and that all of these are legally owned.
Lastly, Form 1118 is the apt form for corporations. Although it almost has the same purpose as Form 1116, this version is admittedly more complex. This corporate form is made up of seven different schedules divided into multiple sections. All in all, that’s a total of 11 pages.
Deadlines And Extensions To Consider
The first step to claim the U.S. Foreign Tax Credit is for these individuals to submit, file, and pay their foreign taxes. The Internal Revenue Service (IRS) consider the different tax years for each country.
For instance, the U.K. has a tax year of April 6 to April 5 the next year compared to January 1 to December 31 of the U.S. Given this, the IRS understands that expats will not be able to submit these documents and pay before April 15, their deadline in the United States.
With this, they have established exceptions to the rules for those people living outside the country. They automatically have a U.S. filing extension up to June 15. If they still do not have enough time to fulfill the requirements, they may ask for an additional extension online. For some circumstances, the IRS will grant this request and extend it up to October 15.
US Citizens Always Need To Pay Taxes
If you’re a U.S. citizen or a resident alien, then your income will be at the mercy of the U.S.
This includes any international currency, or even some other income that’s earned out the U.S. It matters not if you live inside or outside of the U.S. when you received the cash.
Additionally, even when it’s the case that you usually do not get a questionnaire W2, a Wage and Tax Record, or even perhaps a Form 1099 from the lender, you’re still asked to record that particular income.
If you’re a U.S. citizen or a resident alien, your cash flow – for example, almost any foreign currency or some other income that’s made out the U.S. – will be at the mercy of U.S. tax.
In the event you fulfill particular conditions regarding the duration and temperament of one’s stay in a foreign nation, you can be eligible to exclude any of the foreign earned cash.
Some taxpayers could qualify for the overseas Tax Credit, a tax break offered from the US government to decrease the tax obligation of specified citizens.
For taxation reasons, in the event that you aren’t just a citizen of the United States, the IRS may consider you a single resident alien or a non resident alien. You’re a resident alien for taxation purposes in the event that you meet the green card test, or the significant presence test for at least twelve months.
Both U.S. taxpayers and U.S. resident aliens must report their income with the proper U.S. authorities, in order for any credits to be redeemed properly.
The sum which you’re taxed on includes earned income, and unearned revenue – out of foreign (and also non-foreign) origins. The IRS considers any of the following taxable: salary, bonuses, wages, commissions, hints, and net profits from self-employment.
If you’re a U.S. citizen or a U.S. resident alien, then you must also examine your international revenue. Your extra income is recorded using IRS Form 1040.
There are different line items to fill in on this form, based on the kind of revenue you’re reporting. In the event you fulfill particular conditions regarding the duration and type of your stay in a foreign nation, you can sometimes be eligible to exclude some foreign earned cash from your tax return.
For example, for tax year 2020, you might qualify to deduct as much as £100,000 from your your US tax forms.
Overseas Tax Credit
Though it depends on the particular location where you received your income, you are likely to pay taxes on your income in at least that country, as well as the United States.
As a way to pay to help reduce the tax load on this type of income, the U.S. federal government supplies a tax break to decrease the tax obligation of particular taxpayers – this is named the International Tax Credit.
This reduction on your taxes is intended to offset your tax return needing to be filed and paid for in the other country. However, the United States still considers all of your global income to be taxable – so there’s no avoiding Uncle Sam.
What Are The Requirements For Claiming The Foreign Tax Credit?
There are four conditions that the IRS requires, in order for you to get the foreign tax credit. U.S. citizens should be absolutely sure they meet all of these requirements, if they expect to get this particular tax credit.
1. You Personally Must Be Paying The Tax
To get the foreign tax credit, you personally must be paying the tax. This means you can’t use this tax for inheriting items.
For example, if you inherit property, an estate tax is owed – and you wouldn’t be the one paying it. However, if you worked overseas in a bar, that income would quality you for the foreign tax credit.
2. You Must Have Already Been Taxed
This is a little bit like the first requirement, but essentially means that you have to either already have a tax bill waiting for you in a foreign land, or you must have already paid it.
3. The Tax Needs To Be Legal, And Part Of A Foreign Tax Liability
You can’t overcharge the US government – they make sure of it. This rule essentially means that if the Irish government (or any foreign government) made you pay $1,000 in taxes, but refunded $300 of it – you still need to report this change to the IRS.
You can’t charge the US government on that original $1,000 – you need to report that Ireland refunded $300 of this amount to you. Essentially, taxes are required by law all over the globe, and the United States requires that their citizens report all global income and tax returns accurately.
4. It Must Be Income Tax
Income taxes may qualify you for a tax credit – but other types of taxes usually won’t. The foreign tax credit is a pretty big reduction in your overall tax liability, so filing your income taxes accurately is always a good idea.
However, it should be noted that other types of taxes paid to a foreign government usually won’t qualify you for a foreign tax credit. There are also some other stipulations that will disqualify even foreign income taxes from being claimed for a foreign tax credit.
- If the country has been deemed supportive of terrorism. Syria, Sudan, Iran, and North Korea are four of the countries that currently would be disqualified for this stipulation.
- The government is not recognized by the United States – even if it allows U.S. citizens to live there.
- The government does not have diplomatic relations with the United States (or the relationship was ended). This three rules are important, so make sure you don’t work in a country where any of these distinctions apply.
Again, if it’s not an income tax – it won’t qualify you for the foreign tax credit. The IRS considers all of your global income taxable – so always be very thorough when it comes to filing your United States federal income tax return.
The Foreign Tax Credit: What Is It Worth?
Form 1116 will help you determine how much your foreign tax credit will be. This form will help you with two specific calculations.
- How much foreign income tax you have already paid – this could vary, and it’s important to be thorough here.
- What percentage (or amount) of your U.S. tax obligation can be due to your foreign income. If you largely work overseas, this could be 90% or higher, and should be determined in dollars.
The smaller of either of these calculations, is what your foreign tax credit will be.
If you have paid $2,000 in foreign income tax, but your U.S. tax obligation from foreign income is $3,000 – your tax credit would be $2,000. Unfortunately, the government isn’t very generous to U.S. citizens here.
This is one motivator to keep U.S. citizens working inside the country, rather than looking for work outside of the United States.
Claiming The Foreign Tax Credit
The first step to take here, is to compile all of the income and expenses you’ve had for that particular tax year. You will also need Form 1116, which is particular to foreign income.
However, a few exceptions may mean you do not need to use Form 1116, and they are listed below.
- If the total amount of your foreign taxes are less than $300 ($600, if you’re married).
- Passive income only (like investments or dividends) – these would not require Form 1116.
- If you have reported the income (and taxes) on Form 1099-INT, 1099-DIV, or Schedule K-1. These would fall under the requirement of a qualified payee statement, and would not need the use of Form 1116.
If you fit all of these criteria, you can go to line 48 of Schedule 3, and claim the foreign tax credit there. You will not need to file Form 1116 in these cases – but if your income changes next year, this form may be necessary.
Can You Let It Carry Forward?
If you have an excess of leftover tax credit, you can’t get it in cash. However, you may be able to carry this tax credit over for greater than 9 years.
This helps with a future tax return, or even multiple future tax returns. One key caveat that should be noted, is that if you meet the requirements to skip the usage of Form 1116, and claim your credit – this disqualifies you from carrying it forward.
Other Factors To Consider For Taxes On Foreign Income
If you’re an American, the United States considers all of your income (globally) as taxable. This means that your total taxable income includes money made in other countries.
If you are self-employed, you still need to file a U.S. tax return with all of the money you may have made from overseas clients. The IRS needs your income tax return by the due date, and they will look at all your financial accounts, to make sure you have paid the total amount due for the entire tax year.
If you are a green card holder, things get even more complicated. The federal income tax rate applies to all US residents, though some exemptions may occur.
Expats have other rules, and American citizens living inside the United States actually have it easiest, when it comes to filing requirements. If you’re money is coming from a foreign source, you still need to declare it in the United States.
Foreign bank accounts can be audited and seized, so do not try to get around the tax guide that we all must follow. The tax laws in the United States are fairly strict, so we recommend having a qualified tax professional file all of your tax documents.
They will know what rules to follow, what a standard deduction may be for someone in your situation, and will know all the qualifying exclusions you can use to your advantage (like the foreign earned income exclusion).
The Bottom Line On Paying Taxes On Foreign Income
Foreign income can be extremely complex to handle, when it comes to the IRS. Your tax liability goes up with every unusual filing or source of income – especially if you improperly file your tax return with the IRS.
You should see if you pass the physical presence test, or if you are married filing jointly. Another avenue to explore is the residence test.
You should always consider your tax home when filing with the IRS. That is – where do you primarily live? Is this different than where you work?
Are you a primary resident of the United States? U.S. citizens are treated differently when it comes to taxes, and the U.S. tax code is different than nearly every other nation.
When it comes to foriegn income sources, housing expenses can sometimes be deduced, but we recommend hiring a qualified tax professional to handle all of your tax filings – they will know exactly what’s taxable, and what’s not. The United States is pretty strict when it comes to your tax return – and the IRS is not an organization the average American wants to mess with.
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