Deducting Foreign Business Expenses: What to Know

U.S. businesses and self-employed individuals conducting activities abroad can lower their U.S. tax liability by deducting expenses incurred in a foreign country. This principle operates similarly to the deduction of domestic business costs. The ability to deduct these costs reduces overall taxable income, directly impacting the amount of tax owed in the United States.

Determining Deductible Expenses

For any business expense to be deductible, it must be considered both “ordinary and necessary” in carrying on a trade or business. An ordinary expense is one that is common and accepted in your particular field, while a necessary expense is one that is helpful and appropriate for your business. This standard applies equally to costs incurred within the United States and those paid in a foreign country.

Beyond travel, a wide range of foreign operational costs may qualify for deduction. These include rent for a foreign office or factory and utilities for these locations. The cost of business supplies, materials, and equipment purchased and used abroad for business functions can also be deducted.

Businesses can also deduct costs associated with reaching foreign markets. Expenses for advertising targeted at foreign customers are deductible. Fees paid for professional services, such as consulting with foreign legal or accounting experts, are valid business expenses. Salaries, wages, and fees for local employees or independent contractors in a foreign country are also deductible payroll expenses.

Navigating Foreign Travel Expense Rules

The rules for foreign travel are more specific than for domestic travel, particularly when a trip combines business with leisure. If a foreign trip is longer than one week or if less than 75% of the time is spent on business, you must allocate transportation costs between business and personal days. You cannot deduct transportation costs for the time spent on personal activities.

A “business day” is a day where your main activity was for business. Travel days to and from your foreign destination count as business days. Weekends, holidays, or standby days that fall between business days also qualify, provided it is reasonable to remain abroad.

At your destination, you can deduct lodging and other expenses for business days. The cost of business-related meals is 50% deductible, and you can also deduct incidental expenses like tips for porters. Stricter rules apply to conventions held outside the North American area; you must show the meeting is directly related to your business and that the foreign location is reasonable. For cruise ship conventions, the vessel must be a U.S. flagship with all ports of call in the U.S. or its possessions, and the deduction is limited to $2,000 per year.

Substantiation and Recordkeeping Requirements

Claiming any foreign business expense requires meticulous records to prove the cost and its business purpose. The IRS requires contemporaneous documentation, meaning records made at the time you incur the expense. This includes receipts, paid invoices, and bank or credit card statements showing the amount, date, place, and character of the expense.

For travel expenses, a detailed log or diary is necessary. Your travel log should document each day’s activities, distinguishing between business and personal days to support any allocation of costs. Without this proof, deductions can be disallowed during an audit.

You must express all expenses in U.S. dollars on your tax return. You can do this by converting each expense using the exchange rate on the date it was paid. Alternatively, you may use a yearly average currency exchange rate for similar transactions, but you must be consistent in your chosen method.

Claiming Deductions on Your Tax Return

The specific tax form for reporting foreign expenses depends on your business structure. If you are a sole proprietor or a single-member LLC, you will report your foreign business expenses on Schedule C (Form 1040), Profit or Loss from Business. These expenses are combined with your domestic expenses under the appropriate categories, such as “Office expense” or “Travel.”

Corporations report their foreign business expenses on their corporate income tax return, Form 1120. Partnerships and S corporations use Form 1065 and Form 1120-S, respectively, to report these deductions, which then flow through to the individual partners’ or shareholders’ tax returns.

Choosing Between a Deduction or a Credit for Foreign Taxes

When your business pays or accrues foreign income taxes, you have a choice: you can take those taxes as a deduction or claim a foreign tax credit. A deduction for foreign income taxes reduces your U.S. taxable income, similar to any other business expense. This is claimed on the same schedule as your other business expenses.

Alternatively, you can claim a foreign tax credit, which directly reduces your U.S. income tax liability on a dollar-for-dollar basis. Individuals, estates, and trusts claim the credit using Form 1116, Foreign Tax Credit, while corporations use Form 1118. In most cases, a credit provides a greater financial benefit than a deduction.

A taxpayer cannot claim both a deduction and a credit for the same foreign income taxes in the same tax year. While the credit is often the better option, taking a deduction might be advantageous in certain situations. For example, if your business has a net operating loss for the year, a deduction could increase that loss to be carried to other tax years, whereas a tax credit might provide no immediate benefit if you have no tax liability to offset.