How to Claim a Credit for Taxes Previously Paid
Paying tax on the same income in multiple jurisdictions? Understand the tax relief mechanisms designed to prevent this and lower your overall liability.
Income can be subject to taxation by multiple government bodies, such as when a business operates across international borders or an individual lives in one state and works in another. To prevent double taxation on the same income, tax systems provide credits for taxes already paid to one jurisdiction. These credits reduce the amount of tax owed to another government. The availability and application of these credits are governed by specific rules and require careful documentation.
The Foreign Tax Credit
The United States Foreign Tax Credit (FTC) is a non-refundable tax credit for U.S. taxpayers on income earned in other countries. This credit is available to U.S. citizens, resident aliens, and certain nonresident aliens who have paid or accrued foreign income taxes to a foreign country or a U.S. possession. Corporations can claim a similar credit by filing Form 1118, “Foreign Tax Credit—Corporations.”
To be eligible, the foreign tax must meet specific criteria. Only foreign taxes on income, war profits, and excess profits qualify. The tax must be a compulsory payment and not for a specific economic benefit. Taxes that are not creditable include value-added taxes (VAT), sales taxes, property taxes, or any amount you could have had refunded. If a tax treaty specifies a lower tax rate, only the amount legally owed under the treaty is creditable.
The credit is limited to the lesser of the foreign tax paid or the U.S. tax liability on that foreign income, which prevents the credit from reducing U.S. tax on U.S. source income. If creditable foreign taxes paid exceed this limit, the excess must first be carried back to the prior tax year. Any remaining amount can be carried forward for up to ten years.
Choosing Between a Credit or a Deduction
When dealing with foreign taxes, taxpayers can either claim a credit or take an itemized deduction. A tax credit provides a dollar-for-dollar reduction of your U.S. income tax liability. For example, a $1,000 foreign tax credit reduces your U.S. tax bill by $1,000.
A tax deduction reduces your taxable income, and its value depends on your marginal tax rate. If you are in the 24% tax bracket, a $1,000 deduction for foreign taxes paid results in a $240 reduction in your tax liability. The choice to take a credit or a deduction must be applied to all qualified foreign taxes in a given year; you cannot deduct some and credit others.
Taking the credit is more advantageous because it directly offsets tax owed. You can claim the foreign tax credit even if you take the standard deduction, whereas deducting foreign taxes requires you to itemize on Schedule A (Form 1040). A deduction might only be preferable in limited situations, such as when the foreign tax paid does not qualify for the credit.
Information and Forms for the Foreign Tax Credit
To claim the Foreign Tax Credit, individuals, estates, and trusts file Form 1116, “Foreign Tax Credit.” You must gather the total gross income from each foreign country, categorized by income type, such as passive or general income. A separate Form 1116 is required for each income category.
You will need to document the foreign taxes you paid or accrued, translating the amounts into U.S. dollars using the exchange rate on the date the taxes were paid. You must also identify expenses directly related to your foreign source income and allocate a pro-rata share of other deductions not directly related to a specific income source.
Part I of Form 1116 calculates your taxable income from sources outside the United States by subtracting related expenses from your gross foreign income. Part II is where you report the foreign taxes paid or accrued for each country in both the foreign currency and U.S. dollars. An exception to filing Form 1116 exists if your total creditable foreign taxes are not more than $300 ($600 for married filing jointly) and all your foreign income is passive.
Claiming the Foreign Tax Credit
File the completed Form 1116 with your annual tax return. The total credit amount calculated on Form 1116 is entered on Schedule 3 (Form 1040), “Additional Credits and Payments.” For paper filers, Form 1116 is attached to Form 1040.
Tax preparation software integrates this process into its interview questions. The program will populate Form 1116 and transfer the final credit amount to your return automatically.
Credits for Taxes Paid to Other States
Most states with an income tax offer a credit for taxes paid to another state to prevent double taxation. This credit is provided by your resident state for taxes you paid to a non-resident state on the same income. For example, a person who lives in one state but works in another files a resident tax return reporting all income and a non-resident return for the income earned in the work state. The home state then allows a credit, limited to the lesser of the tax paid to the non-resident state or the tax the home state would have charged on that income.
To claim this credit, you must complete the non-resident state tax return first to determine the tax liability. This calculated tax amount, not the tax withheld on your W-2, is used for the credit claim. You will need to attach a copy of the non-resident state’s tax return to your resident state return as documentation. Tax preparation software handles this calculation when you prepare both state returns together.