How to Handle the Passive Income Excess Limit on Form 1116

U.S. taxpayers with foreign source income may be taxed by both the United States and the foreign country. The Foreign Tax Credit (FTC) helps prevent this double taxation by reducing a taxpayer’s U.S. income tax liability. This credit is claimed on Form 1116. A credit limitation restricts the amount claimed in a single year, which is a common issue for passive category income where foreign taxes paid often exceed the allowable credit.

Defining Passive Category Income for Form 1116

For Form 1116, passive category income includes items like interest, dividends, royalties, and certain rents. This classification is important because you must file a separate Form 1116 for each category of foreign income.

The “high-taxed income kick-out” rule prevents blending high-taxed and low-taxed passive income. This rule requires that if foreign passive income is taxed by a foreign country at a rate higher than the highest U.S. tax rate for that same income type, it must be reclassified.

This “kicked out” income moves from the passive category to the “general category” for the FTC calculation. The threshold depends on the income’s character. For instance, foreign interest income is kicked out if the foreign tax rate exceeds the top U.S. ordinary rate of 37%. Foreign qualified dividends are kicked out if the foreign tax rate exceeds the top U.S. capital gains rate of 20%.

To see if the rule applies, calculate the effective foreign tax rate on each group of passive income. For example, if you paid $4,000 in foreign taxes on $10,000 of foreign interest income, your rate is 40%. Since 40% is higher than the 37% U.S. rate, this income is considered high-taxed. The income and its associated taxes are then removed from the passive category calculation and entered on a separate Form 1116 for the general category.

Calculating the Foreign Tax Credit Limitation

The foreign tax credit is not a dollar-for-dollar credit for all foreign taxes paid. Its purpose is to offset only the U.S. tax liability on your foreign-source income, not the tax on your U.S.-source income. The tax code imposes a limitation to ensure the credit does not reduce the U.S. tax you owe on domestic income.

The limitation is calculated on Part III of Form 1116 using a specific formula: (Foreign Source Taxable Income / Total Taxable Income) U.S. Tax Before Credits = FTC Limitation. This formula determines the portion of your U.S. tax liability attributable to your foreign income. The credit you can claim is the lesser of the foreign taxes you paid or this calculated limitation.

For example, a taxpayer has $20,000 in foreign passive income, $100,000 in total taxable income, and a $15,000 U.S. tax liability before credits. The limitation is ($20,000 / $100,000) $15,000, which equals $3,000. If the taxpayer paid $4,000 in foreign taxes, their credit is limited to $3,000. The remaining $1,000 is an “excess credit” that is not lost and can be carried to other tax years.

Managing Excess Foreign Tax Credits

When your foreign taxes paid exceed the limitation, you have an excess credit that can be carried to other tax years. The rules permit a carryback of one year and a carryforward of up to ten years. This provision is helpful for taxpayers with consistently higher foreign tax rates or fluctuating income sources.

The ordering rules for applying excess credits are mandatory. You must first carry the excess credit back to the preceding tax year. If you had an “excess limitation” in that prior year, you can use the carryback to claim an additional credit, which requires filing an amended return.

Any credit remaining after the carryback is carried forward for up to ten years. It must be applied to the earliest year possible that has an excess limitation. If you have carryforwards from multiple years, the credits from the earliest year are used first.

You must maintain your own records of these carryovers, as the IRS does not track them for you. Keep a tally of the excess credits generated, the amounts used, and their expiration dates. Any credit not used within the ten-year carryforward period expires.

Completing Form 1116 for Carrybacks and Carryforwards

Reporting and claiming foreign tax credit carryovers is done on Schedule B of Form 1116, the Foreign Tax Carryover Reconciliation Schedule. This schedule tracks the balance of your carryovers from year to year. You must file a separate Schedule B for each income category with a carryover.

On Schedule B, you will detail carryover amounts from the ten preceding tax years. The form accounts for the original excess credit, any adjustments, and the amount of credit used in subsequent years. This information is used to calculate the total carryover available for the current year.

The total available carryover from Schedule B is entered on Part III of the main Form 1116. This amount is added to the current year’s foreign taxes paid before applying the current year’s limitation. This process allows you to use prior-year credits against any excess limitation in the current year.

Carrying back an excess credit from the current year to the prior year requires filing an amended tax return, Form 1040-X. You must attach a new Form 1116 for the prior year showing the application of the carryback. This recalculates your tax for that year and often results in a refund.