The notion of avoiding double taxation may seem like a ‘no-brainer’ for those who are fortunate enough to live and work overseas. However, there is one particular tax loophole that can be utilized by expatriates seeking to attain tax-free status – the Foreign Tax Credit!
What is the Foreign Tax Credit?
The Foreign Tax Credit is a unique tax deduction available to individuals who are not U.S. citizens or resident aliens. With this allowance, they can offset their liability for paying foreign income taxes with any domestic tax liabilities they may incur while living overseas; thereby limiting the burden of double taxation!
For instance, an independent contractor working abroad may employ several contractors at once. Even though these intermediaries do not have final authority over his or her actions on the job site – leading to double taxation on that salary – employers still must pay taxes on those remunerations. In such cases where there is a disparity between what is owed in taxes in the United States compared to one’s home country, the Foreign Tax Credit comes into play and potentially short circuits double taxation.
Who is Eligible for the Foreign Tax Credit?
Individuals with income from any source, including wages and self-employment income; alimony received; investment income such as capital gains or dividends received; rental income; annuities – like those received through insurance policies – and even tax free benefits like lottery winnings!
If you qualify for the Foreign Tax Credit, you are eligible to offset taxes on your worldwide income with a deductible foreign tax. Here’s how it works:
Say that you had $100,000 in adjusted gross income (AGI) last year. If you incurred an expense related to foreign business activities totaling $20,000 ($20,000 x 50%), then you may be eligible for up to $80,000 in foreign taxes eligible for deduction – which can lower your taxable income by an additional amount of up to $120,000!
How Does the Foreign Tax Credit Work?
When you file your income taxes in the United States, you must declare all your worldwide income. This includes compensation and earnings from any source – be it a job, contract work or freelance work.
If you happen to incur unreimbursed expenses related to earning income within the U.S, you can claim them as deductions on your tax return. If you have foreign tax credits available, they may offset any remaining taxable income; effectively granting you a sizeable tax refund!
If, however, some of that income was subject to foreign taxes and therefore resulting in lower taxes owed than the standard deduction amount by an individual, then that individual would be eligible for up to US$100 (or up to 400%) worth of Foreign Tax Credits – without having to pay tax again on the same funds from which withholding was paid earlier!
What Happens to the Money You Get Back from the IRS?
If your employer pays a portion of the taxes you owe, they can withhold that tax before remitting it to the IRS. It is then up to them when and how they will refund any money remaining.
If you have an employer who does not withhold your foreign income taxes or foreign tax payments, you need to ensure that these funds are returned to you in full. Otherwise, what remains may be subject to federal taxation as well as state taxes – even if those amounts exceed what was initially withheld from one’s paycheck!
Can You Claim Too Much or Too Little Money Back?
Keeping track of your expenditures can be an arduous task, especially if they’re made in foreign currencies. Unfortunately, there is no system in place that permits users to easily determine whether they have received too much or too little back from their foreign taxes – yet!
To complicate matters further, the IRS could force you to pay taxes even if you exceed the foreign tax credits allowed by law. In such situations, it’s possible that you are liable for paying taxes on those earnings. This issue arises when you receive a refund from the government! If any portion of funds returned were utilized towards paying foreign taxes, then one may experience double taxation; potentially leading to an unexpected financial burden.
What Else Should You Know About the Foreign Tax Credit?
In addition to the Foreign Tax Credit, you may also be eligible for a Foreign Income Tax Credit. This is an opportunity for individuals who carry out business activities in foreign countries and achieve profits that are subject to taxation abroad.
Foreign income taxes paid by you or your household members must exceed the allowable credit amount in order for there to be any financial benefit from claiming it. The most notable limitation on the Foreign Income Tax Credit is its maximum of 30%. In turn, if no Foreign Income Tax Credit was claimed – then neither could be granted either!
However, those who claim the Foreign Income Tax Credit might still have tax liability arising from their worldwide income (one which includes funds earned anywhere in the world). To assist with this complexity, anyone seeking assistance with foreign tax debts can contact a qualified specialist such as one at H&R Block.
The Foreign Tax Credit can be an invaluable tool for individuals who reside overseas. If you are in the midst of a relocation, this could be the means to ensure you never incur double taxation!
If you’re interested in learning more about the Foreign Tax Credit, we’ve provided a comprehensive summary along with additional resources where applicable.