The tax option chosen will depend upon whether the filer fits the requirements and elects the Foreign Earned Income and/or Foreign Housing Exclusions, or whether the tax payer qualifies for and chooses to file for a foreign tax credit.
Form 2555: (Tax exclusion / deduction of a set amount given against your foreign income)
This form allows an exclusion of up to $95,199 (2012), $97,600 (2013) and $99,200 (2014) of your foreign earned income if you are a U.S. citizen or a U.S. resident alien living and working in a foreign country. Note: Once you choose to exclude your foreign earned income that choice remains in effect for that year and all later years unless you revoke it.
Form 1116: (Tax credit, generally dollar for dollar – advantageous in countries with high tax rates - and when combined with the Foreign Earned Income Exclusion can usually wipe out your U.S. tax liability)
This form is used to claim a credit for foreign taxes paid. Additional information may need to be entered on the Form 1116 (i.e. country of residence, alternative basis related to income source, amount of income from all sources, lump-sum distributions, foreign audit, boycott entry, the exception to the Line 17 worksheet, etc.). The credit will appear on Form 1040 and will be limited by your tax liability.
This form is used to claim various itemized deductions, including a foreign income tax deduction. The deduction will appear on Schedule A and will be added to your total itemized deductions on Form 1040.
Form 2555 & Form 1116
You may use Form 2555 and Form 1116 on the same return, but you cannot use the same earnings (and taxes paid relating to those earnings) on both forms. For example, if your foreign earned income is $118,000, you can only exclude foreign earned income up to $97,600 (2013 amount) on the Form 2555 which will reduce your taxable income on the return. The remaining foreign earned income of $20,400 may be used on Form 1116. You would need to determine, which amount of the foreign taxes paid are allocable to the $20,400 and only use this portion of the foreign taxes in the calculations on Form 1116.
But, if you want to claim a foreign tax deduction instead of the foreign tax credit, then you would use Schedule A instead of Form 1116. Please note: IRS Publication 514 specifically states "as a general rule, you must choose to take either a credit or a deduction for all qualified foreign taxes." This means you cannot take a foreign tax credit and deduction on the same return. To clarify, you can use Form 2555 and Form 1116 on the same return, and you can use Form 2555 and Schedule A on the same return; however, if you claim a deduction you cannot claim a credit and if you claim a credit, you cannot claim a deduction.
An exception to this rule is if you have foreign taxes other than income taxes (e.g. real and personal property taxes). Those foreign taxes are claimed as a deduction on different lines of the Schedule A. Only in this instance would you be able to claim a foreign tax credit and take a deduction.
Generally, it is more beneficial to claim foreign taxes paid as a credit rather than claiming a deduction. You may wish to do a comparison to determine which is best in your situation.
FOREIGN TAX CREDIT
Q: Isn't there a tax credit for taxes I pay to my foreign country of residence?
A: Yes. Form 1116 allows you to take a credit for those foreign taxes. But the form is very complex and does not necessarily allow 100% credit in the year foreign taxes are paid or accrued. Instead unallowed foreign taxes may be carried forward and applied to subsequent years, which may not be an advantage.
Q: Can I just use Form 1116 in place of Form 2555 (Foreign Earned Income Credit)?
A: Yes, you can. But be careful because you can end up paying more taxes.
Q: What are the benefits of a tax treaty?
A: Tax treaties exist between many countries including the United States. Treaties are intended to protect taxpayers from double taxation by spelling out the kinds of income countries to treaties can tax as well as the rate of taxation. However circumstances can occur in which American expatriates are double taxed.
Q: What is an example of double taxation?
A: In circumstances where the Foreign Earned Income Exclusion is exceeded and the Foreign Tax Credit does not take of the slack, IRS ends up benefiting by taxing the excess income in spite of its already having been taxed abroad.
FOREIGN EARNED INCOME EXCLUSION
Q: Do I have to file a tax return if my income is below the $91,500 Foreign Earned Income Exclusion?
A: IRS says you must file even though the exclusion exempts your income from taxation up to $91,500. Otherwise IRS will require you to file, deny you this exclusion and tax you on your earned income (even though you already paid taxes to the foreign country where you earned the income). Of course you must pass certain residency requirements to qualify for Form 2555.
Q: What do you mean residence requirements?
A: Your tax home must be in a foreign country for either 12 consecutive months or 330 full days.
Q: Both my wife and I earn foreign salaries. Can we both qualify for the Foreign Earned Income Exclusion?
A: Yes. Each of you can exclude up to $91,500 in foreign earnings.
Q: I earn more than $91,500 in foreign source wages. Will I have to pay taxes on the extra income?
A: The Foreign Tax Credit can apply to these taxes. But occasionally this credit does not eliminate a tax liability. The tax form 1116 is complex with the result that foreign taxes paid or accrued are not always fully applied but rather unapplied balances are carried forward.
Q: Do you mean I will have to pay taxes to the IRS when Forms 2555 and 1116 are exhausted even though I have already been fully taxed by the foreign country where I reside?
A: Yes. The problem is more complicated now. TIPRA (Tax iIncrease Prevention and Reconciliation Act of 2005) increased the exclusion amount from $80,000 to $91,500. But it also requires foreign resident taxpayers to pay taxes at the income tax brackets that would apply had the taxpayer been taxed on the $91,500.
The statute of limitations never runs out! Except in the case of fraud or tax evasion the IRS can only audit a tax return three years from the date of filing. If you don't file, they can go back forever.
Am I Eligible to File Form 2555?
To be eligible to file Form 2555 you have to clear two hurdles: first, your tax home is in a foreign country and second, you have to either be a bona fide resident of that country or have had a physical presence in a country or countries outside of the United States
Tax Home Is a Foreign Country
Your tax home is the principal country or jurisdiction in which you carry out your business or employment. It would therefore be logical that you can have only one tax home at any given point in time and, to qualify for Form 2555, this tax home must have been outside of the United States for at least a portion of the tax period you are filing for.
Bona Fide Resident Test
Once you have established that your tax home was a foreign country for at least a portion of the year that you are filing for, then you must move on to see whether you were a bona fide resident or you meet the physical presence test. As a generality, if you had a single foreign country as your tax home for the entire tax period and you were residing in that country for a permanent or indefinite period of time then you will choose to qualify as a bona fide resident. Once you have established yourself as a bona fide resident than it is assumed that you continue to be a bona fide resident until you establish otherwise.
Physical Presence Test
If you don't meet the criteria for being a bona fide resident of another country, then you can look to the physical presence test. To qualify, you must have lived outside the US for at least 330 days of any period of 12 months in a row.
Can I Exclude Income from My Investments?
No, Form 2555 only helps for income earned from your employment or from your trade or business while qualifying under the tests above. If you have paid tax on your foreign investments then you may be able to take a credit for that on your form 1116.