Published on: April 22, 2020

IRS Form 1116 and Its 4 Categories of Foreign Income

Perhaps you lived in another country for a few months last year and earned money, or you worked as a freelance worker for a foreign company. There are many ways that you can find yourself dealing with foreign income come tax time. Yes, you typically need to report that foreign income and owe taxes on it if it exceeds a certain amount. On the Internal Revenue Service (IRS) Form 1116, there are four categories of foreign income. Here’s everything you need to know about foreign income and Form 1116.

Four Categories of Foreign Income for IRS Form 1116

If you’ve earned income in a foreign country, then you use and file Form 1116 to receive a foreign tax credit. When you earn money in another country, you owe money in taxes to the country where you earned the money and to the United States. However, you can deduct the amount of taxes you paid to a foreign government from the amount you owe the United States. 

Of course, first, we need to identify exactly what the IRS considers income when it’s earned in another country. For the purposes of Form 1116, the IRS identifies four categories of foreign income. The categories of income for Form 1116 are:

  • General Category Income
  • Passive Category Income
  • Foreign Branch Category Income
  • Section 951A  Category Income

It’s great to see the categories of Form 1116, but you need a little more information to understand what income each category includes so that you don’t make any mistakes when filing your taxes and taking this credit. There are three more categories of income: 

1. General Category Income

When you think about earning money and income in the most common ways, these are typically found in General Category Income. These types of earnings include salary, wages, and any overseas allowances for an individual employee. It’s money earned while you took part in a trade or as part of a business. It can also include any profits you made in the sale of inventory or gains made when sold a depreciable property in a foreign locale. 

Young businessman in airport with passport to work overseas; foreign work concept

2. Passive Category Income

Passive income is money that you earn without having to perform a specific task or trade to receive. The most common types of passive income include:

  • dividends
  • interest
  • royalties
  • rents
  • annuities
  • and more.

If you sell a property and make a profit from the sale, this is a passive income. You can also make passive income from gains in foreign currency or commodities transactions. Capital gains that occur without active trade or sales are considered passive income. 

3. Foreign Branch Category Income

This refers to any business profit that you receive from a foreign business. This can also include multiple countries and businesses, but they do need to be qualified business units (QBUs). 

4. Section 951A Category Income

Section 951A Category Income is sometimes referred to as global intangible low-taxed income (GILTI). It’s included by United States citizens who are shareholders in foreign companies going business on foreign shores. 

Smaller Income Categories

The IRS recognizes three other smaller categories of income under Form 1116. If they apply to you, you’ll need to include the information on your tax return. Here’s what you need to know:

Section 901(j) Income

This section in Form 1116 is for people who are doing business or earning money in company’s that are sanctioned. For the most part, you can’t receive a credit for foreign taxes imposed by and paid a sanctioned country. The income you make in each sanctioned country is subject to separate foreign tax credit limitations. You must complete a separate Form 1116 for each sanctioned country in which you earned money. 

It’s the United States Secretary of State who designates a state as sanctioned. These are countries that are closely associated with terrorists and other subversive groups. The President of the United States can waive this law and allow the credit.

Certain Income Re-Sourced by Treaty

Sometimes, a treaty with another country treats income earned in the United States as income earned in a foreign country. You can elect to apply the treaty to your income, and it’ll be considered a foreign income for your tax purposes. 

Lump-Sum Distributions

If you paid or accrued a tax debt of a lump-sum distribution from your pension plan in a foreign country, you can take a tax credit. There is a special formula used to determine the tax liability of lump-sum payments on a foreign pension. 

Who Needs to Fill Out IRS Form 1116?

Since most Americans don’t earn money outside of the United States, whether it comes from wages or selling depreciable property at a profit, you may wonder who needs to fill out Form 1116. The person who fills out a Form 1116 must have income and pay taxes in another country. This includes individuals, trusts, and estates. If you paid or accrued taxes in a foreign country or U.S. possession, you need to file a Form 1116 or the credit it offers. 

You would not use this form if you paid taxes in the U.S. Virgin Islands. You would use IRS form 8689.

As a general rule, non-resident aliens can’t take this credit. However, there are expectations, including:

  • Residents of Puerto Rico for the entire year.
  • If you paid taxes in a foreign country or U.S. possession on a trade or income that is connected to the United States. 

Should You Use a Credit or Deduction

If you don’t want to claim a credit for foreign taxes that you paid, you can opt to deduct those taxes instead. To deduct the taxes, you would file Form 1040 or 1040-SR and take the deduction as an itemized deduction in the amount of the taxes on Schedule A. Typically, if you take the credit, then you can’t deduct any part of the foreign taxes. When you take the credit for foreign taxes, then you can take a deduction for a few reasons, including:

  • You aren’t able to take the credit because the taxes were paid for income or financial gains in connection with covered asset acquisition. These are discussed in item 10 in the pamphlet, Foreign Taxes Not Eligible for a Credit. 
  • The boycott provision kept you from taking a tax credit on the foreign income. 
  • If you purchase or sell oil or gas extracted in a foreign country, you pay taxes to that country, and these should be a deduction. 
  • If you pay foreign taxes and request a credit, the denial of the credit means you should ask for a deduction. 
  • When you have to make payments as described in item four or six under Foreign Taxes Not Eligible for a Credit pamphlet, then you can ask for a foreign tax deduction.
  • If you don’t meet the holding period requirement on the payment of taxes or gains, then you need to use it as a deduction. 

You can change your decision to take a deduction instead of credit and a credit instead of a deduction, but you must do so within a special 10-year limitation period. You need to understand that the refund period doesn’t run parallel to the election period so if you wait too long you may miss out on the refund period. 

Which Foreign Taxes Aren’t Eligible for the Credit? 

As an American, you’ve watched the tax laws change and grow more complicated almost every year. One year, you’re paying taxes on a parent’s estate, and the next year, you don’t need to pay estate taxes. So it makes sense that some of the taxes that you pay to a foreign country aren’t eligible for a credit. Here’s a look at some of them that aren’t eligible.

  • In some cases, you may pay more in taxes to a foreign country than you actually owe. You can only ask for a credit on the amount you owe and not the full amount. For instance, you worked in France, and the French government withheld $50 for taxes. According to an agreement between the French and Americans, they can only take $35. You must apply to get your $15 back, and you can’t claim a credit for that amount either, even if you decide not to pursue a refund from the French government. 
  • Section 965(g) disallows some taxes.
  • Taxes paid to foreign countries that are sanctioned. The United States Secretary of State creates this list of countries due to their ties to terrorism. 
  • Sometimes, the portion of taxes paid in connection with a covered asset acquisition is denied. 
  • If you’re claiming an exclusion on Form 8873, Extraterritorial Income Exclusion, you can’t take a credit for the taxes paid on the income.
  • If you pay taxes on dividends on stocks that you’ve only held 16 days in a 31 day period, you can’t take the credit. For preferred-stock dividends attributable, the holding time is greater. It’s for 366 days. 
  • You may have paid foreign taxes that were in conjunction with buying or selling oil or gas extracted in that country. If you don’t have an interest in the oil or it isn’t sold at fair market value, you can’t take the credit. 
  • Sometimes, a foreign country withholds taxes on dividends and you end up making related payments on the substantially similar or related property. 
  • You can’t take a credit if you received the amount of your tax payment back as a subsidy. 
  • If you haven’t held a property for 16 of a 31 day period, and a foreign government withheld taxes, the money isn’t eligible for a credit. 
  • Credits aren’t available for any interest or penalties you have to pay in relation to foreign taxes. 

Foreign Currency Conversion

If you’re paying taxes to a foreign country, you aren’t paying it in United State dollars. You may be paying in Euros or British pounds or some other currency. When this happens, you have to convert the money you paid into U.S. dollars to take your credit. You must convert the currency because it’s never equal. 

For all IRS tax forms, you must report the amount in U.S. dollars even if this means converting its value in the currency you paid into dollars. You need to attach documentation concerning how you arrived at the converted amount in dollars. 

When you’re claiming a credit for taxes you paid to a foreign country, you need to base the amount you paid in U.S. dollars on the conversion rate on the day you paid the taxes or the date they were withheld. If you received a refund of foreign taxes paid, you do the conversion based on the exchange rate on the day you paid or had the taxes withheld. You don’t base it on the exchange rate on the date that you received the refund. 

If you use an accrual basis to report foreign tax paid, you’re going to need to configure the average exchange rate over that year-long period. Once you determine the average exchange rate, you apply it to all the tax payments you made that you’re now seeking credit for on Form 1116. You can’t use this method if any of the following are applicable: 

  • If you paid the foreign taxes more than two years after the related tax period closed, you can’t use this method. 
  • Your foreign tax was owed or paid in an inflationary currency. An inflationary currency is the currency of a country that’s experiencing extreme inflation in both prices and currency for more than 36 months.
  • You paid the taxes in another year than the one that they were owed. 

Sometimes, the accrued taxes aren’t eligible for conversion at the yearly average, so you must use the exchange rate on the date you paid the taxes. If you have accrued and unpaid taxes in an inflationary currency, you must use the exchange rate on the final tax day of that year.

International foreign currencies

Silver Tax Group

At Silver Tax Group, we understand the challenges that you face trying to fill out your own tax forms. When you toss the payment of foreign taxes in the mix, it can be confusing. We’re ready to help you get a handle on your taxes so you don’t pay more than necessary. Contact us today to learn more!

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