The Foreign Tax Credit Vs. The Foreign Income Exclusion

If you are a US person living abroad, you may have more than one option for reducing or eliminating any US Tax liability – but which is better? Let’s take a look.

Obviously, if one choice results in lower taxes, it is likely better to go with that choice – but what about when either method reduces your US taxes to zero. Which one should you take?

Disclaimer: Taxes for expats living abroad are extremely complex. We insist that your best bet is to hire a tax professional who specializes in these tax returns. There are so many unique situations that can lead to penalties and more taxes. This guide is very general and does not replace the IRS publications on how to stay compliant with your taxes.

If you would like to hire us to prepare your US Expat taxes, click here.

The foreign tax credit vs. the foreign earned income exclusion

And the winner is…

The foreign tax credit.

Given the option of taking either, and having NOT claimed the foreign earned income exclusion in the previous year (this is important, see below), my opinion is to choose the credit first nearly every time.

There rally are no “cons” to the foreign tax credit. It is black and white. Cut and dry.

One benefit of the FTC is that in some cases you can even carry forward any “unused” credit. It is also easy to substantiate in an examination, that is, it’s  often easy to prove that you paid income taxes to another country.

Important: I would hesitate, however, to “switch” to the foreign tax credit if you have been claiming the foreign earned income exclusion.

This is because if you claim the foreign earned income exclusion in one year, and you qualify in the next year but choose not to take it, the election is considered “revoked” and it cannot be used for another 5 years without requesting permission from the IRS in a Private Letter Ruling (it’s actually a bit more complicated than that – you can see more on the IRS website here).

So what else is wrong with the foreign earned income exclusion?

foreign earned income exclusionWell, there’s nothing really “wrong” with it. Many of our clients claim it year after year and it’s a pretty good part of the tax code.

But it has its disadvantages.

For one thing, but the physical presence test can be restrictive.  I know US expats that intentionally spend less time while on family visits back to the US just to qualify.

Another reason is that the rules for bona-fide residence test can be “gray”. If an expat is in that gray area, they run the risk of being disallowed in an examination and trapping themselves with a very large tax bill for multiple years.

Plus there is the “revoked” election problem as explained above.

So claim the foreign tax credit then?

I’m not saying that. I’m just saying in many cases the FTC wins out over the FEIE.

Rules of thumb…

For the most part, if you have NOT been claiming the foreign earned income exclusion in prior years, consider the foreign tax credit instead if it reduces your US tax liability to zero.

Another good rule of thumb is if you HAVE been claiming the foreign earned income exclusion, to keep claiming it just in case you need it one day (such as moving to a country with a low tax rate).

Sorry to be a wimp and throw in disclaimers, but the answer really depends.

Each individual situation is dynamic.

To decide which is best, it really takes some forecasting and planning to see how each dynamic situation might play out. It depends on your future plans for presence abroad, the status of your foreign residence, the tax rate in your country of residence, how much you earn, and how these things might change going forward.

For a complete and simple tax guide for US Citizens living abroad, click here.

If you wish to hire us to prepare and file your US Taxes, click here.

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