Foreign tax - Is this allowable?

[FEDUKE404]

Background: Client (MFJ) has for many years been incurring >$600 in foreign tax, thus Form 1116 has been used. Originally most of the foreign taxes were recoverable, and the remainder went into the 10-year holding pot on Form 1116. But in recent years, as a result of the foreign income becoming a smaller percent of overall income (purpose of initial calculations on Form 1116) AND significantly increased itemized deductions (mainly medical), the allowable foreign tax credit has been shrinking and the carryforwards have been growing. It is now likely that the bulk of the existing carryforwards will never be used.

So. . .I was doing some "what if" calculations with my 2015 software. By putting all of the foreign tax on Schedule A (as an itemized deduction), and not using a Form 1116, it appears scenarios could exist where this client could potentially come out better NOT filing a Form 1116. However, what happens to the unused carryforwards? The software still tracks them, via internal worksheet, but for the year when taxes were shown on Schedule A the entries for that year are (as expected) zero. Obviously you cannot take both a deduction and a tax credit simultaneously using the same foreign taxes.

QUESTION: IF this option is allowable (and I think it is!), is it also permissible to select/change the method used for the foreign taxes year-to-year as needed, i.e. based upon the circumstances for the given year? The fact that the tax software is showing the unused carryforwards, in the absence of a filed Form 1116, would seem to indicate this answer is also yes.

Any input. . .whether corrections or suggestions. . .would be welcome!

FE

[TaxGuyBill]

I do VERY little with Foreign Taxes, but yes, that is how I understand how things work.

[FEDUKE404]

Support

I do VERY little with Foreign Taxes, but yes, that is how I understand how things work.

Thanks! I thought there would be more responses. . .but at least you apparently DO see things the same way I do.

The "on/off switch" does involve a lot of variables, and in most places the tax credit is preferable. But, not always. . .

FE

[Roland Slugg]

The "credit vs itemized deduction" choice is one that a taxpayer can make every year. He can switch back and forth, choosing the option that is best for him each tax year. He can not, however, take both a credit and an itemized deduction in the same year (although there is an exception to this general rule for foreign taxes not eligible for the credit). This means that he can not take a deduction for foreign taxes and also take a credit on that same year's return for unused foreign taxes carried over from an earlier year. (Code §904(c)) (Code §904(c) is a real challenge to read. It consists of only two sentences, of which the first is a run-on sentence of nearly 200 words!)

If a taxpayer has unused credits in the 10-year carryover "pot," he is still required to make all the usual calculations in each carryover year. If those calculations yield what would have been an allowable credit in a carryover year in which the itemized deduction option is chosen, then the credit that would have been allowed in that same year must be subtracted from the remaining carryover as if it had been allowed, even though it was not. This treatment is very hard to find in the Code or Regs, but it is explained quite clearly in IRS Pub 514 (on page 24, left column). Whether or not the IRS's rule is consistent with the Code and/or Regs may be questioned, but I would not question or challenge it unless the $$$ involved were significant and the taxpayer was both informed and willing to do so.

[FEDUKE404]

Dealing with Pub 514 issues

One might think this IRS author was also involved in the "clear writing" of the SEHI rules ??

I looked over the Pub 514 reference you provided. While I was already clear that you cannot take both the credit and the deduction in a given year, the "phantom calculations" of a non-existing Form 1116 tax credit with corresponding 10-year carryforwards caught me off guard. Upon selecting the foreign tax amounts as an itemized deduction, the software just fills in zeros for the original/used/carryforward amounts for the "newest" tax year. There is no side-calculation of the amounts of those carryforwards **IF* a phantom Form 1116 had been calculated.

It is indeed a minefield, as pointed out by Roland Slugg. It (generally?) takes an unusual combination of events to make the itemized deduction come out ahead of the foreign tax credit. The return of interest has ~$2k of foreign tax. But the foreign income/deductions are rather low versus total same, and the taxable income is lowered by significant itemized deductions (to include medical). That combination of events makes the Form 1116 credit disappear like a Cheshire cat.

When I have all of the 2016 information AND the 2016 tax software in hand, I can play around with the numbers more. But at this stage, I may just say to heck with it and stay the course with the (reduced) Form 1116 amounts. I think the extra time/work to calculate/track a non-existent Form 1116 and the associated/allowable carryover amounts may be the straw that breaks this camel's back!

Thanks for taking the time to respond!

FE

[Kram BergGold]

One More Idea

If the yearly foreign tax ever drops below $600 and claiming that amount yields a greater credit then preparing Form 1116, then I might consider jettisoning the carry forwards and just claim the amount under the simplified rules. Granted the carry forwards would be permanently gone but if it is unlike they will ever be used then maybe it makes sense.