Foreign Tax Credit (FTC) vs Foreign Earned Income Exclusion (FEIE)

U.S. Tax Help When You’re An Expat In Australia ➥ Foreign Tax Credit (FTC) vs Foreign Earned Income Exclusion (FEIE) AU Income Tax

With US citizens and Green Card Holders being taxed by the US on their worldwide income, regardless of where they’re living, it’s really important to make the best use of the tools available to reduce tax liability in the most efficient way. Two of those tools are Foreign Tax Credit (FTC) and Foreign Earned Income Exclusion (FEIE). Khandra and Seth take a look to help you navigate your way through this complicated area.

What is FTC?

If you’re a US citizen or Green Card Holder paying foreign taxes to a foreign country (for example, paying taxes in Australia) and subject to tax in the US on the same income, FTC may allow you to take a credit for those taxes. This credit reduces your US tax liability.

You may have heard of people using forms 1116 (individuals) or 1118 (corporations): these are to claim FTC.

What is FEIE?

As a US citizen or Green Card Holder living and earning an income abroad (foreign earnings) on which you are taxed, you may qualify to exclude those earnings from your US tax return. The amount you can exclude is adjusted annually by the IRS for inflation (in 2019 you could exclude $105,900 USD; in 2021 the amount was $108,700 USD).

Form 2555 is used to claim FEIE. However, claiming an exclusion does not mean you don’t have to file a US tax return!

Which is better: FTC or FEIE?

There are several complex factors to consider when deciding which tool is the best for your circumstances. While it can be easy to focus on the big reduction in US tax liability by claiming FEIE, this shouldn’t influence your decision without first looking at whether it truly is the optimal way of achieving the best tax outcome.

FEIE Key points:

You’re not able to claim other refundable tax credits.
Once you’ve elected to use FEIE, the decision is binding on future returns.
You can only stop using FEIE by revoking it in a special manner.
Once you’ve revoked FEIE, you cannot use it again for 5 years without permission from the IRS.

So, what are the benefits of FEIE? FEIE has some good effects on a US tax return. The most obvious is the ability to take your gross income in Australia and use it to reduce the US tax liability. Prior to 2005/6, loopholes existed under FEIE that meant using this tool was a wonderful answer to your tax problems. That’s the legacy of FEIE, but things have changed over time. Keeping up to date with those changes makes sure you’re still using the best tool for your circumstances.

There are places where FEIE is absolutely necessary (countries such as Hong Kong or Singapore), although that is not the case in Australia. In fact, of those clients who come to us already using FEIE, we find that most have recently moved to Australia from places where FEIE was their best option. In Australia, their needs are different and when we look into their circumstances, we find that FTC now suits those clients better, and our clients choose to revoke FEIE without any disadvantage to them.

Another potential benefit of FEIE is when considering the Stimulus payment. We’ll look at that in more detail below.

In general, however, we tend to find that FEIE isn’t necessarily the most advantageous way to deal with your taxes.

FTC Key points:

You can carry unused FTC forward to future US tax returns for 10 years.
A person using FTC is eligible for additional child tax credit. You should pay particular attention to this if you have children.
It is a useful tool if you might move to another country for work.
Typically, there are a higher number of unused taxes than when using FEIE. This can act as a safeguard for US tax residents.

When using only FTC, generally speaking you will have unused Australian taxes as far as your US tax return is concerned (those you’ve paid in Australia, but not used to offset the US tax on the same income). These unused taxes can be applied to future tax returns to reduce your US tax liability. This is useful if you were to return to the US and then travel to other countries with tax rates lower than those in Australia. For example, if you were to work in the UAE, you wouldn’t gain FTC from those earnings, but you would be able to use the credits carried over from previous years to reduce your tax liability in the US.

What’s the bottom line?
In Australia, FTC is more commonly used, due to the higher rates of tax here. In our experience, both FTC and FEIE can achieve minimal, if not zero, tax liability in the US. However, we find that FEIE can be more restrictive to US tax residents, who require careful planning to make sure each tax return going forward is done in the most optimal way. It’s therefore very important to seek professional advice to make sure your needs are met.

Are US citizens and Green Card Holders in Australia eligible for the Stimulus payment?

Yes, absolutely! As long as you meet the criteria, you are eligible.

Some people are misled by the term “resident”: it does not mean “living in the US”. US citizens and Green Card Holders are, by their very nature, US tax residents, no matter where they’re living.

Good news on the Stimulus payment

We’ve commonly been asked for advice when our clients haven’t received their Stimulus check, despite being eligible for it. The good news is that the Stimulus payment is an advance payment on 2020 tax year: a refundable credit. If you got the check, nothing will happen in that tax return because you’ve already got the credit, but, if you didn’t, you can make the claim in your 2020 US tax return. Even better, you can provide the IRS with your US bank details and avoid having to wait for the check to arrive!

Does FTC vs FEIE affect whether I’m eligible for the Stimulus payment?

The Stimulus payment is a payment of up to $1,200 USD. Whether you are eligible takes into account your adjusted gross income (AGI). The AGI sets a threshold according to your filing status, above which you are no longer eligible for the Stimulus check.

Using the example of a single filer, their AGI must not exceed $75,000 USD. For every $1,000 USD above that, the Stimulus check amount reduces. While a higher income earner may not receive the full $1,200 USD, they are still likely to receive something. However, the phase out is fully exhausted by the time you hit $99,000 USD.

Keeping that single filer in mind, if they were living and working in Australia, earning $140,000 AUD (roughly $100,000 USD) per year, would they get the Stimulus payment? Well, some would, but some wouldn’t. This is when FTC/FEIE comes into it. In this example, if they claimed FTC, they would be above the threshold for the Stimulus payment and no longer eligible for it. However, if they claimed the exclusion (FEIE), they are likely to be below that threshold and get the Stimulus check as a result. It’s a perfect example of the advantages and disadvantages to each of these complex tools!

If the Stimulus check is something that is really important to you, you might decide to use FEIE. You should be aware though that there’s a range of income where the tool you use will affect the outcome, but if you’re above or below that range, you’ll find you get the same result.