Q: I paid $3,235 in foreign taxes. Form 1116 shows $3,005 of that amount as "disallowed" and $230 as utilized. Could you please explain this?
A: When a taxpayer excludes all or part of his income using Form 2555 (Foreign Earned Income Exclusion), the amount of foreign tax subject to credits is reduced, too. The instructions for Form 1116 read:
"Reduce taxes paid or accrued by the taxes allocable to any foreign earned income excluded on Form 2555 or Form 2555-EZ."
In other words, you cannot exclude foreign income and then use the taxes paid on this income as a credit. The portion of the income attributable to the excluded income is "disallowed," and the remaining foreign tax is applied to calculate the credit toward U.S. tax.
Q: Why does Form 1116 appear twice on my tax declaration, accompanied by different numbers? If the credits shown on both forms are applied, the amount in credits from foreign taxes will equal $20,000 instead of $10,000, meaning the total amount I was liable for in 2010 would be $0 rather than $7,000. What gives?
A: The first Form 1116 is the Foreign Tax Credit Form. The second Form 1116 is Alternative Minimum Tax Foreign Tax Credit (indicated above the form name). The first form calculates the allowed amount of foreign tax credit. The second form calculates the Foreign Tax Credit for AMT (Alternative Minimum Tax). Taxpayers from countries with high tax brackets who owe no U.S. taxes may still owe the AMT. Therefore, calculating the AMT credit is essential to reduce the amount owed in AMT.
❗ Important note: this is not an additional tax credit. This is an alternative tax credit applied to adjust the Alternative Minimum Tax. This form is essential for saving every dollar possible on the AMT in future years. Whatsmore, the IRS requires that it be filed.