The purpose of the foreign tax credit is to prevent income that is derived in a foreign country from being taxed twice: once by the country it was generated in and again by the United States government. If your client paid or accrued foreign taxes to a foreign country on income that was generated from a foreign source and are subject to US tax on the same income, they may be able to take either a credit or an itemized deduction for those taxes.
The difference between taking the amount as a deduction or as a credit is rather simple. If they choose to take the amount as a deduction on their tax return, the foreign income taxes paid will reduce their US taxable income. This means that the amount of income they will have to pay taxes on will be lessened before their tax rate is applied. If they choose to take the credit, the foreign income taxes paid will reduce the US tax liability. This means that the amount of tax that is calculated that they owe will be reduced by the amount of foreign taxes paid. To choose the deduction, they must itemize deductions on Schedule A, Form 1040. To choose the foreign tax credit, they generally must complete Form 1116, Foreign Tax Credit, and attach it to their Form 1040. However, if they meet the following requirements, they will not need to abide by any limit when it comes to claiming a foreign tax credit and do not need to file Form 1116:
If your client chooses to take a deduction for qualified foreign taxes, they must take deductions for all foreign taxes. The same applies to choosing a credit. They may only choose one method, credit or deduction, each year and apply that method to all of their qualified foreign taxes. The only exception to this rule is if they choose to use the credit method but a certain foreign tax is not taken as a credit. In this case, they may use all other taxes on credit basis and use the deduction method for the taxes that are not taken as credit. Taxes that are not taken as credit are as follows:
It is usually more advantageous to they to choose to take a credit over a deduction. This is because: