Foreign Tax Credit Reduced by Qualified Dividends?

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Foreign Tax Credit Reduced by Qualified Dividends?

Postby Electron » Wed Feb 18, 2009 6:24 pm

I finished my Federal Taxes and checked the numbers using a trial version of Turbotax. Everything matches with the exception of the Foreign Tax Credit. My calculation on Form 1116 comes out $82 while Turbotax shows $56. The trial version will not let me view the tax forms to see the details.

The maximum allowable Foreign Tax Credit is less than Foreign Tax paid because my 2008 income is relatively low. Federal Form 1116 will be required because the Foreign Tax paid exceeds $300.

Could Qualified Dividends explain the difference in Foreign Tax Credit? I have significant Qualified Dividends in the 0% bracket.

Form 1116 Instructions indicate that adjustments may be required if one has Qualified Dividends.

Does anyone know exactly how to adjust Line 1a and/or Line 17 on Form 1116?

In actuality, I qualify for the "Adjustment Exception" and may not need to make any adjustments. Turbotax does not indicate whether it is using the Adjustment Exception or not. They do offer the Simplified Foreign Tax Credit Election for AMT Purposes but I believe that is entirely different.

To make matters even more complicated, Turbotax could be in error. I added some capital gain distributions to a mutual fund and offset that amount exactly with a long term loss on a stock, and the Foreign Tax Credit increased to $66. Does that make any sense?

I did find some information on this subject but it is very complicated. It does not cover the 0% bracket case.

http://www.thefreelibrary.com/How+reduc ... 0148055951

Form 1116 seems to be about as complicated as anything I've seen, and it gets even worse under AMT.

Thanks, Kent
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Postby Diablo-D3 » Wed Feb 18, 2009 6:28 pm

Dear op, TurboTax sucks really badly. Use TaxAct instead.
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Postby alvinsch » Wed Feb 18, 2009 6:45 pm

I'm not a tax pro but here's how I view form 1116. The purpose of this form in my view is to make sure you don't get to take a bigger credit than what you would have paid at your US tax rate. So if the foreign tax was paid at 20% of foreign source income but your tax rate is only 15%, the government doesn't want to give you credit for that last 5% because why should they indirectly subsidize a foreign entities higher tax rates if you decide to invest there.

Therefore if you're in a relatively low tax bracket, that might cause some of your 1116 FTC to be limited. Now if you have a lot of foreign source income, greater than $20000, then the government apparently assumes you're probably in the 35% bracket but wants you to still calculate the US tax as if you're in the 15% QDI bracket for this income so they require you to reduce your foreign source income by multiplying it by .4286 (15/35) before doing the form 1116 calculation.

This is why on many of the foreign tax credit worksheets you might receive from mutual funds will have multiple columns for calculating the foreign source income. Most people (< $20000 income), get to use the full foreign source income so if this applies to you make sure not to use the lower qualified dividend column.

I haven't done my 2008 taxes yet but in prior years, Turbotax only asks for your foreign source income and assumes you have adjusted if you are required to. So if you correctly entered your foreign source income into Turbotax when you entered your 1099-div info then I'd assume you are having your FTC limited.

Another possibility is that if you downloaded your 1099-div info, turbotax doesn't know your foreign source income so if you didn't enter it separately, it may be assuming $0.

Hope that at least gives you some things to look at.
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Postby alvinsch » Wed Feb 18, 2009 8:18 pm

I just checked on the 2008 instructions for form 1116 and it has additional restrictions on foreign source income starting this year. Specifically, if your QDI/CG is taxed at 0%, you apparently can't include any of the foreign source income.

http://www.irs.gov/instructions/i1116/ch01.html#d0e742

If you completed the Qualified Dividends and Capital Gain Tax Worksheet in the instructions for your tax return, and are not required to file Schedule D, see Qualified Dividends and Capital Gain Tax Worksheet (Individuals), next, to determine the adjustments you may be required to make. If you completed the Qualified Dividends Tax Worksheet in the Instructions for Form 1041, see Qualified Dividends Tax Worksheet (Estates and Trusts), later, to determine the adjustments you may be required to make. If you are required to file Schedule D, see Schedule D Filers, on this page, to determine the adjustments you may be required to make.

You can elect not to make the adjustments to your qualified dividends and capital gains if you qualify for the adjustment exception. See Adjustment exception under Qualified Dividends and Capital Gain Tax Worksheet (Individuals), Qualified Dividends Tax Worksheet (Estates and Trusts), and Schedule D Filers.
Qualified Dividends and Capital Gain Tax Worksheet (Individuals)

If you completed the Qualified Dividends and Capital Gain Tax Worksheet in your tax return instructions and you do not have to file Schedule D, you may have to adjust the amount of your foreign source qualified dividends and capital gain distributions.
Form 1040 filers. You must adjust the amount of your foreign source qualified dividends and capital gain distributions if both of the following apply:

*

Line 7 of the Qualified Dividends and Capital Gain Tax Worksheet is greater than zero.
*

Line 16 of the Qualified Dividends and Capital Gain Tax Worksheet is less than line 17 of that worksheet.

Form 1040NR filers. You must adjust the amount of your foreign source qualified dividends and capital gain distributions if both of the following apply:

*

Line 5 of the Qualified Dividends and Capital Gain Tax Worksheet is greater than zero.
*

Line 14 of the Qualified Dividends and Capital Gain Tax Worksheet is less than line 15 of that worksheet.

Adjustment exception. If you qualify for the adjustment exception, you can elect not to adjust your foreign source capital gain distributions and qualified dividends. You make this election by not adjusting these items. If you make this election, you must elect not to adjust any of your foreign source qualified dividends or capital gain distributions.

Adjustment exception for Form 1040 filers.

You qualify for the adjustment exception if you meet both of the following requirements.

1.

Line 7 of the Qualified Dividends and Capital Gain Tax Worksheet does not exceed:
1.

$200,300 if married filing jointly or qualifying widow(er),
2.

$100,150 if married filing separately,
3.

$164,550 if single, or
4.

$182,400 if head of household.
2.

The amount of your foreign source capital gain distributions, plus the amount of your foreign source qualified dividends, is less than $20,000. For this purpose, ignore any capital gain distributions or qualified dividends you elected to include on Form 4952, line 4g.

Adjustment exception for Form 1040NR filers.

If you file Form 1040NR, you qualify for the adjustment exception if you meet both of the following requirements.

1.

Line 5 of the Qualified Dividends and Capital Gain Tax Worksheet does not exceed:
1.

$200,300 if you checked filing status box 6,
2.

$100,150 if you checked filing status box 3, 4, or 5, or
3.

$164,550 if you checked filing status box 1 or 2.
2.

The amount of your foreign source capital gain distributions, plus the amount of your foreign source qualified dividends, is less than $20,000.

How to make adjustments. To adjust your foreign source qualified dividends or capital gain distributions, multiply your foreign source qualified dividends or capital gain distributions in each separate category by 0.4286 if the foreign source qualified dividends or capital gain distributions are taxed at a rate of 15%. Include the results on line 1a of the applicable Form 1116.

You adjust your foreign source qualified dividends or capital gain distributions taxed at the 0% rate by not including them on line 1a. Amounts taxed at the 0% rate are on line 10 of the Qualified Dividends and Capital Gain Tax Worksheet in the Form 1040 instructions and line 8 of the Qualified Dividends and Capital Gain Tax Worksheet in the Form 1040NR instructions.

- Al
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Postby Electron » Thu Feb 19, 2009 12:39 am

Al - Thanks for both of your very informative replies.

I saw the note on 0% Qualified Dividends earlier today but was confused somewhat by the instructions. The specified line in the Qualified Dividends Worksheet includes both domestic and foreign qualified dividends and is much larger in my case than the Foreign Source income on Form 1116 Line 1a. Actually, I have a small amount taxed at 15% so maybe that is all that remains on Form 1116 Line 1a after the adjustment for that rate. Beyond that, I believe I qualify for the Adjustment Exception so none of this should need to be done. It is also unclear what Turbotax is doing.

If one was not under the Adjustment Exception I believe the Taxable Income also has to be adjusted using the Worksheet in the Form 1116 Instructions for Line 17. I'll have to try both adjustments and see how it turns out.

I am familiar with the various items in your first note. I hand entered all data for both my own tax calculations and the inputs to Turbotax. I did use the unadjusted column data from the mutual funds that provided more than one column.

I'm now going to try out TaxAct to see how it compares with Turbotax.

I am doing this partly because I will have a Foreign Tax Credit Carryback to 2007 and also a Carryforward to later years. I'd like to handle 2007 correctly and it had the 5% bracket rather than the 0% bracket in 2008. That return did not use all of the allowable Foreign Tax Credit so I can amend that return and get a refund for part of the amount that I can't use in 2008. All of this is described in Publication 514.

I still suspect that Turbotax might be incorrect as my tax case is quite unusual. Total income is respectable but after a very large itemized deduction and a capital loss, all that remains is Qualified Dividends most of which is taxed at 0.00%. My Federal tax will be $0.00 after the Foreign Tax Credit and Recovery Rebate Credit.

Kent
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Postby lazyday » Thu Feb 19, 2009 3:26 am

alvinsch wrote:Specifically, if your QDI/CG is taxed at 0%, you apparently can't include any of the foreign source income.

Well that stinks. Seems only fair though.

Hopefully, foreign taxes paid but credit not taken can be rolled forward to future years until can be taken, but I'm not sure if that would apply to this case.
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Postby kramer » Thu Feb 19, 2009 11:30 am

I posted about this a couple of years ago on the Diehards board and came to the same conclusion (I remember that Al also offered an informative and helpful response at that time, thanks Al!). I am early retired and living on dividends and some capital gains and so my federal income tax should be 0 in 2008 to 2010. In fact, I have to sell stock funds with gains to take full advantage. I am single and my foreign paid taxes are higher than $300 so I must always file Form 1116.

So I will be carrying back my 2008 foreign taxes to the 2007 tax year, a year in which I had a significant amount of work income (and my average tax rate was more than twice as high as my foreign tax rate). For 2009 and 2010, I expect to never recover foreign taxes paid. You can carry forward for 10 years, but I do not expect to ever be able to recover the foreign taxes.

This also reduces the tax cost of ROTH to traditional IRA contributions, since you get some of the foreign tax credit back as your average USA income tax rate goes up.

As a result of this, my effective expense ratio on foreign funds has increased by about 0.15%. So I have started lowering the percentage of my allocation to foreign funds somewhat, since they have effectively become more expensive for me relative to USA stock holdings.

This still affects someone who has less than $300 in foreign taxes, less than the form 1116 threshold. You can only receive this foreign tax credit up to the level of your federal tax bill.

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Postby Electron » Thu Feb 19, 2009 3:17 pm

Thanks all for your comments.

Last night I entered all my tax data into TaxAct 2008 and the Allowable Foreign Tax Credit came out the same as my manual calculation and the amount was different from the number provided by Turbotax!

So, I will proceed using the TaxAct number. TaxAct was easy to use and I like the program. It also asked me whether my Foreign Source Income was under $20K which implies the Adjustment Exception. Turbotax did not ask that question. TaxAct also let me view all the Tax Forms and I learned about some additional entries made on Form 1116.

I'll be able to use some of my extra Foreign Tax Credit by amending my 2007 return. I'm also not sure if I will be able to use all my credit and carryforward credit in future years.

It is still not clear to me how to handle the case where you have Qualified Dividends taxed at both 0% and 15%. In addition, the amount taxed at 0% in the Qualified Dividends worksheet may be larger than the Foreign Source income claimed on Form 1116.

I think the IRS needs an actual worksheet for these cases. Right now it almost seems to be a back of the envelope calculation.
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Postby Wagnerjb » Thu Feb 19, 2009 3:36 pm

Kent – I have done the foreign tax credit in the past (for earned income, not capital gains or dividends), and I also read the overview section of the link you attached. I believe I understand the intent of the FTC, although I cannot speak to the specific worksheets or what TurboTax is doing for you.

The foreign tax credit is intended to prevent you from paying more than the US tax rate on your income. If the US taxes you at 25% and you have already paid 30% to a foreign country, you will get a 25% refund through the FTC. Notice that your credit amounts to the lesser of the US tax or the foreign tax. If your US taxes are at 30% and the foreign taxes were at 20%, you would get an FTC at 20%. Again, it is the lesser of the two.

In your case, you have paid 0% to the US and (for example) 25% to the foreign country. You get the lesser of the two – meaning 0%. This is apparently why you are not generating an FTC in your calculations.

The good news is that you can carry the unused FTC forward, and it seems quite likely that you can utilize the carryforwards. Here is how. In any year, you may very well have foreign dividends where there is no withholding tax paid. So you will include that income in the US and generate a 15% tax liability. But….you have foreign taxes paid, and it doesn’t matter that they were paid in a previous year. In this case, you have US taxes at 15% and foreign taxes at 25%, so you would get a credit of 15%.

As long as you are paying 0% in US taxes, you won’t get a benefit. But as soon as you pay 15% on these dividends you will recapture the benefits.

In my examples, I was assuming you are paying 25% or 30% on your foreign dividends. In reality, you are probably paying a much lower average rate. Some countries have tax withholdings, but others don’t. So, your average foreign tax withholding rate may only be around 5%. But that doesn’t matter this year. For any qualified dividends taxed at 0%, you get no FTC. In reality, if you have some foreign non-qualified dividends taxed at anything other than 0%, your calculations are a blend of the two outcomes I have described.

(In my examples, I use tax rates that appear to be incremental rates specific to the dividends. As others have pointed out, your credit is based on the average tax rate for your US tax return).

Best wishes.
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Postby Electron » Thu Feb 19, 2009 3:53 pm

Andy - Thanks for a very informative explanation. Things are starting to make more sense.

There is an Adjustment Exception described in the Form 1116 Instructions and I do qualify for that. As a result, I do not have to adjust anything for any qualified dividends regardless of the rate paid.

I also discovered that being under the $300/$600 threshold on Foreign Tax Credit can be a gift. If over the limit the credit may be reduced considerably.

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Postby bc3x » Thu Feb 19, 2009 4:01 pm

Kent,

Since the filed 1040 is a legal document, one needs to elect the Adjustment Exception by checking the box that asks the questions about not exceeding the $20,000 foreign income limit. TurboTax "knows" the answer to the question, but one needs to do it formally by checking the box. TaxAct is more explicit about the election. If the box is not checked, the credit would be reduced. Perhaps this explains the discrepancy between the TaxAct/manual calculation and that of TurboTax.

The purpose of the Foreign Tax Credit is to prevent double taxation. The qualified dividends won't be taxed by the US, but only by foreign governments; therefore these dividends won't enter the 1116 picture. The 1116 would deal just with the foreign income taxed at 15%. That would explain why foreign taxes over $300 would yield only under $100 in credit. Still sounds like Uncle Sam is being very avuncular.
Last edited by bc3x on Sat Feb 21, 2009 11:28 am, edited 1 time in total.
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Postby Electron » Thu Feb 19, 2009 4:16 pm

bc3x wrote:Since the filed 1040 is a legal document, one needs to elect the Adjustment Exception by checking the box that asks the questions about not exceeding the $20,000 foreign income limit. TurboTax "knows" the answer to the question, but one needs to do it formally by checking the box.

I don't recall seeing that option in Turbotax. Maybe I missed it. The only thing I remember seeing is the one time election for AMT Purposes.

It was called the "Simplified Foreign Tax Credit Election for AMT Purposes".
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Postby alvinsch » Thu Feb 19, 2009 5:09 pm

KAWill70 wrote:
bc3x wrote:Since the filed 1040 is a legal document, one needs to elect the Adjustment Exception by checking the box that asks the questions about not exceeding the $20,000 foreign income limit. TurboTax "knows" the answer to the question, but one needs to do it formally by checking the box.

I don't recall seeing that option in Turbotax. Maybe I missed it. The only thing I remember seeing is the one time election for AMT Purposes.

It was called the "Simplified Foreign Tax Credit Election for AMT Purposes".

I've been entering foreign tax credit info into turbotax since 1999 and I've never seen any $20000 election box either. I've had to adjust the foreign source income before entering the numbers in Turbotax for the correct numbers to come out on form 1116.

I don't see how TaxAct could be doing the adjustment calculation correctly since I've had really complicated worksheets where I had to adjust varing percentages of the income for every different company. There's no way TaxAct could recreate the worksheets sent by some of my funds unless you entered every country's source income, the QDI/non-QDI breakdown for each country, etc. They can't be recreated from just your 1099-DIV.

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Postby bc3x » Thu Feb 19, 2009 5:16 pm

Kent,

The check-off box was definitely in the Deluxe version when I was experimenting with it at the TurboTax website.

The Simplified Limitation Election refers to the choice of using the marginal/capital gains rates instead of using the 26% or 28% AMT rates for calculation of Foreign Tax Credit as an offset to the AMT. If you don't make this election, a second Form 1116 or the AMT Form 1116, needs to be filed with the Form 6251 (AMT). TurboTax makes a big deal about making this election and I agree with them. Again you make this election formally by answering that question. Once made, the election can only be rescinded with IRS's approval. See page 11 of Form 6251 Instructions.
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Postby alvinsch » Thu Feb 19, 2009 5:33 pm

bc3x wrote:The check-off box was definitely in the Deluxe version when I was experimenting with it at the TurboTax website.


I've always used the CD Basic version so that might explain it.
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Postby bc3x » Thu Feb 19, 2009 5:39 pm

Al,

If one does not qualify for the Adjustment Exception, it simply means that for the purpose of calculating the Foreign Tax Credit, the marginal rate rather than the more favorable Capital Gain rates would apply. The math is not that complicated, even with multiple funds. Besides, Vanguard won't be providing country-by-country breakdowns anymore.

TaxAct 2008, even the basic, Standard version, did a very nice job completing the 1116 with multiple funds.

Shouldn't say "no way" until you've tried it yourself.
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Postby Electron » Thu Feb 19, 2009 5:46 pm

alvinsch wrote:I don't see how TaxAct could be doing the adjustment calculation correctly . .

It is doing the Adjustment Exception since I qualify. In that case, Form 1116 Line 1a is my total unadjusted Foreign Source Income and Line 17 is also unchanged.

Vanguard's adjustment columns seem to use a slightly different number from what I see in the Form 1116 Instructions. They appear to be using 0.4276 instead of 0.4286.

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Postby Electron » Thu Feb 19, 2009 8:10 pm

bc3x wrote:TaxAct 2008, even the basic, Standard version, did a very nice job completing the 1116 with multiple funds.

I will spend more time with TaxAct but so far I am quite impressed with it. It may also be lower cost than Turbotax.

One additional question:

I also had Foreign Income and Foreign Tax Credit from two individual stocks (Royal Dutch Shell and Encana).

In both cases, Vanguard Brokerage withholds 15% of the dividends for Foreign Tax.

Is my Foreign Source Income from these stocks simply the dividends received before the 15% withholding?

Thanks, Kent
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Postby bc3x » Fri Feb 20, 2009 8:08 am

Kent,

TaxAct Desktop 2008, Standard, with e-file is a free download. I would think that California has the same chart as NYS for the transfer of line items from the 1040 to the state return and probably has the fill-in and save forms too. If that's the case, consider TaxAct Standard Desktop for the federal return and federal e-file for free, then do the California return by hand and all you have to pay is the price of postage. Did you notice the nice feature for carryback and carryover? It's much cheaper than TurboTax.

What does your 1099-DIV say about the two individual stocks? I understand that VBS is a bit pokey these days sending tax documents. Because I don't own individual stocks, I will defer to other forum members, who do, for their input.
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Postby Electron » Fri Feb 20, 2009 3:58 pm

bc3x wrote:What does your 1099-DIV say about the two individual stocks? I understand that VBS is a bit pokey these days sending tax documents.

The brokerage 1099 correctly reported the Foreign Tax paid which was 15% of the dividends received from the two stocks.

The Foreign Source Income for Form 1116 is left to the taxpayer. In reality, I don't know how it could be anything other than the full dividend amount paid from those stocks.

I receive the dividends minus the 15% that is withheld for Foreign Tax, and I assume that amount is also paid to the respective countries.

Yes, the brokerage 1099 can be a bit late. It is delayed into February if you hold things such as REITs. Otherwise, it is mailed in late January.

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Postby bc3x » Fri Feb 20, 2009 6:31 pm

Kent,

Until someone more knowledgeable comes along, the following is my best guess.

If you have the figures in Box 1a, Box 1b and Box 6 for the 2 stocks, then you should be able to file the 1116. Just to be on the safe side, it would not hurt to check with VBS to be certain that they have the same understanding that you do about the 1099-DIV boxes.

This is what I assume that you've already done with the 1116. Box a has been checked for passive category income. Part I line A has "Dividends". Part I column A (under Foreign Countries or U.S. Possessions) has "RIC" so you won't have to list the individual companies. Part II line A under "(j) Date paid or accrued" you have "1099 Taxes" to get around the problem of listing the foreign taxes in Euros/pounds sterling and loonies. See page 13 and 15 of the 1116 Instructions for details.
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