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I'm having trouble understanding some of Form 1116 for Foreign Tax Credit.

I dug through that form a few days ago. Here is my understanding of what it does:

1. Start with gross foreign source income.
2. Subtract out deductible expenses directly attributable to foreign source income.
3. Subtract out a pro rata share of deductible expenses not specifically attributable to the foreign source income.
4. After steps 1 through 3, you get a proxy for foreign source taxable income. Figure what percentage this is of your total taxable income.
5. Your foreign tax credit is limited to your total tax liability * the percentage figured in step 4.

What the adjustments to inputs do: If your foreign source income is from qualified dividends and your total income is much higher than mine, as measured by specific lines of your Form 1040 mentioned in the instructions to Form 1116, you must adjust the foreign source income and deductible expenses by a percentage the instructions give you. The math works out so that this adjustment is the same as ratcheting down a 35% tax rate so that you are limited to a 15% tax rate for purposes of the foreign tax credit. As near as I can figure the theory, the point is to not give 35% bracket taxpayers more of a foreign tax credit than the 15% US income tax they would have paid on qualified dividends. I suspect there's holes in the algebra where it won't work out as intended, but I didn't go analyzing things that deeply because my income is too low to trigger the adjustments.

Figuring this stuff out would be easier if the IRS gave a plain English explanation of why the forms read the way they do, instead of forcing you to work through the math and figure out the reasoning (if any) behind the way the forms work.

Patzer
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