After reading my previous post Too Much Hassle in Claiming Foreign Tax Credit on IRS Form 1116, several readers said they used tax software OLT this year because OLT had supported Form 1116 and its Schedule B sooner than TurboTax. My gut reaction was:
It’s great that OLT was able to do it fast but does it produce the correct numbers?
Project Management Triangle
In other words, does the project management triangle still hold?
You know the saying you can have any two out of the three — good, fast, and cheap — but not all three at the same time. Which two will you pick?
I posited in my previous post that the majority of Form 1116’s filed using the H&R Block software are wrong because users don’t realize that it asks them to calculate adjustments manually outside the software, and they don’t see the option to bypass manual adjustments when it’s hidden in the Forms mode. How well does OLT do?
A Four-Way Test
I made up a simple test case:
John, single, earned $50,000 as an independent contractor. He received $5,000 in dividends from an international stock fund, 100% of which was foreign-source income. $4,000 out of the $5,000 was qualified dividends. The fund reported $500 in foreign taxes paid. John had no other income or deductions.
I ran this in four different software packages:
- TurboTax Deluxe (download version)
- H&R Block Premium (download version)
- FreeTaxUSA (online only)
- OLT (online only)
I took the default path in each software, i.e. how a typical user would use it. Here are the bottom-line results:
|Foreign Tax Credit|
Four software packages, three different answers. Don’t you love it?
Now, which answer is correct? Based on my limited understanding of how it should work, I say TurboTax and FreeTaxUSA did it correctly for this simple case, but it’s possible these two aren’t 100% correct either (see comment #5 from Steve). I don’t see FreeTaxUSA generating the necessary Schedule B to carry the excess credit to next year. H&R Block and OLT calculated the credit amount wrong. FreeTaxUSA will calculate the wrong credit amount when the user doesn’t qualify for the adjustment exception.
Tax software won’t always give the wrong answer. You’ll get 100% credit when there’s a wide gap between the foreign taxes paid and the maximum credit allowed. Even if the software calculates the maximum credit wrong, the error may not be large enough to affect your bottom-line number. The thing is, you never know when the faulty logic in the software affects the final number and when it doesn’t. Even if the final number happens to be correct, the Form 1116 you’re filing is still wrong because other numbers on that form are wrong.
Of the four tested, only TurboTax calculates the required adjustment to your foreign-source income when you don’t qualify for the adjustment exception. The other three all ask you to read the instructions and calculate the required adjustment manually outside the software. Because most users don’t realize this, they’ll misrepresent their income when they don’t adjust. Even if they realize they must adjust, it’s quite difficult to calculate the adjustment anyway, which is why H&R Block, FreeTaxUSA, and OLT wash their hands of it in the first place. They turn lazy programming into a user error —
“I said you might need to adjust the income. It’s not my fault that you didn’t.”
When you do qualify for the adjustment exception, as in the test case used here, H&R Block doesn’t make it easy to activate the exception in the interview. You have to know to look for that option in the Forms mode. H&R Block and OLT calculate incorrectly because they omit above-the-line deductions. FreeTaxUSA includes above-the-line deductions in the calculation but it doesn’t generate the necessary Schedule B for you to carry the excess credit to the following year.
When it comes to a complex tax form such as Form 1116, producing the correct numbers should be the top priority. Fast and cheap isn’t the right approach when it’s difficult to verify whether the results are correct. Although TurboTax isn’t necessarily 100% correct and it was late in supporting Form 1116 and the new Schedule B, it was worth the wait.
If you’re stuck with filing Form 1116 for the foreign tax credit, use TurboTax. It doesn’t do everything correctly but other software packages within a consumer’s budget aren’t any better. Here’s a walkthrough of how to use it: How to Enter Foreign Tax Credit Form 1116 in TurboTax.
I’m so glad to get out of this though, for reasons I mentioned in the previous post Too Much Hassle in Claiming Foreign Tax Credit on IRS Form 1116. Even with TurboTax, I have no interest in becoming an expert in Form 1116.
Say No To Management Fees
If you are paying an advisor a percentage of your assets, you are paying 5-10x too much. Learn how to find an independent advisor, pay for advice, and only the advice.
Drake Professional software calculates everything correctly.
Harry Sit says
Do you mean Drake gives the same result as TurboTax and FreeTaxUSA for this test case?
Drake does NOT automatically calculate the adjustment for qualified dividends.
Can you please clarify when an adjustment to income is required and how it’s calculated? Turbotax’s suggested adjusted income is way higher than my income in 2021. Should I adjust it to equate my AGI? Thank you for your help!!
Harry Sit says
Which line(s) on Form 1116 are you referring to? If you’re talking about Line 3e, it’s a gross income. It’s normal when it’s higher than your AGI.
The adjustments and adjustment exception I mentioned in this post are to Line 1a (gross foreign-source income) and Line 18 (total taxable income) on Form 1116. The adjustments are required when you’re in the 32% tax bracket or above or when your total foreign qualified dividends and capital gains distributions exceed $20k. The adjustments to those two lines will reduce both numbers.
Thank you Harry! I was referring to line 3dA (Calculated gross income from all sources). I don’t know how TT calculated it, but it’s way higher than the income I had in 2021!
My line 1a amount was also adjusted down significantly. My foreign long term capital gain was higher than $20K. It’s about $170K, but was adjusted down to $70K for line 1a. Why do you think that is? When I change it from long term capital gain to ordinary income (was just trying different things out), it didn’t adjust much down at all.
Harry Sit says
Your 3dA is actually 3eA. Items A and B in that small worksheet feed into the line below, 3e, not the line above. You’ll see a list of line items if you right-click on that item A and click on Data Source. It’s a gross income, before any above-the-line deductions. It’s normal when it’s higher than your AGI. The adjustment procedures for Line 1a and Line 18 are in Form 1116 instructions if you really want to know. Be glad TurboTax is doing all this work for you. It isn’t fun if you must do it yourself with other software.
This was my first year dealing with Form 1116, and it was annoying. You inspired me to TLH a portion of my taxable international funds and move them into my non-taxable accounts. Hopefully, I won’t have to deal with Form 1116 for the foreseeable future.
Eric B says
I did exactly that and am happy with the result. I had to file 1116 once (or maybe twice), but then reduced my international holdings in taxable to the point where I’ve been consistently under the threshold for the past 3 years.
“Even with TurboTax, I have no interest in becoming an expert in Form 1116.” Based on this excellent post, it sort of seems like, in the process of explaining to us why it’s not worth becoming an expert, you became an expert. Time to reverse those trades you did 😉
Harry Sit says
There’s a saying “The more you know, the more you realize you don’t know.” I reached the point of realizing how much I don’t know and don’t want to know about Form 1116.
Jon: I agree with you. Harry needs to get those foreign tax-paying investments back in his taxable account. He can’t give Form 1116 intricacies up. We foreign tax credit filers need him.
Harry, thanks for the post. I used your test case in TT and HRBlock. With regard to Block, I see that Block adjusted line 18 by default, which is incorrect unless line 1 income is also adjusted. When I manually check the “do not adust line 18 checkbox” on Block, I see that the difference between Block foreign tax credit ($381) and TT foreign tax credit ($349) is that Block software does not have a $3533 deduction for SE tax on Line 3b, and TT software includes it.
Form 1116 instructions for lines 3a and 3b say: . “Enter on lines
3a and 3b any deductions (other than
interest expense) that:
• Aren’t shown on line 2, and
• Aren’t definitely related to your U.S.
Isn’t the $3533 SE tax deduction/adjustment “definitely related to John’s US source income”? If so, it should not be deducted on line 3b. Do you know of authority for including the SE tax adjustment from self-employment in the US as a line 3b entry? Looks like Block and TT disagree on the matter.
Another point for both Block and TT is that for foreign taxes reported on Form 1099, neither one enters “1099 taxes” on line 8(l) by default. You have to make that entry happen by checkbox or manual entry.
Harry Sit says
I have no idea what’s definitely related and what’s not. Instead of the SE tax, try an HSA contribution. It’s possible that TurboTax isn’t correct either. It gives one more reason just to avoid this form altogether.
Another part of Form 1116 instructions says: “Enter on line 3b any other deductions that don’t definitely relate to any specific type of income (for example, the deduction for alimony paid from Schedule 1 (Form 1040), line 19a)”. So HSA contribution looks like the same “non definitely related to income” type item as alimony, as does student loan interest.
Since line 3b entries effectively reduce the allowed foreign tax credit, anyone who entered SE tax deduction on Form 1116 3b in the past could file amended tax returns to get refunds of their omitted foreign tax credit.
My conclusion is that if you prepare Form 1116, you cannot depend on either Block or TT software to default to the right answer – you must read and try to understand the 1116 instructions and manually modify entries on the forms.
The suggestion about amending past returns was made in jest.
Harry Sit says
Form 1116 instructions are full of rabbit holes like this. Here’s another one:
“If the law of a U.S. state to which you pay income taxes doesn’t specifically exempt foreign source income from tax, you may be required to make a special allocation of state taxes you paid. See Pub. 514 for more information.”
I don’t see any software really doing this.
Harry Sit says
I figured out how to back out above-the-line deductions related to U.S. income from line 3b via the interview. Suppose you have both 1/2 SE tax and HSA deductions and your SE income is 100% U.S. By default, TurboTax includes all above-the-line deductions in line 3b. Now, you enter a negative value for the SE tax deduction when it asks about “Other Deductions Not Definitely Related.” This will back out the SE tax and leave only the HSA deductions on line 3b.
Using DIY tax software to complete Form 1116 lines 2 and 3:
As long as you understand (1) the meaning of “expenses definitely related to” your foreign income (Line 2), the meaning of “pro-rata share of deductions NOT definitely related” (Line 3), (2) how the IRS intends those items to be used to calculate allowable foreign tax credit, (3) what assumptions your tax software makes for those entries, and (4) how to adjust those entries if needed, you will be able to properly complete lines 2 and 3 of Form 1116. Easy, eh?
If you have qualified dividend or capital gain income, Form 1116 lines 1a and 18 have even more complexity – which DIY tax software does not eliminate.
I hope Congress ups the $300/$600 limit so I can avoid filing Form 1116.
1. Interesting about allocating state income taxes. I read Pub 514 about this. Not clear to me whether you need to to make this allocation only if you itemize, or even if you take standard deduction. Since the pub does not say ‘only if you itemize’, it looks like we are supposed to do this even if we take the standard deduction. Ooops.
2. Pub 514 defines the term “definitely related”. I conclude SE tax deduction should not go on Line 3b. I don’t have SE income, but looks like IRS owes you some money…… If you do prepare amended returns, be sure to handle that state income tax allocation properly…..
Re allocating/deducting state income taxes: Further reading indicates that a taxpayer would allocate/deduct state income taxes on foreign tax income only when state income taxes are deducted from gross income on the return. If the return had the standard deduction and state income taxes were not otherwise deducted, then no allocation of state income taxes for foreign income would be required.
IRS has a training practice dealing with Form 1116 allocations and deductions. Search: IRS INT-P-230 Allocation and apportionment of deductions
Laws affecting foreign tax credit are complex because provisions come from over 10 different sections of Internal Revenue Code and 4 Treasury regulations. Most provisions apply to both individual taxpayers and businesses.
Harry Sit says
I did another test with itemized deductions ($30k state tax, $50k charity donations). TurboTax put $10k (SALT cap) on line 3a. H&R Block did nothing. TurboTax at least is going in the right direction by doing something with the state tax.
Hard to decipher the Pub. 514 language about special allocations for state taxes. Form 1116 has become so complex that widespread, accidental misreporting is inevitable. Maybe the software vendors will catch up eventually. Until then, people will muddle through and try to get it close enough.
George K says
Don’t give Turbotax too high marks yet. It still handles carryforward incorrectly, or at least deceptively. In this example, the carry generated in the current tax year 2021 is 5000 – 349 = $4,651. Turbotax will automatically carry that amount forward to 2022. But that is wrong. It must first be carried back to 2020, and whatever portion can be utilized in 2020 must be subtracted off the amount carried forward to 2022. You don’t get to choose whether or not to carry it back — you must carry it back before carrying it forward.
George K says
Oops, sorry, the carry generated in 2021 is 500 – 349 = $151. Comment unchanged otherwise.
I agree with you about first carrying back a year then carrying forward. From what I have read, if in the carryback year your tax return did not have a Form 1116 (perhaps the amount of foreign tax in that tax year did not require Form 1116 to be filed), then the credit could be carried forward to the next return having a Form 1116. There is a rule that carryback/carryforward must be done on a return having a Form 1116.
What a giant mess. I am a CPA and even so I won’t be wasting my time with this over trivial amounts.
If the IRS wants to correct it they can do it.
Just a comment for those who move foreign investments into pretax or Roth accounts: It is easier from a tax perspective, sure, but at the cost of roughly the amount of tax withheld.
If you get a foreign dividend of $100, $15 is withheld and you only receive $85. By filing Form 1116 you will get some or all of that $15 (as a credit used to pay your taxes). If you do not file Form 1116, you are only getting the $85.
It may be worth it to abandon the foreign tax withheld, but just recognize the X% dividend is really only around 85% of X%. If you have $1,500 in foreign tax withholding in total, you are giving away that $1,500 to avoid filing a tax form.
Harry Sit says
It’s true you’ll lose the taxes paid to the foreign governments but it isn’t the only factor. The previous post linked in the opening paragraph goes into other factors that compensate for the loss. It’s more or less a wash in the end in the grand scheme and it can even be a net gain for some people to move the international stock funds to their IRA.
The proposed FY 2023 federal budget has the following about foreign tax credit, which, if enacted, could reduce need for filing Form 1116:
“The proposal would increase the threshold for the foreign tax credit limitation exception to $600 ($1,200 in the case of a joint return) and would index this threshold to inflation. The proposal would be effective for foreign income taxes paid or accrued in taxable years beginning after December 31, 2022.”
From Page 92, General Explanations of the Administration’s Fiscal Year 2023 Revenue Proposals
Ana C. Gutierrez says
Hi Harry, from reading the instructions for Form 1116, I understand that I also have to file Schedule C (Form 1116) as I accrue foreign taxes and exchange rates changed between the accrual and the payment. My understanding is that I have to file it even if the re-determination will not change my FTC. Is that correct? I’ve used H&R Block for years, but as you mention, they think that it’s okay to take away electronic filing because of these schedules. Any thought on what software supports schedule C?
Thank you very much.
Harry Sit says
Sorry, I’m not familiar with Form 1116’s Schedule C.
TurboTax Deluxe 2021 has Schedule B, Form 1116. It does not have Schedule C. A reply to a post about a week ago on TurboTax community forum discussing Form 1116 redetermination and Schedule C said to download the schedule from the IRS, attach it to the return, and mail in the return.
If TurboTax and Block do not support efiling returns with that schedule, I doubt you will find any other do-it-yourself tax software that will handle it.
My experience this year with both Block and TT is that neither one prepares Form 1116 correctly unless you manually make some entries on the form view, not just depend on replying to questions asked by the software.
I ran one return through both programs and got two different results – both in tax liability and in the forms to be filed. After some research, I believe Block got the tax right and Turbotax got the forms right.
Overriding the mistake in Turbotax did not flow through to the liability unless I also overrode several subsequent fields. In Block I could just print the needed forms, already completed by the program, and include them. And manually prepare Schedule B.
What a mess.