STUDENT COURSEBOOK

For Use in Preparing Tax Year 2002 Returns

Department of the Treasury

Internal Revenue Service

Publication 678IN (Rev. 2002) IRSCatalog Number 10433V www.irs.gov

IRS VOLUNTEERS

INTERNATIONAL ISSUES

FOR USE IN IRS VOLUNTEER PROGRAMS

VITA Volunteer Income Tax Assistance

TCE Tax Counseling for the Elderly






Lesson 1. Introduction to International Issues . . . . . . . . . . 1

Lesson 2. Filing Status Issues . . . . . . . . . . . . . . . . . . . . . . . 7

Lesson 3. Exemptions for Foreign

Spouse or Dependent . . . . . . . . . . . . . . . . . . . . . 11

Lesson 4. Taxpayer Identification Numbers and 

Other Entity Issues . . . . . . . . . . . . . . . . . . . . . . . . 17

Lesson 5. Foreign Earned Income Exclusion . . . . . . . . . . . 21

Lesson 6. Foreign Tax Credit . . . . . . . . . . . . . . . . . . . . . . . . . 41

Lesson 7. Self Employment Tax . . . . . . . . . . . . . . . . . . . . . . 81

Lesson 8. Travel Expenses . . . . . . . . . . . . . . . . . . . . . . . . . . 91

Lesson 9. Home Leave . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 107

Lesson 10. Rental Income and Expenses . . . . . . . . . . . . . . . 113

Table of Contents

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TABLE OF CONTENTS 








Table of Contents

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STUDENT NOTES






INTRODUCTION

Welcome to the world of international tax assistance! In this

supplement, you will learn about the issues that affect

Americans and U.S. resident aliens who live outside the United

States. This publication is designed specifically for VECTA volunteers assisting U.S. taxpayers living abroad.

OBJECTIVES

At the end of this lesson the student will be able to:

1. Define worldwide income.

2. Compute the U.S. dollar value of a foreign currency if given

an exchange rate table. 

3. Determine if average annual exchange rate figures can 

be used.

WORLDWIDE INCOME

U.S. citizens and U.S. resident aliens are required to file a U.S.

tax return based on their worldwide income. It has been a popular misconception that a person only has to file a U.S. tax

return if he or she has income from the United States, especially if he or she pays taxes to another country. While U.S. citizens and U.S. resident aliens living abroad can claim tax

benefits such as the foreign earned income exclusion and the

foreign tax credit (later lessons), they have the same filing

requirements as U.S. citizens living in the United States. This

applies whether their income is from within or outside the U.S.

Types of income, such as child support, which would not be

taxed in the U.S., are generally not taxed if from outside the

U.S. But, types of income which would be taxable if from within

the U.S. are also taxable if from outside the U.S.

You may wish to refer to the lists of taxable and nontaxable

income on the applicable pages of your Volunteer Assistor’s student text (Publication 678 Lesson 3) for types of taxable and

nontaxable income.

Lesson 1 1

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INTERNATIONAL ISSUES 








2 Lesson 1

, ,g ,

Texas, for XYZ Corporation. In September 2002, he transferred

to their office in Stuttgart, Germany. While in Germany, he

earned $30,000. His worldwide wages earned in 2002 would be

$70,000. Line 7 of his Form 1040 would show $70,000.

Exercise 1

Marta Brener lives in Mussbach, Germany. Her 2002 income

included $22,000 in wages earned in Germany. She earned

$3,000 in interest from her U.S. bank and $2,000 unemployment compensation from the state of Iowa. What is Marta’s

worldwide gross income?

Exercise 2

Mary Carlton lives in Belgium. Her 2002 income included

$10,000 in wages from her Belgian employer. She received

$2,000 interest from her U.S. bank, $8,000 in alimony payments and $8,000 in child support payments from her 

ex-spouse. What is her worldwide gross income?

Exercise 3

Would Marta Brener (Exercise 1) have to file a U.S. tax return

for 2002? Would Mary Carlton (Exercise 2) have to file a U.S.

tax return?

Exchange Rates

Another question that you will frequently be asked is “What

exchange rate do I use?” The exchange rates of foreign currencies to the U.S. tax dollar change on a daily basis. All

amounts on the U.S. tax return must be stated in U.S.

dollars. Since most taxpayers abroad receive some kind of

income in foreign currency, you will find situations when you

will need to convert foreign income into U.S. dollars in order to

put these income amounts on the return. Most countries have a

medium of currency compared to which the value of the dollar

is larger. Very few countries have mediums compared to which

the U.S. dollar is smaller. Exchange rates are stated in two

ways: the foreign currency to the U.S. dollar, and the dollar’s

value in the foreign currency.

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ggy 

To convert a sum of money into U.S. dollars, you would divide

the foreign currency by the exchange rate.

Example 2

If you received 3,000 Euros on a day that the exchange rate was

1.7115 Euros to $1 U.S., you would have $1,752.85 in equivalent

U.S. dollar value (3,000/1.7115 = 1,752.85). To convert a sum of

money into U.S. dollars when the currency unit is larger in

value, you can use the same process.

Example 3

Caryn received 200 Euros on a day that the exchange rate was

.5514 Euros to one U.S. dollar. In U.S. 

dollars, she would have $362.71 (200/.5514 = 362.71).

Exercise 4

Convert the following amounts to U.S. dollars.

a. 36,000 Euros (1.7115 exchange rate) ________

b. 800 Euros (.5514 exchange rate) ____________

When to Convert. Now that you have information on how 

to calculate exchange rates, we now need to discuss what

exchange rates to use. Actually, what exchange rate to use is

determined by the date of the transactions; that is the date on

the check or the date money is credited to the taxpayer’s

account. If the taxpayer has income which was received evenly

throughout the year, he or she can use the average annual

exchange rate if the foreign exchange rate was relatively stable

during the year. The average annual exchange rate is available

from IRS offices throughout the world generally starting

around January 15. 

IRS also distributes information to its worldwide offices concerning the quarterly exchange rates for various currencies.

Example 4

Edward Pasco worked in Dallas for Megacorp Incorporated

from January until September 2002. On September 29, he was

transferred to their Mexico City office where he will be working

for 3 years. While in the U.S., Edward earned his salary in U.S.

dollars. When he moved to Mexico, he was paid in Mexican

pesos. Since he did not receive his salary in foreign currency

throughout the year, he should not use the annual average

exchange rate. He should use the average rates for October,

November, and December.

Lesson 1 3

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4 Lesson 1

y, 

overseas IRS offices. The phone numbers of these offices are

listed in Publication 54. You may also contact banks who provide international currency exchange services. Since a taxpayer

“should use the rate that most nearly reflects the value of the

foreign currency” (Publication 54) at the time he or she receives

the income, the taxpayer may use an exchange rate that is different from the rates posted in our worldwide offices if he finds

it to be a truer representation.

Exercise 5

Deborah Vance lives and works in Manila, Philippines. In

2002, she had the following income: 16,000 Filipino pesos 

in wages, 1,200 Filipino pesos interest income and $500 in U.S.

interest from her U.S. bank. On June 7, 2002, she sold her car

and made a profit of 2,000 Philippine pesos (fully taxable capital gain). Since these items are fully taxable, what is the total

income to be reported on her U.S. tax return (in U.S. dollars)?

For this exercise assume that the 2002 average annual

exchange rate for the Philippine peso is 40.25 pesos to 1.00

U.S. dollar and the exchange rate for June 7, 2002 was 32.55

pesos to 1.00 U.S. dollar.

Wages ______________________________

Interest ____________________________

Capital Gain ________________________

Total 2002 Income ____________________

Sometimes, you may get questions on exchanging money when

there is “blocked income” or “soft currency”. Questions on these

issues should be referred to IRS. “Blocked income” refers to a

situation where a taxpayer cannot convert foreign currency to

U.S. dollars. This is generally due to local law or local government policy. There are special tax rules that exist when there is

blocked income which allows a person to choose to put off reporting part of their income. “Soft currency” refers to a situation

where a person can only convert back to U.S. dollars an amount

that equals what he brought into that country in U.S. dollars.

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Lesson 1 5

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 SUMMING UP THIS LESSON 

 U.S. citizens (and resident aliens) are taxed on worldwide

income and must file U.S. tax returns even if all the income

is from foreign sources.

 You have learned how to exchange foreign currency to U.S.

dollar equivalent values. 

 Exchange rates used should reflect the closest accurate

rate.




6 Lesson 1

1. $27,000

2. $20,000

3. Yes. Yes.

4. a. $21,034.18

b. $1,450.85

5. Wages 16,000.00 ÷ 40.25 = $397.52

Interest 1,200.00 ÷ 40.25 = $29.81 from Philippines plus

$500 interest from U.S. = $529.81

Capital Gain 2,000.00 ÷ 32.55 = $61.44

Total 2002 Income – $988.77

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INTERNATIONAL ISSUES ANSWERS TO EXERCISES










INTRODUCTION

Many areas of the tax return are directly tied to the filing status of the taxpayer. Therefore, it is extremely important to

have the correct status and to complete the tax return consistent with the filing status chosen. 

With these tax returns there are some interesting twists and

turns that are possible. It is important to have your reference

material handy when things get a little unusual to help you

complete the return accurately. The discussion below should

help. Remember: the rules discussed only apply to a taxpayer that is a U.S. citizen or resident alien.

OBJECTIVES

At the end of this lesson, you will be able to:

■ Determine the correct filing status for resident aliens.

■ Explain how to treat a nonresident spouse as a resident.

SINGLE

The normal rules apply. If the taxpayer is unmarried on

December 31 and does not qualify for another filing status then

the filing status is SINGLE.

MARRIED FILING SEPARATE

If married taxpayers do not choose to file joint or they are not

eligible for another, more favorable, filing status, then they

must file Married Filing Separately.

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FILING STATUS ISSUES 








8 Lesson 2

In order to file Married Filing Jointly, the taxpayers must be

married on the last day of the tax year and agree to file a joint

return. However, “A joint return generally cannot be made if

either spouse is a nonresident alien at any time during the tax

year” (Pub 17).

Nonresident Spouse Treated as a Resident

If, at the end of the tax year, the taxpayer is married and one

spouse is a U.S. citizen or a resident alien and the other spouse

is a nonresident alien, the taxpayer can elect to treat the nonresident spouse as a U.S. resident. This includes situations in

which one spouse is a nonresident alien at the beginning of the

tax year, but a resident alien at the end of the year, and the

other spouse is a nonresident alien at the end of the year.

If this choice is made, the taxpayer and spouse are

treated for income tax purposes as residents for the

entire tax year. For example, neither the taxpayer nor the

spouse can claim tax treaty benefits as a resident of a foreign

country for a tax year for which the choice is in effect.

Taxpayers must file a joint income tax return for the year the

choice is made, but the taxpayer and spouse can file joint or

separate returns in later years. 

Example 1

Debra Green, a U.S. citizen for all of tax year 2002, is married

to Charles, a nonresident alien. Debra and Charles make the

choice to treat Charles as a resident alien by attaching a statement to their joint return for 2002. Debra and Charles must

report their worldwide income in 2002 and later years unless

the choice is ended or suspended. Although they must file a

joint return for 2002, they can file joint or separate returns for

later years.

Example 2

Jim and Judy Adams are married and both are nonresident

aliens. In June 2002, Jim became a resident alien and

remained a resident for the rest of the year. Jim and Judy both

choose to be treated as resident aliens by attaching a statement

to the 2002 joint return. Jim and Judy must report their worldwide income in 2002 and later years unless the choice is ended

or suspended. They must file a joint return for 2002, but they

can file either joint or separate returns for later years.

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Attach a statement, signed by both spouses, to the joint return

for the first tax year for which the choice applies. It should contain the following:

1. A declaration that one spouse was a nonresident alien and

the other spouse a U.S. citizen or resident alien on the last

day of the tax year, and that the taxpayer and spouse chose

to be treated as U.S. residents for the entire tax year, and

2. The name, address, and social security number or ITIN of

each spouse. (If one spouse died, include the name and

address of the person making the choice for the deceased

spouse.)

The choice can also be made by filing a joint amended return.

Publication 54 contains specifics on this option.

Suspending the Choice

The choice to be treated as a resident alien does not apply to

any later tax year if neither spouse is a U.S. citizen or resident

alien at any time during the tax year.

Example 3

Dick Brown was a resident alien on December 31, 1999, and

married to Judy, a nonresident alien. They chose to treat Judy

as a resident alien and filed joint returns for tax years 1999

and 2000. On January 10, 2001, Dick became a nonresident

alien. Judy had remained a nonresident alien throughout the

period. Dick and Judy can file joint or separate returns for

2001. However, since neither Dick nor Judy is a resident alien

at any time during 2002, their choice is suspended for that

year. If either has U.S. source income or foreign source income

effectively connected with a U.S. trade or business in 2002,

they must file separate returns as nonresident aliens. If Dick

becomes a resident alien again in 2003, their choice is no longer

suspended.

Ending the Choice

Once made, the choice to be treated as a resident applies to all

later years unless suspended or ended in one of the ways

shown below. If the choice is ended for any of these reasons,

neither spouse can make a choice in any later tax year.

Lesson 2 9

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10 Lesson 2

HEAD OF HOUSEHOLD

In general, in order to claim Head of Household status, the

taxpayer must: 

1. Be unmarried or considered unmarried on the last day of the

year and 

2. Have paid more than half the cost of keeping up a home for

the year and 

3. Have a qualifying person in the home for more than half the

year.

The general rules are discussed in Publication 17 and should be

consulted often to determine if a taxpayer qualifies for this filing status.

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py y

● The revocation must be made by the due date for filing the tax

return for that year.

● The spouse who revokes must attach a signed statement declaring

that the choice is being revoked. If the spouse revoking the choice

does not have to file a return and does not file a claim for refund, 

send the statement to the Internal Revenue Service Center where

the last joint return was filed.

● The statement revoking the choice must include the following:

● The name, address, and social security number (or taxpayer

identification number) of each spouse.

● The name and address of any person who is revoking the choice

for a deceased spouse.

● A list of any states, foreign countries, and possessions that have

community property laws in which either spouse is domiciled or

where real property is located from which either spouse receives

income.

Death ● The death of either spouse ends the choice, beginning with the first

tax year following the year the spouse died.

● If the surviving spouse is a U.S. citizen or resident and is entitled to

the joint tax rates as a surviving spouse, the choice will not end until

the close of the last year for which these joint rates may be used.

● If both spouses die in the same tax year, the choice ends on the first

day after the close of the tax year in which the spouses died.

Divorce or ● A divorce or legal separation ends the choice as of the beginning of

Legal separation the tax year in which the legal separation occurs.

Inadequate ● The Internal Revenue Service can end the choice for any tax year

records that either spouse has failed to keep adequate books, records, and

other information necessary to determine the correct income tax

liability, or to provide adequate access to those records.






INTRODUCTION

In general, the rules that govern the claiming of exemptions

are the same for these returns as they are for other returns.

The special rules that can be applied will be discussed below.

Remember: in order to claim an exemption for someone,

all the rules must be met, and this needs to be communicated to the taxpayer.

PERSONAL EXEMPTIONS

Each taxpayer is allowed a personal exemption (unless the

taxpayer is claimed by someone else). On a Married Filing

Separate return a spouse’s personal exemption may be claimed

by the taxpayer if the spouse had no gross income and is not

claimed by anyone else. Remember: a spouse is never the

dependent of the taxpayer. 

DEPENDENTS

The five dependency tests are essentially the same for taxpayers living overseas.

Citizenship Test. To meet this test a person must be a U.S.

citizen or national, or a resident of the U.S., Canada or Mexico

for some part of the tax year. If a U.S. citizen marries a nonresident alien, any child born to them may be entitled to U.S. citizenship. In most instances the U.S. parent will register the

child with the U.S. Embassy or Consulate closest to where they

live. If the child may claim U.S. citizenship, the child meets the

citizenship test for dependency purposes, even though the family is living in a foreign country. Proof of citizenship is not

required to be atttached to the return. But if the item is questioned by the IRS, the U.S. citizen parent will have to obtain

the necessary documentation from the U.S. government.

Example 1

Betty Glinn, a U.S. citizen, is married to Giovanni Glinn, an

Italian citizen. They are currently living in Rome. Their daughter, Patricia, meets the citizenship test for dependency since

she is entitled to U.S. citizenship because of her U.S. parent.

Lesson 3 11

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SPOUSE OR DEPENDENT 








12 Lesson 3

p

stances, the adopted child can meet the citizenship test if he or

she lives with the U.S. citizen parent for the entire tax year

(except for temporary absences).

ALIEN STATUS

Throughout this course material, we refer to U.S. citizens or

resident aliens. In order to apply the tax law correctly, you

need to determine alien status.

The first issue that must be decided is whether the taxpayer is

a nonresident alien. If he/she is a nonresident alien then the

taxpayer must be referred to get specialized help. Your training

covers only the tax law as it applies to a citizen or a resident

alien so this determination is very important. Remember that

we are discussing taxes here. A resident for tax purposes is not

necessarily a resident for immigration purposes.

The following is an excerpt from Publication 519 (U.S. Tax

Guide for Aliens). This section discusses the rules for determining alien status. These issues are complex. In this lesson, we

will use examples to review the differences between resident

and non-resident aliens.

Glance or read over the following material, especially the flow

chart, and get a feel for what is involved.

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1 If this is your first or last year of residency, you may have a dual status for the year. See the

discussion of Dual Status Aliens, in Publication 519. 2 In some circumstances you may still be considered a nonresident alien under an income tax

treaty between the U.S. and your country. Check the provisions of the treaty carefully.

3 Do not count the days you were unable to leave the United States because of a medical condition that arose while you were in the United States.

4 If you meet the substantial presence test for 2003, you may be able to choose treatment as a

U.S. resident alien for part of 2002. For details see Substantial Presence Test under Resident

Aliens, and First-year choice under Dual-Status Aliens, in Publication 519.

NONRESIDENT ALIENS

If the taxpayer is an alien (not a U.S. citizen), he or she is considered a nonresident alien unless he or she meets one of the

two tests described next under Resident Aliens.

RESIDENT ALIENS

This section describes the two tests taxpayers must use to

determine if they are resident aliens of the United States. 

A taxpayer is a resident alien of the United States for tax purposes if he or she meets either the green card test or the substantial presence test for the calendar year (January

1-December 31). 

Start here to determine your status for 2002

Were you physically present in the United States on at least 31

days during 2002?

Were you a lawful permanent resident of the United States (had a 

“green card”) at any time during 2002?

Were you physically present in the United States on at least 183

days during the 3-year period consisting of 2000, 2001, and 

2002, counting all days of presence in 2002, 1/3 the days of

presence in 2001, and 1/6 the days of presence in 2000?3

Were you physically present in the United States on at least 183

days during 2002?

Can you show that for 2002 you have a tax home in a foreign 

country and have a closer connection to that country than to the 

United States?

You are a

resident alien

for U.S. tax 

purposes.1,2

You are a

nonresident

alien for U.S.

tax purposes.

No

No

No4

No

Yes

Yes

Yes

Yes

Yes

No

Lesson 3 13

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14 Lesson 3

You are a resident for tax purposes if you are a lawful permanent resident of the United States at any time during the calendar year. (However, see Dual Status, later.) This is known

as the “green card” test. You are a lawful permanent resident of

the United States at any time if you have been given the privilege, according to the immigration laws, of residing permanently in the United States as an immigrant. You generally

have this status if the Immigration and Naturalization Service

(INS) has issued you an alien registration card, also known as

a “green card.” You continue to have resident status under this

test unless it is taken away from you or is administratively or

judicially determined to have been abandoned.

Substantial Presence Test

You will be considered a U.S. resident for tax purposes if you

meet the substantial presence test for the calendar year. To

meet this test, you must be physically present in the United

States on at least:

1. 31 days during the current year, and

2. 183 days during the 3-year period that includes the current

year and the two years immediately before that, counting:

a. All the days you were present in the current year (2002)

and

b. 1/3 of the days you were present in the first year before

the current year (2001) and

c. 1/6 of the days you were present in the second year

before the current year (2000).

Example 2

You were physically present in the United States on 120 days

in each of the years 2000, 2001, and 2002. To determine if you

meet the substantial presence test for 2002, count the full 120

days of presence in 2002, 40 days in 2001 (1/3 of 120), and 20

days in 2000 (1/6 of 120). Since the total for the 3-year period is

180 days, you are not considered a resident under the substantial presence test for 2002.

The term United States includes the following:

1. All 50 states and the District of Columbia

2. The territorial waters of the United States, and

3. The seabed and subsoil of those submarine areas that are

adjacent to the U.S. territorial waters and over which the

United States has exclusive rights under international law

to explore and exploit natural resources.

The term does not include U.S. possessions and territories or

U.S. air space.

Pub678IN-Lesson 3 10/25/02 Turn 3 Page 14






You are treated as present in the United States on any day if

you are physically present in the country at any time during

the day. However, there are exceptions to this rule. Do not

count the following as days of presence in the United States for

the substantial presence test:

1. Days you regularly commute to work in the United States

from a residence in Canada or Mexico.

2. Days you are in the United States for less than 24 hours

when you are in transit between two places outside the

United States.

3. Days you were unable to leave the United States because of

a medical condition that developed while you were in the

United States.

4. Days you were an exempt individual.

Regular commuters from Canada or Mexico. Do not count

the days on which you regularly commute to work in the

United States from your residence in Canada or Mexico. You

are considered to commute regularly if you commute to work in

the United States on more than 75 percent of the workdays

during your working period.

For this purpose, commute means to travel to work and return

to your residence within a 24-hour period. Workdays are the

days on which you work in the United States or Canada or

Mexico. Working period means the period beginning with the

first day in 2002 which you are physically present in the

United States to work. If your work requires you to be present

in the United States only on a seasonal or cyclical basis, your

working period begins on the first day of the season or cycle on

which you are present in the United States to work and ends

on the last day of the season or cycle on which you are in the

United States to work. Thus, you may have more than one

working period in 2002, and your working period may begin in

one calendar year and end in the following calendar year.

Exempt individual. For the substantial presence test, do not

count days for which you are an exempt individual. The term

“exempt individual” does not refer to someone exempt from

U.S. tax, but to anyone in the following categories.

1. An individual temporarily present in the United States as a

foreign government-related individual.

2. A teacher or trainee, temporarily present in the United

States under a “J” or “Q” visa, who substantially complies

with the requirements of the visa.

Lesson 3 15

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16 Lesson 3

,,,Q, y p

the requirements of the visa.

4. A professional athlete temporarily in the United States to

compete in a charitable sports event.

After reviewing the rules above, if there are still questions,

refer the taxpayer to Publication 519 or to the IRS Information

line for alien status determination.

DUAL STATUS

In general, for the first and last year of resident alien status the

taxpayer will be considered a “dual status” alien (both resident

and nonresident) and special rules apply. Generally, dual status

aliens should be referred to the IRS or paid tax professional.

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 SUMMING UP THIS LESSON 

Remembering that a resident alien is treated the same 

as a citizen for tax purposes, here are the main issues:

1. Does the taxpayer have a “green card”? If so, then the taxpayer will be considered a resident alien.

2. Has the taxpayer been here long enough to qualify for the

substantial presence test? If so, then the taxpayer is considered a resident alien on a year by year basis (this applies

even though the person may be considered “illegal”).

3. Remember that certain people are “exempt individuals” and

do not count days toward the substantial presence test.






INTRODUCTION

Every U.S. Federal tax return that is filed, must have each person identified by a number. Each person refers to the taxpayer,

the taxpayer’s spouse if the taxpayer is married, and any

dependent claimed on the return. The identifying number will

be a social security number for those persons who qualify to be

issued one. All others must have an individual taxpayer identification number (ITIN). 

INDIVIDUAL TAXPAYER IDENTIFICATION

NUMBERS (ITIN’S)

Beginning in July 1996, foreign taxpayers who were unable to

get a social security number were able to apply for a tax return

processing number called an ITIN. These taxpayers were

unable to get an SSN because they were either not legally

admitted into the United States or, some other social security

regulation prevented the issuing of an SSN. This ITIN functions the same as a social security number as it regards the filing and processing of a tax return. It has no bearing on the

alien’s legal status or permission to work. An ITIN can be

received by the taxpayer, spouse, and dependents because all

have to be identified with a “number” on a tax return. While

the ITIN is valid for processing and exemptions, it is not

valid for Earned Income Credit. Only taxpayers with

valid SSN’s can claim EIC.

Lesson 4 17

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NUMBERS AND OTHER

ENTITY ISSUES 








18 Lesson 4

ppg

status, and 2) Personal/true identity (see Form W-7 and

Instructions at the end of this lesson). The Form W-7 and original documentation, certified copies from the issuing agency or

custodian of the original document, or approved notarized

copies (see Form W-7 Instructions) must be presented and validated at an IRS walk-in office (for those in the U.S.) or mailed

to the Philadelphia Service Center for validation. Once validated, the number will be issued in four to six weeks. If a person cannot get an SSN and is required to file a return or

files a return to claim a refund, he/she must obtain an

ITIN to file.

Note: An individual who is not close to an IRS office can contact the IRS Internet site to locate acceptance agents. An acceptance agent is an individual or entity, such as a university,

bank, or accounting firm, who has entered into a formal agreement with the IRS that permits the agent to assist applicants

in obtaining ITINs. The agent reviews the applicant’s documentation and forwards the completed application (Form W-7) and

required documentation to IRS for processing. These agents are

located in both the U.S. and outside the U.S. The countries

listed include Canada, Germany, Japan and Venezuela. Other

individuals outside the U.S. may contact a U.S. Embassy to

have their documents inspected. This process allows them to

send for the ITIN without the possibility of losing their original 

documents. The Internet site is: http://www.irs.gov

SSN’S, ITIN’S AND FILING

The following is a discussion on the use and necessity of these

numbers when filing these returns.

The Taxpayer

Each taxpayer is required to have his/her own SSN or ITIN

and to file the tax forms with this number in the appropriate

places. With citizens or legal resident aliens who are able to get

an SSN, this should not be a problem. They will tell or show

you their SSN. Use the information they give you and file the

return.

Note: Canadians have a number like a Social Security Number,

but it’s for their old age pension. Do not use this number on a

U.S. tax return. Canadians often have both a U.S. and Canadian Social Security Number.

If the taxpayer does not have either a valid SSN or ITIN direct

them to either Form SS-5 for an SSN (if they are eligible), or a

W-7 for an ITIN. Explain to him/her that they must have a

number before you can file the return.

Pub678IN-Lesson 4 10/25/02 Turn 3 Page 18






If the spouse is a citizen or legal resident alien able to get an

SSN, use the SSN you’re given and file the return.

If the taxpayer elects to file a married filing joint return

with the nonresident alien spouse, then the spouse needs an

ITIN.

Dependents

The tax forms require that an SSN or ITIN be listed for each

dependent. For citizen or resident alien dependents, SSN’s

should be obtained from the Social Security Administration

(SSA) and used. If the SSA will not issue an SSN for the dependent, have the taxpayer file for an ITIN for the dependent. If

the dependent has not received the SSN or ITIN by filing time,

file an extension until one is obtained. 

Lesson 4 19

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20 Lesson 4

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STUDENT NOTES






INTRODUCTION

Section 61 of the Internal Revenue Code states that all income

is taxable unless some other section of the Code specifically

exempts it. In this lesson, we will discuss the foreign earned

income exclusion which is provided in Section 911 of the Code.

It was enacted by Congress to give an incentive to Americans

working overseas. By claiming this benefit, American taxpayers

overseas may exclude up to $80,000 of earned income in 2002.

Obviously, the taxpayers you assist are very interested in this

provision of the law because it can reduce the taxpayer’s taxable income substantially. As a volunteer, your responsibility

will be to inform the taxpayer about the exclusion and help the

taxpayer to claim the exclusion on the return.

OBJECTIVES

At the end of this lesson you will be able to:

1. Determine whether the taxpayer qualifies for the foreign 

earned income exclusion.

2. Calculate the foreign earned income exclusion on Form 2555

or Form 2555 EZ.

CHOOSING THE EXCLUSION

The foreign earned income exclusion is voluntary. The initial

choice of the exclusion on Form 2555 or Form 2555 EZ must be

filed with a timely filed return (including any extensions), a

return amending a timely filed return, or a late filed return

(determined without regard to any extensions) filed within one

year from the original due date of the return. Regulations provide that the initial choice can be made after the above time

limits if the tax return shows no income tax after taking into

account the exclusion. The initial choice may also be made after

the above time limits even if tax will be due provided that the

tax return is filed prior to the Internal Revenue Service discovering the taxpayer failed to make the election. To take advantage of these new time limits the top of Form 1040 should be

noted “Filed Pursuant to Section 1.911–7(a)(2)(i)(D).” The

choice is made by attaching Form 2555 or Form 2555 EZ to the

individual’s tax return for the year.

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EXCLUSION 








22 Lesson 5

yy

unless the taxpayer revokes it.

REVOCATION

The taxpayer may revoke the choice for any tax year. The revocation is accomplished by attaching a statement to the return

or amended return for the first year the taxpayer no longer

wishes to claim the exclusion. The statement must indicate

that the exclusion is being revoked, and what years are being

revoked. A 1990 revenue ruling holds that a person who has

elected the exclusion but who in a subsequent year chooses to

claim a foreign tax credit on qualifying earned income is considered to have revoked his election.

When an exclusion is revoked, the taxpayer may not claim the

exclusion again for the next 5 tax years without the approval of

the IRS.

REQUIREMENTS

It would be very easy to figure the exclusion if all income a person earned overseas were exempt from tax. But that is not the

case. There are various requirements that must be met. When

assisting taxpayers in foreign countries, you will find that

many of them have a misconception that all their income is

exempt, and as a result, they do not need to file. So, for those

taxpayers, the most important requirement that you will

explain to them is the requirement to file a tax return.

There are two requirements to qualify for the foreign earned

income exclusion. First, the taxpayer must show that his or her

tax home is in a foreign country. The second requirement is

that the taxpayer meet either the bona fide residence test or

the physical presence test.

The requirements are applied separately to each individual. If

a husband and wife are each working overseas, each must meet

both requirements. If they do so, each is entitled to an exclusion of up to $80,000.

Tax Home. To claim the foreign earned income exclusion, the

taxpayer’s tax home must be in a foreign country. Generally,

one’s tax home is the general area of the taxpayer’s main place

of business, employment, or post of duty, regardless of where

the taxpayer maintains his or her family home.

If the taxpayer does not have a regular or main place of business because of the nature of the work, then the tax home is

the place where the taxpayer regularly lives.

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py, , g

On the other hand, when the taxpayer is assigned overseas on

business for an indefinite period, the tax home is overseas and

the taxpayer may be eligible for the foreign earned income

exclusion. Often, the difference between temporary and indefinite is the duration of the stay.

Effective for 1993 and later years the law provides that the taxpayer will not be treated as temporarily away from home if the

employment away from home exceeds one year. Therefore the

person will generally be considered to have a tax home in a foreign country if the employment in the foreign country will be

for more than one year. However for purposes of the foreign

earned income exclusion a person will not be considered to have

a tax home in a foreign country for any time during which his

abode is in the United States.

Three questions are important in showing whether or not a

U.S. home is the regular place of abode. The questions that you

should ask the taxpayer are:

1. Did you use your home in the United States as a residence 

while you worked at your job in the United States just 

before going abroad to your new job, and did you continue to

maintain work contacts, job seeking, leave of absence, ongoing business, etc.) in that area in the United States during the time you worked abroad?

2. Are your living expenses duplicated at the U.S. and foreign 

home because your work requires you to be away from your 

U.S. home?

3. Do you have a family member or members continuing to live

at your U.S. home, or do you frequently use your U.S. home

for lodging during the period you work abroad?

If the taxpayer cannot answer “yes” to at least two of these

three questions, the taxpayer will be considered indefinitely

assigned to the new location abroad. Thus, since the tax home

is abroad, no expenses for travel, meals, or lodging while there

are deductible. However, one may be able to exclude earnings

from income under the foreign earned income exclusion rules.

If he/she realistically expects the job to last, and it does last,

less than 1 year and that he/she will return to the U.S. home,

and can answer “yes” to all three questions, the taxpayer is

considered temporarily away from home. The taxpayer does not

qualify for the foreign earned income exclusion, but may qualify to deduct away-from-home expenses.

Lesson 5 23

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24 Lesson 5

pj

home, the location of the tax home depends on all the facts and

circumstances.

Period of Stay. Another qualification for the exclusion is the

length of time the taxpayer stays overseas. This requirement

can be satisfied in one of two ways. The taxpayer must be:

1. A U.S. citizen or resident alien from a tax treaty country 

who is a bona fide resident of a foreign country or

countries for an uninterrupted period that includes an 

entire tax year, or

2. A U.S. citizen or a U.S. resident alien who is physically

present in a foreign country or countries for at least 330 

full days during any period of 12 consecutive months.

Bona Fide Residence Test. In order to qualify for this test,

the taxpayer must be a U.S. citizen, or a resident alien from a

treaty country. A revenue ruling permits U.S. resident aliens

who are residents of countries that have tax treaties with the

U.S. to qualify for the bona fide residence test. This is because

those treaties contain nondiscrimination clauses. Resident

aliens from nontreaty countries cannot claim the bona fide residence test.

To meet the test, the taxpayer must show that he or she has set

up permanent quarters in the foreign country. If the tax return

is selected to be examined by the IRS, the taxpayer should be

prepared to verify the facts that establish whether the bona

fide residence test has been satisfied. If the taxpayer has made

a statement to the authorities of the foreign country that he or

she is not a resident of that country and the officials hold that

the taxpayer is not subject to their tax as a resident the taxpayer does not qualify as a bona fide resident.

Bona fide residence must be for an uninterrupted period that

includes an entire tax year. An entire tax year is from January

1 through December 31 for taxpayers who file their income tax

returns on a calendar year basis.

Taking a brief trip to the U.S. will not prevent the taxpayer

from being a bona fide resident, as long as the intention is clear

to return to the foreign country of residence, without unreasonable delay.

Bona Fide Residence For Part of the Year. Once the taxpayer has established bona fide residence in a foreign country

for an uninterrupted period that includes a complete tax year,

the taxpayer will qualify as a bona fide resident for the period

starting with the date the taxpayer actually began the

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g, qy 

resident for part of a tax year.

Example 1

Sarah Burns moved to Thailand on March 1, 2000. She lived

there until September 14, 2002. On September 15, 2002 she

moved back to the United States. Since she was a bona fide resident of a foreign country for the entire year of 2001, she qualified as a bona fide resident from March 1, 2000 through

September 14, 2002. She may claim the exclusion in 2000 and

2002 as well as 2001.

Physical Presence Test. The other test that may be met

instead of the bona fide residence test is the physical presence

test. In this test, intention of stay is not a factor. To qualify, the

taxpayer must be physically present in a foreign country 330

full days during a period of 12 consecutive months. The 12-

month period may begin with any day of the calendar month. It

ends the day before the same calendar day 12 months later.

In order for a day to count for the test, it must be a full day in

a foreign country. When arriving from the U.S., or returning to

the U.S., any day in which part of the time is spent in the U.S.

or over international waters does not count as a qualifying day

in a foreign country.

The taxpayer may move about from one place to another in a

foreign country, or to another foreign country without losing

full days. But if any part of the taxpayer’s travel is not within a

foreign country or countries and takes 24 hours or more, the

taxpayer will lose full days.

Example 2

The taxpayer leaves Southhampton, England, by ship at 10:00

p.m. on July 6 and arrives in Lisbon at 6:00 a.m. on July 8.

Since the trip takes more than 24 hours, the taxpayer loses as

full days, July 6, 7, and 8. If the taxpayer remains in Lisbon,

the first full day is July 9.

If the taxpayer is in transit between two points outside the

United States and is physically present in the United States for

less than 24 hours, the taxpayer is not treated as present in the

United States during the transit, but is treated as traveling

over areas not within any foreign country.

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26 Lesson 5

gg, p

February 12. He arrives in Miami at 3:00 pm to change planes.

He leaves for Toronto at 7:00 pm and arrives at 10:00 pm. He

has not lost a day because he was in transit between two points

outside the U.S., and was present in the U.S. only four hours.

Figuring the 12 Month Period. Any 12-month period may be

used if the 330 days in a foreign country fall within that period.

If necessary, more than one period may be used, including periods that overlap. By using more than one period, it may be possible to meet the physical presence test for an entire stay, even

though there may have been intervening visits to the U.S.

WAIVER OF TIME REQUIREMENTS

Both the bona fide residence test and the physical presence test

contain minimum time requirements that one must meet before

one qualifies under that test. The bona fide residence test

requires residence in a foreign country or countries for an uninterrupted period that includes an entire tax year (January 1–

December 31 for calendar year taxpayers). The physical presence test requires presence in a foreign country or countries for

330 days during a period of 12 consecutive months.

The minimum time requirements may be waived, however, if

forced to leave a foreign country because of war, civil unrest, or

similar adverse conditions in that country. The taxpayer also

must be able to show that he/she reasonably could have

expected to meet the minimum time requirements if it had not

been for the adverse conditions. Before one can qualify for the

waiver, the person must actually have their tax home in the

foreign country and be a bona fide resident of, or be physically

present in, the foreign country.

U.S. TRAVEL RESTRICTIONS

There are U.S. federal travel restrictions that generally prohibit U.S. citizens and residents from traveling in certain countries. Time spent in these countries in violation of U.S. law will

not qualify for either the bona fide residence test or the physical presence test. Income earned from these sources does not

count as foreign earned income. Currently, the countries to

which travel restrictions apply are Cuba, Libya, and Iraq.

Pub678IN-Lesson 5 10/25/02 Turn 3 Page 26






Foreign Country. In order to qualify for the bona fide residence or physical presence test, a taxpayer must be a resident

of or present in a foreign country. “Foreign country” does not

include Puerto Rico, Guam, the Northern Mariana Islands, the

Virgin Islands, or U.S. possessions such as American Samoa,

Wake Island, the Midway Islands and Johnston Island.

Earned Income. To qualify for the exclusion, income must be

earned income. Examples of earned income are salaries, wages,

commissions, and professional fees. Income from a sole proprietorship or partnership may or may not be earned income,

depending on whether the income was produced by personal

services or capital investment. In these situations, the taxpayer

may need to refer to the IRS or professional assistance.

Earned income is not dividends, interest, capital gains,

alimony, social security benefits, pensions, or annuities.

Payments made by the U.S. government to its employees do not

qualify for the exclusion. Included as part of the government

are such activities as post exchanges, commissaries, and officers clubs. However, amounts paid by the United States or its

agencies to persons who are not their employees may qualify as

foreign earned income for purposes of the exclusion.

Earned income includes all compensation for services rendered.

Allowances for housing, cost-of-living, education, home leave,

moving and similar items are included in earned income.

Source of earned income. The source of earned income is the

place where the services are performed. To qualify for the

exclusion, services must be performed in a foreign country.

Where the payments come from or where they are deposited is

not a factor in the source of the income. If a taxpayer works

predominantly in a foreign country, but does some work in the

U.S., an adjustment must be made to the total of foreign

earned income.

Example 4

Charles Thompson works and lives in the Bahamas. After vacation, he worked 50 weeks in 2002. For one week, he attended a

business meeting in Florida. 1/50 or 2% of his wages are not

foreign earned income, because that week was spent working in

Florida.

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28 Lesson 5

In addition to the foreign earned income exclusion, the taxpayer may also separately claim an exclusion for housing

expenses if they exceed a specified amount. As with the foreign

earned income exclusion, to qualify for these items, the taxpayer must have a tax home overseas and qualify under the

bona fide residence or physical presence test. One important

advantage of the housing exclusion is that it may be claimed in

addition to the earned income exclusion. While the earned

income exclusion is limited to $80,000, taxpayers whose earned

income is above $80,000, by claiming the housing exclusion,

may reduce their taxable income even further. Taxpayers with

questions on the housing exclusion may refer to the IRS. The

foreign housing deduction is claimed by self-employed individuals who do not have employer-provided housing amounts.

FORM 2555 OR 2555 EZ

If the taxpayer wishes to claim the foreign earned income

exclusion, it is necessary to complete Form 2555 or 2555 EZ.

Form 2555 or 2555 EZ is attached to Form 1040. Anyone who

files Form 2555 or 2555 EZ must file their tax return with the

Internal Revenue Service Center, Philadelphia, PA 19255.

Generally, taxpayers living overseas are given an additional

two months to file their return. To take advantage of this additional time, the taxpayer must attach a statement to the return

explaining that he or she is living overseas.

To be able to use Form 2555 EZ the taxpayer must be a U.S.

citizen or resident alien who has wages and salaries, but not

self-employment income. The total foreign earned income must

be $80,000 or less, and the person cannot be claiming any business or moving expenses. The person also may not be claiming

the foreign housing exclusion or deduction. Anyone not meeting

the above restrictions must file Form 2555. Those individuals

meeting the above restrictions should complete all four sections

of Form 2555 EZ.

For those who must file Form 2555, part of the form is for general information, and must be completed by all taxpayers who

claim the exclusion.

Taxpayers who claim the bona fide residence test must complete Part II. Taxpayers who qualify under the physical presence test must complete Part III. The IRS determines whether

Pub678IN-Lesson 5 10/25/02 Turn 3 Page 28






q

plete, the IRS may disallow the exclusion.

Part IV, completed by all taxpayers, is where foreign earned

income is listed. It must be completed in U.S. dollars. If the

taxpayer has difficulty in converting income, IRS can provide

exchange rates to be used. However, the taxpayer is not

required to use only rates provided by the IRS or the federal

government. Note that earned income includes not only wages

and salaries but also noncash income and allowances and reimbursements received by the taxpayer.

Page 3 of the form is where the exclusion is computed. Taxpayers claiming only the basic exclusion fill out Parts V and

VII. Most of the lines are self-explanatory. The concept of qualifying period is essential. For those qualifying under the bona

fide residence test, this qualifying period is the period of actual

residence. For the physical presence test, the qualifying period

or periods is chosen by the taxpayer. Any period may be chosen

as long as 330 days are spent in a foreign country during the

period.

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30 Lesson 5

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Draft as of

5/15/2002

General Information

OMB No. 1545-1326

Foreign Earned Income Exclusion Form 2555-EZ

Department of the Treasury

Internal Revenue Service  See separate instructions.  Attach to Form 1040.

Name shown on Form 1040 Your social security number

Your foreign address (including country) Your occupation

Employer’s name

For Paperwork Reduction Act Notice, see page 3 of separate instructions. Cat. No. 13272W Form 2555-EZ (2002)

4 5

6

9 Employer is (check any that apply):

A U.S. business

A foreign business

Other (specify) 

10a

If you answered “Yes,” enter the tax year for which the revocation was effective. 

b Of what country are you a citizen/national? 

Have you ever revoked the foreign earned income exclusion? Yes No

7 Employer’s U.S. address (including ZIP code) 8 Employer’s foreign address

● Are a U.S. citizen or a resident alien.

● Earned wages/salaries in a foreign country.

● Had total foreign earned income of

$80,000 or less.

● Do not have self-employment income.

● Do not have business/moving expenses. And You:

You May Use

This Form

If You:

b

c

a

b

c

● Do not claim the foreign housing

exclusion or deduction.

Part II

● Are filing a calendar year return that

covers a 12-month period.

11a List your tax home(s) during 2002 and date(s) established. 

If you filed Form 2555 or 2555-EZ after 1981, enter the last year you filed the form. 

If you did not file Form 2555 or 2555-EZ after 1981, check here  and go to line 11a now.

d

1 Bona Fide Residence Test

Yes No

Enter the date your bona fide residence began  , and ended (see instructions)  .

2 Physical Presence Test

Yes No

b

a

b

a

Tests To See If You Can Take the Foreign Earned Income Exclusion

Were you a bona fide resident of a foreign country or countries for a period that includes an entire tax year

(see page 2 of the instructions)?

Were you physically present in a foreign country or countries for at least 330 full days during—

● If you answered “Yes,” you meet this test. Fill in line 1b and then go to line 3.

● If you answered “No,” you do not meet this test. Go to line 2 to see if you meet the Physical Presence Test.

2002 or

any other period of 12 months in a row starting or ending in 2002?

● If you answered “Yes,” you meet this test. Fill in line 2b and then go to line 3.

● If you answered “No,” you do not meet this test. You cannot take the exclusion unless you meet the

Bona Fide Residence Test above.

The physical presence test is based on the 12-month period from  

● If you answered “No,” you cannot take the exclusion. Do not file this form.

Tax Home Test. Was your tax home in a foreign country or countries throughout your period of bona fide

residence or physical presence, whichever applies?

 

through  .

3

Yes No

● If you answered “Yes,” you can take the exclusion. Complete Part II below and then go to page 2.

Part I

Attachment

(99) Sequence No. 34A

2002






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Draft as of

5/15/2002

Form 2555-EZ (2002) Page 2

$80,000 00

Enter the number of days in your qualifying period that fall within 2002

Did you enter 365 on line 14?

Multiply line 13 by line 15

 .

Enter, in U.S. dollars, the total foreign earned income you earned and received in 2002 (see

instructions). Be sure to include this amount on Form 1040, line 7

Foreign earned income exclusion. Enter the smaller of line 16 or line 17 here and in

parentheses on Form 1040, line 21. Next to the amount enter “2555-EZ.” On Form 1040, subtract

this amount from your income to arrive at total income on Form 1040, line 22 

18

13

14

15

16

17

Maximum foreign earned income exclusion 13

14

15

17

18

16

Part IV Figure Your Foreign Earned Income Exclusion

Enter “1.000.”

Part III

(d) Income earned in U.S. 

on business (attach computation)

(c) Number of days

in U.S. on business (a) Date arrived in U.S. (b) Date left U.S.

Days Present in the United States—Complete this part if you were in the

United States or its possessions during 2002.

12

Divide line 14 by 365 and enter the result as

a decimal (rounded to at least three places).

Yes.

No.

days

Form 2555-EZ (2002)




32 Lesson 5

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Draft as of

5/14/2002

OMB No. 1545-0067

Form 2555 Foreign Earned Income

Department of the Treasury

Internal Revenue Service

 See separate instructions.  Attach to Form 1040.

For Use by U.S. Citizens and Resident Aliens Only

Name shown on Form 1040 Your social security number

Your foreign address (including country) Your occupation

Employer’s name 

Employer’s U.S. address 

Employer’s foreign address 

Employer is (check

any that apply):

A foreign entity A U.S. company

Other (specify) 

Self

A foreign affiliate of a U.S. company

If, after 1981, you filed Form 2555 to claim either of the exclusions or Form 2555-EZ to claim the foreign earned income

exclusion, enter the last year you filed the form. 

Have you ever revoked either of the exclusions? Yes No

If you answered “Yes,” enter the type of exclusion and the tax year for which the revocation was effective. 

Did you maintain a separate foreign residence for your family because of adverse living conditions at your

tax home? See Second foreign household on page 3 of the instructions

If “Yes,” enter city and country of the separate foreign residence. Also, enter the number of days during your tax year that

you maintained a second household at that address. 

List your tax home(s) during your tax year and date(s) established. 

Next, complete either Part II or Part III. If an item does not apply, enter “NA.” If you do not give

the information asked for, any exclusion or deduction you claim may be disallowed.

Taxpayers Qualifying Under Bona Fide Residence Test (See page 2 of the instructions.)

10 Date bona fide residence began  , and ended 

11 Kind of living quarters in foreign country  Purchased house Rented house or apartment Rented room

Quarters furnished by employer

12a Did any of your family live with you abroad during any part of the tax year?

If “Yes,” who and for what period? 

Have you submitted a statement to the authorities of the foreign country where you claim bona fide residence

that you are not a resident of that country? (See instructions.)

13a

b Are you required to pay income tax to the country where you claim bona fide residence? (See instructions.)

If you answered “Yes” to 13a and “No” to 13b, you do not qualify as a bona fide resident. Do not complete the rest of

this part.

If you were present in the United States or its possessions during the tax year, complete columns (a)–(d) below. Do not

include the income from column (d) in Part IV, but report it on Form 1040.

14

(d) Income earned in

U.S. on business

(attach computation)

(c) Number of days in U.S.

on business

(d) Income earned in

U.S. on business

(attach computation)

(c) Number of days in U.S.

on business

(b) Date left

U.S. (a) Date arrived in U.S. (b) Date leftU.S. (a) Date arrived in U.S.

15a List any contractual terms or other conditions relating to the length of your employment abroad. 

b Enter the type of visa under which you entered the foreign country. 

c Did your visa limit the length of your stay or employment in a foreign country? If “Yes,” attach explanation

Did you maintain a home in the United States while living abroad?

e If “Yes,” enter address of your home, whether it was rented, the names of the occupants, and their relationship

to you. 

For Paperwork Reduction Act Notice, see page 4 of separate instructions. Cat. No. 11900P Form 2555 (2002)

Yes No

Yes No

Yes No

Yes No

Yes No

Yes No



3

4a

5

6a

c

8a

9

7

1 2

b

a

d

b

e

c

b

a

d

b c

d

d

b

Part I

Part II

General Information

b If you did not file Form 2555 or 2555-EZ after 1981 to claim either of the exclusions, check here  and go to line 7.

Of what country are you a citizen/national? 

Attachment (99) Sequence No. 34

2002




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Draft as of

5/14/2002

Form 2555 (2002) Page 2

Taxpayers Qualifying Under Physical Presence Test (See page 2 of the instructions.)

16 The physical presence test is based on the 12-month period from  through 

17 Enter your principal country of employment during your tax year. 

If you traveled abroad during the 12-month period entered on line 16, complete columns (a)–(f) below. Exclude travel between

foreign countries that did not involve travel on or over international waters, or in or over the United States, for 24 hours or

more. If you have no travel to report during the period, enter “Physically present in a foreign country or countries for the entire

12-month period.” Do not include the income from column (f) below in Part IV, but report it on Form 1040.

18

(f) Income earned in U.S.

on business (attach

computation)

(e) Number of days in U.S.

on business

(d) Full days

present in

country

(a) Name of country

(including U.S.) (b) Date arrived (c) Date left

All Taxpayers

Note: Enter on lines 19 through 23 all income, including noncash income, you earned and actually or constructively received during

your 2002 tax year for services you performed in a foreign country. If any of the foreign earned income received this tax year

was earned in a prior tax year, or will be earned in a later tax year (such as a bonus), see the instructions. Do not include

income from line 14, column (d), or line 18, column (f). Report amounts in U.S. dollars, using the exchange rates in effect

when you actually or constructively received the income.

If you are a cash basis taxpayer, report on Form 1040 all income you received in 2002, no matter when you performed

the service.

Amount 2002 Foreign Earned Income (in U.S. dollars)

19 Total wages, salaries, bonuses, commissions, etc. 19

20 Allowable share of income for personal services performed (see instructions):

a In a business (including farming) or profession 20a

b In a partnership. List partnership’s name and address and type of income. 

20b

21 Noncash income (market value of property or facilities furnished by employer—attach statement

showing how it was determined):

a Home (lodging) 21a

b Meals 21b

c Car 21c

d Other property or facilities. List type and amount.  

21d

22 Allowances, reimbursements, or expenses paid on your behalf for services you performed:

a Cost of living and overseas differential 22a

b Family 22b

c Education 22c

d Home leave 22d

e Quarters 22e

f For any other purpose. List type and amount. 

22f

g Add lines 22a through 22f 22g

23 Other foreign earned income. List type and amount. 

23

24 Add lines 19 through 21d, line 22g, and line 23 24

25 Total amount of meals and lodging included on line 24 that is excludable (see instructions) 25

Subtract line 25 from line 24. Enter the result here and on line 27 on page 3. This is your 2002

foreign earned income 

26

26

Part III

Part IV

Form 2555 (2002)




34 Lesson 5

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Draft as of

5/14/2002

Form 2555 (2002) Page 3

Taxpayers Claiming the Housing Exclusion and/or Deduction

28 Qualified housing expenses for the tax year (see instructions) 28

Number of days in your qualifying period that fall within your 2002 tax

year (see instructions)

29

29

30 Multiply $29.70 by the number of days on line 29. If 365 is entered on line 29, enter $10,842.00 here 30

31

Subtract line 30 from line 28. If the result is zero or less, do not complete the rest of this part

or any of Part IX

31

32 Enter employer-provided amounts (see instructions) 32

Divide line 32 by line 27. Enter the result as a decimal (rounded to at least three places), but do

not enter more than “1.000”

33

33

Housing exclusion. Multiply line 31 by line 33. Enter the result but do not enter more than the

amount on line 32. Also, complete Part VIII 

34

34

Note: The housing deduction is figured in Part IX. If you choose to claim the foreign earned

income exclusion, complete Parts VII and VIII before Part IX.

Taxpayers Claiming the Foreign Earned Income Exclusion

35 Maximum foreign earned income exclusion 35 $80,000 00

● All others, enter the number of days in your qualifying period that

fall within your 2002 tax year (see the instructions for line 29).

36

● Otherwise, divide line 36 by the number of days in your 2002 tax year and enter the result

as a decimal (rounded to at least three places).

37

38 Multiply line 35 by line 37 38

39 Subtract line 34 from line 27 39

40 Foreign earned income exclusion. Enter the smaller of line 38 or line 39. Also, complete Part VIII  40

Taxpayers Claiming the Housing Exclusion, Foreign Earned Income Exclusion, or Both

41 Add lines 34 and 40 41

Deductions allowed in figuring your adjusted gross income (Form 1040, line 35) that are allocable

to the excluded income. See instructions and attach computation

42

42

Subtract line 42 from line 41. Enter the result here and in parentheses on Form 1040, line 21.

Next to the amount enter “Form 2555.” On Form 1040, subtract this amount from your income

to arrive at total income on Form 1040, line 22 

43

43

Taxpayers Claiming the Housing Deduction—Complete this part only if (a) line 31 is more than line

34 and (b) line 27 is more than line 41.

44 Subtract line 34 from line 31 44

45 Subtract line 41 from line 27 45

46 Enter the smaller of line 44 or line 45 46

Note: If line 45 is more than line 46 and you could not deduct all of your 2001 housing deduction

because of the 2001 limit, use the worksheet on page 4 of the instructions to figure the

amount to enter on line 47. Otherwise, go to line 48.

47 Housing deduction carryover from 2001 (from worksheet on page 4 of the instructions) 47

48 Housing deduction. Add lines 46 and 47. Enter the total here and on Form 1040 to the left of

line 34. Next to the amount on Form 1040, enter “Form 2555.” Add it to the total adjustments

reported on that line  48

 .

 .

Part VIII

Part VII

Part VI

Part IX

Part V

36 ● If you completed Part VI, enter the number from line 29.

37 ● If line 36 and the number of days in your 2002 tax year (usually 365) are the same, enter “1.000.”

27

All Taxpayers

27 Enter the amount from line 26

Are you claiming the housing exclusion or housing deduction?

No. Go to Part VII.





Yes. Complete Part VI.

Form 2555 (2002)

days

days
, y 

than $80,000. If the number of qualifying days in the tax year

is less than 365, the $80,000 limit is lowered proportionally.

Example 5

Tina York is claiming the exclusion. Her qualifying period is

March 15, 2001 to March 14, 2002. On line 36 of Form 2555,

Tina enters 73 days because 73 days of her qualifying period

fall in the 2002 tax year.

On line 37, she divides 73 by 365, and enters the result, “.200.”

On line 38, $80,000 is multiplied by .200, which results in

“$16,000.”

5/1

Taxpayers Claiming the Foreign Earned Income Exclusion

35 Maximum foreign earned income exclusion 35 $80,000 00

● All others, enter the number of days in your qualifying period that

fall within your 2002 tax year (see the instructions for line 29).

36

● Otherwise, divide line 36 by the number of days in your 2002 tax year and enter the result

as a decimal (rounded to at least three places).

37

38 Multiply line 35 by line 37 38

39 Subtract line 34 from line 27 39

40 Foreign earned income exclusion. Enter the smaller of line 38 or line 39. Also, complete Part VIII  40

 .

Part VII

36 ● If you completed Part VI, enter the number from line 29.

37 ● If line 36 and the number of days in your 2002 tax year (usually 365) are the same, enter “1.000.”





days



Lesson 5 35

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Exhibit 3 Form 255

80,000 00

200

16,000 —

73

Regardless of how much foreign earned income Tina had, her

exclusion can be no more than $16,000.




36 Lesson 5

The only other item that presents some problems is line 42.

“Deductions Allowed in Figuring Your Adjusted Gross Income.”

The reasoning behind this line is that it is not consistent to

claim a credit or deduction related to excluded income. To the

extent a deduction is claimed that is allocable to the exclusion,

the exclusion must be reduced by that deduction.

Self-Employment Tax. The taxpayer must take all earned

income into account in figuring self-employment tax, even

though the income is exempt from income tax because of the

foreign earned income exclusion.

An individual is allowed a deduction for one-half of self-employment tax on the Form 1040. In essence this deduction is related

to the operation of the business. Therefore, if foreign earned

income is excluded, the deduction for S.E. tax must be allocated

to the excluded income. The amount allocated to excluded

income reduces the Foreign Earned Income exclusion allowed.

The following formula is used to determine the amount of the

deduction allocable to excluded income:

Excluded Earned Income Self-Employment Tax Deduction

Qualifying Earned Income (From Form 1040, Line 29)

When the qualifying earned income is fully excluded, none of

the self-employment tax deduction is allowed; therefore the full

amount of this deduction is put on line 42 of Form 2555. This

will reduce your Foreign Earned Income exclusion by the

amount of the deduction. However, the self-employment tax

deduction is still entered on line 29 of Form 1040.

Itemized Deductions. The treatment for itemized deductions

is somewhat different. In reporting itemized deductions on

Schedule A (Form 1040) that are wholly or partly allocable to

excluded income, the taxpayer must reduce the gross deduction

by the disallowed amount in arriving at the net deduction

shown on Schedule A. Then the taxpayer attaches a statement

showing how the deductible amount was figured and writes

“Form 2555” in the upper right corner of Schedule A. The most

common itemized deductions that are allocable to excluded foreign earned income are unreimbursed employee business

expenses. The same formula, as presented above, is used to

determine the amounts allocable to the excluded foreign

income.

Pub678IN-Lesson 5 10/25/02 Turn 3 Page 36

x






py

of the move, if the taxpayer has at least 120 days of his qualifying period during the tax year, the moving expense is allocated

solely to the year of the move. If the taxpayer has less than 120

full days in the tax year, the moving expense is allocated to

income in the year of the move, and the year after. Taxpayers

affected by this provision may want to seek assistance from the

IRS or a tax preparer.

After adjusting the exclusion for any deductions allocable to

excluded income the net exclusion needs to be carried to Form

1040. The amount from Form 2555 EZ line 18 or Form 2555

line 43 is entered in parenthesis on Form 1040 line 22. It is

subtracted from other sources of income.

EXTENSIONS

For some taxpayers, the regular filing deadline may come

before they have met either the bona fide residence test or the

physical presence test. If they expect to meet one of these tests

and qualify for the exclusion, they may wish to file Form 2350,

“Application for Extension of Time to File U.S. Income Tax

Return.” This form should be filed with the Internal Revenue

Service Center, Philadelphia, PA 19255. The form may also be

approved by IRS representatives at overseas offices. By filing

the form, the taxpayer may be granted an extension to file 30

days after they qualify for one of these tests.

Example 6

Margaret took a job in Thailand. She left the U.S. in July of

2002: She expects to qualify as a bona fide resident. Since she

will not qualify until the end of the year 2003, Margaret may

file Form 2350 to request an extension to January 30, 2004 to

file her 2002 return.

Lesson 5 37

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 SUMMING UP THIS LESSON 

The foreign earned income exclusion is very important to taxpayers who work overseas. When you help taxpayers, you will

need to ask them questions, so you can determine whether or

not they qualify. If they qualify, it is necessary to complete

Form 2555 or Form 2555 EZ.

In this lesson, we have discussed the basic examples of the

exclusion. When a taxpayer has a more complex situation, refer

him or her to additional sources of help, such as the IRS or a

private tax preparer.




38 Lesson 5

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1. What form is used to claim the foreign earned income

exclusion?

2. When can the exclusion be elected?

3. How can the exclusion be revoked?

4. May the taxpayer claim the exclusion if gone from the U.S. 

temporarily on business?

5. How long a period is needed to qualify for the bona fide

residence test?

6. Elizabeth Roberts moved to Taiwan on January 24, 2002. 

During 2002, she earned $43,000 working for an importexport business. She qualifies under the physical presence 

test. Complete Part VII of Form 2555.

SUMMARY EXERCISES 





LESSON 5

5/1

Taxpayers Claiming the Foreign Earned Income Exclusion

35 Maximum foreign earned income exclusion 35 $80,000 00

● All others, enter the number of days in your qualifying period that

fall within your 2002 tax year (see the instructions for line 29).

36

● Otherwise, divide line 36 by the number of days in your 2002 tax year and enter the result

as a decimal (rounded to at least three places).

37

38 Multiply line 35 by line 37 38

39 Subtract line 34 from line 27 39

40 Foreign earned income exclusion. Enter the smaller of line 38 or line 39. Also, complete Part VIII  40

 .

Part VII

36 ● If you completed Part VI, enter the number from line 29.

37 ● If line 36 and the number of days in your 2002 tax year (usually 365) are the same, enter “1.000.”





days

Exhibit 4 Form 2555






1. Form 2555 or Form 2555 EZ

2. The exclusion must be filed with a timely filed return 

(including any extensions), a return amending a timely filed

return, or a late filed return (determined without regard to 

any extensions) filed within one year from the original due 

date of the return. Taxpayers who would not have a tax 

after claiming the exclusion may elect the exclusion even 

after the above dates.

3. The exclusion is revoked by attaching a statement to the 

return or amended return for the first year the taxpayer no 

longer wishes to claim the exclusion. It also may be revoked 

when the taxpayer chooses to claim the foreign tax credit on

otherwise excludible income.

4. No, the taxpayer may not claim the exclusion. If temporarily

away on business, the tax home has not changed.

5. The period must include an entire tax year.

6. See filled in Exhibit.

Exhibit

Lesson 5 39

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FOREIGN EARNED INCOME

EXCLUSION ANSWERS TO EXERCISES 





LESSON 5

5/1

Taxpayers Claiming the Foreign Earned Income Exclusion

35 Maximum foreign earned income exclusion 35 $80,000 00

● All others, enter the number of days in your qualifying period that

fall within your 2002 tax year (see the instructions for line 29).

36

● Otherwise, divide line 36 by the number of days in your 2002 tax year and enter the result

as a decimal (rounded to at least three places).

37

38 Multiply line 35 by line 37 38

39 Subtract line 34 from line 27 39

40 Foreign earned income exclusion. Enter the smaller of line 38 or line 39. Also, complete Part VIII  40

 .

Part VII

36 ● If you completed Part VI, enter the number from line 29.

37 ● If line 36 and the number of days in your 2002 tax year (usually 365) are the same, enter “1.000.”





days

Exhibit 5 Form 255

341

80,000 00

934

74,720 00

43,000 00

43,000 00




40 Lesson 5

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STUDENT NOTES






INTRODUCTION

In the introductory lesson, the topic of worldwide income was

discussed. U.S. citizens and residents compute their U.S. taxes

based on their worldwide income. This sometimes leads to a situation where a U.S. citizen may be paying twice on the same

income—once to the government of the foreign country where

the income was sourced and once to the U.S. Government. In

order to avoid this double taxation, a foreign tax credit was created. This allows an individual to take a tax credit for taxes

paid to a foreign government on income from sources in a foreign country. This lesson will address the foreign tax credit

only as it applies to U.S. citizens, and residents.

Just like other tax credits, the foreign tax credit is a dollarfor-dollar reduction in the amount of taxes. However, in some

cases, not all taxes paid to a foreign government can be used in

the computation of the foreign tax credit. In this chapter, we

will discuss what taxes are eligible for the foreign tax credit

and how to claim the foreign tax credit.

OBJECTIVES

At the end of this lesson, you will be able to:

1. Determine which types of taxes qualify for the foreign tax

credit.

2. Correctly complete a Form 1116.

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FOREIGN TAX CREDIT 








42 Lesson 6

There are several factors to consider when determining if a tax

paid to a foreign government is eligible for the foreign tax

credit. They include:

1. Was the income foreign source? 

2. What type of tax was paid to the foreign government? 

3. Will the taxpayer receive some kind of specific economic benefit from the payment of this tax?

In this part of the lesson, we’ll study the criteria for claiming

the foreign tax credit.

The taxpayer must have income from a foreign country on

which he/she is taxed by a foreign country. The tax imposed on

the income must be similar to the income tax imposed in the

U.S. This simply means that the income must be from a country other than the U.S. and that the tax paid must be similar 

to U.S. income tax. Let’s look at some examples.

Example 1

Robb and Betty Grant are U.S. citizens who reside in France.

The schedule B on their U.S. tax return contains the following:

$500, Lee County National Bank (U.S.)

$600, Banque National de Paris (French)

They paid income taxes on both types of interest to both countries. On their U.S. tax return, they can compute a foreign tax

credit against the taxes that they pay to the U.S. on the interest received from the French bank. They would need to check

with the French taxing authorities to determine if they can

claim a similar tax credit on their French tax return for the

interest income from the U.S. bank.

Example 2

Marie Elliott is a U.S. citizen who lives in Hong Kong. She

owns a house in Hong Kong and paid $2,000 in real estate

taxes for her home and $1,000 in personal property taxes. She

also paid $300 in income taxes to the government of Hong

Kong. She is not able to claim a foreign tax credit for either the

real estate taxes paid or the personal property taxes paid since

these two taxes are not income taxes. She can, however, use the

$300 in income taxes paid to Hong Kong to compute a foreign

tax credit. (Note—she can take the real estate taxes that she

paid and deduct them as itemized deductions if she itemizes on

her U.S. tax return. Foreign personal property taxes are only

deductible if they relate to the production of income or a

trade/business.)

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The following is a list of the income on Anne’s U.S. income tax

return. She is a U.S. citizen living in Canada. She also had to

pay taxes on each of these types of income to Canada. Indicate

on which of the following a foreign tax credit may be computed.

_______ a. Wages from her job in the U.S.

_______ b. Interest income from a U.S. bank.

_______ c. Interest income from a Canadian bank.

_______ d. Dividend income from a U.S. corporation.

_______ e. Dividend income from a Canadian corporation.

Exercise 2

Determine if the following taxes paid to a foreign government

can be used to compute the foreign tax credit. All taxpayers are

U.S. citizens.

_______ a. Martha pays $1,200 a year in taxes. This tax is

based on the number and types of appliances which

she owns and uses in her home.

_______ b. Jean pays an inheritance tax to the Spanish government. It is based on an inheritance she received

upon the death of an uncle.

_______ c. Dorothy lives in Jamaica. She paid $1,500 to the

Jamaican government for her salaried income which

she earned in Jamaica.

_______ d. Henry lives in Haiti. He paid $100 in taxes to the

Haitian government. This tax was based on his type

of living accommodations, the location of his residence and the size of this family.

In addition to the requirements that the tax be paid to the foreign country on income derived from a foreign country and the

tax be an income tax similar to the income tax as defined under

U.S. law, the tax must also not be payment for a specific economic benefit. Simply put, the “tax” cannot actually be a “payment” that results in an individual receiving goods, services or

the right to use certain properties which are not available to

others who are subject to the income tax that is generally

imposed by the foreign country. A taxpayer cannot receive any

specific benefit, directly or indirectly from paying a tax.

Lesson 6 43

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44 Lesson 6

y p

in this country. This country has a two tier income tax system.

Everyone pays income tax at graduated rates depending upon

their income. Bob also pays income tax based upon the profits

of his business. This second level of income tax gives Bob the

right to reduced fees for telephones, utilities and rents for his

business. The government of Country X calls it an income tax

because it is based upon the profits of the business. If Bob did

not pay this tax, he could not rent a government-owned building and he would pay significantly more for the utilities and his

business telephone usage. Since Bob receives a specific economic benefit for the second tier of income tax that he pays, he

cannot use those tax payments to compute a foreign tax credit

on his U.S. tax return. However, the first tier of income taxes

are similar to U.S. income taxes and can be used to figure his

foreign tax credit.

Country Restrictions. Aside from the restrictions that we

have already discussed, there are also certain countries to

which a taxpayer may pay foreign income taxes but cannot

claim a foreign tax credit. Generally the reason a credit may

not be claimed for tax paid to one of these countries is because

the Secretary of State has designated the country as one that

repeatedly provides support for acts of international terrorism.

The credit can also be denied to countries with which the

United States has no diplomatic relations, or countries whose

government the United States does not recognize. At the time

of this writing, income taxes paid to the following countries are

not eligible for the foreign tax credit.

CUBA

IRAN

IRAQ

LIBYA

NORTH KOREA

SYRIA

SUDAN

Example 4

Ralph is a U.S. citizen who has investments in both Belgium

and Iran. On these investments Ralph pays income tax to these

two countries by withholding tax from his dividend checks.

Ralph can claim the taxes paid to Belgium when computing the

foreign tax credit. The income taxes paid to Iran do not qualify

for a foreign tax credit.

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The foreign tax credit is computed on Form 1116 which is then

attached to the Form 1040. We will study the Form 1116 section by section.

TYPES OF INCOME

Let’s take a look at the first part of the Form 1116. (See Exhibit

1.) It has no separate number or title. Here the type of income

is identified. A separate Form 1116 must be completed for each

different type of income category. We will only be studying

three income categories: passive income, high withholding tax

interest and general limitation income. Remember that you can

only check one income category per form and you must fill out

separate Forms 1116 if you have more than one income category.

Passive Income. Passive income generally includes the following types of income: dividends, interest, royalties, rents and

annuities. If you are assisting a person who has one of these

types of passive income from a foreign country, and he or she

paid income taxes to a foreign country, you would compute a

foreign tax credit.

Example 5

Darlene is a U.S. citizen living in Venezuela. She keeps a bank

account in the Banco Nacional de Venezuela. In 2002, she

received $380 in interest income from the Venezuelan bank.

She also paid Venezuelan income taxes on this interest income.

On her U.S. return, she would claim a foreign tax credit for the

taxes paid to Venezuela on her interest income. She would

check the box for the “Passive income” category on Form 1116.

High Withholding Tax Interest. Certain interest income is

not included in the passive income category. If the taxpayer you

are helping had interest income on which at least 5% foreign

gross income tax was withheld, then this income is classified as

high withholding tax interest and not passive income.

Lesson 6 45

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Exhibit 1 Form 1116

t as of

02

OMB No. 1545-0121 Foreign Tax Credit Form 1116 (Individual, Estate, or Trust)

Department of the Treasury

Internal Revenue Service

 Attach to Form 1040, 1040NR, 1041, or 990-T. Attachment  See separate instructions. Sequence No. 19

Name Identifying number as shown on page 1 of your tax return

Passive income Lump-sum distributions

High withholding tax Dividends from a DISC or former DISC

interest

Financial services income General limitation income

Certain distributions from a foreign

sales corporation (FSC) or former

FSC

a Shipping income

b

c

d

e

g

h

i

Use a separate Form 1116 for each category of income listed below. See Categories of Income on page 3 of the instructions. Check only one

box on each Form 1116. Report all amounts in U.S. dollars except where specified in Part II below.

f

Section 901(j) income

j

Certain income re-sourced by treaty

(99)

2002




46 Lesson 6

g

maintains a bank account in a London bank. According to local

law, the bank withholds a mandatory 27.5% of interest income

as income tax. Since the withholding rate is at least 5%, the

high withholding tax interest category would be checked on his

Form 1116.

Example 7

Regina lives in Singapore and is a U.S. citizen. She has both

dividend income and interest income from countries outside the

United States. Her foreign bank withholds 15% of her interest

income for income taxes. She also pays foreign income taxes on

her dividend income. Regina must complete two Forms 1116.

Her foreign dividend income is “passive income” and indicated

as such on one Form 1116. Her foreign interest income is in the

“high withholding tax interest” category and is on another

Form 1116. The credits on these separate Forms 1116 will eventually be combined. This will be studied later in this lesson.

General Limitation Income. The final income category on

Form 1116 is the “general limitation income” category. If the

person you are helping has foreign income that does not come

under any of the other categories on Form 1116, then that foreign income comes under the general limitation income category. Most often, this would be wages earned in a foreign

country that an individual does not exclude, or excludes only

part of, under the foreign earned income exclusion.

Example 8

Siegfried lives in Switzerland and is a U.S. citizen. He works in

Switzerland and pays income taxes to Switzerland on his earnings. He does not elect to claim a foreign earned income exclusion. He can claim a foreign tax credit for the taxes paid on his

earnings to the Swiss government. He checks the box for the

general limitation income category on his Form 1116.

High Taxed Income. If the individual you are assisting has

passive income which is taxed by a foreign government at a

rate that is higher than the highest U.S. income tax rate, then

the foreign tax credit for that income would be computed under

the general limitation category. (Passive income was discussed

earlier in this lesson.) In 2002, the highest U.S. income tax rate

is 38.6%. Therefore, if the person pays more than 38.6% on the

foreign source passive income for which he or she claimed the

credit, then the credit is computed under the “general limitation” category.

Pub678IN-Lesson 6 10/25/02 Turn 3 Page 46






account in Brazil and pays 45% income tax on her interest

income. Even though interest income is normally passive

income for purposes of the foreign tax credit, this income would

be listed under the “general limitation” category on Form 1116

since the rate of income tax she pays on this passive income is

higher than the highest U.S. income tax rate.

Example 10

Bernard is a resident of Barbados and a U.S. citizen. He keeps

a bank account in Barbados. In 2002 he paid 17% income tax

on his interest income from his bank account in Barbados.

Since 17% (the tax rate he paid) is not more than 38.6% (the

highest U.S. income tax rate) and since the 17% that Bernard

paid was not paid by withholding, this income fails into the

“passive income” category of Form 1116.

COMPLETING FORM 1116

We have already discussed how to complete the income category section of the Form 1116. A separate Form 1116 must be

completed for each income category. In addition, the top of

Form 1116 has a line to indicate the name of the country of 

residence of the taxpayer.

Part I is used to figure the taxable income from foreign sources

in each income category. If the person you are helping has one

type of foreign income that comes from several foreign countries, you use one Form 1116. You will note that there is room

on Form 1116 for up to 3 countries.

Example 11

George is both a U.S. citizen and resident. He has interest

income from both Canada and Mexico, as well as the U.S. He

need only complete one Form 1116 since all the interest income

is in the passive income category.

Lesson 6 47

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48 Lesson 6

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Exhibit 2 Form 1116 Draft

6/25/20

gy , y

Taxable Income or Loss From Sources Outside the United States (for Category Checked Above)

Foreign Country or U.S. Possession Total

A B C (Add cols. A, B, and C.)

Enter the name of the foreign country or U.S.

possession 

Gross income from sources within country

shown above and of the type checked above (see

page 7 of the instructions):

1

1

Part I

l

Exhibit 3 Form 1116 Draft

6/25/20

Taxable Income or Loss From Sources Outside the United States (for Category Checked Above)

Foreign Country or U.S. Possession Total

A B C (Add cols. A, B, and C.)

Enter the name of the foreign country or U.S.

possession 

Gross income from sources within country

shown above and of the type checked above (see

page 7 of the instructions):

1

1

Part I

l

gy p 

that income separately for each foreign country.

Example 12

George had $300 in interest income from his

Canadian bank and $200 in interest income from his

Mexican bank. See the completed Form 1116, line 1

for his income in Exhibit 2 which follows.

Note: If the taxpayer you are assisting has claimed

the foreign earned income exclusion, enter on line 1 of

Form 1116 for general limitation income only the

amount of earned income not excluded.

Example 13

Monique lives in France and is a U.S. citizen. She

earned $84,000 in 2002 in France. Monique claimed

the foreign earned income exclusion of $80,000

(discussed in an earlier lesson). As illustrated in

Exhibit 3 below, she would only enter $4,000 on line 1

of her Form 1116 ($84,000 earned Income – $80,000

exclusion).

Lines 2–5 are probably the hardest and most confusing lines to complete on the Form 1116. Let’s review

the situations that we will not be studying.

Canada Mexico

300 200 500

France

4,000 4,000






yg py 

the income claimed on line 1 such as employee business

expenses, and the income claimed on line 1 was earned

income, then you may recommend that this person seek 

professional assistance or contact the IRS.

2. Investment Interest Expense. If a person borrowed

money in order to purchase investment property such as stock,

then some special allocations may need to be done. They may

wish to contact the IRS or seek a professional preparer.

3. Foreign Losses. If the person you are helping had any type

of foreign losses such as net losses from selling capital assets

or a net loss from being a limited partner, they may wish to

hire a professional preparer or contact the IRS if they wish

to prepare their own return.

Now that we have discussed what areas are beyond the scope of

VITA, let’s continue with the completion of Part I.

Line 3. You will complete line 3a if you completed a Schedule A

for the person you are assisting to itemize his or her deductions. The total of the itemized deductions not directly related

to foreign or U.S. income are medical expenses, real estate

taxes and gifts to charity.

If the person you are assisting does not itemize deductions,

then the standard deduction claimed on line 38 of the Form

1040 would be entered on line 3a. The next two examples and

exhibits should help to clarify the entries on this line.

Example 14

Betty is claiming a foreign tax credit. She is single and had

itemized deductions of $4,900 for 2002. Her Schedule A

includes $4,200 of real estate taxes and $700 of charitable contributions. (See Exhibit 4.)

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Exhibit 4 Form 1116 ( )

3 Pro rata share of other deductions not definitely

related:

Certain itemized deductions or standard

deduction (see instructions)

a

b Other deductions (attach statement)

c Add lines 3a and 3b

d Gross foreign source income (see instructions)

e Gross income from all sources (see instructions)

f Divide line 3d by line 3e (see instructions)

g Multiply line 3c by line 3f

4 P t h f i t t ( i t ti )

4,900

4,900




50 Lesson 6

gg

had itemized deductions of $2,500. Since the standard deduction for a single person for 2002, is $4,700, it is more advantageous to take the standard deduction. Rebecca’s Form 1116

would therefore have a $4,700 entry on line 3a. (See Exhibit 5.)

Since we will not be doing tax returns having directly allocable

expenses, or expenses other than itemized deductions or the

standard deduction, line 3c will be the same as line 3a.

All income from foreign sources in the category checked at the

top of Form 1116 is listed on line 3d. If the foreign earned

income exclusion was claimed on Form 2555 and if the Form

1116 is for the general limitation category, then the amount of

the claimed exclusion is included here as well. For example, on

line 3d for Monique from one of our prior examples the entry

would be $84,000. That’s the sum of $4,000 from line 1 plus the

$80,000 exclusion she claimed. Under most circumstances, line

3d and line 1 will be the same.

Line 3e is gross income from all sources. Usually, this line will

be the same as line 22 of the Form 1040. If a Form 2555 was

completed and the Foreign Earned Income Exclusion was

claimed, then the amount of the exclusion must be added back

to the gross income amount on line 22.

The next step is to determine the percentage of foreign source

income to total income. This is done by dividing line 3d by line

3e and entering the answer on line 3f.

Now take line 3c and multiply it by the percentage you determined on line 3f and enter this answer on line 3g. Carry the

answer on line 3f to 4 decimal places. For our purposes line 6

will then be the same as line 3g. This number represents the

amount of your deductions allocated to foreign income in the

given category.

On line 7, you would subtract line 6 from line 1. You would

then carry the answer from line 7 to Part III, line 14 of the

Form 1116.

Pub678IN-Lesson 6 10/25/02 Turn 3 Page 50

Exhibit 5 Form 1116 li e 1 (attac stateme t)

3 Pro rata share of other deductions not definitely

related:

Certain itemized deductions or standard

deduction (see instructions)

a

b Other deductions (attach statement)

c Add lines 3a and 3b

d Gross foreign source income (see instructions)

e Gross income from all sources (see instructions)

f Divide line 3d by line 3e (see instructions)

g Multiply line 3c by line 3f

4 P t h f i t t ( i t ti )

4,700

4,700






Part II. Foreign Taxes Paid or Accrued. Part II of Form

1116 deals with the amount of foreign taxes paid or that may

be owed (accrued). Since the foreign tax credit is allowed when

a U.S. taxpayer either pays or accrues taxes to a foreign government, the amount paid or owed to a foreign government

must be indicated on the tax return in this section.

Before we can discuss how to complete Part II, we need to 

discuss cash basis and accrual basis taxpayers. A cash basis

taxpayer is one who reports income when actually or constructively received, and expenses when they are paid. The

majority of people who file individual income tax returns are

cash basis taxpayers. If the person is a cash basis taxpayer, he

or she has a choice to take foreign tax credit using the cash or

accrual method.

Example 16

Marie is a U.S. citizen who resides in Argentina, where she is

currently employed. She is paid every week on Thursday. Her

last payday for 2002 is December 30th. She is paid based upon

the time she worked in the previous week Sunday through

Saturday. Since she is a cash basis taxpayer, she claims on her

2002 tax return the income that she was paid from January 1,

2002 through December 31, 2002 no matter when she earned it

or when she may have been entitled to it. She also claims as

deductions, expenses for which she actually paid in 2002 even

though she may have incurred the debt prior to 2002.

An accrual basis taxpayer computes income and deductions differently. A person who is on the accrual basis computes income

when he or she actually earned it or became entitled to it.

Therefore, his or her deductions are computed based on when

those debts were incurred, but not necessarily paid.

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Foreign Taxes Paid or Accrued (see page 13 of the instructions)

Credit is claimed Foreign taxes paid or accrued for taxes (you must check one) In foreign currency In U.S. dollars

Paid (s) Other

foreign taxes

paid or

accrued

(w) Other

foreign taxes

paid or

accrued

(x) Total foreign

taxes paid or

accrued (add cols.

(t) through (w))

Taxes withheld at source on: Taxes withheld at source on: Accrued

Country

(q) Rents

and royalties

(u) Rents

and royalties

(o) Date paid

or accrued (p) Dividends (r) Interest (t) Dividends (v) Interest

A

B

C

8 Add lines A through C, column (x). Enter the total here and on line 9, page 2  8

For Paperwork Reduction Act Notice, see page 16 of the instructions. Cat. No. 11440U Form 1116 (2002)

Part II

(m)

(n)




52 Lesson 6

py

taxpayer, then she would declare as her 2002 income the money

she had earned from her employer through December 31, even

though she would not have been paid for her last week’s work

until early 2003.

When computing the amount of foreign taxes for Part II of

Form 1116, you will need to know if the taxpayer is on a cash

basis or an accrual basis. If the person you are helping does not

know, then he or she is probably on a cash basis. If the person

is on a cash basis, the foreign tax credit is figured using the foreign taxes actually paid in 2002. If he or she is on an accrual

basis, the credit will be for the foreign taxes accrued for the

income earned in 2002.

A taxpayer on the cash basis may choose to use the accrual

method to determine the foreign tax credit. However, once this

choice has been made the taxpayer must use the accrual

method for the foreign tax credit on all future tax returns.

In the U.S., we have a pay-as-you-go system. That means that

we pay taxes on taxable income as we make it. When a wageearner gets a paycheck, an amount has already been withheld

by his or her employer for federal income tax. If there has not

been withholding on taxable income, then estimated tax payments must be made.

Many foreign countries have a different system. In some cases,

the individual simply reports his or her taxable income and the

government involved computes the tax and bills the taxpayer.

In other instances, taxpayers make payments in one year for

income made the previous year. In these instances, a cash basis

taxpayer may wish to use the accrual basis for computing the

foreign tax credit since his or her U.S. tax would be based on

the income made in 2002 but they would not actually pay the

taxes or know the actual tax amount until after the end of the

tax year. But remember that once the choice to use the accrual

method has been made, it must be used on all future tax

returns in computing the foreign tax credit.

On Part II of Form 1116, you must indicate if the credit is

being claimed for foreign taxes actually paid in 2002 or if it is

being claimed for foreign taxes accrued during 2002. Just as

there is space in Part I of the form to claim income from 3 different countries, there is space in Part II for claiming payments

to these 3 different countries. Part II also has two separate 

sections in which you indicate the amounts withheld, paid, 

or accrued in the foreign currency and then convert these

amounts into U.S. dollars.

Pub678IN-Lesson 6 10/25/02 Turn 3 Page 52






gyg ,

then the exchange rate that is the most accurate for the date of

the payment should be used. If the person you are helping had

tax withheld throughout the year, then you can use the annual

average exchange rate. If the person you are assisting is using

the accrual method to claim his or her foreign taxes paid, you

must generally use the average exchange rate for the tax year.

Column (x) of the Form 1116 Part II is a summary (in U.S. dollars) of all the foreign taxes paid or accrued on income in the

category checked at the top of Form 1116. Line 8 of Part II is

the total of foreign taxes paid or accrued to all foreign countries.

If the foreign taxes are paid or accrued on foreign income that

falls into more than one separate category of income, but the

tax is not specifically allocable to any one of the items of

income, an allocation of the tax to each separate category must

be made. This allocation is made by multiplying the total foreign income by a fraction. The numerator of the fraction is the

net income of each of the separate categories. The denominator

is total net foreign income. Figure the net income by deducting

from each any expenses, deductions, etc. that are allocable to

the income under the laws of the foreign country. If there is no

specific allocation under foreign law, apportion the expenses,

deductions, etc. using the principles of U.S. tax law.

In some cases, the rates of foreign tax are different for different

types of income. Because the tax for each type of income is

readily determined, the allocation is generally not needed.

We have now finished studying how to complete the first page

of the Form 1116. Let’s do some exercises to practice working

with the form.

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54 Lesson 6

Charles is a U.S. citizen who lives and works in the United

Kingdom. He takes the foreign earned income exclusion for his

wages. His only other foreign income is interest income from

his London bank. British income taxes were withheld at 27.5%.

In 2002, his gross interest income from his London bank was

£1,200. The average exchange rate for 2002 for purposes of this

exercise was £.6 to the U.S. dollar. Charles uses the single filing status on his tax return and claims a standard deduction

for 2002. He had earned income of $60,000 which he excluded.

He also had U.S. interest income of $3,000 and his only other

income was a short term capital gain of $35,000 from a U.S.

source. Since 27.5% is also the tax rate for interest income in

the United Kingdom, he had no additional income tax due to

Great Britain on his interest income. Parts of Charles’ Form

1040 are reproduced below. Compute the first page of the Form

1116 for Charles.

Pub678IN-Lesson 6 10/25/02 Turn 3 Page 54




Lesson 6 55

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7 Wages, salaries, tips, etc. Attach Form(s) W-2 7

Income 8a Taxable interest. Attach Schedule B if required 8a

b Tax-exempt interest. Do not include on line 8a 8b Attach

Forms W-2 and

W-2G here.

Also attach

Form(s) 1099-R

if tax was

withheld.

9 Ordinary dividends. Attach Schedule B if required 9

10 Taxable refunds, credits, or offsets of state and local income taxes (see page 22) 10

11 Alimony received 11

12 Business income or (loss). Attach Schedule C or C-EZ 12

Enclose, but do

not attach, any

payment. Also,

please use

Form 1040-V.

13 Capital gain or (loss). Attach Schedule D if required. If not required, check here  13

14 Other gains or (losses). Attach Form 4797 14

15a IRA distributions 15a 15b b Taxable amount (see page 23)

16a Pensions and annuities 16a b Taxable amount (see page 23) 16b

17 Rental real estate, royalties, partnerships, S corporations, trusts, etc. Attach Schedule E 17

18 Farm income or (loss). Attach Schedule F 18

19 Unemployment compensation 19

20a Social security benefits 20a b Taxable amount (see page 25) 20b

21 21

22 Add the amounts in the far right column for lines 7 through 21. This is your total income  22

IRA deduction (see page 27) 24

23

Archer MSA deduction. Attach Form 8853

26

25

One-half of self-employment tax. Attach Schedule SE

27

Self-employed health insurance deduction (see page 30)

26

28

27

Self-employed SEP, SIMPLE, and qualified plans

29

28

Penalty on early withdrawal of savings

30

29

Alimony paid b Recipient’s SSN 

Add lines 23 through 33a 34

30

Subtract line 34 from line 22. This is your adjusted gross income 

31

Adjusted

Gross

Income

35

If you did not

get a W-2,

see page 21.

Cat. No. 11320B Form 1040 (2002)

Other income. List type and amount (see page 27)

Moving expenses. Attach Form 3903

24

25

For Disclosure, Privacy Act, and Paperwork Reduction Act Notice, see page 72.

32 32

Student loan interest deduction (see page 28)

31

33a

Tuition and fees deduction (see page XX)

34

33a

35

Educator expenses (see page xx) 23

ft as of

002

Itemized deductions (from Schedule A) or your standard deduction (see left margin)

Form 1040 (2002) Page 2

36 Amount from line 35 (adjusted gross income) 36

37a Check if:

Tax and

Credits

Add the number of boxes checked above and enter the total here  37a

Single,

$4,700

If you are married filing separately and your spouse itemizes deductions, or

you were a dual-status alien, see page 31 and check here 

b

37b

38 38

39 Subtract line 38 from line 36 39

40

If line 36 is $103,000 or less, multiply $3,000 by the total number of exemptions claimed on

line 6d. If line 36 is over $103,000, see the worksheet on page 32

40

41 Taxable income. Subtract line 40 from line 39. If line 40 is more than line 39, enter -0- 41

42 42

45

You were 65 or older, Blind; Spouse was 65 or older, Blind.

Tax (see page 33). Check if any tax is from a Form(s) 8814 b Form 4972

45

Head of

household,

Standard

Deduction

for—

43

44

Alternative minimum tax (see page 34). Attach Form 6251

Add lines 42 and 43 

43

44

● People who

checked any

box on line

37a or 37b or

who can be

claimed as a

dependent,

see page 31.

● All others:

Foreign tax credit. Attach Form 1116 if required

60,000 00

5,000 00

35,000 00

(60,000 00)

40,000 00

40,000 00

40,000 00

4,700 00

35,300 00

3,000 00

32,300 00

5,074 00

5,074 00

Form 2555




56 Lesson 6

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Draft as of

6/25/2002

OMB No. 1545-0121 Foreign Tax Credit Form 1116 (Individual, Estate, or Trust)

Department of the Treasury

Internal Revenue Service

 Attach to Form 1040, 1040NR, 1041, or 990-T. Attachment  See separate instructions. Sequence No. 19

Name Identifying number as shown on page 1 of your tax return

Passive income Lump-sum distributions

High withholding tax Dividends from a DISC or former DISC

interest

Financial services income General limitation income

Certain distributions from a foreign

sales corporation (FSC) or former

FSC

Resident of (name of country) 

Note: If you paid taxes to only one foreign country or U.S. possession, use column A in Part I and line A in Part II. If you paid taxes to

more than one foreign country or U.S. possession, use a separate column and line for each country or possession.

Taxable Income or Loss From Sources Outside the United States (for Category Checked Above)

Foreign Country or U.S. Possession Total

A B C (Add cols. A, B, and C.)

Enter the name of the foreign country or U.S.

possession 

Gross income from sources within country

shown above and of the type checked above (see

page 7 of the instructions):

1

1

Deductions and losses (Caution: See pages 9, 12, and

13 of the instructions):

2 Expenses definitely related to the income on

line 1 (attach statement)

3 Pro rata share of other deductions not definitely

related:

Certain itemized deductions or standard

deduction (see instructions)

a

b Other deductions (attach statement)

c Add lines 3a and 3b

d Gross foreign source income (see instructions)

e Gross income from all sources (see instructions)

f Divide line 3d by line 3e (see instructions)

g Multiply line 3c by line 3f

4 Pro rata share of interest expense (see instructions):

a Home mortgage interest (use worksheet on

page 12 of the instructions)

b Other interest expense

5 Losses from foreign sources

6 Add lines 2, 3g, 4a, 4b, and 5 6

7 Subtract line 6 from line 1. Enter the result here and on line 14, page 2  7

Foreign Taxes Paid or Accrued (see page 13 of the instructions)

Credit is claimed Foreign taxes paid or accrued for taxes (you must check one) In foreign currency In U.S. dollars

Paid (s) Other

foreign taxes

paid or

accrued

(w) Other

foreign taxes

paid or

accrued

(x) Total foreign

taxes paid or

accrued (add cols.

(t) through (w))

Taxes withheld at source on: Taxes withheld at source on: Accrued

Country

(q) Rents

and royalties

(u) Rents

and royalties

(o) Date paid

or accrued (p) Dividends (r) Interest (t) Dividends (v) Interest

A

B

C

8 Add lines A through C, column (x). Enter the total here and on line 9, page 2  8

For Paperwork Reduction Act Notice, see page 16 of the instructions. Form 1116 (2002)

Shipping income

Cat. No. 11440U

Part I

Part II

a

b

c

d

e

g

h

i

k

(m)

(n)

l

Use a separate Form 1116 for each category of income listed below. See Categories of Income on page 3 of the instructions. Check only one

box on each Form 1116. Report all amounts in U.S. dollars except where specified in Part II below.

f

Section 901(j) income

j

Certain income re-sourced by treaty

(99)

2002

Charles Green 000 - 00 - 6492




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, g

actual computation of the Foreign Tax Credit. This is relatively

simple if you just follow the form line by line.

Line 9. This is the amount you just calculated from Part II,

line 8. It’s the amount of foreign taxes paid or accrued, depending on the method used.

Line 10. This is beyond the scope of VITA. For information

purposes, many countries have a higher tax on income than we

do in the United States. That means that a higher tax is paid

to a foreign government than would be due on the U.S. tax

return attributable to the taxable income in the separate

income category. The tax credit on a U.S. return is limited to

the amount of U.S. tax. Also, there are separate limits in computing the amount of credit based upon the category checked

off on the front page of the Form 1116. These situations result

in possible carrybacks and carryovers but the rules can be complex. Individuals may wish to seek the guidance of the IRS

before completing this computation. VITA volunteers will not be

computing carrybacks and carryovers.

Line 11. A total of lines 9 and 10.

Line 12. A reduction to the foreign taxes paid or accrued has to

be made under certain circumstances. For our purpose, we will

cover the most common situation. This is the reduction for

taxes allocable to income excluded under the foreign earned

income exclusion. The formula for this reduction is:

Excluded Foreign Earned Income

_______________________________ x Foreign Tax = Reduction Total Foreign Earned Income

For our purposes, if the foreign law taxes foreign earned

income and some other income (for example, earned income

from U.S. sources or a type of income not subject to U.S. tax),

and the taxes cannot be segregated, then the denominator of

this fraction is the total amount of income subject to foreign tax.




58 Lesson 6

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Example 18

Marsha is a U.S. citizen who resides in Germany for all of

2002. She had wages of $85,000, and excluded $80,000 on her

U.S. tax return. She also earned $5,000 interest on a German

bank account. She paid $2,000 income tax to Germany on this

income. She will allocate the $2,000 income tax as follows:

Step 1 — Allocate the tax to Passive and to General Limitation

Income.

$5,000 Passive Income: ________ x $20,000 = $1,111 $90,000

$85,000 General Limitation Income: __________ x $20,000 = $18,889 $90,000

Step 2 — Calculate the credit reduction attributable to

excluded income.

$80,000 (excluded income) ________________________________________ x $18,889 = $17,778 $85,000 (total foreign income)

There are other reductions which can be indicated on line 12.

However, they are all beyond the scope of VITA. These include

taxes attributable to boycott operations, or certain mineral

income. It is suggested that taxpayers with these types of situations may wish to seek professional assistance.

Exhibit 9 Form 1116

ft as of

002

Form 1116 (2002) Page 2

Figuring the Credit

9 Enter the amount from line 8. These are your total foreign taxes paid

or accrued for the category of income checked above Part I 9

10 Carryback or carryover (attach detailed computation) 10

11 Add lines 9 and 10 11

12 Reduction in foreign taxes (see page 13 of the instructions) 12

13 Subtract line 12 from line 11. This is the total amount of foreign taxes available for credit 13

Part III

18,889

18,889

17,778

1,111




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gp

available for the credit computation.

We will continue on and discuss the remaining lines in Part III

of Form 1116.

Line 14—This is the amount from Part I, line 7.

Line 15—These adjustments are beyond the scope of VITA.

Line 16—Should be the same as line 14.

Line 17—Enter here the amount on line 39 from the U.S.

Form 1040.

Line 18—Divide line 16 by line 17. Go to 4 decimal places. If

line 16 is larger than line 17, then enter the whole

number 1.

Line 19—Enter the amount from line 42 of the U.S. Form

1040.

Line 20—Multiply line 19 by the percentage arrived at on line

18. This will be the maximum amount of credit

which an individual may claim.

Line 21—Compare lines 13 and 20. Enter the smaller of the

two amounts on line 21.

If you only have to complete one Form 1116, then enter the

same number on line 31 of Part IV.

Exhibit 10 Lines 13-21 Form 1116

Draft as 6/25/2002

13 Subtract line 12 from line 11. This is the total amount of foreign taxes available for credit 13

14 Enter the amount from line 7. This is your taxable income or (loss) from

sources outside the United States (before adjustments) for the category

of income checked above Part I (see page 14 of the instructions) 14

15 Adjustments to line 14 (see page 14 of the instructions) 15

16 Combine the amounts on lines 14 and 15. This is your net foreign

source taxable income. (If the result is zero or less, you have no foreign

tax credit for the category of income you checked above Part I. Skip

lines 17 through 21. However, if you are filing more than one Form

1116, you must complete line 19.)

Individuals: Enter the amount from Form 1040, line 39. If you are a

nonresident alien, enter the amount from Form 1040NR, line 37.

Estates and trusts: Enter your taxable income without the deduction

for your exemption

17

17

18 Divide line 16 by line 17. If line 16 is more than line 17, enter “1” 18

Individuals: Enter the amount from Form 1040, line 42. If you are a nonresident alien, enter the

amount from Form 1040NR, line 40.

19

19

20 Multiply line 19 by line 18 (maximum amount of credit) 20

Enter the smaller of line 13 or line 20. If this is the only Form 1116 you are filing, skip lines 22 through

30 and enter this amount on line 31. Otherwise, complete the appropriate line in Part IV (see page

15 of the instructions) 

21

21

Caution: If you figured your tax using the special rates on capital gains, see page 15 of the instructions.

16

Estates and trusts: Enter the total of Form 1041, Schedule G, lines 1a and 1b, or the total of Form 990-T,

lines 36 and 37




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Let’s complete the Form 1116 for Charles in exercise 3. What is

the amount on line 21 of Part III?




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Draft as of

6/25/2002

Form 1116 (2002) Page 2

Figuring the Credit

9 Enter the amount from line 8. These are your total foreign taxes paid

or accrued for the category of income checked above Part I 9

10 Carryback or carryover (attach detailed computation) 10

11 Add lines 9 and 10 11

12 Reduction in foreign taxes (see page 13 of the instructions) 12

13 Subtract line 12 from line 11. This is the total amount of foreign taxes available for credit 13

14 Enter the amount from line 7. This is your taxable income or (loss) from

sources outside the United States (before adjustments) for the category

of income checked above Part I (see page 14 of the instructions) 14

15 Adjustments to line 14 (see page 14 of the instructions) 15

16 Combine the amounts on lines 14 and 15. This is your net foreign

source taxable income. (If the result is zero or less, you have no foreign

tax credit for the category of income you checked above Part I. Skip

lines 17 through 21. However, if you are filing more than one Form

1116, you must complete line 19.)

Individuals: Enter the amount from Form 1040, line 39. If you are a

nonresident alien, enter the amount from Form 1040NR, line 37.

Estates and trusts: Enter your taxable income without the deduction

for your exemption

17

17

18 Divide line 16 by line 17. If line 16 is more than line 17, enter “1” 18

Individuals: Enter the amount from Form 1040, line 42. If you are a nonresident alien, enter the

amount from Form 1040NR, line 40.

19

19

20 Multiply line 19 by line 18 (maximum amount of credit) 20

Enter the smaller of line 13 or line 20. If this is the only Form 1116 you are filing, skip lines 22 through

30 and enter this amount on line 31. Otherwise, complete the appropriate line in Part IV (see page

15 of the instructions) 

21

21

Summary of Credits From Separate Parts III (see page 16 of the instructions)

22 Credit for taxes on passive income 22

23 Credit for taxes on high withholding tax interest 23

24 Credit for taxes on financial services income 24

25 Credit for taxes on shipping income 25

26

Credit for taxes on dividends from a DISC or former DISC and certain

distributions from a FSC or former FSC

26

27

Credit for taxes on certain income re-sourced by treaty

27

28

Credit for taxes on lump-sum distributions

28

29 Credit for taxes on general limitation income 29

30 Add lines 22 through 29 30

32 Reduction of credit for international boycott operations. See instructions for line 12 on page 13 32

33 Subtract line 32 from line 31. This is your foreign tax credit. Enter here and on Form 1040, line 45;

Form 1040NR, line 43; Form 1041, Schedule G, line 2a; or Form 990-T, line 40a  33

Part IV

Part III

Caution: If you figured your tax using the special rates on capital gains, see page 15 of the instructions.

16

Estates and trusts: Enter the total of Form 1041, Schedule G, lines 1a and 1b, or the total of Form 990-T,

lines 36 and 37

Form 1116 (2002)

31 Enter the smaller of line 19 or line 30 31




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More Than One Form 1116. Part IV of the Form 1116 is used

as a summary of the foreign tax credit. As you can tell from our

discussion thus far, there may be occasions when you will need

to complete more than one Form 1116 for the same taxpayer. 

If this is the case, you would complete Part IV on only one

Form 1116. It does not matter which Form 1116 you choose. 

You would indicate in Part IV of the summary Form 1116 the

amount of the credit computed on line 21 of Part III from each

Form 1116. Line 30 is then a total of all Forms 1116 and, for

our purposes, line 32 should be the same as line 30. Please note

that again the reduction of the credit for international boycott

operations (line 31) is beyond the scope of this program and

will not be discussed.

Summary of Credits From Separate Parts III (see page 16 of the instructions)

22 Credit for taxes on passive income 22

23 Credit for taxes on high withholding tax interest 23

24 Credit for taxes on financial services income 24

25 Credit for taxes on shipping income 25

26

Credit for taxes on dividends from a DISC or former DISC and certain

distributions from a FSC or former FSC

26

27

Credit for taxes on certain income re-sourced by treaty

27

28

Credit for taxes on lump-sum distributions

28

29 Credit for taxes on general limitation income 29

30 Add lines 22 through 29 30

32 Reduction of credit for international boycott operations. See instructions for line 12 on page 13 32

33 Subtract line 32 from line 31. This is your foreign tax credit. Enter here and on Form 1040, line 45;

Form 1040NR, line 43; Form 1041, Schedule G, line 2a; or Form 990-T, line 40a  33

Part IV

Form 1116 (2002)

31 Enter the smaller of line 19 or line 30 31




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Barry is a U.S. citizen living in France. He will claim a foreign

earned income exclusion for the first $80,000 of his wages. He

earned $137,500 wages while working in France during 2002.

He recieved G1,210 interest on a French savings account and

$2,500 in a U.S. savings account. He also had $7,500 U.S.

sourced rental income. Barry paid G27,500 French taxes on

December 31, 2002. Assume an average conversion rate of

G.90909 to $1. (Note G is the currency symbol for the Euro

which became the official French currency on January 1, 2002).

Do not assume that the French interest income is high withholding tax interest. An extract of Barry’s Form 1040 is

attached for your convenience. Complete Barry’s Forms 1116.

(Round all dollar amounts to the nearest dollar and all decimal

amounts to four places.)




64 Lesson 6

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7 Wages, salaries, tips, etc. Attach Form(s) W-2 7

Income 8a Taxable interest. Attach Schedule B if required 8a

b Tax-exempt interest. Do not include on line 8a 8b Attach

Forms W-2 and

W-2G here.

Also attach

Form(s) 1099-R

if tax was

withheld.

9 Ordinary dividends. Attach Schedule B if required 9

10 Taxable refunds, credits, or offsets of state and local income taxes (see page 22) 10

11 Alimony received 11

12 Business income or (loss). Attach Schedule C or C-EZ 12

Enclose, but do

not attach, any

payment. Also,

please use

Form 1040-V.

13 Capital gain or (loss). Attach Schedule D if required. If not required, check here  13

14 Other gains or (losses). Attach Form 4797 14

15a IRA distributions 15a 15b b Taxable amount (see page 23)

16a Pensions and annuities 16a b Taxable amount (see page 23) 16b

17 Rental real estate, royalties, partnerships, S corporations, trusts, etc. Attach Schedule E 17

18 Farm income or (loss). Attach Schedule F 18

19 Unemployment compensation 19

20a Social security benefits 20a b Taxable amount (see page 25) 20b

21 21

22 Add the amounts in the far right column for lines 7 through 21. This is your total income  22

IRA deduction (see page 27) 24

23

Archer MSA deduction. Attach Form 8853

26

25

One-half of self-employment tax. Attach Schedule SE

27

Self-employed health insurance deduction (see page 30)

26

28

27

Self-employed SEP, SIMPLE, and qualified plans

29

28

Penalty on early withdrawal of savings

30

29

Alimony paid b Recipient’s SSN 

Add lines 23 through 33a 34

30

Subtract line 34 from line 22. This is your adjusted gross income 

31

Adjusted

Gross

Income

35

If you did not

get a W-2,

see page 21.

Cat. No. 11320B Form 1040 (2002)

Other income. List type and amount (see page 27)

Moving expenses. Attach Form 3903

24

25

For Disclosure, Privacy Act, and Paperwork Reduction Act Notice, see page 72.

32 32

Student loan interest deduction (see page 28)

31

33a

Tuition and fees deduction (see page XX)

34

33a

35

Educator expenses (see page xx) 23

Form 1040

Draft as of

4/23/2002

Itemized deductions (from Schedule A) or your standard deduction (see left margin)

Form 1040 (2002) Page 2

36 Amount from line 35 (adjusted gross income) 36

37a Check if:

Tax and

Credits

Add the number of boxes checked above and enter the total here  37a

Single,

$4,700

If you are married filing separately and your spouse itemizes deductions, or

you were a dual-status alien, see page 31 and check here 

b

37b

38 38

39 Subtract line 38 from line 36 39

40

If line 36 is $103,000 or less, multiply $3,000 by the total number of exemptions claimed on

line 6d. If line 36 is over $103,000, see the worksheet on page 32

40

41 Taxable income. Subtract line 40 from line 39. If line 40 is more than line 39, enter -0- 41

42 42

46

47

52

Education credits. Attach Form 8863

45

50

Other credits. Check applicable box(es):

49

54

55

Add lines 45 through 53. These are your total credits

49

Subtract line 54 from line 44. If line 54 is more than line 44, enter -0- 

54

55

You were 65 or older, Blind; Spouse was 65 or older, Blind.

a Form 3800

b Form 8801 c Specify

Tax (see page 33). Check if any tax is from a Form(s) 8814 b Form 4972

48

45

Retirement savings contributions credit. Attach Form 8880

Child tax credit (see page XX)

Credits from:

48

52

50

Head of

household,

$6,900

Married filing

jointly or

Qualifying

widow(er),

$7,850

Married

filing

separately,

$3,925

Standard

Deduction

for—

Credit for the elderly or the disabled. Attach Schedule R

43

44

46

Alternative minimum tax (see page 34). Attach Form 6251

Add lines 42 and 43 

Credit for child and dependent care expenses. Attach Form 2441

47

43

44

● People who

checked any

box on line

37a or 37b or

who can be

claimed as a

dependent,

see page 31.

● All others:

53

Foreign tax credit. Attach Form 1116 if required

53

a Form 8396 b Form 8859

51 Adoption credit. Attach Form 8839 51

125,000

3,600

7,500

(80,000)

56,100

56,100

Form 2555

56,100

4,700

51,400

3,000

48,400

9,421

9,421




Lesson 6 65

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Draft as of

6/25/2002

OMB No. 1545-0121 Foreign Tax Credit Form 1116 (Individual, Estate, or Trust)

Department of the Treasury

Internal Revenue Service

 Attach to Form 1040, 1040NR, 1041, or 990-T. Attachment  See separate instructions. Sequence No. 19

Name Identifying number as shown on page 1 of your tax return

Passive income Lump-sum distributions

High withholding tax Dividends from a DISC or former DISC

interest

Financial services income General limitation income

Certain distributions from a foreign

sales corporation (FSC) or former

FSC

Resident of (name of country) 

Note: If you paid taxes to only one foreign country or U.S. possession, use column A in Part I and line A in Part II. If you paid taxes to

more than one foreign country or U.S. possession, use a separate column and line for each country or possession.

Taxable Income or Loss From Sources Outside the United States (for Category Checked Above)

Foreign Country or U.S. Possession Total

A B C (Add cols. A, B, and C.)

Enter the name of the foreign country or U.S.

possession 

Gross income from sources within country

shown above and of the type checked above (see

page 7 of the instructions):

1

1

Deductions and losses (Caution: See pages 9, 12, and

13 of the instructions):

2 Expenses definitely related to the income on

line 1 (attach statement)

3 Pro rata share of other deductions not definitely

related:

Certain itemized deductions or standard

deduction (see instructions)

a

b Other deductions (attach statement)

c Add lines 3a and 3b

d Gross foreign source income (see instructions)

e Gross income from all sources (see instructions)

f Divide line 3d by line 3e (see instructions)

g Multiply line 3c by line 3f

4 Pro rata share of interest expense (see instructions):

a Home mortgage interest (use worksheet on

page 12 of the instructions)

b Other interest expense

5 Losses from foreign sources

6 Add lines 2, 3g, 4a, 4b, and 5 6

7 Subtract line 6 from line 1. Enter the result here and on line 14, page 2  7

Foreign Taxes Paid or Accrued (see page 13 of the instructions)

Credit is claimed Foreign taxes paid or accrued for taxes

(you must check one) In foreign currency In U.S. dollars

Paid (s) Other

foreign taxes

paid or

accrued

(w) Other

foreign taxes

paid or

accrued

(x) Total foreign

taxes paid or

accrued (add cols.

(t) through (w))

Taxes withheld at source on: Taxes withheld at source on: Accrued

Country

(q) Rents

and royalties

(u) Rents

and royalties

(o) Date paid

or accrued (p) Dividends (r) Interest (t) Dividends (v) Interest

A

B

C

8 Add lines A through C, column (x). Enter the total here and on line 9, page 2  8

For Paperwork Reduction Act Notice, see page 16 of the instructions. Form 1116 (2002)

Shipping income

Cat. No. 11440U

Part I

Part II

a

b

c

d

e

g

h

i

k

(m)

(n)

l

Use a separate Form 1116 for each category of income listed below. See Categories of Income on page 3 of the instructions. Check only one

box on each Form 1116. Report all amounts in U.S. dollars except where specified in Part II below.

f

Section 901(j) income

j

Certain income re-sourced by treaty

(99)

2002

Barry Adams 000 - 00 - 5741




66 Lesson 6

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Draft as of

6/25/2002

Figuring the Credit

9 Enter the amount from line 8. These are your total foreign taxes paid

or accrued for the category of income checked above Part I 9

10 Carryback or carryover (attach detailed computation) 10

11 Add lines 9 and 10 11

12 Reduction in foreign taxes (see page 13 of the instructions) 12

13 Subtract line 12 from line 11. This is the total amount of foreign taxes available for credit 13

14 Enter the amount from line 7. This is your taxable income or (loss) from

sources outside the United States (before adjustments) for the category

of income checked above Part I (see page 14 of the instructions) 14

15 Adjustments to line 14 (see page 14 of the instructions) 15

16 Combine the amounts on lines 14 and 15. This is your net foreign

source taxable income. (If the result is zero or less, you have no foreign

tax credit for the category of income you checked above Part I. Skip

lines 17 through 21. However, if you are filing more than one Form

1116, you must complete line 19.)

Individuals: Enter the amount from Form 1040, line 39. If you are a

nonresident alien, enter the amount from Form 1040NR, line 37.

Estates and trusts: Enter your taxable income without the deduction

for your exemption

17

17

18 Divide line 16 by line 17. If line 16 is more than line 17, enter “1” 18

Individuals: Enter the amount from Form 1040, line 42. If you are a nonresident alien, enter the

amount from Form 1040NR, line 40.

19

19

20 Multiply line 19 by line 18 (maximum amount of credit) 20

Enter the smaller of line 13 or line 20. If this is the only Form 1116 you are filing, skip lines 22 through

30 and enter this amount on line 31. Otherwise, complete the appropriate line in Part IV (see page

15 of the instructions) 

21

21

Summary of Credits From Separate Parts III (see page 16 of the instructions)

22 Credit for taxes on passive income 22

23 Credit for taxes on high withholding tax interest 23

24 Credit for taxes on financial services income 24

25 Credit for taxes on shipping income 25

26

Credit for taxes on dividends from a DISC or former DISC and certain

distributions from a FSC or former FSC

26

27

Credit for taxes on certain income re-sourced by treaty

27

28

Credit for taxes on lump-sum distributions

28

29 Credit for taxes on general limitation income 29

30 Add lines 22 through 29 30

32 Reduction of credit for international boycott operations. See instructions for line 12 on page 13 32

33 Subtract line 32 from line 31. This is your foreign tax credit. Enter here and on Form 1040, line 45;

Form 1040NR, line 43; Form 1041, Schedule G, line 2a; or Form 990-T, line 40a  33

Part IV

Part III

Caution: If you figured your tax using the special rates on capital gains, see page 15 of the instructions.

16

Estates and trusts: Enter the total of Form 1041, Schedule G, lines 1a and 1b, or the total of Form 990-T,

lines 36 and 37

Form 1116 (2002)

31 Enter the smaller of line 19 or line 30 31




Lesson 6 67

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Draft as of

6/25/2002

OMB No. 1545-0121 Foreign Tax Credit Form 1116 (Individual, Estate, or Trust)

Department of the Treasury

Internal Revenue Service

 Attach to Form 1040, 1040NR, 1041, or 990-T. Attachment  See separate instructions. Sequence No. 19

Name Identifying number as shown on page 1 of your tax return

Passive income Lump-sum distributions

High withholding tax Dividends from a DISC or former DISC

interest

Financial services income General limitation income

Certain distributions from a foreign

sales corporation (FSC) or former

FSC

Resident of (name of country) 

Note: If you paid taxes to only one foreign country or U.S. possession, use column A in Part I and line A in Part II. If you paid taxes to

more than one foreign country or U.S. possession, use a separate column and line for each country or possession.

Taxable Income or Loss From Sources Outside the United States (for Category Checked Above)

Foreign Country or U.S. Possession Total

A B C (Add cols. A, B, and C.)

Enter the name of the foreign country or U.S.

possession 

Gross income from sources within country

shown above and of the type checked above (see

page 7 of the instructions):

1

1

Deductions and losses (Caution: See pages 9, 12, and

13 of the instructions):

2 Expenses definitely related to the income on

line 1 (attach statement)

3 Pro rata share of other deductions not definitely

related:

Certain itemized deductions or standard

deduction (see instructions)

a

b Other deductions (attach statement)

c Add lines 3a and 3b

d Gross foreign source income (see instructions)

e Gross income from all sources (see instructions)

f Divide line 3d by line 3e (see instructions)

g Multiply line 3c by line 3f

4 Pro rata share of interest expense (see instructions):

a Home mortgage interest (use worksheet on

page 12 of the instructions)

b Other interest expense

5 Losses from foreign sources

6 Add lines 2, 3g, 4a, 4b, and 5 6

7 Subtract line 6 from line 1. Enter the result here and on line 14, page 2  7

Foreign Taxes Paid or Accrued (see page 13 of the instructions)

Credit is claimed Foreign taxes paid or accrued for taxes

(you must check one) In foreign currency In U.S. dollars

Paid (s) Other

foreign taxes

paid or

accrued

(w) Other

foreign taxes

paid or

accrued

(x) Total foreign

taxes paid or

accrued (add cols.

(t) through (w))

Taxes withheld at source on: Taxes withheld at source on: Accrued

Country

(q) Rents

and royalties

(u) Rents

and royalties

(o) Date paid

or accrued (p) Dividends (r) Interest (t) Dividends (v) Interest

A

B

C

8 Add lines A through C, column (x). Enter the total here and on line 9, page 2  8

For Paperwork Reduction Act Notice, see page 16 of the instructions. Form 1116 (2002)

Shipping income

Cat. No. 11440U

Part I

Part II

a

b

c

d

e

g

h

i

k

(m)

(n)

l

Use a separate Form 1116 for each category of income listed below. See Categories of Income on page 3 of the instructions. Check only one

box on each Form 1116. Report all amounts in U.S. dollars except where specified in Part II below.

f

Section 901(j) income

j

Certain income re-sourced by treaty

(99)

2002

Barry Adams 000 - 00 - 5741




68 Lesson 6

Pub678IN-Lesson 6 10/25/02 Turn 3 Page 68

Draft as of

6/25/2002

Figuring the Credit

9 Enter the amount from line 8. These are your total foreign taxes paid

or accrued for the category of income checked above Part I 9

10 Carryback or carryover (attach detailed computation) 10

11 Add lines 9 and 10 11

12 Reduction in foreign taxes (see page 13 of the instructions) 12

13 Subtract line 12 from line 11. This is the total amount of foreign taxes available for credit 13

14 Enter the amount from line 7. This is your taxable income or (loss) from

sources outside the United States (before adjustments) for the category

of income checked above Part I (see page 14 of the instructions) 14

15 Adjustments to line 14 (see page 14 of the instructions) 15

16 Combine the amounts on lines 14 and 15. This is your net foreign

source taxable income. (If the result is zero or less, you have no foreign

tax credit for the category of income you checked above Part I. Skip

lines 17 through 21. However, if you are filing more than one Form

1116, you must complete line 19.)

Individuals: Enter the amount from Form 1040, line 39. If you are a

nonresident alien, enter the amount from Form 1040NR, line 37.

Estates and trusts: Enter your taxable income without the deduction

for your exemption

17

17

18 Divide line 16 by line 17. If line 16 is more than line 17, enter “1” 18

Individuals: Enter the amount from Form 1040, line 42. If you are a nonresident alien, enter the

amount from Form 1040NR, line 40.

19

19

20 Multiply line 19 by line 18 (maximum amount of credit) 20

Enter the smaller of line 13 or line 20. If this is the only Form 1116 you are filing, skip lines 22 through

30 and enter this amount on line 31. Otherwise, complete the appropriate line in Part IV (see page

15 of the instructions) 

21

21

Summary of Credits From Separate Parts III (see page 16 of the instructions)

22 Credit for taxes on passive income 22

23 Credit for taxes on high withholding tax interest 23

24 Credit for taxes on financial services income 24

25 Credit for taxes on shipping income 25

26

Credit for taxes on dividends from a DISC or former DISC and certain

distributions from a FSC or former FSC

26

27

Credit for taxes on certain income re-sourced by treaty

27

28

Credit for taxes on lump-sum distributions

28

29 Credit for taxes on general limitation income 29

30 Add lines 22 through 29 30

32 Reduction of credit for international boycott operations. See instructions for line 12 on page 13 32

33 Subtract line 32 from line 31. This is your foreign tax credit. Enter here and on Form 1040, line 45;

Form 1040NR, line 43; Form 1041, Schedule G, line 2a; or Form 990-T, line 40a  33

Part IV

Part III

Caution: If you figured your tax using the special rates on capital gains, see page 15 of the instructions.

16

Estates and trusts: Enter the total of Form 1041, Schedule G, lines 1a and 1b, or the total of Form 990-T,

lines 36 and 37

Form 1116 (2002)

31 Enter the smaller of line 19 or line 30 31




Lesson 6 69

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Finally, if the person you are assisting wishes, the amount paid

in foreign taxes may be claimed as an itemized deduction in the

taxes portion of Schedule A if he or she itemizes deductions. If

the person chooses to claim the foreign taxes paid as an itemized deduction they may not claim the foreign tax credit.

Taxpayers will be able to claim the credit without using Form

1116 if the following requirements are met.

1. The taxpayer is an individual.

2. The only foreign source income for the tax year is passive

income (dividends, interest, royalties, etc.) that is reported on

a payee statement (such as a Form 1099-DIV or 1099-INT).

3. The qualified foreign taxes for the year are not more than

$300 ($600 if filing a joint return) and are reported on a

payee statement.

4. The taxpayer elects this procedure for the tax year.

If the taxpayer makes this election, he or she cannot carry back

or carry over any unused foreign tax to or from this year.

Most overseas taxpayers will not be eligible to make this election because they will not be able to meet requirement 2 above,

no Form 1099 will be available.




70 Lesson 6

Pub678IN-Lesson 6 10/25/02 Turn 3 Page 70

 SUMMING UP THIS LESSON 

 In order to qualify for a foreign tax credit, income on which

the taxes are paid must be foreign source.

 The tax being paid must be similar to U.S. income tax.

 The individual paying the tax cannot derive a specific economic benefit and still claim the foreign tax credit.

 The foreign tax credit is computed on Form 1116.

 A separate Form 1116 must be completed for passive

income, interest income which is subject to a gross withholding rate of at least 5%, and other income that falls

under the general limitation category.

 If passive income, minus allocations, is subject to tax at a

rate that is higher than 38.6%, then it falls into the general limitation category.

 If an individual claims the foreign earned income exclusion, the excluded amount is not shown on line 1 of Part I

of the Form 1116.

 A cash basis taxpayer may choose the accrual method to

claim the foreign tax credit. Once the choice has been

made, the taxpayer must continue to use the accrual

method.

 If the accrual method of claiming the foreign tax credit is

used, use the average annual currency exchange rate to

convert the foreign money into U.S. dollars.

 If all or part of the taxes claimed in Part II of Form 1116

are attributable to income excluded under the foreign

earned income exclusion, then the taxes available for credit

must be reduced by the taxes paid or accrued on the

excluded income. The reduction is entered on Part III, 

line 12.

 If there is more than one Form 1116 for the same person,

Part IV need only be completed on one of the forms.




Lesson 6 71

Pub678IN-Lesson 6 10/25/02 Turn 3 Page 7

1. c,e

2. a. no

b. no

c. yes

d. no










72 Lesson 6

Pub678IN-Lesson 6 10/25/02 Turn 3 Page 72





Exercise 3 Form 1116

Draft as of

6/25/2002

OMB No. 1545-0121 Foreign Tax Credit Form 1116 (Individual, Estate, or Trust)

Department of the Treasury

Internal Revenue Service

 Attach to Form 1040, 1040NR, 1041, or 990-T. Attachment  See separate instructions. Sequence No. 19

Name Identifying number as shown on page 1 of your tax return

Passive income Lump-sum distributions

High withholding tax Dividends from a DISC or former DISC

interest

Financial services income General limitation income

Certain distributions from a foreign

sales corporation (FSC) or former

FSC

Resident of (name of country) 

Note: If you paid taxes to only one foreign country or U.S. possession, use column A in Part I and line A in Part II. If you paid taxes to

more than one foreign country or U.S. possession, use a separate column and line for each country or possession.

Taxable Income or Loss From Sources Outside the United States (for Category Checked Above)

Foreign Country or U.S. Possession Total

A B C (Add cols. A, B, and C.)

Enter the name of the foreign country or U.S.

possession 

Gross income from sources within country

shown above and of the type checked above (see

page 7 of the instructions):

1

1

Deductions and losses (Caution: See pages 9, 12, and

13 of the instructions):

2 Expenses definitely related to the income on

line 1 (attach statement)

3 Pro rata share of other deductions not definitely

related:

Certain itemized deductions or standard

deduction (see instructions)

a

b Other deductions (attach statement)

c Add lines 3a and 3b

d Gross foreign source income (see instructions)

e Gross income from all sources (see instructions)

f Divide line 3d by line 3e (see instructions)

g Multiply line 3c by line 3f

4 Pro rata share of interest expense (see instructions):

a Home mortgage interest (use worksheet on

page 12 of the instructions)

b Other interest expense

5 Losses from foreign sources

6 Add lines 2, 3g, 4a, 4b, and 5 6

7 Subtract line 6 from line 1. Enter the result here and on line 14, page 2  7

Foreign Taxes Paid or Accrued (see page 13 of the instructions)

Credit is claimed Foreign taxes paid or accrued for taxes

(you must check one) In foreign currency In U.S. dollars

Paid (s) Other

foreign taxes

paid or

accrued

(w) Other

foreign taxes

paid or

accrued

(x) Total foreign

taxes paid or

accrued (add cols.

(t) through (w))

Taxes withheld at source on: Taxes withheld at source on: Accrued

Country

(q) Rents

and royalties

(u) Rents

and royalties

(o) Date paid

or accrued (p) Dividends (r) Interest (t) Dividends (v) Interest

A

B

C

8 Add lines A through C, column (x). Enter the total here and on line 9, page 2  8

For Paperwork Reduction Act Notice, see page 16 of the instructions. Form 1116 (2002)

Shipping income

Cat. No. 11440U

Part I

Part II

a

b

c

d

e

g

h

i

k

(m)

(n)

l

Use a separate Form 1116 for each category of income listed below. See Categories of Income on page 3 of the instructions. Check only one

box on each Form 1116. Report all amounts in U.S. dollars except where specified in Part II below.

f

Section 901(j) income

j

Certain income re-sourced by treaty

(99)

2002

Charles Green

x

United

Kingdom

2,000 2,000

4,700

4,700

2,000

100,000

.0200

94

94 94

1,906

United Kingdom

x

12/31/02 330 550 550

550

000 - 00- 6492




Lesson 6 73

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Exercise 4 Form 1116

Draft as of

6/25/2002

Form 1116 (2002) Page 2

Figuring the Credit

9 Enter the amount from line 8. These are your total foreign taxes paid

or accrued for the category of income checked above Part I 9

10 Carryback or carryover (attach detailed computation) 10

11 Add lines 9 and 10 11

12 Reduction in foreign taxes (see page 13 of the instructions) 12

13 Subtract line 12 from line 11. This is the total amount of foreign taxes available for credit 13

14 Enter the amount from line 7. This is your taxable income or (loss) from

sources outside the United States (before adjustments) for the category

of income checked above Part I (see page 14 of the instructions) 14

15 Adjustments to line 14 (see page 14 of the instructions) 15

16 Combine the amounts on lines 14 and 15. This is your net foreign

source taxable income. (If the result is zero or less, you have no foreign

tax credit for the category of income you checked above Part I. Skip

lines 17 through 21. However, if you are filing more than one Form

1116, you must complete line 19.)

Individuals: Enter the amount from Form 1040, line 39. If you are a

nonresident alien, enter the amount from Form 1040NR, line 37.

Estates and trusts: Enter your taxable income without the deduction

for your exemption

17

17

18 Divide line 16 by line 17. If line 16 is more than line 17, enter “1” 18

Individuals: Enter the amount from Form 1040, line 42. If you are a nonresident alien, enter the

amount from Form 1040NR, line 40.

19

19

20 Multiply line 19 by line 18 (maximum amount of credit) 20

Enter the smaller of line 13 or line 20. If this is the only Form 1116 you are filing, skip lines 22 through

30 and enter this amount on line 31. Otherwise, complete the appropriate line in Part IV (see page

15 of the instructions) 

21

21

Summary of Credits From Separate Parts III (see page 16 of the instructions)

22 Credit for taxes on passive income 22

23 Credit for taxes on high withholding tax interest 23

24 Credit for taxes on financial services income 24

25 Credit for taxes on shipping income 25

26

Credit for taxes on dividends from a DISC or former DISC and certain

distributions from a FSC or former FSC

26

27

Credit for taxes on certain income re-sourced by treaty

27

28

Credit for taxes on lump-sum distributions

28

29 Credit for taxes on general limitation income 29

30 Add lines 22 through 29 30

32 Reduction of credit for international boycott operations. See instructions for line 12 on page 13 32

33 Subtract line 32 from line 31. This is your foreign tax credit. Enter here and on Form 1040, line 45;

Form 1040NR, line 43; Form 1041, Schedule G, line 2a; or Form 990-T, line 40a  33

Part IV

Part III

Caution: If you figured your tax using the special rates on capital gains, see page 15 of the instructions.

16

Estates and trusts: Enter the total of Form 1041, Schedule G, lines 1a and 1b, or the total of Form 990-T,

lines 36 and 37

Form 1116 (2002)

31 Enter the smaller of line 19 or line 30 31

550

550

550

1,906

1,906

35,300

.0540

5,074

274

274

274

274




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Exercise 4 – Calculations

Currency Conversion and U.S. Income

Form 1040 Pounds Conversion Dollars

 Line # £ Rate $ 

Item

Wages (U.K.) 7 36,000 x 1.6667 = 60,000

Interest (U.K.) 8a 1,200 x 1.6667 = 2,000

Interest (U.S.) 8a 3,000

Short Term Capital Gain (U.S.) 13 35,000

Foreign Income Exclusion 21 (60,000)

Total Income and AGI 22, 33, 34 40,000

Less - Standard Deduction 36 (4,700)

Balance 37 35,300

Less - Exemption 38 (3,000)

Taxable Income 39 32,300

Tax 40 5,074

Tax Allocation

 £ Rate $ 

Wages £36,000 x 27.5% = 9,900 x 1.6667 = 16,500

Interest £1,200 x 27.5% = 330 x 1.6667 = 550

Total Foreign Taxes Paid 10,230 17,050

Taxes allocated to Wages (60,000 ÷ {60,000 + 2,000}) x 17,050 = 16,500

Taxes allocated to Interest (1,100 ÷ {125,000 + 1,100}) x 25,000 = 550

Total Allocated Taxes 17,050








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Exercise 5 Form 111

Draft as of

6/25/2002

OMB No. 1545-0121 Foreign Tax Credit Form 1116 (Individual, Estate, or Trust)

Department of the Treasury

Internal Revenue Service

 Attach to Form 1040, 1040NR, 1041, or 990-T. Attachment  See separate instructions. Sequence No. 19

Name Identifying number as shown on page 1 of your tax return

Passive income Lump-sum distributions

High withholding tax Dividends from a DISC or former DISC

interest

Financial services income General limitation income

Certain distributions from a foreign

sales corporation (FSC) or former

FSC

Resident of (name of country) 

Note: If you paid taxes to only one foreign country or U.S. possession, use column A in Part I and line A in Part II. If you paid taxes to

more than one foreign country or U.S. possession, use a separate column and line for each country or possession.

Taxable Income or Loss From Sources Outside the United States (for Category Checked Above)

Foreign Country or U.S. Possession Total

A B C (Add cols. A, B, and C.)

Enter the name of the foreign country or U.S.

possession 

Gross income from sources within country

shown above and of the type checked above (see

page 7 of the instructions):

1

1

Deductions and losses (Caution: See pages 9, 12, and

13 of the instructions):

2 Expenses definitely related to the income on

line 1 (attach statement)

3 Pro rata share of other deductions not definitely

related:

Certain itemized deductions or standard

deduction (see instructions)

a

b Other deductions (attach statement)

c Add lines 3a and 3b

d Gross foreign source income (see instructions)

e Gross income from all sources (see instructions)

f Divide line 3d by line 3e (see instructions)

g Multiply line 3c by line 3f

4 Pro rata share of interest expense (see instructions):

a Home mortgage interest (use worksheet on

page 12 of the instructions)

b Other interest expense

5 Losses from foreign sources

6 Add lines 2, 3g, 4a, 4b, and 5 6

7 Subtract line 6 from line 1. Enter the result here and on line 14, page 2  7

Foreign Taxes Paid or Accrued (see page 13 of the instructions)

Credit is claimed Foreign taxes paid or accrued for taxes

(you must check one) In foreign currency In U.S. dollars

Paid (s) Other

foreign taxes

paid or

accrued

(w) Other

foreign taxes

paid or

accrued

(x) Total foreign

taxes paid or

accrued (add cols.

(t) through (w))

Taxes withheld at source on: Taxes withheld at source on: Accrued

Country

(q) Rents

and royalties

(u) Rents

and royalties

(o) Date paid

or accrued (p) Dividends (r) Interest (t) Dividends (v) Interest

A

B

C

8 Add lines A through C, column (x). Enter the total here and on line 9, page 2  8

For Paperwork Reduction Act Notice, see page 16 of the instructions. Form 1116 (2002)

Shipping income

Cat. No. 11440U

Part I

Part II

a

b

c

d

e

g

h

i

k

(m)

(n)

l

Use a separate Form 1116 for each category of income listed below. See Categories of Income on page 3 of the instructions. Check only one

box on each Form 1116. Report all amounts in U.S. dollars except where specified in Part II below.

f

Section 901(j) income

j

Certain income re-sourced by treaty

(99)

2002

Barry Adams

France

45,000 45,000

4,700

4,700

125,000

136,100

.9184

4,316

4,316 4,316

40,684

x

12/31/02 27,260 24,782 24,782

24,782

France

x

000 - 00 - 5741




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Exercise 5 Form 1116

Draft as of

6/25/2002

Form 1116 (2002) Page 2

Figuring the Credit

9 Enter the amount from line 8. These are your total foreign taxes paid

or accrued for the category of income checked above Part I 9

10 Carryback or carryover (attach detailed computation) 10

11 Add lines 9 and 10 11

12 Reduction in foreign taxes (see page 13 of the instructions) 12

13 Subtract line 12 from line 11. This is the total amount of foreign taxes available for credit 13

14 Enter the amount from line 7. This is your taxable income or (loss) from

sources outside the United States (before adjustments) for the category

of income checked above Part I (see page 14 of the instructions) 14

15 Adjustments to line 14 (see page 14 of the instructions) 15

16 Combine the amounts on lines 14 and 15. This is your net foreign

source taxable income. (If the result is zero or less, you have no foreign

tax credit for the category of income you checked above Part I. Skip

lines 17 through 21. However, if you are filing more than one Form

1116, you must complete line 19.)

Individuals: Enter the amount from Form 1040, line 39. If you are a

nonresident alien, enter the amount from Form 1040NR, line 37.

Estates and trusts: Enter your taxable income without the deduction

for your exemption

17

17

18 Divide line 16 by line 17. If line 16 is more than line 17, enter “1” 18

Individuals: Enter the amount from Form 1040, line 42. If you are a nonresident alien, enter the

amount from Form 1040NR, line 40.

19

19

20 Multiply line 19 by line 18 (maximum amount of credit) 20

Enter the smaller of line 13 or line 20. If this is the only Form 1116 you are filing, skip lines 22 through

30 and enter this amount on line 31. Otherwise, complete the appropriate line in Part IV (see page

15 of the instructions) 

21

21

Summary of Credits From Separate Parts III (see page 16 of the instructions)

22 Credit for taxes on passive income 22

23 Credit for taxes on high withholding tax interest 23

24 Credit for taxes on financial services income 24

25 Credit for taxes on shipping income 25

26

Credit for taxes on dividends from a DISC or former DISC and certain

distributions from a FSC or former FSC

26

27

Credit for taxes on certain income re-sourced by treaty

27

28

Credit for taxes on lump-sum distributions

28

29 Credit for taxes on general limitation income 29

30 Add lines 22 through 29 30

32 Reduction of credit for international boycott operations. See instructions for line 12 on page 13 32

33 Subtract line 32 from line 31. This is your foreign tax credit. Enter here and on Form 1040, line 45;

Form 1040NR, line 43; Form 1041, Schedule G, line 2a; or Form 990-T, line 40a  33

Part IV

Part III

Caution: If you figured your tax using the special rates on capital gains, see page 15 of the instructions.

16

Estates and trusts: Enter the total of Form 1041, Schedule G, lines 1a and 1b, or the total of Form 990-T,

lines 36 and 37

Form 1116 (2002)

31 Enter the smaller of line 19 or line 30 31

24,782

24,782

15,860

8,922

40,684

40,684

51,400

.7915

9,421

7,457

7,457

195

7,457

7,652

7,652

7,652




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Exercise 5 Form 1116

Draft as of

6/25/2002

OMB No. 1545-0121 Foreign Tax Credit Form 1116 (Individual, Estate, or Trust)

Department of the Treasury

Internal Revenue Service

 Attach to Form 1040, 1040NR, 1041, or 990-T. Attachment  See separate instructions. Sequence No. 19

Name Identifying number as shown on page 1 of your tax return

Passive income Lump-sum distributions

High withholding tax Dividends from a DISC or former DISC

interest

Financial services income General limitation income

Certain distributions from a foreign

sales corporation (FSC) or former

FSC

Resident of (name of country) 

Note: If you paid taxes to only one foreign country or U.S. possession, use column A in Part I and line A in Part II. If you paid taxes to

more than one foreign country or U.S. possession, use a separate column and line for each country or possession.

Taxable Income or Loss From Sources Outside the United States (for Category Checked Above)

Foreign Country or U.S. Possession Total

A B C (Add cols. A, B, and C.)

Enter the name of the foreign country or U.S.

possession 

Gross income from sources within country

shown above and of the type checked above (see

page 7 of the instructions):

1

1

Deductions and losses (Caution: See pages 9, 12, and

13 of the instructions):

2 Expenses definitely related to the income on

line 1 (attach statement)

3 Pro rata share of other deductions not definitely

related:

Certain itemized deductions or standard

deduction (see instructions)

a

b Other deductions (attach statement)

c Add lines 3a and 3b

d Gross foreign source income (see instructions)

e Gross income from all sources (see instructions)

f Divide line 3d by line 3e (see instructions)

g Multiply line 3c by line 3f

4 Pro rata share of interest expense (see instructions):

a Home mortgage interest (use worksheet on

page 12 of the instructions)

b Other interest expense

5 Losses from foreign sources

6 Add lines 2, 3g, 4a, 4b, and 5 6

7 Subtract line 6 from line 1. Enter the result here and on line 14, page 2  7

Foreign Taxes Paid or Accrued (see page 13 of the instructions)

Credit is claimed Foreign taxes paid or accrued for taxes

(you must check one) In foreign currency In U.S. dollars

Paid (s) Other

foreign taxes

paid or

accrued

(w) Other

foreign taxes

paid or

accrued

(x) Total foreign

taxes paid or

accrued (add cols.

(t) through (w))

Taxes withheld at source on: Taxes withheld at source on: Accrued

Country

(q) Rents

and royalties

(u) Rents

and royalties

(o) Date paid

or accrued (p) Dividends (r) Interest (t) Dividends (v) Interest

A

B

C

8 Add lines A through C, column (x). Enter the total here and on line 9, page 2  8

For Paperwork Reduction Act Notice, see page 16 of the instructions. Form 1116 (2002)

Shipping income

Cat. No. 11440U

Part I

Part II

a

b

c

d

e

g

h

i

k

(m)

(n)

l

Use a separate Form 1116 for each category of income listed below. See Categories of Income on page 3 of the instructions. Check only one

box on each Form 1116. Report all amounts in U.S. dollars except where specified in Part II below.

f

Section 901(j) income

j

Certain income re-sourced by treaty

(99)

2002

Barry Adams

x

France

1,100 1,100

4,700

4,700

1,100

136,100

.0081

38

38 38

1,062

12/31/02 240 218 218

218

France

000 - 00 - 5741




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Exercise 5 Form 1116

Draft as of

6/25/2002

Form 1116 (2002) Page 2

Figuring the Credit

9 Enter the amount from line 8. These are your total foreign taxes paid

or accrued for the category of income checked above Part I 9

10 Carryback or carryover (attach detailed computation) 10

11 Add lines 9 and 10 11

12 Reduction in foreign taxes (see page 13 of the instructions) 12

13 Subtract line 12 from line 11. This is the total amount of foreign taxes available for credit 13

14 Enter the amount from line 7. This is your taxable income or (loss) from

sources outside the United States (before adjustments) for the category

of income checked above Part I (see page 14 of the instructions) 14

15 Adjustments to line 14 (see page 14 of the instructions) 15

16 Combine the amounts on lines 14 and 15. This is your net foreign

source taxable income. (If the result is zero or less, you have no foreign

tax credit for the category of income you checked above Part I. Skip

lines 17 through 21. However, if you are filing more than one Form

1116, you must complete line 19.)

Individuals: Enter the amount from Form 1040, line 39. If you are a

nonresident alien, enter the amount from Form 1040NR, line 37.

Estates and trusts: Enter your taxable income without the deduction

for your exemption

17

17

18 Divide line 16 by line 17. If line 16 is more than line 17, enter “1” 18

Individuals: Enter the amount from Form 1040, line 42. If you are a nonresident alien, enter the

amount from Form 1040NR, line 40.

19

19

20 Multiply line 19 by line 18 (maximum amount of credit) 20

Enter the smaller of line 13 or line 20. If this is the only Form 1116 you are filing, skip lines 22 through

30 and enter this amount on line 31. Otherwise, complete the appropriate line in Part IV (see page

15 of the instructions) 

21

21

Summary of Credits From Separate Parts III (see page 16 of the instructions)

22 Credit for taxes on passive income 22

23 Credit for taxes on high withholding tax interest 23

24 Credit for taxes on financial services income 24

25 Credit for taxes on shipping income 25

26

Credit for taxes on dividends from a DISC or former DISC and certain

distributions from a FSC or former FSC

26

27

Credit for taxes on certain income re-sourced by treaty

27

28

Credit for taxes on lump-sum distributions

28

29 Credit for taxes on general limitation income 29

30 Add lines 22 through 29 30

32 Reduction of credit for international boycott operations. See instructions for line 12 on page 13 32

33 Subtract line 32 from line 31. This is your foreign tax credit. Enter here and on Form 1040, line 45;

Form 1040NR, line 43; Form 1041, Schedule G, line 2a; or Form 990-T, line 40a  33

Part IV

Part III

Caution: If you figured your tax using the special rates on capital gains, see page 15 of the instructions.

16

Estates and trusts: Enter the total of Form 1041, Schedule G, lines 1a and 1b, or the total of Form 990-T,

lines 36 and 37

Form 1116 (2002)

31 Enter the smaller of line 19 or line 30 31

218

218

218

1,062

1,062

51,400

.0207

9,421

195

195

195

195




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Exercise 5 – Calculations

Euro Conversion and U.S. Income

Form 1040 Euros Conversion Dollars

 Line # £ Rate $ 

Item

Wages (France) 7 137,500 x 0.90909 = 125,000

Interest (France) 8a 1,210 x 0.90909 = 1,100

Interest (U.S.) 8a 2,500

Net Rents (U.S.) 17 7,500

Foreign Income Exclusion 21 (80,000)

Total Income and AGI 22, 33, 34 56,100

Less - Standard Deduction 36 (4,700)

Balance 37 51,400

Less - Exemption 38 (3,000)

Taxable Income 39 48,400

Tax 40 9,421

Tax Allocation

 £ Rate $ 

Taxes Paid 27,500 0.90909 25,000

Taxes allocated to Wages (125,000 ÷ {125,000 + 1,100}) x 25,000 = 24,782

Taxes allocated to Interest (1,100 ÷ {125,000 + 1,100}) x 25,000 = 218

Total Allocated Taxes 25,000

Reduction (Form 1116, Part III, Line 12)

(80,000 ÷ 125,000) x 24,782 $15,860








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STUDENT NOTES






INTRODUCTION

The rules for paying self-employment tax are generally the

same whether the taxpayer lives in the U.S. or abroad. This

lesson covers who is considered to be a self-employed individual

and who is subject to self-employment tax when abroad.

OBJECTIVES

At the end of this lesson you will be able to:

1. Determine who is a self-employed individual.

2. Compute the self-employment tax for a U.S. citizen or resident abroad.

3. Compute the deduction for self-employment tax.

EMPLOYEE OR SELF-EMPLOYED

A self-employed person is generally one who either:

1. Carries on a trade or business as a sole proprietor or

independent contractor.

2. Is a member of a partnership that carries on a trade

or business.

3. Otherwise in business for himself or herself.

SELF-EMPLOYMENT TAX

The self-employment tax is a social security tax for individuals

who work for themselves. It is similar to the social security tax

withheld from the pay of wage earners.

Social security benefits are available to individuals who are

self-employed just as they are to wage earners. Payments of

self-employment tax contribute to an individual’s coverage

under the social security system.

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SELF EMPLOYMENT TAX 








82 Lesson 7

gpyy

Self-employment tax consists of two parts, social security and

medicare. For 2002, social security tax is paid on the first

$84,900 of net income. The medicare tax is imposed on the full

amount of net income.

Note: If your self-employment income is $400 or more, you

must file a return even though your income is below the minimum amount for income tax filing purposes.

Effect of Foreign Earned Income Exclusion. You must

take all of your earned income into account in figuring your

self-employment tax, even though the income is exempt from

income tax because of the foreign earned income exclusion.

Example 1

You are in business abroad as a consultant and qualify for the

foreign earned income exclusion. Your foreign earned income is

$70,000, business expenses $20,000, resulting in net earnings

of $50,000. You must pay self-employment tax on the net

income even though you excluded all of your earned income.

Exemption from U.S. Self-Employment Tax. The United

States may reach agreements with foreign countries to eliminate dual coverage and dual contributions (taxes) to social

security systems for the same work. As a general rule, selfemployed persons who are subject to dual taxation will only be

covered by the social security system of the country where they

reside.

For more information, consult Publication 54, “Tax Guide for

U.S. Citizens and Resident Aliens Abroad.”

TAX FORMS

Form 1040, U.S. Individual Income Tax Return, is used to report 

self-employment tax. Both income tax and self-employment 

tax are due at the same time. Schedule SE, Social Security SelfEmployment Tax, is used to figure the tax. Even if the taxpayer

is not otherwise required to file an income tax return, he or she

must file both Form 1040 and Schedule SE to pay self-employment tax.

The Schedule SE includes a flowchart to determine if the short

or long form is required.

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Although there are three methods available to compute selfemployment tax, VITA volunteers will only use the regular

method. Taxpayers who wish to use the other methods should

seek paid professional assistance. There are no limits on who

may use the regular method. Most taxpayers use this method.

Under the regular method, the net income from your business

or profession is generally your net self-employment earnings

from Schedules C, C-EZ, F. and K-1 (Form 1065).

If you have more than one trade or business, your net earnings

from self-employment are the combined net earnings from each

of your businesses. A loss in one business will reduce the

income earned in another. You must claim all allowable deductions including depreciation when figuring your net earnings

from self-employment.

Even though the income may be exempt from income tax

because of foreign earned income exclusion, you must take all

of your earned income into account in figuring your selfemployment tax. Refer to Publication 54, Tax Guide for U.S.

Citizens and Resident Aliens Abroad, regarding the effect of the

foreign earned income exclusion on U.S. self-employment tax.

Example 1

Susan J. Brown is sole proprietor of a dress shop, “Milady

Fashions.” Her Schedule C shows a net profit of $35,100.

Susan’s completed Schedule SE is shown at the end of this section.

If Susan were the proprietor of more than one business, she

would have combined the profits and losses from all of them and

filled out only one Schedule SE. If, in addition to operating her

dress shop, Susan had worked for wages totaling $84,900 or

more, she would have already paid the maximum amount of

social security tax owed on her wages, but she would still be subject to the medicare portion (2.9%) of self employment tax. In this

case, she would use the long Schedule SE.

The line numbers shown below in bold type refer to the line

numbers on the sample filled-in Schedule SE on the 

following page.

Line 1. Since Susan has no earnings from farm self-employment,

she leaves line 1 blank.

Line 2. Susan enters the net profit from her Schedule C,

$35,100.

Line 3. Since Susan has no farm income, she enters the same

amount on line 3.

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84 Lesson 7

Line 5. Susan determines her self-employment tax by using

the first option on Line 5. She multiplies $32,415 on Line 4 by

15.3%. She enters $4,959 on Line 5. This is her self-employment tax. She also enters this amount on Line 47 of Form

1040.

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Lesson 7 85

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Draft as of

6/19/2002

SCHEDULE SE OMB No. 1545-0074

(Form 1040) Self-Employment Tax Department of the Treasury

Internal Revenue Service

Attachment  Attach to Form 1040.  See Instructions for Schedule SE (Form 1040). Sequence No. 17

Name of person with self-employment income (as shown on Form 1040) Social security number of person

with self-employment income 

Who Must File Schedule SE

You must file Schedule SE if:

● You had net earnings from self-employment from other than church employee income (line 4 of Short Schedule SE or line 4c of

Long Schedule SE) of $400 or more or

Exception. If your only self-employment income was from earnings as a minister, member of a religious order, or Christian Science

practitioner and you filed Form 4361 and received IRS approval not to be taxed on those earnings, do not file Schedule SE. Instead,

write “Exempt–Form 4361” on Form 1040, line 56.

Section A—Short Schedule SE. Caution. Read above to see if you can use Short Schedule SE.

Net farm profit or (loss) from Schedule F, line 36, and farm partnerships, Schedule K-1 (Form

1065), line 15a

1

1

Net profit or (loss) from Schedule C, line 31; Schedule C-EZ, line 3; Schedule K-1 (Form 1065),

line 15a (other than farming); and Schedule K-1 (Form 1065-B), box 9. Ministers and members

of religious orders, see page SE-1 for amounts to report on this line. See page SE-2 for other

income to report

2

2

3 Combine lines 1 and 2 3

Net earnings from self-employment. Multiply line 3 by 92.35% (.9235). If less than $400,

do not file this schedule; you do not owe self-employment tax 

4

4

5 Self-employment tax. If the amount on line 4 is: 

For Paperwork Reduction Act Notice, see Form 1040 instructions. Schedule SE (Form 1040) 2002

● You had church employee income of $108.28 or more. Income from services you performed as a minister or a member of a

religious order is not church employee income. See page SE-1.

Cat. No. 11358Z

Deduction for one-half of self-employment tax. Multiply line 5 by

50% (.5). Enter the result here and on Form 1040, line 29

● $84,900 or less, multiply line 4 by 15.3% (.153). Enter the result here and on 

Form 1040, line 56.

● More than $84,900, multiply line 4 by 2.9% (.029). Then, add $10,527.60 to the

result. Enter the total here and on Form 1040, line 56.

May I Use Short Schedule SE or Must I Use Long Schedule SE?

Did You Receive Wages or Tips in 2002?

Was the total of your wages and tips subject to social security

or railroad retirement tax plus your net earnings from

self-employment more than $84,900?

Did you receive tips subject to social security or Medicare tax

that you did not report to your employer?

Are you using one of the optional methods to figure your net

earnings (see page SE-3)?

Are you a minister, member of a religious order, or Christian

Science practitioner who received IRS approval not to be taxed

on earnings from these sources, but you owe self-employment

tax on other earnings?

Did you receive church employee income reported on Form

W-2 of $108.28 or more?

You May Use Short Schedule SE Below You Must Use Long Schedule SE on the Back





Yes



No Yes







No

No

No

No

Yes



Yes



Yes



Yes



 







No

Note. Even if you had a loss or a small amount of income from self-employment, it may be to your benefit to file Schedule SE and

use either “optional method” in Part II of Long Schedule SE. See page SE-3.

6

5

6



(99)

2002

35,100

35,100

32,415

4,959

2,480

Susan Brown 000 00 6193




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This deduction for one-half of the SE tax will reduce Susan’s

income subject to income tax. However, if all of Susan’s selfemployment income qualifies for the foreign earned income

exclusion, this deduction is allocable to the excluded income

and must be included on line 42 the Form 2555. This prevents

the deduction from reducing other taxable income. See the earlier chapter on foreign earned income exclusion for additional

information.

 SUMMING UP THIS LESSON 

 As a volunteer assisting taxpayers abroad, you may be asked

questions regarding self-employment tax. In this lesson you

have learned how to determine if you are considered a selfemployed individual and how to compute the self-employment tax.




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Exercise 1

You must pay self-employment tax if you have net earnings

from self-employment of $_________ or more year.

Exercise 2

John has a business abroad in 2002, as a private contractor

and his self-employed income qualifies for the foreign earned

income exclusion. His foreign earned income is $64,000, business expenses $19,000, and net earnings $45,000. Since his foreign earned income is completely excluded, is he liable for

self-employment tax? If yes, what amount of income is subject

to self-employment tax?

Exercise 3

The United States may reach agreements with foreign countries to eliminate dual coverage and dual contributions (taxes)

to social security systems for the same work. These agreements

may be applicable to self-employed persons.

True/False

Exercise 4

Janice Thompson is a self-employed baby-sitter overseas. She 

is a U.S. citizen living with her husband. He is a U.S. Army

officer and also a U.S. citizen. She operates her sole proprietor

babysitting service out of their off base apartment. She has no

wage income. Her Schedule C shows a net profit of $9,500 in

2002. She qualifies for the foreign earned income exclusion.

She receives no exemption from any agreement to exclude her

self-employment tax.

Compute her self-employment tax for 2002 on the blank

Schedule SE.




88 Lesson 7

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Draft as of

6/19/2002

SCHEDULE SE OMB No. 1545-0074

(Form 1040) Self-Employment Tax Department of the Treasury

Internal Revenue Service

Attachment  Attach to Form 1040.  See Instructions for Schedule SE (Form 1040). Sequence No. 17

Name of person with self-employment income (as shown on Form 1040) Social security number of person

with self-employment income 

Who Must File Schedule SE

You must file Schedule SE if:

● You had net earnings from self-employment from other than church employee income (line 4 of Short Schedule SE or line 4c of

Long Schedule SE) of $400 or more or

Exception. If your only self-employment income was from earnings as a minister, member of a religious order, or Christian Science

practitioner and you filed Form 4361 and received IRS approval not to be taxed on those earnings, do not file Schedule SE. Instead,

write “Exempt–Form 4361” on Form 1040, line 56.

Section A—Short Schedule SE. Caution. Read above to see if you can use Short Schedule SE.

Net farm profit or (loss) from Schedule F, line 36, and farm partnerships, Schedule K-1 (Form

1065), line 15a

1

1

Net profit or (loss) from Schedule C, line 31; Schedule C-EZ, line 3; Schedule K-1 (Form 1065),

line 15a (other than farming); and Schedule K-1 (Form 1065-B), box 9. Ministers and members

of religious orders, see page SE-1 for amounts to report on this line. See page SE-2 for other

income to report

2

2

3 Combine lines 1 and 2 3

Net earnings from self-employment. Multiply line 3 by 92.35% (.9235). If less than $400,

do not file this schedule; you do not owe self-employment tax 

4

4

5 Self-employment tax. If the amount on line 4 is: 

For Paperwork Reduction Act Notice, see Form 1040 instructions. Schedule SE (Form 1040) 2002

● You had church employee income of $108.28 or more. Income from services you performed as a minister or a member of a

religious order is not church employee income. See page SE-1.

Cat. No. 11358Z

Deduction for one-half of self-employment tax. Multiply line 5 by

50% (.5). Enter the result here and on Form 1040, line 29

● $84,900 or less, multiply line 4 by 15.3% (.153). Enter the result here and on 

Form 1040, line 56.

● More than $84,900, multiply line 4 by 2.9% (.029). Then, add $10,527.60 to the

result. Enter the total here and on Form 1040, line 56.

May I Use Short Schedule SE or Must I Use Long Schedule SE?

Did You Receive Wages or Tips in 2002?

Was the total of your wages and tips subject to social security

or railroad retirement tax plus your net earnings from

self-employment more than $84,900?

Did you receive tips subject to social security or Medicare tax

that you did not report to your employer?

Are you using one of the optional methods to figure your net

earnings (see page SE-3)?

Are you a minister, member of a religious order, or Christian

Science practitioner who received IRS approval not to be taxed

on earnings from these sources, but you owe self-employment

tax on other earnings?

Did you receive church employee income reported on Form

W-2 of $108.28 or more?

You May Use Short Schedule SE Below You Must Use Long Schedule SE on the Back





Yes



No Yes







No

No

No

No

Yes



Yes



Yes



Yes



 







No

Note. Even if you had a loss or a small amount of income from self-employment, it may be to your benefit to file Schedule SE and

use either “optional method” in Part II of Long Schedule SE. See page SE-3.

6

5

6



(99)

2002

Janice Thompson 000 00 4921




Lesson 7 89

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SELF EMPLOYMENT TAX ANSWERS TO EXERCISES





Exercise 1

$400

Exercise 2

Yes 

John must take all of his earned income into account in figuring his self-employment tax, even though the income is exempt

from income tax because of the foreign earned income exclusion.

John’s $45,000 net earnings are subject to self-employment 

tax in 2002.

Exercise 3

True. Agreements may apply to self-employed persons.




90 Lesson 7

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Draft as of

6/19/2002

SCHEDULE SE OMB No. 1545-0074

(Form 1040) Self-Employment Tax Department of the Treasury

Internal Revenue Service

Attachment  Attach to Form 1040.  See Instructions for Schedule SE (Form 1040). Sequence No. 17

Name of person with self-employment income (as shown on Form 1040) Social security number of person

with self-employment income 

Who Must File Schedule SE

You must file Schedule SE if:

● You had net earnings from self-employment from other than church employee income (line 4 of Short Schedule SE or line 4c of

Long Schedule SE) of $400 or more or

Exception. If your only self-employment income was from earnings as a minister, member of a religious order, or Christian Science

practitioner and you filed Form 4361 and received IRS approval not to be taxed on those earnings, do not file Schedule SE. Instead,

write “Exempt–Form 4361” on Form 1040, line 56.

Section A—Short Schedule SE. Caution. Read above to see if you can use Short Schedule SE.

Net farm profit or (loss) from Schedule F, line 36, and farm partnerships, Schedule K-1 (Form

1065), line 15a

1

1

Net profit or (loss) from Schedule C, line 31; Schedule C-EZ, line 3; Schedule K-1 (Form 1065),

line 15a (other than farming); and Schedule K-1 (Form 1065-B), box 9. Ministers and members

of religious orders, see page SE-1 for amounts to report on this line. See page SE-2 for other

income to report

2

2

3 Combine lines 1 and 2 3

Net earnings from self-employment. Multiply line 3 by 92.35% (.9235). If less than $400,

do not file this schedule; you do not owe self-employment tax 

4

4

5 Self-employment tax. If the amount on line 4 is: 

For Paperwork Reduction Act Notice, see Form 1040 instructions. Schedule SE (Form 1040) 2002

● You had church employee income of $108.28 or more. Income from services you performed as a minister or a member of a

religious order is not church employee income. See page SE-1.

Cat. No. 11358Z

Deduction for one-half of self-employment tax. Multiply line 5 by

50% (.5). Enter the result here and on Form 1040, line 29

● $84,900 or less, multiply line 4 by 15.3% (.153). Enter the result here and on 

Form 1040, line 56.

● More than $84,900, multiply line 4 by 2.9% (.029). Then, add $10,527.60 to the

result. Enter the total here and on Form 1040, line 56.

May I Use Short Schedule SE or Must I Use Long Schedule SE?

Did You Receive Wages or Tips in 2002?

Was the total of your wages and tips subject to social security

or railroad retirement tax plus your net earnings from

self-employment more than $84,900?

Did you receive tips subject to social security or Medicare tax

that you did not report to your employer?

Are you using one of the optional methods to figure your net

earnings (see page SE-3)?

Are you a minister, member of a religious order, or Christian

Science practitioner who received IRS approval not to be taxed

on earnings from these sources, but you owe self-employment

tax on other earnings?

Did you receive church employee income reported on Form

W-2 of $108.28 or more?

You May Use Short Schedule SE Below You Must Use Long Schedule SE on the Back





Yes



No Yes







No

No

No

No

Yes



Yes



Yes



Yes



 







No

Note. Even if you had a loss or a small amount of income from self-employment, it may be to your benefit to file Schedule SE and

use either “optional method” in Part II of Long Schedule SE. See page SE-3.

6

5

6



(99)

2002

9,500 00

9,500 00

8,773 00

1,342 00

671 00

Janice Thompson 000 00 4921






INTRODUCTION

This section will deal with the expenses of an individual who is

an employee and who has incurred employee business

expenses.

OBJECTIVES

1. Determine when employee business expenses are deductible.

2. Determine what expenses are deductible.

3. Determine how to report the expenses.

4. Complete Form 2106 “Employee Business Expenses”.

5. Determine how to complete the expenses when the taxpayer is

eligible and elects to take the foreign earned income exclusion.

TRAVEL EXPENSES

Travel expenses incurred must be ordinary and necessary when

carrying out the duties of your employer while away from your

home, for your job. Ordinary expenses are those that are customary for the type of travel being done. Necessary expenses

are those that are appropriate and helpful to achieving the purpose of the travel. Treatment of the various expenses, allowances, and reimbursements depends on whether allowances

and reimbursements were received and whether the expenses

were more than allowances and reimbursements, or whether

the allowances and reimbursements were more than the

expenses. It also depends on whether or not your employer

included these allowances and reimbursements as income on

Form W-2. These situations will be discussed in this lesson.

Away from Home Overnight. For costs other than transportation the taxpayer must be “away from his tax home

overnight”. “Tax Home” is defined as the taxpayer’s main place

of business. “Overnight” is defined as a period substantially

longer than an ordinary day’s work during which the taxpayer

would need time off for sleep or rest.

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TRAVEL EXPENSES 








92 Lesson 8

yy , g, 

London where you have lodging and meal expenses during the

week. You travel back and forth from London to Manchester on

weekends. You may not deduct any of your expenses for travel,

meals, and lodging in London because that is your main place

of business and the travel on weekends is not for business reasons.

DEDUCTIBLE EXPENSES

Travel expenses that are ordinary and necessary while traveling away from your home for business purposes include such

things as:

1. Air, rail and bus transportation,

2. Operating and maintaining your car,

3. Taxi fares or other costs of transportation between the 

airport or station and your hotel, from one customer to

another, or from one place of business to another.

4. Transportation from the place where you eat and sleep to

your temporary work assignment,

5. Baggage and charges and transportation costs for sample

and display material,

6. Meals and lodging when you are away from home on

business.

7. Cleaning and laundry expenses,

8. Telephone and telegraph expenses,

9. Public stenographer’s fees,

10. Operating and maintaining house trailers,

11. Tips that are incidental to any of these expenses, and

12. Other ordinary and necessary expenses related to travel.

Car Expenses. If you use your car for business purposes you

are entitled to the actual expenses which would include such

things as gas, oil, repairs, insurance and depreciation on your

car or, you can use the standard mileage rate. The standard

mileage rate is 36.5 cents per mile for 2002. If you use the car

for both business and personal mileage you should maintain a

log book. You will have to allocate the expenses between business and personal use. If you lease a car to use for qualified

business expenses you may have to include an amount called

the inclusion amount in your income, depending on the FMV of

the vehicle (for more information on deducting actual car

expenses see Publication 463). 

Pub678IN-Lesson 8 10/25/02 Turn 3 Page 92






y py

bursed for substantiated meal expenses, the reimbursement

will generally be nontaxable and the expenses will not be

claimed.

HOW TO REPORT

The following discusses how the taxpayer should report his/her

allowable expenses for travel, meals & lodging. Self-employed

individuals must report their expenses on the appropriate form

used to report their business income and expenses by using

Schedule C, Form 1040. Employees, including outside sales persons, must complete Form 2106, Employee Business Expenses,

and attach it to their Form 1040 to claim these expenses.

Expenses paid by an employee under a “reimbursement or

other expense allowance arrangement” with an employer generally do not need to be claimed and the employer will not

include the reimbursement as taxable income on the employee’s

Form W-2. To qualify as nontaxable reimbursements, the

arrangement must require that the employee substantiate the

expenses to the employer and return any excess reimbursements. Per Diem or other fixed allowance reimbursements that

are similar to allowances specified by the Federal government

will also be nontaxable to the extent that the amounts do not

exceed government rates.

Form 2106 needs to be completed if:

1. The taxpayer received a reimbursement or an allowance and

the employer included the amount on Form W-2, or a Form

1099 as taxable income,

2. The taxpayer seeks to deduct expenses in excess of the

amounts paid under a reimbursement allowance

arrangement,

3. The taxpayer received no reimbursement for his or her

employee business expenses, or,

4. The taxpayer received reimbursement or an allowance and

did not account to his or her employer for the expenses.

If the expenses equal the reimbursements and the taxpayer

accounted to his or her employer, the taxpayer does not have to

complete Form 2106 unless item (1) above applies.

Example 2

George Grant has incurred qualified employee business

expenses. His company’s policy is that all employees must turn

in a travel voucher showing all expenses incurred and the company reimburses the employee an amount equal to the

expenses. George does not have to file a Form 2106 because he

reports directly to his employer and is reimbursed in full.

Lesson 8 93

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94 Lesson 8

y pyp,

W-2 shows that her employer reimbursed Judy $2,000. Judy

will have to file Form 2106 and claim $1,500.00 as an employee

business expense on Form 2106 subject to the 50% meals limitation and 2% limitation on Schedule A. The entire $2,000

reimbursement must be reported as income on line 7, Form

1040.

Claiming Employee Business Expenses on Form 1040.

The taxpayer can only claim employee business expenses on

Form 1040 as a miscellaneous itemized deduction subject to the

overall 2% limitation. Exceptions are provided for certain government officials, qualified performing artists, and individuals

with a disability. For more information on these exceptions see

the instructions for Form 2106.

Example 4

Frank Falls has a total of $2,000 of unreimbursed

employee business expenses after reducing meals by 50% and

no other miscellaneous itemized deductions. His total adjusted

gross income is $52,000. Frank is entitled to a total of $960 as

a miscellaneous itemized deduction. (2,000 – [52,000 x .02] =

$960)

FORM 2106

Form 2106 is divided into 2 parts. Part I deals with all the

expenses and Part II deals specifically with car expenses. Part II

should be completed, if applicable, before entering an amount

in Line 1, Part I.

Look at Part II section A. This section deals with general information about the vehicle and is self-explanatory. The taxpayer

should have this information from his or her records to assist

you in preparing the form.

Pub678IN-Lesson 8 10/25/02 Turn 3 Page 94

Exhibit 1 Form 2106, Part II






, py , 

the standard mileage rate for the same vehicle.

As mentioned previously the taxpayer is entitled to 36.5¢ per

mile for business mileage. The business standard mileage rate

may not be used to compute the deductible expenses of vehicles

used for hire, such as taxicabs, two or more automobiles used

simultaneously (such as fleet operations), or any vehicle that is

leased, rather than owned, by the taxpayer. The business standard mileage rate may not be used if the automobile has previously been depreciated using a method other than straight-line

for its estimated useful life. The standard rate may not be used

if additional first-year depreciation has been claimed, or if the

taxpayer used ACRS or MACRS depreciation.

For those taxpayers who are using the actual expense method,

vehicles placed in service after September 10, 2001 are eligible

for the additional 30% depreciation and an increased first year

deduction. Property placed in service outside of the U.S. must

be depreciated using the straight-line method.

If, after using the business standard mileage rate, the taxpayer

uses actual costs, the taxpayer must use straight-line depreciation for the automobile’s estimated useful life.

Section C of Part II, Form 2106 deals with the actual expenses

incurred. The taxpayer would have to give you this information

from his or her records for you to assist in preparing the Form

2106. Since this section deals with depreciation you should

advise the taxpayer to seek professional assistance. The

amount from line 29 Part II is carried to the front of Form 2106

and placed on line 1.

Lesson 8 95

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Exhibit 2 Form 2106, Part II




96 Lesson 8

p ppy py

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Form 2106

Step 1 of Form 2106 is used to summarize the employee business expenses of the taxpayer. Column A is used for all

expenses except meals and entertainment. Column B is used

only for meals and entertainment expenses. Step 1 must

always be filled out. (Note: If the employer did not reimburse

the employee for any of the expenses, skip Step 2 and go

directly to Step 3 to figure the amount deductible.

Step 2 is filled out only if the taxpayer is reimbursed by the

employer and the reimbursement is not shown as income to the

taxpayer on a Form W-2 or Form 1099, and the employee seeks

a deduction for additional expenses not paid by the employer.

On line 7, only include amounts from Box 13 of Form W-2 identified as code “L”.

Many overseas employees will receive Forms W-2 reflecting

only a portion of their total compensation while others will

receive no Form W-2 at all.

Reimbursements received under a reimbursement arrangement

described above need not be shown as income on Form 1040

and will be reflected on Form 2106, line 7 only if additional

expenses are claimed. Reimbursements for the unsubstantiated

travel expenses must be included as income on Form 1040 and

will not be included in Step 2 of Form 2106.

Form 2106, Step 2

Exhibit 3

Exhibit 4






pypy

is allowed as a miscellaneous itemized deduction on the taxpayer’s Schedule A Form 1040. This amount will be reduced by

2% of the taxpayer’s adjusted gross income unless the taxpayer

is a qualified performing artist.

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Form 2106 Step 3

Example 5

John Scott is a U.S. citizen and an employee for an English

company. He normally works out of their London office.

However, John was temporarily assigned to the Paris office for

the last 7 months of 2002. He had his car sent there so he can

carry out his duties. He purchased the car on 6-1-2001, and did

incur employee business expenses for that year. He elected in

2001 to use the standard mileage rate on his 2001 tax return.

While in France he did some sight-seeing and had recorded personal mileage. John incurred the following expenses during

2002:

Lodging—$10,640

Meals—$7,350

Transportation to & from Paris office from London 

office—$300

Total mileage on car for 2002—23,720

Average daily roundtrip commute—10 miles

Commuting mileage for 2002—1,530

Business mileage—16,290

Parking fees & tolls—$586

John is reimbursed $8,300 for lodging and $4,000 for meals.

The $4,000 for the meals is shown as income on John’s W-2

Form. The $8,300 is not shown as taxable income on John’s

Form W-2 because the lodging expenses were properly

accounted for. See Exhibit 1 for how the Form 2106 would be

filled out.

Exhibit 5




98 Lesson 8

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John Scott

5,946 00

586 00

10,940 00

7,350 00

17,472 00 7,350 00

8,300 00

9,172 00 7,350 00

9,172 00 3,675 00

12,847 00

Sales Manager 000 00 3361




Lesson 8 99

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6 1 01

23,720

16,290

64

10

1,530

5,900

X

X

X

5,946 00

x




100 Lesson 8

y ,

taxable income on John’s W-2. He will be entitled to an itemized miscellaneous deduction of $12,847. If John’s adjusted

gross income was $60,000, John would have to reduce the

$12,847 by $1,200 ($60,000 x .02) giving him a total of $11,674

as a net miscellaneous deduction if John had no other miscellaneous deductions.

Exercise 1

Susan Troop, social security number 000-00-6789, works in

Manila and is temporarily assigned to her company’s Tokyo,

Japan office. Her round trip air fare is $375. She also incurred

lodging expenses of $2,760 and meal expenses of $1,420. She

used mass transportation while in Tokyo and spent $357. Her

employer, who is in the retail sales trade, did not reimburse 

her for any of the expenses. Complete the Form 2106 for

Susan Troop.

Pub678IN-Lesson 8 10/25/02 Turn 3 Page 100




Lesson 8 101

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Susan Troop Retail Sales Trade 000 00 6789




102 Lesson 8

If the taxpayer is eligible and elects the foreign earned income

exclusion he or she must adjust the amount of the business

deductions related to the income excluded. The disallowed portion of the expenses is calculated by dividing the excluded foreign earned income by total foreign earned income.

Example 6

Harold Will is a U.S. citizen, employed as a salesperson in a

foreign country and is eligible and elects to exclude $78,000

of his $98,500 a year salary. His AGI is $30,000. He had a total

of $2,000 of unreimbursed employee business expenses of which

$500 was for meals; these expenses are deductible only as miscellaneous itemized deductions on Schedule A (Form 1040).

First, it is necessary to complete Form 2106. On that form

Harold reduces the meal expenses by 50% of the $500 amount

spent, yielding a total of $1,750 ($250 & $1,500).

Harold must reduce the $1,750 by 79% (78,000/98,500) 

because he excluded 79% of his earned income. Thus $1,383 

of his expenses are not deductible. Harold carries the $367

($1,750 – $1,383) deductible amount to Schedule A.

Harold also has $500 of other miscellaneous deductions subject

to the 2% of AGI limit. He adds the $367 from Form 2106 plus

the $500 for a total of $867 miscellaneous expenses. 2% of

Harold’s AGI is $600 (.02 x 30,000). Harold’s deductible miscellaneous itemized deductions are $267 ($867 – $600).

If Harold did not have the other miscellaneous expenses of

$500 he would not have been able to claim any miscellaneous

deductions. His remaining expenses ($367) would have been

less than 2% of his AGI ($600).

Pub678IN-Lesson 8 10/25/02 Turn 3 Page 102




Lesson 8 103

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1. Which of the following taxpayers would be entitled to

employee business expenses and if so indicate the type of

expense?

Vehicle expenses

Lodging

Meals

Travel

a. Joseph Fulton works in London and drives from and to

his house every day.

Answer_________________________________________________

b. Mary Banks works in Paris and had to go to Lyon for the

day to conduct business. She returns home to Paris that

evening. She used her car.

Answer_________________________________________________

c. Alice Canton is a nurse working in Rome, Italy. Her

employer gives her a temporary assignment for 2 months in

Oslo, Norway.

Answer_________________________________________________

2. What form do you use to calculate a taxpayer’s employee

business expenses?

Answer_________________________________________________

3. When are employee business expense reimbursements not

included in gross income?

Answer_________________________________________________

4. When are the employee business expenses itemized miscellaneous deductions?

Answer_________________________________________________

5. How are reimbursements that are more than expenses

incurred treated?

Answer_________________________________________________




104 Lesson 8

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 SUMMING UP THIS LESSON 

Reimbursements from an accountable plan for substantiated

employee business expenses are not included as income on the

employee’s return if the employee is required to return, and

does return, any excess reimbursements.

 If the reimbursements are included as income, deductible

expenses are allowed as miscellaneous itemized deductions

subject to the 2% limitation.

 Travel expenses for meals, lodging and incidentals must be

incurred while “away from home overnight” to be

deductible.

 Form 2106 is used to calculate the amount of itemized

deductions that are in excess of reimbursements.

 If reimbursements exceed expenses, the excess is income to

the employee and must be reported on Form 1040. (If reimbursements exceed expenses it is probably a nonaccountable plan, and therefore the entire reimbursement is

taxable).

 If it is the company’s policy for the employees to account for

business expenses to the employer by supplying the

employer with documented evidence and the employer

reimburses the employee for the amount in full, Form 2106

is not required.

If the taxpayer is eligible for and elects the foreign earned

income exclusion, certain adjustments must be made to the

gross amount deductible as employee business expenses.




Lesson 8 105

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Susan Troop

3,492 00

1,420 00

3,492 00 1,420 00

3,492 00 1,420 00

3,492 00 710 00

4,202 00

Retail Sales Trade 000 00 6789




106 Lesson 8

1. a.) No (They are commuting expenses)

b.) Yes. Vehicle expense

c.) Yes. Travel, lodging, meals.

2. Form 2106

3. When the employee is required to substantiate his business

expenses under a reimbursement arrangement and return

any excess allowance to his employer. Also, Per Diem reimbursements that are similar to allowances specified by the

Federal government will be nontaxable to the extent that

the amounts do not exceed government rates.

4. When the expenses are more than the amount reimbursed.

Itemized deductions are also created in the case of an

employee reimbursed under a nonaccountable plan.

5. They are treated as income and shown on line 7 of Form

1040. If reimbursement in excess of expenses exists, the

plan is probably a nonaccountable one, and therefore the

entire reimbursement is taxable—not just the excess.

Pub678IN-Lesson 8 10/25/02 Turn 3 Page 106

ANSWERS TO SUMMARY EXERCISES 










INTRODUCTION

In a previous lesson you learned that employees are entitled to

deduct certain expenses for conducting business while away

from their main place of work. This lesson will deal with certain business expenses while traveling at home in the United

States.

OBJECTIVES

1. Determine who is eligible for home leave expenses.

2. Determine what expenses are deductible.

HOME LEAVE

Section 903 of the Foreign Service Act of 1980 provides that the

head of a Foreign Affairs Agency may order a member of the

Service who is a citizen of the United States to take home leave

upon completion of 18 months of continuous service abroad;

and shall so order as soon as possible after completion of 3 years

of continuous service abroad. The intent of this legislation is to

“re-Americanize” foreign service employees.

Because members of the foreign service are required by law to

take a leave of absence, they are allowed to deduct amounts

paid for travel, meals, and lodging while on home leave as

employee business expenses. The taxpayers who are eligible for

this leave will deduct these expenses on a Form 2106 just like

an employee that is conducting business away from the home.

As with all deductible employee business expenses, records and

receipts must be maintained to support the deductions that are

taken. The deductible expenses are those we discussed in the

previous lesson and these expenses are subject to the same

limitations.

Any expenses paid for on behalf of a foreign service member’s

family are personal expenses and therefore are not deductible.

Lesson 9 107

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HOME LEAVE 








108 Lesson 9

 SUMMING UP THIS LESSON 

 Taxpayers who are U.S. citizens and members of the foreign service can deduct travel, meals and lodging expenses,

while on home leave, as employee business expenses by

using Form 2106.

 Expenses incurred by members of the family are personal

expenses and therefore they are not deductible.

SUMMARY EXERCISE

1. Larry Lee is a foreign service employee. He has been stationed in a foreign country for 3 years and comes back to the

United States for 4 weeks on home leave. His family accompanies him. He incurred expenses for travel of $1,500; meals

$850; and lodging $1,400. His family incurred expenses for

travel of $2,500; meals $1,700; and lodging $2,200 Larry was

reimbursed $450 for his travel to and from his post of duty

and did not show it as income. (Larry rented a car. He did

not use his own car.)

a. Is Larry eligible for a home leave deduction? Yes or No.

b. Can Larry deduct the expenses that this family members

incur? Yes or No.

c. Complete Form 2106.

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Lesson 9 109

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Larry Lee Foreign Service 000 00 2649




110 Lesson 9

1. a. Yes

b. No

c. See completed Form 2106

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HOME LEAVE ANSWERS TO EXERCISES 








Lesson 9 111

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Larry Lee

2,900 00

850 00

2,900 00 850 00

450 00

2,450 00 850 00

2,450 00 425 00

2,875 00

Foreign Service 000 00 2649




112 Lesson 9

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STUDENT NOTES






INTRODUCTION

Generally, you must include in gross income all amounts

received from rental properties, including rental receipts

received from your former residence. Both United States citizens and resident aliens must report rental income, regardless

whether the rental property is located in the United States or

in a foreign country. Rental income and expenses are reported

on Schedule E (Form 1040), Supplemental Income Schedule,

Part 1. Additional information on rental income can be found in

Publication 527, “Residential Rental Property,” and Publication

946, “How to Depreciate Property.” The lesson, “Rental Income

and Expenses,” defines rental income, discusses rental

expenses, and how to report these items on the return.

OBJECTIVES

At the end of this lesson you will be able to:

1. Determine how to report rental income.

2. Determine how to report rental expenses.

3. Determine how to report rental income when property is

used for personal purposes either part of the year or during

the entire year.

4. Determine how to compute deductible depreciation expense.

5. Identify the application of at-risk and passive activity rules.

RENTAL INCOME

Rental income may include other payments in addition to the

normal and ordinary rents received. Include in gross rental

income advance rent, security deposits, payments for canceling

a lease, expenses paid by the tenant, and the fair market value

of property or services received in exchange for rental payments. The security deposit is not included when the taxpayer

plans on returning the deposit at the end of the lease. A taxpayer using the cash basis of accounting, reports the income

when actually received. Taxpayers using the accrual accounting

method report the income in the year they are entitled to

receive payments.

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RENTAL INCOME AND EXPENSES








114 Lesson 10

The deductible rental expenses are reported on the Schedule E,

Part I, (see Exhibit 1) lines 5 through 18.

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Schedule E

Deductible expenses include any ordinary and necessary

expenses, such as expenses for repairs, maintenance, certain

operating expenses and depreciation.

Repairs and Improvements. A deduction for a repair is a

current year deduction, however, the cost of an improvement

must be depreciated over the useful life of the improvement.

The distinction between a repair and an improvement is that a

repair keeps the property in good operating condition, whereas

an improvement adds to the life or value of the property or

adapts it to new uses. The following chart helps illustrate the

difference between repairs and improvements.

REPAIRS IMPROVEMENTS

Painting Adding a Room

Fixing Gutters Putting up a Fence

Repairing Driveways Putting in plumbing or wiring

Replacing Window Glass Replacing hot water tank

Mending Leaks Putting on a new roof

Exhibit 1






p, g , , 

lation increases the basis of the property. Depreciation will be

discussed later in this chapter.

Other Expenses. Some of the other expenses that may be

deducted from gross rental income include salary and wages,

utilities, rental of equipment, insurance premiums, interest

expense (mortgage interest), advertising, taxes, and commissions paid for rental income. If any part of the property tax is

for local benefits, such as putting in streets and sidewalks, that

portion of the property tax is added to the basis of the property

rather than deducted as an ordinary expense. Insurance premiums paid in advance must be prorated over the period covered

by the policy by both the cash basis and accrual basis taxpayer.

If the rental is a condominium or cooperative, the maintenance

fee is deductible. See Publication 527, Residential Rental

Property, for taxes and interest deductions on cooperatives.

Generally, mortgage interest expense is fully deductible.

However, if the taxpayer has interest expense other than mortgage interest, refer him or her to the Internal Revenue Service

or a professional preparer.

Ordinary and necessary travel and transportation expenses

attributable to the production of income are deductible. If a

personal automobile is used, the taxpayer may use the standard mileage rate for business mileage. The standard mileage

rate is 36.5 cents per mile for the year 2002. When using the

standard mileage rate, parking fees and tolls may also be

deducted. The standard mileage rate method may be selected

on a yearly basis. However, if changing to actual expense after

using the standard mileage method, accelerated depreciation

may not be used. In order to claim depreciation under the

actual expense method for transportation expenses, the vehicle

must be used more than 50 percent for business, including for

the production of rental income. If the travel incurred on behalf

of a rental property is into or outside of the United States, the

trip may have a dual purpose. Substantiation of the pleasure

and business purpose and allocation of the expenses may be

required. When a tenant does not pay the rent, the cash-basis

landlord cannot take a deduction for the unpaid rent, since a

deduction can never be taken for a payment that has never

been included in income.

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116 Lesson 10

Special rules apply when rental property is used for personal

purposes, or as a rental without the intent to make a profit.

When renting part of the property, certain expenses must be

divided between rental use and personal use. When figuring

the division of expenses, the taxpayer may use any reasonable

method. The most common methods used are based on the

number of rooms in the dwelling or on the total area of the

dwelling.

Example 1

Mary Alma rents one room in her house. The total square

footage of her house is 1,000 square feet. The rental room measures 10 feet by 10 feet (100 square feet). She may deduct 10%

of any allowable expense that benefited the renter. She may

deduct 100% of any expenses that relate only to the rental portion of the house, such as painting the rented room.

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Mary Alma, in the example above, has the following expenses

attributable to the entire property:

Taxes $1,000

Utilities $ 600

Mortgage Interest $ 800

Depreciation $ 500

Also wallpapering expense of $100 for the tenant’s room only.

a. What is the allowable expense deduction on Schedule E?

Answer:_____________________________________________

b. What is the allowable expense deduction on Schedule A?

Answer:_____________________________________________

For property changed to rental use in the tax year other than

the beginning of the year, the allocation of expenses should be

made between the number of days in the year for personal use

and the number of days for rental use.

Example 2

John Princeton is transferred overseas and begins renting out

his residence on October 1, 2002. For 2002, he may deduct

three-twelfths (25 percent) of his yearly expenses such as taxes,

interest and utilities as rental expenses.

Vacation Home and Other Dwelling Units. Certain limitations apply to rental expenses for vacation homes or other

dwellings that are used by the taxpayer for personal use during

the year. A dwelling unit for this purpose includes a house,

apartment, condominium, mobile home, boat or similar property. However, the limitation does not apply to hotel, motel, inn

or similar dwelling unit. The limitation on deductions applies if

a dwelling unit is used as a residence during the tax year for

personal purposes for greater than:

1. 14 days or

2. 10 percent of the number of days during the tax year the

property is rented at fair market value.

See Publication 527 for a discussion of the limitations.

Use as home before or after renting. If you use a dwelling

unit as your main home before or after renting it, or trying to

rent it, you may not have to count the days you use it as your

main home as days of personal use.

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118 Lesson 10

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the days on which you use the property as your main home are

not counted as days of personal use.

Do not count as days of personal use the days you used the

property as your main home.

a) During the year in which you began renting it or offering

it for rent, but before you began renting it or offering it

for rent, or

b) During the year in which you stopped renting it or offering it for rent, but after you stopped renting it or offering

it for rent.

Example 3

On February 28, 2000, you moved out of the house you had

lived in for 6 years because you accepted a job in another town.

You rent your house at a fair rental price from March 15, 2000,

to May 14, 2002. On June 1, 2002, you move back to town and

move back into your house.

Your use of the house as your main home from January 1 to

February 28, 2000, and from June 1 to December 31, 2002, is

not counted as personal use.

Since these days are not counted as days of personal use the

limitations on deductions discussed above do not apply.

Depreciation

The cost of property with a useful life of one year or more and

used in a trade or business or held for the production of income

is recovered by allowing an annual deduction called depreciation. The most common methods for the depreciation are called

ACRS (Accelerated Cost Recovery System) for property placed

in service after 1980 and before 1987 and MACRS (modified

ACRS) for property placed in service after 1986. Both of these

depreciation methods have an alternative method that may be

chosen that generally increases the number of years the property is depreciated over and therefore decreases the annual

deduction. The method used for property placed in service

before 1981 is referred to as straight line or declining balance.

Depreciable property includes buildings, machinery, furniture,

equipment and vehicles. As discussed earlier any cost for additions or improvements must also be depreciated. Depreciation

is allowed or allowable. What this means is, if you did not

claim depreciation that you were entitled to claim in an earlier

year you must still reduce your basis in the property by the

amount of depreciation that you did not deduct. The depreciaPub678IN-Lesson 10 10/25/02 Turn 3 Page 118






pp

ating real property the value of land is not depreciable.

Basis. The total of the yearly deductions for depreciation can

never be more than the cost or other basis. Generally, the cost

(purchase price) of the property including the cost of improvements is the basis for depreciation. However, if the taxpayer

acquired the property, other than buying it, the basis may be

figured differently than using the original cost. An example is

an acquisition through inheritance or gift. For further information on the basis of inherited or gifted property refer to Publication 551, Basis of Assets. When property is converted from

personal use to rental use the basis is the lesser of the adjusted

basis or fair market value (FMV) at the time of conversion.

Example 4

Jen and Tom purchased a house in 1985 for $85,000. In 2002,

they were transferred overseas and decided to rent out their

personal residence. The value in 2002 was $125,000. The basis

for depreciation is $85,000. Assume that the value of land was

excluded in determining the cost of the house.

Adjusted Basis. The basis of property must be increased or

decreased to reflect certain adjustments before the depreciation

deduction is computed. For example, to the purchase price of a

home add the cost of any improvements, minus any casualty

losses or depreciation previously deducted and minus the land

value to find the adjusted basis. Since land can never be depreciated, an allocation between land and building must be done

based generally on assessed value. Where property is acquired

in a purchase along with a trade-in, the basis must be adjusted.

Example 5

Neil Bates traded in old appliances for his rental property with

an adjusted basis of $500 and got new appliances with a fair

market value of $2,000. He paid $1,000.00 in cash, his basis for

depreciation in the new appliances is $1,500 (the $500 adjusted

basis plus the $1,000 cash).

Placed in Service. For depreciation purpose, property is considered placed in service when it is in a condition or state of

readiness and availability for use. However, a depreciation

deduction may not be claimed until the property is used in

business or for the production of income.

Property Classes and Recovery Periods. The Accelerated

Cost Recovery System (ACRS) and Modified Accelerated Cost

Recovery System (MACRS) use the class life of depreciable

property to determine the recovery period. If property is used

as a personal residence before 1987 and converted to rental

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120 Lesson 10

, gppy y

generally falls into a 5-, 7-, or 27.5-year recovery period.

A home converted in 1998 to a rental property would be depreciated over a recovery period of 27.5 years. A stove also used in

this same rental would be assigned a 7 year recovery period.

Property, both real and personal, located outside the United

States has a longer recovery period. Although the true physical

life of the property may be less, under MACRS the recovery

period is fixed. MACRS requires that a convention for half-year

or mid-quarter be used. Under this special rule, in the year the

property is placed in service the depreciation deduction is prorated. Publication 946, How to Depreciate Property, contains

tables of depreciation with the conventions already incorporated. Examples of the tables are shown below.

MACRS charts

Table A

MACRS 5-Year Property

Half-year Mid-quarter 

convention convention

First Second Third Fourth

Year quarter quarter quarter quarter

1 20.00% 35.00% 25.00% 15.00% 5.00%

2 32.00 26.00 30.00 34.00 38.00

3 19.20 15.60 18.00 20.40 22.80

4 11.52 11.01 11.37 12.24 3.68

Table B

MACRS 7-Year Property

Half-year Mid-quarter 

convention convention

First Second Third Fourth

Year quarter quarter quarter quarter

1 14.29% 25.00% 17.85% 10.71% 3.57%

2 24.49 21.43 23.47 25.51 27.55

3 17.49 15.31 16.76 18.22 19.68

4 12.49 10.93 11.97 13.02 14.06

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Table 1

Residential Rental Property (27.5-year)

Use the column for the month of taxable year placed in service

Year 1 2 3 4 5 6 7 8 9 10 11 12

1 3.485% 3.182% 2.879% 2.576% 2.273% 1.970% 1.667% 1.364% 1.061% 0.758% 0.455% 0.152%

2 3.636% 3.636% 3.636% 3.636% 3.636% 3.636% 3.636% 3.636% 3.636% 3.636% 3.636% 3.636%

3 3.636% 3.636% 3.636% 3.636% 3.636% 3.636% 3.636% 3.636% 3.636% 3.636% 3.636% 3.636%

4 3.636% 3.636% 3.636% 3.636% 3.636% 3.636% 3.636% 3.636% 3.636% 3.636% 3.636% 3.636%

Table 2

Residential Rental Property (31.5-year)

Use the column for the month of taxable year placed in service

Year 1 2 3 4 5 6 7 8 9 10 11 12

1 3.042% 2.778% 2.513% 2.249% 1.984% 1.720% 1.455% 1.190% 0.926% 0.661% 0.397% 0.132%

2 3.175% 3.175% 3.175% 3.175% 3.175% 3.175% 3.175% 3.175% 3.175% 3.175% 3.175% 3.175%

3 3.175% 3.175% 3.175% 3.175% 3.175% 3.175% 3.175% 3.175% 3.175% 3.175% 3.175% 3.175%

4 3.175% 3.175% 3.175% 3.175% 3.175% 3.175% 3.175% 3.175% 3.175% 3.175% 3.175% 3.175%

For property located outside of the United States, the taxpayer

must use an alternative method of depreciation under MACRS.

Therefore, residential rental property located in a foreign country would be depreciated over a 40-year recovery period.

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122 Lesson 10

The depreciation deduction is shown on line 20 of Schedule E

(see Exhibit 2). Use Form 4562, Depreciation and Amortization

only if you placed an asset in service in the current year, you

depreciate listed property or you claim a Section 179 expense.

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Schedule E

AT-RISK AND PASSIVE LOSS

Very often rental property shows a net loss because the rental

expenses are greater than the rental income. In this situation

there are two potential restrictions on how much of the loss can

offset other sources of income.

The first restriction is the at-risk rule. This rule provides that

you can claim a loss for no more than you could actually lose

from the activity. That is, you can claim a loss only up to the

amount for which you are personally at-risk in the activity.

Generally you are considered at-risk for the amount of cash

and property contributed to the activity from which you are

not protected against personal liability with the exception of

casualty insurance.

The Tax Reform Act of 1986 added other limitations to deducting rental losses. Prior to the law, losses from passive activities

could offset all other income (for example wages, interest, and

dividends) without any restrictions. Rental activities, by definition of the law, are always considered to be a passive activity.

The passive activity law states that passive activity losses can

only be deducted from passive activity income. A passive activity is a trade or business being conducted without that taxExhibit 2






y g

of the taxpayer in the operation of the trade or business,

whereas, active participation does not require regular, continuous and substantial involvement. Active participation requires

that the taxpayer participate in making management decisions

or arranging for others to provide services in a significant and

bona fide sense. Management decisions include approving new

tenants, setting rental terms, approving capital or repair

expenditures and similar decisions. It is important to understand the difference between active and material participation

as it pertains to rentals, because of a special $25,000 offset

allowed for certain rental losses. Up to $25,000 of rental losses

($12,500 for married taxpayers filing separate and living apart

for the entire year) may be used to offset any and all nonpassive income if the taxpayer actively participates in the residential rental activity. The following list is an example of

nonpassive income.

1. Salaries, wages, commissions or tips.

2. Self-Employment income from a trade or business in which

the taxpayer materially participates (may be partnership,

but not limited partnership income).

3. Distributive shares of income through pass-through entities

(such as S corporations) that is not income from a passive

activity.

4. Portfolio income (gross income from interest, dividends,

annuities, or some royalties).

Example 6

Lynn Ferris, a United States citizen, lives in Europe and has

wages paid by the U.S. Government of $25,000 and interest

income of $100. She rented out her home located in the United

States in 2002, and incurred $1,000 in rental loss. Although her

sister collects the rent, Lynn makes all of the bottom line decisions as to whom, and, for what amount, the property will be

rented. While Lynn is outside of the United States, she pays

her sister to manage the property. The rental loss of $1,000

may be offset against her gross income of $25,100 because she

is considered to be an active participant in the rental activity.

Phase-Out of Offset. The amount allowed to offset nonpassive

income is reduced once the taxpayer’s adjusted gross income

exceeds $100,000 ($50,000 for married filing separately). It is

completely phased out when AGI exceeds $150,000 ($75,000 for

married filing separately). Refer taxpayers with an AGI over

$100,000 to the Internal Revenue Service or a professional preparer.

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124 Lesson 10

Form 8582, Passive Activity Loss Limitations is filed to summarize losses and income from all passive activities. Check the

instructions for Form 1040 to determine if the taxpayer is

required to file Form 8582 when he or she has rental losses.

Generally, taxpayers who have only one passive loss generated

from a rental activity and an adjusted income of less than

$100,000 will not be required to file Form 8582. If any

questions arise beyond the scope of this lesson regarding filing

Form 8582, refer the taxpayer to the Internal Revenue Service

or a professional preparer.

SELLING RENTAL PROPERTY

The sale of rental property is reported on Form 4797, Sales of

Business Property. A gain is the amount realized minus the

adjusted basis of the property.

Example 7

Pat Drake sold her rental property for $60,000. She had purchased the house for $30,000 and had claimed $10,000 for

depreciation. Her gain is $40,000

The gain is figured as follows:

1. Selling price $60,000

2. Less selling expenses 0

3. Amount realized $60,000

4. Basis $30,000

5. Less depreciation $10,000

6. Adjusted basis $20,000 $20,000

7. Gain (line 3 minus 6) $40,000

The gain may be either capital gain or ordinary gain depending on the depreciation claimed. If part of the property was 

also used for personal uses, the sale is reported as two separate

sales. A loss is the adjusted basis of the property minus the

amount realized. A loss for any personal use of property cannot be deducted.

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 SUMMING UP THIS LESSON 

As a volunteer, you will assist taxpayers who have rental 

properties. In this lesson you learned what qualified as rental

income and rental expenses. You studied how to figure and

report the following:

 The proration needed when the property is used both for

personal and rental purposes.

 Depreciation expense.

 Rental losses.

ANSWERS

Exercise 1

a. $390 (10% of total expenses of $2,900=$290 plus 100 for

wallpaper)

b. $1,620 (90% of mortgage interest and taxes)

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126 Lesson 10

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STUDENT NOTES