Quick overview

U.S. taxation applies to citizens and residents on worldwide income, which creates the risk of double taxation when income is also taxed abroad. To mitigate that, the Internal Revenue Code and IRS practice provide two primary individual relief tools: the Foreign Tax Credit (FTC) and the Foreign Earned Income Exclusion (FEIE). Corporations and other entities have additional international rules (for example, Subpart F and GILTI for controlled foreign corporations). Use of these provisions can materially change a filer’s U.S. tax outcome — but eligibility, documentation, and interactions with tax treaties matter.

(Authoritative references: IRS — Foreign Tax Credit and IRS — Foreign Earned Income Exclusion.)

How the two main options differ

  • Foreign Tax Credit (FTC)

  • Purpose: Offset U.S. tax liability with income taxes paid to a foreign government on the same income.

  • How to file: Generally claimed on Form 1116 (unless you qualify for the exception), and reported on Form 1040.

  • Limits and details: Credit is limited to the amount of U.S. tax attributable to foreign-source taxable income. FTC uses separate baskets (categories) of income in some cases. Unused FTC amounts can typically be carried back 1 year and carried forward up to 10 years. The credit applies to income taxes and certain taxes in lieu of income tax; many withholding and social-type taxes are not eligible.

  • Election: Instead of claiming a credit, a taxpayer may sometimes deduct foreign taxes as an itemized deduction — but the credit usually provides greater tax relief.

  • Foreign Earned Income Exclusion (FEIE)

  • Purpose: Allow qualifying U.S. individuals living and working abroad to exclude a portion of foreign earned income from taxable U.S. income.

  • How to file: Claim FEIE using Form 2555 (or 2555-EZ where applicable) with Form 1040.

  • Eligibility tests: Must meet either the bona fide residence test (an uninterrupted period as a bona fide resident of another country) or the physical presence test (330 full days in a 12‑month period outside the U.S.).

  • Amount: The FEIE amount is adjusted annually for inflation. For historical perspective, the exclusion was about $120,000 for tax year 2023; check the IRS Form 2555 instructions for the current year’s limit.

  • Limitations: FEIE only excludes earned income (wages, self-employment income tied to personal services). It does not exclude passive income (interest, dividends), and claiming FEIE can affect certain credits and benefits (for example, it may limit ability to claim foreign tax credits for the excluded wages).

Practical decision factors: when to use FTC, FEIE, or both

  1. Compare total U.S. tax on your foreign‑source income to foreign taxes paid. If foreign taxes exceed or closely match U.S. tax on that income, the FTC often produces the best result.
  2. If you live overseas and have mostly earned income taxed lightly or not at higher U.S. rates, FEIE may be more valuable because it directly removes income from U.S. tax calculations.
  3. You can use both: for example, exclude earned wages up to the FEIE limit with Form 2555, and use Form 1116 to claim credits on foreign tax paid on other (nonexcluded) income. Be careful: taxes attributable to excluded income generally are not creditable.
  4. Self‑employment taxes: FEIE does not exempt you from self‑employment tax; U.S. self‑employment tax rules and totalization agreements (Social Security agreements) with some countries will determine treatment.

Filing steps and documentation

  • Track all foreign income and foreign taxes paid. Maintain pay stubs, employer letters, foreign tax notices, and translated records when necessary.
  • Choose and prepare the correct forms: Form 1116 for most FTC claims; Form 2555 for FEIE. See our guide on when to use Form 2555 vs Form 1116 for practical filing examples and exceptions. (See internal resource: “When to Use Form 2555 vs Form 1116 for Foreign Income”.)
  • Claiming FTC: allocate foreign taxes to income categories and compute the limitation worksheet. If taxes were withheld on your pay, obtain your foreign employer’s statement or your foreign tax return and proof of payment.
  • Claiming FEIE: document qualifying days and residence status (visas, employment letters, housing records). Use the physical presence test calendar or the bona fide residence descriptions on Form 2555 instructions.
  • Consider tax treaty provisions: tax treaties can change residency, withholding, and taxation rules; they can also provide tie‑breaker rules for dual residents.

Business and corporate considerations

Businesses and pass‑through entities face additional international tax rules: branch profit taxes, Subpart F rules, Global Intangible Low‑Taxed Income (GILTI), and foreign tax credit limitations across entity levels. Corporations may claim FTCs for foreign income taxes paid, but the rules differ for passthrough owners and controlled foreign corporations. If your situation involves a nonresident or foreign corporation, consult specialized guidance.

Common mistakes and red flags that trigger problems

  • Failing to claim the more favorable relief (credit vs. exclusion) after comparing results. The IRS allows amended returns in many cases but claims are time‑limited.
  • Misallocating foreign taxes to excluded income. Taxes properly attributable to excluded wages are generally not creditable.
  • Poor documentation: missing foreign tax return pages, translations, or bank confirmations of tax payments.
  • Overlooking reporting obligations: even if you exclude income with FEIE, you may still need to file FinCEN Form 114 (FBAR) or IRS Form 8938 for foreign financial assets.
  • Ignoring totalization agreements and self‑employment tax exposure for U.S. freelancers working abroad.

Examples (illustrative)

Example A — FTC best:
Jane earns $100,000 abroad. Foreign tax paid equals $25,000; U.S. tax on that foreign‑source income would be $22,000. Claiming the FTC offsets the entire U.S. tax on that income and eliminates U.S. tax on the same wages, while preserving potential access to other U.S. credits.

Example B — FEIE helpful:
Mark lives overseas and earns $90,000 in wages. If he qualifies for the FEIE and the exclusion amount exceeds his foreign wages, those wages can be removed from U.S. taxable income entirely, which may lower or eliminate his U.S. tax liability on that pay.

Example C — Combined use:
A U.S. citizen has $150,000 of wages (part excluded under FEIE) and $30,000 of foreign investment income taxed abroad. After excluding wages up to the FEIE limit, the taxpayer can seek FTC on taxes paid on the investment income (not on excluded wages).

Practical tips

  • Run a side‑by‑side calculation before filing to see which approach (or combination) produces the lowest overall U.S. tax and to verify interactions with credits, deductions, and self‑employment taxes.
  • Keep digital and physical copies of foreign returns and proof of tax payments for at least the period allowed for FTC carrybacks/forwards (typically 10 years for carryforwards).
  • Use the IRS instructions for Form 1116 and Form 2555 and review the relevant tax treaty language when residency or treaty benefits are relevant (IRS: Foreign Tax Credit; IRS: Foreign Earned Income Exclusion).
  • Consider professional help: complex cross‑border situations (multi‑country income, CFC/ownership issues, or sizable foreign taxes) often benefit from an international tax specialist.

Final notes and disclaimer

This article summarizes U.S. rules and common practice as of 2025 and refers to primary IRS guidance, but tax outcomes depend on facts and current inflation adjustments and law changes. For the most current numeric limits and for personalized planning — especially if you have multi‑jurisdictional income, self‑employment exposure, or ownership in foreign entities — consult a qualified tax professional. This content is educational and not individualized tax advice.

Authoritative sources: IRS — Foreign Tax Credit (https://www.irs.gov/individuals/international-taxpayers/foreign-tax-credit); IRS — Foreign Earned Income Exclusion (https://www.irs.gov/individuals/international-taxpayers/foreign-earned-income-exclusion).