Karen, a U.S. citizen, earns $40,000 of taxable income from U.S. sources, $20,000 in taxable wages from Country A and $20,000 in taxable interest from Country B. The U.S. tax rate is 25%. The tax on Country A income is $8,000, and Country B charges no tax on the interest income. Assuming two baskets are needed for the two types of income because the interest is passive income, Karen's foreign tax credit that can be claimed is
A)$5,000.
B)$10,000.
C)$20,000.
D)none of the above.

Question

Quizplus · Accepted Answer

The foreign tax credit that Karen can claim is limited to the lesser of the actual foreign taxes paid or the U.S. tax liability on the foreign income. Karen paid $8,000 in taxes to Country A on her wages and $0 to Country B on her interest income. The U.S. tax rate is 25%, so the U.S. tax on her total foreign income ($40,000) would be $10,000 (25% of $40,000). However, because there are two baskets of income (active and passive), we calculate the limit for each separately. For the wages from Country A ($20,000), the U.S. tax would be $5,000 (25% of $20,000), which is less than the $8,000 paid to Country A, so the limit for the credit on the wages is $5,000. For the interest from Country B ($20,000), since no tax was paid, there is no credit to claim. Therefore, the total foreign tax credit Karen can claim is $5,000.