FTC for individuals: treatment of 3% phaseout of itemized deductions.

Beginning with 1991, under Sec. 68, certain itemized deductions for U.S. Federal income tax purposes are "phased out" for individuals over certain income levels. The deductions are reduced by 3% of the excess of adjusted gross income (AGI) over $100,000 ($50,000 for married individuals filing separately), adjusted for inflation beginning in 1992. The total reduction, however, cannot exceed 80% of the deductions that were subject to the phaseout. The 3% phaseout is applied to total itemized deductions, excluding medical expenses, investment interest expense, and casualty, theft and gambling losses.

For taxpayers claiming a foreign tax credit (FTC)in a year when the itemized deduction phaseout applies, the question arises as to how the phaseout amount is allocated among each category of itemized deductions subject to the phaseout. This is important since, in computing foreign-source taxable income for FTC purposes, each category of itemized deductions is allocated separately between U.S.and foreign-source income under Regs. Sec. 1.861-8.

Example 1: Taxpayer T, who is subject to the 3% phaseout, is claiming an FTC and has only two types of itemized deductions for the year, moving expenses and charitable contributions. T's moving expenses relate to a foreign move and are considered 100% directly allocable to foreign-source income. Since the 3% phaseout is calculated on T's total itemized deductions subject to the phaseout, she will need to know how much of the 3% phaseout is attributable to moving expenses and how much to charitable contributions; her moving expenses will be 100% directly allocable to foreign sources (consistent with Regs. Sec. 1.911-6(b)(1)) while her charitable contributions will be ratably allocated between U.S and foreign sources under Regs. Sec. 1.861-8(e)(9)(iv). (Note: Prop. Regs. Sec. 1.861-8(e)(12), which would allocate the charitable deduction to U.S. and foreign sources based on the U.S. or foreign use of the contribution, has not been considered in this example.)

The IRS set forth in 1991 Publication 514, Foreign Tax Credit for Individuals, that the 3% phaseout should be allocated among the various-itemized deductions subject to the phaseout by multiplying each deduction by a ratio of the phaseout amount over total itemized deductions subject to phaseout. This will ratably reduce all itemized deductions subject to the phaseout. See Example 2 on page 450.

From Arthur Hayes, CPA, and Trevor Dagg, CPA, New York, N.Y.