Foreign Tax Credit: Gross Income Sourced at Beneficiary Level

[mkaprelian]

I have a Schedule K-1 from a trust that includes an entry in Box 14 with Code B (Foreign taxes) of $419. There is another entry in Box 14 with Code E (Net investment income) of $38,775. The $38,775 amount is the sum of amounts in Boxes 1, 2a and 5 on this Schedule K-1.

Turbotax prompts me to "Enter the following detail about the foreign income reported on your Schedule K-1." My problem is that there is no "foreign income" explicitly reported on the Schedule K-1. So where do I find the 3 items (below) called for in the interview? I do have a copy of the trust's tax return, with its Form 1116 and the general allocation percentages for each beneficiary. 

First, I need "Gross Income Sourced at Beneficiary Level." I suppose this is the $38,775 amount reported in Box 14 with Code E.

Second, I need "Gross Income Sourced at Beneficiary Level: U.S. Source Income." For this number, I suppose I can take the amount on line 3e of the trust's Form 1116 ("Gross income from all sources"), subtract the amount on line 3d of the trust's Form 1116 ("Gross foreign source income"), and multiply the difference by the beneficiary's general allocation percentage (in this case, about 52%).

Third, I need "Gross Income Sourced at Beneficiary Level: Foreign Source Income." For this number, I suppose I can take the amount on line 3d of the trust's Form 1116 ("Gross foreign source income"), and multiply it by the beneficiary's general allocation percentage.

This seems like it makes some sense, except that I would expect item 1 to equal the sum of items 2 and 3. Is it a problem that they do not? Should item 1 NOT be the amount reported in Box 14 with Code E? Should I be looking elsewhere for the numbers to enter on this interview screen?

There is an extensive but meandering and confusing discussion of this topic here.

[jtax]

I would expect your #1 to equal the sum of your #2 and #3. If not then something doesn't feel quite right. 

Instead of box 14 code E, what happens if you look at the trust's 1041 line 9 (total income) and apply your beneficiary %? The 14/E may be reduced by a share of trust expenses (1040 lines 10-22) and possibly (though not commonly) be off because the trust has non-investment income (e.g. running an operating business?)

In the 1116 process this is all getting at the data needed to computer the tax code section 904 limitation on the foreign-tax credit. https://www.law.cornell.edu/uscode/text/26/904 :

(a)Limitation

The total amount of the credit taken under section 901(a) shall not exceed the same proportion of the tax against which such credit is taken which the taxpayer’s taxable income from sources without the United States (but not in excess of the taxpayer’s entire taxable income) bears to his entire taxable income for the same taxable year.

perhaps more understandable, the FTC is limited to

US tax liability times [foreign-sourced income / worldwide income]

[mkaprelian]

Thanks for a thoughtful response, and also for the reference to code section 904. I agree that it would "feel" better if item #1 equals the sum of item #2 and item #3 in my example. But if I take your suggestion (look at the trust's 1041 line 9 (total income) and apply my beneficiary's %), item #1 still would not equal the sum of item #2 and item #3. What WOULD work, at least from an arithmetic standpoint, would be to use the amount on line 3e of the trust's Form 1116 (gross income from all sources) and apply my beneficiary's % for the amount in item #1. 

Now here's where it gets confusing. Section 904 refers to the taxpayer's "taxable income." It seems to me that the beneficiary's "taxable income" from this Schedule K-1 would be the amount shown in Box 14, Code E. After all, the trust is distributing net income (DNI) to the beneficiaries and deducting the DNI from its income; the beneficiaries add the DNI to their income. pay taxes on the net income distributed.

So, to make the sums work out, rather than the hybrid approach I started with, I can either 1) say the beneficiary's "entire taxable income" is the Box 14, Code E amount and the beneficiary's foreign source taxable income is the trust's gross foreign source taxable income times the beneficiary's general allocation percentage; or 2) say the beneficiary's "entire taxable income" is the trust's gross income from all sources from the trust's Form 1116, line 3e, times the beneficiary's general allocation percentage and the beneficiary's foreign source taxable income is the trust's gross foreign source taxable income times the beneficiary's general allocation percentage (in which case both the trust and the beneficiary would have the same ratio of foreign source taxable income to entire taxable income, which also "feels right," despite some dissonance with the DNI point outlined above).  In both cases, the U.S. source income would be the difference between the other two numbers. I guess I'll try them both and see if there's a difference in the foreign tax credit on the beneficiary's return. The numbers are such that the difference between these approaches is likely immaterial, although I suppose it's possible that Turbotax might flag an error of some sort. 

I suppose  I should note that all of the "foreign source income" and "foreign taxes paid" on the beneficiary's Schedule K-1 are from a single mutual fund (RIC) investment and that the trust distributed all of its DNI. The beneficiary paid foreign taxes on some personal investments that also will figure into the calculation.

I'd appreciate any additional insights you might have.

[mkaprelian]

So after much tearing of hair and gnashing of teeth, I think my solution is: Gross Income Sourced at the Beneficiary Level is the amount reported on Schedule K-1 in Box 14 with Code E. I realize that is described as "net investment income" but it's a gross number from the beneficiary's standpoint.

To get foreign source income, I reverse-engineered (correctly, I hope) how Turbotax computed the other amounts on the beneficiary's Schedule K-1. The key (for me, at least) is that Turbotax allocates certain "attorney, accountant and return preparer fees" reported on line 14 of the Trust's Form 1041 to some, but not all, income items in arriving at the income distributed to beneficiaries. Here, the entire amount on line 14 was allocated to "Interest Income" (Form 1041, line 1) and "Total Ordinary Dividends" (Form 1041, line 2a), specifically to non-qualified dividends.

The Trust's foreign source income included both qualified and non-qualified dividends. I divided the Trust's foreign non-qualified dividends by the sum of the Trust's interest income and all non-qualified dividends to arrive at the percentage of the Trust's "attorney accountant and return preparer fees" allocated to foreign source income. I multiplied the total "attorney accountant and return preparer fees" by this percentage and subtracted the result from the Trust's foreign source income to arrive at the "Gross Income Sourced at Beneficiary Level: Foreign Source Income." "Gross Income Sourced at Beneficiary Level: U.S. Source Income" is then "Gross Income Sourced at Beneficiary Level" (Box 14, Code E) minus "Gross Income Sourced at Beneficiary Level: Foreign Source Income." These results are for the amounts distributed to all beneficiaries.  Multiply them by the beneficiary's general allocation percentage to get the beneficiary's foreign tax credit .

I had expected the "attorney accountant and return preparer fees" to be allocated ratably across all the income income items reported on the beneficiary's Schedule K-1, rather than just interest income and non-qualified dividends. But it turns out that the Instructions for Form 1041 and Schedules A, B, G, J, and K-1 (2024) state: "deductions that aren't directly attributable to a specific class of income may generally be allocated to any class of income, as long as a reasonable portion is allocated to any tax-exempt income."