Should I use 2555 or 1116?

I filed my US taxes using forms 1040 and 2555.  According to my figures I would be getting a small refund.

Then I got a notice that I had made an error and that I owe $2700!  I just got off the phone with the IRS trying to sort this out.

Apparently, you no longer simply subtract your UK income from your total US+UK income and then pay tax on the difference.  There is a worksheet through which you figure out how much tax you would owe on your total income, then subtract the amount of tax you would owe on the UK income, and pay the remaining tax.  The two methods are not equivalent.

This matters only for people who had income from both countries in a year.  That's my situation as we moved over here in 2007, so I worked in both countries.  In the future, all my income will be UK.

The IRS guy suggested that I withdraw my 2555 and use 1116 instead.  The latter form is for a tax credit for the amount of UK tax paid.  If this method results in a smaller amount of tax owed, I could go this route.  The catch is, if I use 1116 this year, I cannot use 2555 again for 5 years, so I had better be sure that 1116 will work out best for the next few years as well as for this one.

Two questions:

Does this all sound right?  Did I understand properly?

Has anyone else been in this situation?  Which route did you take?

I'm not sure what to do because we simply do not have $2700.  Literally, we don't have it.  Making the move over here wiped us out.  I'm very disappointed in this new system, as it works out to NOT actually getting an exclusion for all my UK income--I am paying some tax on it.  I was already freakin' pissed that I have to file US taxes for the rest of my life, and that was when I figured that I wouldn't actually owe any US tax.

If you revoke the claim for the foreign earned income exclusion for 2007 to avoid the effects of the stacking rule then you cannot claim the exclusion for the next 5 years.

If taxes rise under Obama as much as predicted this may end up costing you more than $2,700.

The IRS notice is 99% certain to be wrong because their software can't cope with the interaction between the exclusion & credits.

You may want to pay for a professional to file an amended return.

Thanks for your reply.

Can there be an interaction between exclusion and credits?  I thought I had to choose one or the other.

Yup, - it relates to the scaledown of foreign taxes, deductions and expenses.  You'd want optimise to figure the best answer plus - sometimes - the larger carryovers. 

If taxes rise under Obama as much as predicted this may end up costing you more than $2,700.

That was a wholly unnecessary comment!

Don't worry about it, Aless.  We have morons-a-plenty in the US who freak out at the thought of paying any tax, and view it as somehow inappropriate that they should be held responsible for their share of the highways, schools, etc. etc.  Generally they're also not aware of the real facts that make their claims farcical, as well. 

Much as my implication of the lack of IQ to go with such a mentality is personally irresistable , that group of people can't seem to address any issue without introducing their broken politics into it .

  T

This was not a political comment and it is remains daft to interpret it as ever being one.

It was an accurate statement based on predictions of the likely tax under a Democratic President when it was made on July 31, 2008 (given increases in marginal tax rates under all recent Democratic adminstrations).  We now have a different position where Obama seems to moving moving away from the policies expected last Summer of a Democratic administration into one where increases in the National Debt are more likely than tax rises.

Given that the comment was referring to tax planning for 2009 through 2014 - when no-one knows what tax rates will be it was - in fact - an entirely accurate and sensible comment.

Whether all who use this forum would agree with what Tom T. is implying; i.e. that all Americans overseas should file returns, pay tax and disclose full details of their Oyster cards, debit cards, Starbucks cards and bank accounts to the US Government annually is quite a different and unrelated issue...