2555 vs 1116

As I continue to work through my wife's US tax return, I have now to decide whether to deduct Foreign Earned Income via 2555 or apply Foreign Tax Credits via 1116. According to my calculations, both get me to a zero tax bill in the US, but it is better to use Foreign Tax Credits instead of deducting Foreign Earned Income, as I would then build up foreign tax credits for future years.

My problem is that last year, the big 4 accountancy firm has elected to use 2555 instead and there is a note in the instructions that says once you have elected to exclude income, you have to maintain that choice or otherwise it would not be available to you for 5 years. Has anyone encountered this before? Unfortunately I don't fully follow the implications of this neither from the 2555 instructions, nor the Pub54 IRS disclosure. Can I exclude less than the minimum of the upper threshold ($107,600) and the actual foreign earned income? For example, could I just to maintain the election exclude only $1 and claim foreign tax credits for the remainder?

Choosing the Exclusion(s)
To choose either of the exclusions, complete the appropriate parts of Form 2555 and file it with your Form 1040, 1040-SR, or 1040-X. Your initial choice to claim the exclusion must usually be made on a timely filed return (including extensions) or on a return amending a timely filed return. However, there are exceptions. See Pub. 54 for details. Once you choose to claim the exclusion(s), that choice remains in effect for that year and all future years unless it is revoked. To revoke your choice, you must attach a statement to your return for the first year you don't wish to claim the exclusion(s). If you revoke your choice, you can't claim the exclusion(s) for your next 5 tax years without the approval of the IRS. See Pub. 54 for more information.

My reading of the instructions is that they don't want someone to chop and change year by year, so if you are happy with going the FTC route, and I think that is a good option, just be prepared to do so for at the least the next 5 years.

My reading is slightly different to yours in that I believe you can claim the FEIE and subsequently revoke it, but once you revoke it, you have to wait 5 years before claiming it again. I therefore read it that if this is your first year of filing, then you can claim the FEIE until such time as you revoke it and move to using the FTC.

Completing F1116 and the FTC is clearly more accurate but it is just more burdensome and time consuming.

My reading is slightly different to yours in that I believe you can claim the FEIE and subsequently revoke it, but once you revoke it, you have to wait 5 years before claiming it again. I therefore read it that if this is your first year of filing, then you can claim the FEIE until such time as you revoke it and move to using the FTC.

Completing F1116 and the FTC is clearly more accurate but it is just more burdensome and time consuming.

You may well be correct, it's not something I've ever had to consider since we were retired by the time we moved to England and have no earned income so FTCs has been our only option, but they are very time consuming, at least for my tiny mind.

Thank you both. Aren't you both saying the same thing then?

Considering the generally higher tax rates in the UK, I should always be better off with FTC in my mind, so it is a mystery to me why the big 4 firm chose to do the FEIE last year and I'm considering amending last year's return to get those carried over foreign tax credits back. Not sure how IRS would look at me amending a big 4 filed return though... might cause suspicions 

I'll get to the bottom of that and then will have to tackle Forms 3520, Form 3520-A (for the ISA), Forms 8621 (PFIC). Let's hope that these are more self explanatory, I can't promise though that I won't have more questions!

Without knowing your exact circumstances it's difficult to give a full opinion.

The option to use the FEIE is limited in the first place due to the earned income cap ($107,600 in 2020). Assuming that your circumstances allow you to use the FEIE, then the main reason for doing so (other than ease of form filling) is that assuming you have some interest/investment income, that has not been taxed in the UK (ISA income, premium bond earnings, gambling winnings etc) then your standard deduction can them be used to ensure you pay no tax in the us also - this is I would guess the most likely reason your accountants chose this route.

Going the FTC route while giving you a carry forward balance of unused taxes (primarily earned income in the general category) can create a US tax liability on passive category income because it hasn't been taxed in the UK - and the standard deduction available to use is apportioned across income categories in proportion to the income in that category as a proportion of total income - i.e if 1% of incoem is passive, then only 1% of your standard deduction can be applied against passive income.

It's complicated, the only way to work out what is best is to calculate both ways and see the end result. 

Since last years return was prepared by a big 4 firm, may I ask who was the client: the wife, or a company the wife worked for? If a company was the client, that may have a bearing on why the 2555 was selected.

There has also been an assumption in several past threads that using 1116 may result in tax due to the IRS if there was no tax paid to the UK on passive income. It's likely this would be a false assumption, but with the important caveat that each situation is unique.