On Form 1116, Part I, line 2 requires you to enter deductions that are definitely related to the foreign-source gross income reported on line 1a.
“Definitely related” deductions are expenses that can be directly identified with a specific class of foreign-source gross income under the allocation and apportionment rules of IRC sections 861–865 and related regulations. These expenses must have a direct and proximate connection to the income being reported.
Eligible Expenses for Line 2
Business expenses directly allocable to foreign-source income:
- Cost of goods sold allocable to foreign sales
- Wages and salaries directly associated with earning foreign-source income
- Rent, utilities, and office expenses for foreign operations
- Supplies, advertising, and other operating costs directly tied to foreign-source income
- Depreciation or amortization deductions properly allocable to foreign operations
Other directly allocable deductions:
- Expenses that can be specifically traced to the production of the foreign-source income reported on line 1a
- Any deductible expenses that are directly connected with the activity generating the foreign income
Important Restrictions
- Expenses must be directly allocable; general overhead or shared expenses are not included on line 2 and must instead be apportioned under Form 1116 allocation rules
- Interest expense is not entered on line 2; it must be allocated and apportioned separately under the Form 1116 interest allocation rules
- Do not include deductions related to excluded or exempt income, including income excluded under Form 2555 (Foreign Earned Income Exclusion)
- Foreign taxes themselves are not entered on line 2; they are reported separately in Part II of Form 1116.
Allocation vs. Apportionment
- Definitely related deductions (Line 2): Expenses directly tied to a specific class of foreign-source income
- Indirect or shared expenses: Must be apportioned between U.S. and foreign income using reasonable methods under the §861 regulations and reported on the appropriate lines of Form 1116.
Documentation Requirement
- Taxpayers must maintain supporting records showing how each expense is directly related to the foreign-source income
- A supporting statement may be required when multiple categories of deductions are included
Tax Rule Reference
The allocation and apportionment of deductions are governed by Internal Revenue Code sections 861 through 865 and related Treasury regulations. Additional guidance is provided in Publication 514 (Foreign Tax Credit for Individuals).
Source:
Form 1116 Instructions (2025)
Publication 514 (2025)
Disclaimer: Always verify details with the current year’s official IRS forms and instructions, or consult a tax professional for personalized advice.