US tax liabilities and requirements to file US tax and information returns are impacted by community property laws that exist in many foreign countries across the globe. Today’s blog post will examine some of these issues and set the stage for upcoming posts dealing with community property in the international context and how it affects a married couple’s US tax obligations when only one of the spouses is a US individual.
Readers of my blog may know from previous posts that generally, unless the couple enjoys dealing with complicated US tax matters and filings, holding title to assets jointly with a non-US citizen spouse is risky business! Many may keep their assets completely separate to avoid nasty US tax complications. However, this alone may not help – community property laws may override any such attempt to keep assets “separate”.
What is Community Property?
Although community property is not defined in the US Internal Revenue Code, Poe v. Seaborn, 282 US 101 (1930) decided by the United States Supreme Court, gives us a succinct overview. In that case, the Court held that in a community property state (as relevant, Washington), due to the operation of state law, a married person’s income is divided with his spouse such that the income earned by one spouse is immediately one half the property of the other spouse. Under “community property” principles generally, community property is property (i) that is not otherwise classified as “separate property” (ii) held by a married couple who are domiciled in a community property jurisdiction (iii) under the laws of the relevant jurisdiction each spouse has a “vested” undivided one-half ownership interest in the community property owned by the couple (iv) at death or divorce, the law entitles each spouse / the surviving spouse the right to partition the community property and receive one-half. While there is considerable variation in the community property laws in different jurisdictions, the takeaway is that the husband and wife are considered to own equal and undivided half interests in each item of community property (meaning income earned from the half owned by the US spouse can be taxed under US laws); and income earned by one spouse is generally treated as if it had been earned one-half by each, again, raising a serious US tax issue for the US spouse.
Community Property Jurisdictions
In today’s world, it is very common to see international marriages and what I call “migrating couples” (those who move from one country to another). Many individuals involved in an international marriage or in “migrations” are unaware of the potential US tax consequences that can result when community property rules come into play as a result of their unique facts. The impact of community property laws can be unexpected and diverse and the fact of the matter is that community property laws may affect a couple if they have ever lived in a community property jurisdiction.
First, the couple have to be “domiciled” in a community property jurisdiction. What do we mean by “domiciled”? It’s complicated and we will examine the concept in another blog post. Briefly now, let’s look at the places where we might find application of community property rules. In the United States, nine states have community property regimes: Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington and Wisconsin. In addition, the state of Alaska permits its residents to elect application of a community property regime. Many foreign countries also have community property systems. Outside of the US, community property regimes can commonly be found in many civil law (as opposed to common law) countries. The US legal system is based on English common law, and civil law systems can be unfamiliar and confusing to Americans.
The civil law is a codified body of law, with comprehensive, continuously updated legal codes. On the other hand, common law is generally uncodified, meaning there is no comprehensive compilation of legal rules and statutes to be followed. Civil law developed in continental Europe and was applied to the colonies of European imperial powers (e.g., colonies of Spain and Portugal). Community property rules may differ widely among the different countries that have adopted the system. Many Latin American countries (Argentina, Brazil, Chile, Colombia, Venezuela) have some form of community property regime. In addition other countries such as China, Costa Rica, Denmark, France, Italy, Mexico, Netherlands, Philippines, Russia, South Africa, Spain, Sweden, Switzerland, and Ukraine have a community property regime. By contrast, “common law” countries following the common law (e.g., England, Canada, Australia) do not follow any type of community property regimes.
US Tax – Why Do We Need to Worry About Community Property?
As mentioned above, in Poe v. Seaborn, the US Supreme Court held that when a jurisdiction with community property rules provides that each spouse is the owner of an undivided one-half interest in the couple’s community property, then it follows that each spouse can be taxed on one –half of the community income. This rule can be very troublesome in cases of migrating couples or international marriages.
For example, assume a couple are domiciled in a foreign country having a community property regime. The wife is a US citizen and a stay-at-home mom, the husband, a hedge fund manager, is not a US citizen or green card holder. Husband earns a seven figure salary and owns significant foreign assets, acquired during the marriage in his sole name. Will the US wife be required to file a US tax return and report half of the salary earned by her foreign husband, half of the investment earnings from his solely titled assets? Will she be required to file FBARs or other foreign information tax returns such as Form 5471 or 8938 even though she does not have legal title to the foreign assets? Based on the Poe v. Seaborn decision, the wife is treated as an owner of half of these assets!
Tax liabilities and requirements to file US tax and information returns will undoubtedly come as an unwelcome surprise to the couple. We’ll look in greater detail in a later blog post at specific tax issues that arise on account of the community property concept such as the US spouse’s ownership of foreign financial accounts, foreign stock, the filing rules that are implicated and so on.
Readers must also bear in mind that it is possible in the international context that a married couple’s property rights (and concomitant US tax obligations) may change as they change their marital domicile. This is a situation occurring more and more frequently in today’s global economy. In this regard, one of two competing doctrines would govern the situation. Under the doctrine of “immutability”, property acquired by the married couple after they have changed their domicile is subject to the regime which was established prior to the domicile change. In contrast, the doctrine of “mutability”, provides that any property acquired after a change in domicile is to be governed by the law of domicile at the time of the property acquisition.
To further complicate matters, some countries, follow a part-mutability/part-immutability concept. Under this concept, for example, if a husband and wife change their marital domicile from a common law jurisdiction to a community property jurisdiction, the character of property acquired by them prior to the move will not be affected and rights to those items of property (or substitutions for such property) will be governed by the common law. Property acquired by the couple after the change in marital domicile, however, will be governed by the community property regime of their new domicile.
Some Relief — Internal Revenue Code Section 879
Internal Revenue Code Section 879 generally overrides application of Poe v. Seaborn. Instead of applying community property laws, Section 879 applies special allocation rules when either or both of the spouses are nonresident aliens (provided that an election under Section 6013(g) or (h) has not been made by the couple; generally this is an election to treat a nonresident alien individual as a US resident. You can read more on this at my blog post here).
When Section 879 applies, community income is allocated according to these special rules:
- Earned Income: Earned income is taxed only to the spouse who performed the services which earned the income. Earned income generally includes wages, salaries, professional fees, and other amounts received as compensation for personal services. Code Section 911(d)(2) is a useful reference for understanding earned income.
- Trade or Business Income: When income is earned from a trade or business (other than a business conducted by a partnership) the income is taxed only to the spouse carrying on the business. However, if the trade or business is jointly operated, then taxation will result to each spouse on the basis of the spouse’s respective distributive share of the gross income and deductions of the business.
- Partnership Income: The spouse who is the partner in the partnership will be taxed on the distributive share of partnership income or loss.
- Separate Property: Sometimes, depending on the laws of the community property jurisdiction, income earned from separate property (such as an inheritance or a gift to one spouse) is treated under the laws of that jurisdiction as community income, one-half owned by each spouse. Code Section 879 changes this rule and taxes such income only to the spouse owning the separate property.
- Other Property: If the community income does not fall within the special set of allocation rules enunciated by Section 879, then it is allocated between the spouses as provided under the applicable community property laws. Thus, if the spouses have a vested interest in certain types of community income they will be subject to the rule of Poe v. Seaborn. Each spouse can then be treated as owning one-half and the US spouse can be subject to US tax on his or her half of the community income. Typically, the type of income involved will be passive income such as dividends, interest, rents, royalties, or gains from community property.
Published June 23, 2018
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This communication is for general informational purposes only which may or may not reflect the most current developments. It is not intended to constitute tax advice or a recommended course of action. Professional tax advice should be sought as the information here is not intended to be, and should not be, relied upon by the recipient in making a decision.