Attention all mixed nationality couples, with one spouse having US citizenship or US resident status while the other is a nonresident alien (NRA)! Your tax advisor should be looking at all possible issues surrounding your fact pattern. If you live in a foreign jurisdiction or US state (there are 9 of them) with a community property system, you need specialist US tax advice. If your current tax advisor is not addressing these issues, you need to contact me for help — vljeker@us-taxes.org As one of my Twitter followers said “This lady knows…” Yes, dear reader, she does.
Part I of my blog post on this topic explained the basics of community property and how US tax laws can override certain community property principles when a US/NRA married couple is involved. The blog posts for the next two weeks will look at a smattering of real-life examples demonstrating how community property laws can impact the US tax situation of the married couple with mixed nationality. When one individual is a US person and the other a NRA special tax planning is needed. Surely, there are many other situations in which community property rules can wreak havoc on a couple’s tax planning, but some significant traps are discussed in these posts. Be smart! Don’t get caught out.
Single Member US LLC – Single Member, You Say?
In the US LLC context, let’s say that we have a non-US husband, Harry and that he is married to Wilma, a US citizen. The couple are domiciled in Switzerland (or even China!). Harry uses funds from his solely titled bank account into which he deposits his salary in order to set up a US LLC. Harry believes that he is the sole member and that as such, the LLC is a “single member disregarded entity”. Harry is wondering if he needs to file Form 5472 based on certain transactions he had with the LLC during the year. He comes to me for advice.
Here’s where we tell Harry the bad news. Harry and Wilma are domiciled in Switzerland. Under the Swiss community property regime (unless the couple elects otherwise by written documentation), Wilma is deemed to own one-half of the LLC (as well as one-half of Harry’s bank account). The LLC will be treated under US tax default rules as a “partnership” for US tax purposes; it cannot be a single member disregarded entity since under the law, it has two members. US tax consequences will result and must be sorted out for Harry, perhaps for Wilma, and even for the entity. For example, if treated as a partnership, the entity itself will have withholding obligations with respect to Harry. Wilma will be required to report and pay tax on her share of the partnership income even if she did not think she was a partner in the LLC.
In Argosy Technologies, LLC, T.C. Memo. 2018-35, one can see that careful planning must be done beforehand. In Argosy, the husband and wife owners of a business asserted that their business was a single-member LLC in order to avoid collection of the penalty for failure to timely file 2010 and 2011 partnership returns. The taxpayers were unsuccessful because Argosy Technologies LLC had previously filed partnership returns for two years and elected unified audit procedures applicable to partnerships. The court stated that since Argosy had represented itself as a partnership by filing partnership returns, it could not then argue that it was another entity. In addition, the husband and wife resided in New York, which is not a community property state.
Foreign Trusts – OOOPS!
If funding a foreign trust, it is critical to ensure that it is funded with the separate property of the non-US person spouse. If community property is used this can put the US individual in a precarious US tax situation since he or she can be subject to US income tax under certain “foreign grantor trust” (FGT) rules, on half of the trust’s worldwide income. Whether a foreign trust is a “grantor” trust is determined specifically under provisions of the US Internal Revenue Code (IRC Sections 671-679). Putting much complexity aside, as relevant here, a FGT can be created when a US person funds (or transfers assets to) the foreign trust and there is potential for the trust to have a US beneficiary. In this case, the US person is treated as the tax owner of the foreign trust under the so-called “grantor trust” rule of IRC § 679. He or she is taxed on the trust income allocable to his share of the funding of the trust. With community property, this would be one-half of the trust income. Let’s not forget the FGT tax filing requirements that would be required of such an unfortunate US spouse – and the penalties that can apply for failure to file them.
Foreign Corporations – OOOPS Again!
Another sticky situation arises when one spouse is a US person, and is deemed to own an interest under community property laws, in a foreign corporation, thereby causing the corporation to be classified as a so-called “controlled foreign corporation” (commonly referred to as a “CFC”) or a “passive foreign investment company” (also known as the dreaded “PFIC”). When community property rules apply, even a simple foreign mutual fund titled solely in the name of the NRA spouse can result in a tax nightmare for the US citizen spouse.
More real life examples will follow in next week’s blog post. Stay tuned.
Published August 27, 2018 UPDATED August 4 2019
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Nearly all foreign jurisdictions have marital regime rules of “immutability’, All US states and territories follow “partial mutability” where a change of domicile changes the regime as to future marital assets and income but not prior-acquired (or any inherited) assets unless commingled. That said, one can change a foreign marital regime (from CP to SP) by court order. Although supposed to be a rarity, in fact many foreign judges just rubber stamp the petition. Conflicts of CP/SP are common and US tax law does not necessarily follow reality. The IRM outline of community property and list of foreign jurisdictions leaves a lot to be desired: https://www.irs.gov/irm/part3/irm_03-038-147r#idm140240658251680
There’s a discussion of the German system in Angerhofer v IRS https://www.leagle.com/decision/198690187aytc8141851 Lane-Burslem is another interesting Tax Court case because it involved a USG employee abroad with a NRA spouse http://uniset.ca/other/cs2/70TC613.htm The tax law was changed thereafter to withdraw any possible benefit even with different facts. In real life, the wealthy entering into a marriage with a U.S. citizen will have a pre-nup or a marriage contract. The tragedy is where children of the marriage have unwanted US citizenship attributed because the US parent had qualifying prior residence. Who would have thought that a tax advisor might need to advise a pre-birth divorce of convenience to avoid that happening where the US parent is the father? And things can get particularly weird when IVF or surrogacy is involved. The post discusses cases of hybrid entities treated as pass-through in one country and as an entity in another. That can work to the advantage or the detriment of the US taxpayer. I can say from experience that the rate of compliance — which for many US expatriates and Accidental Americans would be a practical impossibility anyway, is low. The complexity of forced heirship, the (non-)recognition of disclaimer, attempted abandonment of assets, the effects of exchange rate fluctuations over time, commonly lead to double and confiscatory taxation, It’s no surprise that the law cases of record almost all relate to parties who have moved (or immigrated to) the USA and not those who have never lived in the USA or have abandoned the USA permanently and have a foreign nationality. The number of expatriation pales against the number who find workarounds — or whose US connection is not obvious — and who are untroubled by FATCA. That’s a national disgrace as laws that are seen to be flouted with impunity by some (and that includes certain US-based politicians) invite evasion by others. Targeting overseas Americans with revocation of passports creates further anomalies: dual nationals may not care and like certain former green-card holders may see the hysterical warnings of those they call “compliance condors” as a source of amusement rather than fear.
Lastly: the IRS office (Ogden UT) charged with taxation of foreign trusts seems not to know or care to know with any accuracy whether a foreign relationship is indeed a “trust” for US tax law or not. As early as 1955 the courts ruled that an entity could be a trust: http://www.uniset.ca/other/cs6/24TC829.html A “trust” may not be a trust of its qualities are more like tenancy in common: https://www.gov.uk/government/organisations/land-registry As a practical matter the middle-class taxpayer without expensive professional resources is always at risk: of 35% or $10,000 penalties, and of grantor trust rules that leave to the taxpayer to guess who may be deemed an “owner” and who is a potential beneficiary or controlling person. It gets worse insofar as a beneficiary is a NRA but proof of that status requires applying for, and being denied, a U.S. passport. Who would take the risk given the courts’ fluidity in regard to U.S. citizenship: Justice Ginsburg said that Morales-Santana is not retroactive in its changes to nationality law. But maybe it is retroactive: the principle of unconstitutionality of discrimination of nonmarital children did not begin with that case.
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Could you explain your reasoning on why you believe a two member US LLC is a corporation by default? Looking at 26 CFR § 301.7701-3(b)(1)(i), “Except as provided in paragraph (b)(3) of this section, unless the entity elects otherwise, a domestic eligible entity is – (i) A partnership if it has two or more members.” It would appear that a two member US LLC’s default classification would be a partnership, no?
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Thank you for your comment. I am on vacation right now, but a brief look at the Reg looks as if your analysis is indeed correct and mine is not. The post was written last year; it looks as if I may have been confusing a domestic LLC with a foreign entity that is similar to a domestic LLC . I need to clarify both possible examples — In the case of a foreign entity if both members (e.g., Husband and Wife) have limited liability (e.g., for a foreign type LLC such as a Mexican Sociedad de Responsabilidad), the default characterization is a “corporation” rather than a “partnership”. See 26 CFR § 301.7701-3(b)(2)(i).
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