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 — firstname.lastname@example.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 “corporation” for US tax purposes; it cannot be a single member disregarded entity since under the law, it has two members. Tax classification of the entity as a “corporation” means double-taxation can result. The first level of US income tax will be at the corporate level; after the corporation pays income tax, and distributes a dividend to its owners, Harry and Wilma, another level of income tax will result. This level of tax will be assessed on the individuals themselves. As for Harry, a nonresident alien individual, the corporation will be required to withhold tax at a 30% rate unless the lower Swiss Treaty rate applies and Harry files the proper paperwork. As for Wilma, she will be required to report the dividend as income on her US tax return and pay tax on the amount. And, yes, going back to Harry’s original question, Form 5472 will still be required since US corporations that are at least 25% owned by non-US shareholders must file the form.
Harry and Wilma can try to take the position that under Rev. Proc. 2002-69 they can still treat the LLC as a “disregarded entity” or a “partnership” (rather than a “corporation”) even though they have not made an entity classification election on Form 8832. However, without making this election, it is unclear the IRS would accept this position. Furthermore, even if the position was accepted, US tax consequences will still 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.
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 for Argosy case on May 6, 2019
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