Part I of my blog post 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. This was followed by a blog post posing a smattering of real-life examples that demonstrated how community property laws can impact the US tax situation of the married couple with mixed nationality. Today’s post offers more real life examples.
Remember, when one individual is a US person and the other a NRA, special tax planning is needed. 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.
Let’s Not Forget Mr. FBAR!
Form 114: Report of Foreign Bank and Financial Accounts (“FBAR”) is an annual form that anyone who has been reading my blog has certainly heard of. The FBAR must be filed annually by US persons who (among other things) have a financial interest in any bank, securities or other financial account in a foreign country which exceeds in the aggregate, $10,000. Let us return to our mixed nationality couple, Harry (a NRA) and Wilma (his US citizen spouse) who are living in Switzerland. Due to the community property rules in their country of domicile, Wilma is an owner of one-half of Harry’s bank account. She may need to file an FBAR if the value of the entire account (not just her share) exceeded USD 10,000 at any time in the tax year. And, with regard to the foreign trust situation discussed in the earlier blog – If a US person such as Wilma, is treated as the tax owner of a foreign trust due to community property rules and that trust has offshore accounts, the US person will have to file this form reporting the trust’s accounts. You can learn more about FBAR, Form 114 here and here.
S Corporation Status Destroyed by Community Property Laws
Often, a small business or start-up will utilize an “S corporation” election for its business, due to the advantage of obtaining “flow-through” tax treatment given to its shareholders. Generally, an S corporation is a corporation formed under a particular State’s incorporation laws. (More information about S corporations at my tax blog posts here and here).
With the US tax reform legislation enacted in December 2017, S corporation status looks as if it is becoming far more popular than ever before due to the new Internal Revenue Code Section 199A 20% pass-through rules. Making the election is easy, but the corporation must be eligible to elect S corporation status and the eligibility factors must be maintained. Among other requirements, an S corporation cannot have a shareholder who is a NRA.
Just how unpredictable the matter can become when community property laws come into play is illustrated by the case of Ward v. U.S., 661 F.2d 226 (Ct. Cl. 1981). The Ward case demonstrates that if a US citizen marries a NRA in a jurisdiction that deems their property to be community property, the NRA spouse will become a shareholder in the corporation by operation of the community property laws. Once this happens, this will destroy the S election. In the Ward case, the spouses had in fact, executed a prenuptial agreement providing that certain property (including the corporate stock) was to remain the separate property of the US citizen spouse. The agreement was found to be unenforceable, with the result that the S corporation stock was treated as community property. As a result, the NRA spouse was treated as a shareholder, destroying the S status of the corporation.
US Estate and Gift Tax
Without belaboring the points, under community property rules, each spouse will be treated as owning one-half of each asset comprising community property. This raises US gift and estate tax issues for BOTH the US and NRA spouse. For example, a gift transfer of money from the US spouse’s US bank account can raise US gift tax issues for the NRA-spouse who will be deemed by virtue of the community property laws to have made a gift of half the funds. A gift made by the NRA spouse of foreign real property titled solely in his or her name will be treated as a gift of one-half having been made by the US spouse. This will require the US individual to file a gift tax return and/or pay gift tax.
Think too, about the US estate tax issues that are raised. The US Estate tax rules apply to a US person (a US citizen or “resident” domiciled in the US) differently than to a NRA (non-US citizen and not domiciled in the US). The estate of a US person is taxed on the fair market value of all of the worldwide assets owned by the individual at the time of death (or an alternate valuation date). On the other hand, upon death of an NRA, the estate will be subject to the US Estate tax only on assets located, or deemed to be located, within the US. The Estate tax is assessed on the fair market value of the property at a maximum 40% current rate.
In addition, a very generous exemption from Federal estate tax exists for the US person. On the other hand, only a paltry exemption exists for the NRA. For US citizens or “residents”, the basic exemption amount increased under the recent tax reform legislation from US $5 million to $10 million (it applies for those dying after December 31 2017 and before January 1 2026; the amount is indexed annually for inflation and is worth close to $11.2 million in 2018). For such nonresident alien individuals, however, the estate tax exclusion amount remains at a shabby US$ 60,000 worth of assets located (or treated as located) in the US.
Often, mixed nationality couples will title US real estate solely in the name of the US spouse since the lifetime exclusion amount available to a US citizen can often shelter the value of the property from estate taxation. Application of community property laws destroys this planning since the NRA spouse will be deemed to own half the property.
Published September 10, 2018
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