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November 14, 2013 - Phil Hodgen

Community Property and Form 8854’s Balance Sheet

I received a question by email this morning from a CPA I know in New York:

I have a [Country X] couple who were Long Term Residents. They had their green cards for more than [a bunch of] years. They are at a joint, net worth level, that puts them over the $2,000,000 threshold. However, their net worth is about $4,000,000. [Country X] is a community property country. Do you ever apply community property rules when you complete a Form 8854?

The Situation

Interpreting the insider jargon for you guys, my CPA friend is saying that the husband and wife have had green cards long enough to be “long term residents” for purposes of Section 877A–the exit tax rules. She does not want her clients to be treated as covered expatriates when they abandon their green cards. (If the husband and wife are treated as covered expatriates, then there will be mark-to-market tax imposed on their assets, IRAs will be treated as distributed in full, etc. etc. All the bad stuff.)

One way that an individual achieves “covered expatriate” status is by being rich. “Rich” is defined by the IRS as having more than $2,000,000 in net worth. There are other ways to become a covered expatriate but they are not important for the purposes of this blog post. The couple in question has a net worth above $2,000,000 but less than $4,000,000. They will both abandon their green cards.

If they can successfully argue that they are precisely 50/50 owners of all of their assets, then each of them will report a net worth of under $2,000,000, and will escape the United States without tax. The only headache will be that of my CPA friend has messy tax returns to file. If the net worth of $4,000,000 must be reported for each individual (or jointly), then they have a problem.

Two Form 8854 Filings

When you prepare the balance sheet on Form 8854 to prove to the IRS that you are (or are not) a covered expatriate, you put your own assets on the balance sheet. In this case, the husband and the wife will each file a final U.S. income tax return using the filing status “Married Filing Separately” because on December 31, 2013 both will be nonresident aliens–their green cards will have been cancelled.

Each of them will prepare a Form 8854 showing his and her assets and liabilities, and this will be attached to the separate tax returns. The Form 8854 is not a combined husband-and-wife form.

Jointly-Owned Property and Form 8854

How do you deal with jointly owned property? Simple–divide it among the owners in the correct percentage. If there are three co-owners and one expatriates, then one-third of the assets are reported on the expatriating person’s Form 8854.

Community property is particularly easy. Every asset, no matter what, that has been acquired during marriage will be considered equally owned by the husband and the wife–by law. It does not matter who holds title to the asset. Community property rules vary from country to country, so sometimes you need to do a bit of archeology into the other country’s specific community property rules to see what they say. But in general, this is how things work.

So at first glance, the answer to my CPA friend’s question is simple. Take the heroic position that the community property laws of Country X mandate that all of their assets should be treated as owned equally by the spouses, no matter whose name is on title.

Complications

Alas, nothing is simple. Country X happens to have two types of marriages. When couples get married they can choose to have their property rights governed under one of two different systems. One is a classic community property set of rules as I have described. The other system is . . . different from the community property rules.

You don’t want to become an expert in Country X marital property laws just for the purpose of getting a nice couple cleanly out of the United States via a correctly-prepared Form 8854.

Sledgehammers Fix Everything

A younger version of me was a factory worker. There I learned to revere the five pound sledgehammer. It fixed everything, and was referred to with a certain reverence up and down the line. (Custom van fabrication–take an empty van, put carpet, stereo, pimpin’ swivel seats, etc. etc. in them. Also a breakfast cereal factory, making corn flakes ‘n stuff.)

These life lessons remain useful to those of us who practice tax law. There are a few blunt instruments we can use to cudgel and bludgeon facts until magic occurs.

The first method for achieving the desired result is a spousal agreement. Husband and wife agree amongst themselves that no matter what the law of Country X might say, they agree that all assets are community property. Every country I have ever seen (well, except for Indonesia) allows community property rules to be trumped like this. I am going to refer to this as a transmutation agreement, because that is what California calls it. You are transmuting the character of separate property to community, or vice versa. ((I like the word “transmutation” because it sounds vaguely theological. You might recall that I recently read Will and Ariel Durant’s volume on the Reformation, so all of this “angels dancing on the head of a pin” stuff is still resonating with me.))

Such an action–transmuting the character of an asset from separate property under Country X law to community property under Country X law–might trigger a taxable gift from one spouse to the other. If there is a $1,000,000 asset that Country X would call the husband’s separate property, then converting it to community property will be a $500,000 transfer to the wife. Transfers to noncitizen spouses are not eligible for the marital deduction, so for transfers above $143,000 (the number in 2013; it adjusts annually for inflation) there will be a taxable gift.

This would assume that the IRS:

  1. has someone actually look at the Form 8854 balance sheets;
  2. asks critical questions;
  3. finds the underlying situation as a matter of Country X law prior to the transmutation agreement and compares it to the balance sheet after the transmutation agreement;
  4. engages in the extremely exciting exercise of retaining Country X expert lawyers to advise on the laws related to this transfer; and
  5. decides to send the taxpayers a little letter requesting a love offering to the United States Government’s Bucket ‘o Booty.

Unlikely. But we don’t live in the world of probabilities. We live in the world of certainties. Or we do as much as we can, anyway.

Here’s the deal. If all of that happens, H and W just file the appropriate gift tax returns (late) and report the taxable gift and use up some of their unified credit. No tax. Paperwork only. Easy.

This suggests an even easier solution. Since the couple is leaving the United States never to return, they can burn their unified credits like gangsta pyromaniacs. They can make gifts to each other, file Form 709s as needed, and be done with it.

Result and Recommendations

Note what has happened here. We used a simple agreement between the spouses (not filed anywhere, but be sure to follow all the formalities in case you are audited by the IRS) to cause the couple to have an equal split of assets. They can exit the country and report the assets on Form 8854 truthfully and correctly. Each has a net worth of under $2,000,000. Neither is a covered expatriate.

My suggestion–if this strategy is followed–is to file gift tax returns. Remember that when you sign Form 8854 you are saying to the U.S. government “all my tax filings are up to date and on file with you”. If gift tax returns should have been filed but weren’t, they that statement is false, and you are a covered expatriate.

Since a gift tax return is prudent anyway, my next suggestion is to just cook up whatever gift tax returns are necessary to equalize the asset ownership between the spouses and file them. The husband and wife are leaving the USA forever so they don’t care about the unified credit.

A lot of this is overkill. The likelihood of the IRS coming in to challenge a married couple’s allocation of all assets as 50/50 between themselves is negligible. But the Service loves excessive overkill. Just look at the penalties built into the Code. With a bit of paperwork you can prevent potential blowback.

Or just run with it.

Expatriation