Community Property for Americans Married to Nonresidents

Let’s look at the taxation of income earned by spouses living in community property jurisdictions. When a U.S. person is married to a nonresident alien, the tax rules are different.

The normal rules: two U.S. taxpayers

The normal rules are described in IRS Publication 555.¹ Where spouses are subject to community property rules and they file separately, community income is split equally between the two spouses. The community property jurisdiction might be California. Or it might be any one of a number of countries outside the United States.

Different rules for a nonresident alien spouse

When one of the spouses is a nonresident alien, the rules are different.A U.S. person married to a nonresident alien may not, except for a few situations, file a joint return.² Head of household status is denied to a nonresident alien.³ This means that a nonresident alien may only claim single or married filing separate status.

Earned income

For a couple filing separately with community income under the local laws, how will they split the income so it is properly reported by the nonresident alien spouse and the U.S. taxpayer spouse?Earned income is allocated entirely to the earning spouse. ⁴

Earned income defined

Earned income is defined by a cross-reference to the foreign earned income exclusion rules. Section 879(a)(1) defines earned income as follows:

Earned income (within the meaning of section 911(d)(2)), other than trade or business income and a partner's distributive share of partnership income, shall be treated as the income of the spouse who rendered the personal services[.]

Section 911(d)(2)(A) defines earned income as follows:

The term “earned income” means wages, salaries, or professional fees, and other amounts received as compensation for personal services actually rendered, but does not include that part of the compensation derived by the taxpayer for personal services rendered by him to a corporation which represents a distribution of earnings or profits rather than a reasonable allowance as compensation for the personal services actually rendered.⁵

Earned income rules applied

We have a simple rule: allocate earned income to the spouse who earns it, regardless of the local community property rules. This can cause unexpected results. Consider this example, where a U.S. citizen is subject to U.S. income tax on income that is not (under local law) hers.

Example

A U.S. citizen lives abroad and is married to a nonresident alien. They live in a community property jurisdiction so that earned income is treated as equally owned by both spouses.The U.S. citizen spouse is the sole wage earner in the family. Under local law, the U.S. citizen spouse is deemed to own half of the earned income, and the nonresident alien spouse is deemed to own the other half.Section 879(a)(1) says the wages are allocated for U.S. income tax purposes to the U.S. citizen spouse. The U.S. citizen will file claiming married filing separate status, and will report 100% of earned income as taxable, even though under local laws 50% of the earned income belongs to the nonresident alien spouse.

One wonders about this.⁶ Under the local laws of the country where the U.S. citizen spouse lives, only half of the income is hers. Yet the U.S. government taxes her on 100% of the income.It is equally possible for Section 879 to define earned income as nontaxable to a U.S. citizen even though under local law 50% of it is hers.

Example

A U.S. citizen lives abroad and is married to a nonresident alien. They live in a community property jurisdiction so that earned income is treated as equally owned by both spouses.The nonresident alien spouse is the sole wage earner in the family. Under local law, the U.S. citizen spouse is deemed to own half of the earned income, and the nonresident alien spouse is deemed to own the other half.Section 879(a)(1) says the wages are allocated for U.S. income tax purposes to the nonresident alien spouse. The U.S. citizen spouse will file claiming married filing separate status, and will report no earned income, even though under local laws 50% of the earned income belongs to the U.S. citizen spouse.

Earned income: write the rules yourself

Under the laws of many countries, it is possible to trump community property rules by agreement between the spouses. U.S. citizens married to nonresident aliens should do this. By doing so, they can take themselves out of Section 879 entirely and allocate income in a tax-efficient way.Section 879 only forces an allocation of community income.⁷ A spousal agreement can make the earned income be treated for local law purposes as separate property of one of the spouses. If the nonresident alien spouse is treated as the sole owner of the income under local law, then Section 879 will not re-allocate half of the income.

Example

A U.S. citizen is married to a nonresident alien. The nonresident alien is the sole wage-earner in the family. Under local community property law, each spouse is deemed to own half of the income.However, under local community property law the spouses can agree between themselves as to the characterization of the earned income as community or separate income. They make a valid agreement under local law to treat the earned income as the separate property income of the nonresident alien.The U.S. citizen spouse files a U.S. income tax return, using the married filing separate status. No earned income is reportable on that income tax return because it is not community income.

Trade or business income

Section 879 merely points to a different part of the Code so you can figure out how to allocate community income between a U.S. citizen spouse and a nonresident alien spouse when you are dealing with “trade or business income” and a partner’s distributive share of partnership income:

Trade or business income . . . shall be treated as provided in section 1402(a)(5).⁸

The rule is simple: community income derived from a trade or business is allocated to the spouse who did the work:

[T]he gross income and deductions attributable to such trade or business shall be treated as the gross income and deductions of the spouse carrying on such trade or business or, if such trade or business is jointly operated, treated as the gross income and deductions of each spouse on the basis of their respective distributive share of the gross income and deductions[.]⁹

Trade or business income means income in which both personal services and capital are material income producing factors.¹⁰ Thus, a sole proprietorship that is a service business will allocate its income as earned income under Section 879 rather than trade or business income.The fact that a spouse has management and control attributed to him or her by community property laws does not give that spouse a share of the income. Only by actively working in the business does the spouse receive an allocated share of the income:

The term “management and control” means management and control in fact, not the management and control imputed to the husband under the community property laws of a State, foreign country or possession of the United States. For example, a wife who operates a pharmacy without any appreciable collaboration on the part of a husband is considered as having substantially all of the management and control of the business despite the provisions of any community property laws of a State, foreign country, or possession of the United States, vesting in the husband the right of management and control of community property.¹¹

The allocation rules for trade or business income thus trump the community property rules of the relevant jurisdiction.

Example

A U.S. citizen is married to a nonresident alien. The nonresident alien is engaged in a trade or business. Under the local community property laws, the U.S. citizen is deemed to have a 50% interest in the income generated from the trade or business. Nevertheless, for U.S. income tax purposes the U.S. citizen does not include any of the income from the business on her U.S. income tax return.

Distributive share of partnership income

Community property rules do not matter when allocating the distributive share of partnership income between spouses where one is a nonresident alien. The spouse who is the partner will take the entire amount of community income from the partnership into his or her income for U.S. tax purposes:

If any portion of a spouse's distributive share of the income of a partnership, of which the spouse is a member, is community income for the taxable year, all of that distributive share shall be treated as the income of that spouse and shall not be taken into account in determining the income of the other spouse. If both spouses are members of the same partnership, the distributive share of the income of each spouse which is community income shall be treated as the income of that spouse. A spouse's distributive share of the income of a partnership that is community income shall be determined as provided in section 704 and the regulations thereunder.¹²

If spousal agreements are possible under the laws of the local jurisdiction, use them to convert the character of the income from community to separate property. Section 879 only controls the allocation of community income from a partnership to one spouse or another. It does not control the allocation of separate property. This may be the only possible way to avoid an over-allocation of income to the U.S. tax system.

Income from separate property

Income from separate property is allocated to the spouse in one of two ways. If the local community property rules say that separate property generates separate income, then Section 879 cannot throw a trump card. Section 879 only forces reallocation of community income. The separate income belongs to the spouse who owns the separate property.If the local community property rules say that separate property generates community income, that income will nevertheless be allocated—for U.S. income tax purposes—to the spouse owning the separate property: ¹³

Any community income for the taxable year . . . which is derived from the separate property of one of the spouses shall be treated as the income of that spouse. The determination of what property is separate property for this purpose shall be made in accordance with the laws of the State, foreign country, or possession of the United States in which, in accordance with paragraph (a)(1) of this section, the recipient of the income is domiciled or, in the case of income from real property, in which the real property is located.¹⁴

This rule does not apply to earned income, income derived from a trade or business, or partnership income.¹⁵

Everything else

For all other types of community income, Section 879 instructs us to follow the allocation rules under local law.¹⁶

Election to be U.S. resident taxpayer

Recall that a U.S. citizen with a nonresident alien spouse cannot use the married filing jointly filing status.¹⁷ However, the nonresident alien can make an election to be treated as a U.S. person for the purposes of income taxation. There are two separate rules, one for nonresidents in their first year of residency who are married to U.S. citizens or residents,¹⁸ and one for nonresident aliens married to U.S. citizens or residents.¹⁹If either of these elections has been made, the Section 879 rules governing allocation of community property will not apply. This makes sense, because the basic premise of Section 879(a) is to provide rules to allocate community income between U.S. taxpayers and nonresident aliens. Making the election to treat a nonresident alien as a U.S. taxpayer eliminates the need for these rules.

Thanks and Disclaimer

I am a lawyer but not your lawyer, and this is not legal advice. I would recommend that you seek professional help but that implies a need for psychiatry. Maybe that is appropriate - tax law has been proven to cause insanity. :-)