When You Own Half an IRA and Pay Income Tax on All of the IRA

COMMUNITY PROPERTY AND FEDERAL TAX LAW

Federal tax sometimes produces unexpected results when community property rules are in play. Today I want to talk about what happens in expatriation projects when there is an IRA that is classified as community property.

In brief:

• Half of the IRA value is included in the expatriate’s balance sheet for the net worth test.
• The entire IRA is deemed distributed upon expatriation if the taxpayer is a covered expatriate.

SAMPLE FACTS

H and W are both U.S. citizens.

H has an IRA with a value of $100,000. The IRA is a community property asset because it was acquired and funded with community income earned while H and W were residents of a community property jurisdiction. Arbitrarily I will assume they were residents of California.

H renounces U.S. citizenship and is a covered expatriate.

Let’s look at what happens on H’s final U.S. income tax return.

THE NET WORTH TEST

Everyone who renounces U.S. citizenship must report personal net worth on Form 8854, Part II, Schedule B.

H has an IRA worth $100,000. He only reports a $50,000 asset on Line 6. Here’s why.

Community property under state law

California law says that the IRA is a community property asset. That means that H is treated as owner of 50% of the economic value of the asset and W is treated as owner of 50% of the economic value of the asset, even though the IRA is in H’s name only.

State law determines property rights

It is a basic principle of U.S. tax law that state law determines the property rights of the taxpayer, and Federal law determines how those property rights are taxed. Morgan v. Commissioner, 309 U.S. 78 (1940).

Therefore, California law tells Federal tax law that H is the owner of an asset worth $50,000.

The net worth test

IRC Section 877A(g)(1) says a covered expatriate is an expatriate who meets the requirements of IRC Section 877(a)(2)(A), (B), or (C). IRC Section 877(a)(2)(B) says an expatriate is a covered expatriate if he or she has a net worth of $2,000,000 or more.

How do you compute your net worth for the net worth test? Notice 97-19, Section III says:

Notice 2009-85, Section 2.B adopts the Notice 97-19 test for application to the current expatriation rules at IRC Section 877A:

The rule is simple: your personal net worth includes an interest in an asset that would be taxable as a gift if you gave away that interest on the day before expatriation.

Why H’s IRA is $50,000 for the net worth test, not $100,000

The net worth test is hypothetical. It asks one question: if H gave away everything he owns on the day before expatriation, what would be taxable as a gift?

A hypothetical gift does not need the actual permission of the IRA custodian. A restriction in a custodial agreement does not take an asset off the balance sheet. Federal tax law does not prohibit the assignment of an IRA either. It only treats the assignment as a distribution to H. Reg. Section 1.408-4(a)(2).

H can only give away what he owns. He cannot give away W’s community property rights in the IRA without her written consent. Cal. Family Code Section 1100(b).

So the only real question is how much of the IRA belongs to H, and whether it would be taxable as a gift. Applying the Morgan v. Commissioner principle:

• California law determines the answer to H’s ownership, and the answer is that H owns 50%. His hypothetical transfer is $50,000.
• Federal tax law would certainly say this gratuitous transfer is “taxable under Chapter 12 of Subtitle B of the Code,” even after we ignore sections 2503(b) through (g), 2513, 2522, 2523, and 2524 as Notice 97-19 requires.

Put $50,000 on line 6 of the Form 8854 balance sheet.

DEEMED DISTRIBUTION (FOR A COVERED EXPATRIATE)

The deemed distribution rule

A covered expatriate who owns an IRA is treated as receiving a full distribution of that IRA on the day before the expatriation date. IRC Section 877A(e)(1)(A) says:

How do you know that this refers to an IRA? It doesn’t use the words “individual retirement account” anywhere.

Specified tax deferred account = IRA

An IRA is a “specified tax deferred account.” There is a multi-step chain in the definition. Here’s how it works.

IRC Section 877A(e)(2) says:

We go to IRC Section 7701(a)(37)(A) and it says:

Finally, we go to IRC Section 408(a), which contains the details of what an IRA is.

• IRC Section 877A(e)(2) says a “specified tax deferred account” is an “individual retirement plan” and tells us to use IRC Section 7701(a)(37) to figure out what an individual retirement plan is.
• IRC Section 7701(a)(37) says an “individual retirement plan” is whatever IRC Section 408(a) creates.
• IRC Section 408(a) defines an “individual retirement account.”

Therefore we have the chain of definitions: specified tax deferred account = individual retirement plan = individual retirement account.

Why community property rules don’t apply to the deemed distribution

That little logic chain is handled. Now back to the deemed distribution rule. The covered expatriate “shall be treated as receiving a distribution of his entire interest in such account.” IRC Section 877A(e)(1)(A).

What is “his entire interest?”

That phrase “his entire interest” should logically refer to H’s community property interest in the IRA, right? As shown above, Federal tax law looks at state law (in this case, California) to determine that H owns a 50% community property interest. This would treat H as receiving a $50,000 deemed distribution from his IRA.

Wrong. The general rule (“look at state law for determining property rights, then look at Federal tax law to see what tax is paid”) has a specific statutory override.

IRC Section 408(g) is short:

Note the words “this section.” IRC Section 408(g) overrides community property law only inside IRC Section 408, which creates IRAs. IRC Section 877A(e) uses the IRC Section 408(a) definition of an IRA, so IRC Section 408(g) comes with it. Therefore, when we apply IRC Section 877A(e)(1) to calculate the value of the deemed distribution of a covered expatriate’s interest in an IRA, we ignore community property laws.

Deemed distribution: the entire IRA balance

If we ignore community property rules, H is treated as owning the entire IRA. If he is treated as owning the entire IRA, he is treated as receiving a deemed distribution of the entire balance of the IRA on the day before his expatriation date – the entire $100,000 balance.

WHY THE DIFFERENCE?

Why does H have a $50,000 IRA for the net worth test and a $100,000 deemed distribution from that IRA because he is a covered expatriate?

The net worth test uses gift tax principles, and the gift tax respects California community property law. The deemed distribution rule uses the IRC Section 408 definition of an IRA, and IRC Section 408 tells us to ignore community property law. Two different sets of rules give two different answers for the same asset.

Yes, H receives a deemed distribution of W’s community property half of the IRA, and pays income tax on that deemed distribution.

CONCLUSION

When I was first asked this question, my instinctive response for the deemed distribution amount was “well of course just the covered expatriate’s community property interest, not the whole IRA.” IRC Section 408(g) is one of those tiny yet decisive “exception to the rule” annoyances you find everywhere in the Code.

When someone asks you a tax question, don't answer off the top of your head. Do the research. Make sure there is water in the swimming pool before you jump off the diving board.