Special Planning Considerations for “Mixed” (U.S./Non-U.S.) Couples 

Stanton R. Farmer, Thun Financial Advisors, Copyright © 2017

Introduction: Financial Planning Considerations for Mixed Nationality Couples

As part of their financial planning, mixed nationality couples must decide the extent to which they share or separate their financial lives, including their accumulated wealth and liabilities (particularly their tax obligations). U.S. citizenship-based taxation has many planning repercussions for mixed-nationality families (i.e., where only one spouse is a U.S. citizen), and these are particularly acute when a mixed U.S./non-U.S. couple live and work outside of the U.S. and the family is subject to multiple countries’ tax rules. How such a couple should proceed depends on a combination of financial and personal factors, including:

  • Immigration and tax residence statuses (in the U.S. and elsewhere);
  • Where the couple currently lives and where the couple plans to retire;
  • The relative incomes of the couple (is one spouse sole breadwinner or are their earnings more evenly divided?);
  • The relative family wealth the spouses come from; and
  • Personal attitudes toward marital “sharing.”

 

Filing Status, Joint Accounts and  Signatory Authority     

U.S. Filing Status:  If a mixed nationality couple lives and works abroad, they will be tax residents with corresponding tax obligations in the country where they live; the American citizen or permanent resident will also have tax obligations in the United States and must choose a filing status for the annual U.S. income tax return. The filing status may have considerable impact on the total tax bill for the mixed-nationality couple and a decision must be made to either fully bring the non-U.S. spouse into the U.S. tax system or limit the scope of that taxing authority as it applies to the non-U.S. spouse.

A couple may choose to file jointly, because the “married filing separately” filing status is the most punitive filing status, both in terms of the marginal income tax brackets and in terms of forfeiting quite a few potential tax credits and deductions (for example, a rapid phaseout of the deductibility for IRA contributions or eligibility to make Roth contributions). The decision to opt-in the nonresident spouse to the U.S. tax system is a once-in-a-lifetime election for both the U.S. and the non-U.S. spouse (even if they divorce and later remarry).  Effectively, the nonresident spouse is electing to become a “resident alien” under the Internal Revenue Code (under I.R.C. Sec. 6013(g)).  The couple can do so by signing and attaching a statement to their first joint tax return stating that the couple not only elects to do so, but is also qualified to make the election. A couple qualifies for this election if they are married and neither spouse has ever made the election before (even in a prior marriage).

There is an additional way to thread the needle and gain some U.S. tax advantages while keeping a spouse out of the U.S. tax system by way of the “head of household” filing status.  Usually, this filing status is only available for unmarried individuals with dependents. However, where a U.S. citizen is married to a nonresident alien at any time during the year, and the U.S. citizen has a qualifying person (generally, a parent, a child or other relative for which the citizen spouse provides support and can claim an exemption for on their tax return), then the U.S. citizen spouse may claim “head of household” status if the couple does not make the aforementioned “resident alien” election.  This allows the American spouse more favorable tax brackets, deductions, and exemptions in the United States than the married filing separately filing status, lowering the overall tax bill. However, the head of household status offers potentially less relief than offered through the joint filing election.

Despite the advantages of electing married filing jointly status, joint filing status in the U.S. still won’t make sense when the non-U.S. spouse:

  • Is unlikely to choose to relocate to the United States in the future;
  • Is a breadwinner, will earn income above the U.S. foreign earned income exclusion (FEIE), and resides in a low-tax or no-tax jurisdiction (i.e., otherwise has little to no tax liability);
  • Owns a considerable amount of the couple’s wealth, and particularly where the non-U.S. spouse:
  • Has a portfolio of Passive Foreign Investment Company (PFIC) investments such as foreign mutual funds or ETFs (unless the PFICs are sold off);
  • Is a major shareholder in a foreign corporation which would make the spouse subject to the U.S. foreign controlled foreign corporation (CFC) tax rules; or
  • Is the beneficiary of a non-U.S. trust and would be subject to the U.S. foreign trust reporting and tax rules.
  • May receive a significant inheritance or have a large change in their financial situation in the future.

Finally, the married filing jointly election doesn’t make sense if either spouse is uncomfortable with the joint liability of signing off on the U.S. Form 1040 filing.   By consenting to the joint filing, one spouse is not just signing off on the veracity and completeness of the reporting with regards to their own income, but also the veracity and completeness of their spouse’s income reporting, and will be jointly and severally liable for inaccurate or errant filings.  This is an obligation that was unlikely to have been discussed prior to marriage and should be discussed before any elections are made.

 

Joint Ownership of Assets

A related, but distinct, issue facing couples is whether (regardless of tax filing status) they should own all or some of their assets jointly or separately. The decision to comingle financial assets is certainly common between couples, but it is not obligatory. In certain circumstances, including mixed nationalities and/or tax residences, there are multiple reasons to keep matters separate.

 

Joint foreign (non-U.S.) account ownership

Assuming a mixed nationality couple do not file U.S. taxes jointly, but still own assets jointly outside of the United States, the attribution of interest, dividends and/or capital gains income between the spouses becomes an important issue. In order to avoid bringing all income earned by the non-U.S. spouse under the purview of the IRS., the U.S. spouse will need to make a defensible determination as to how the investment income is attributed.  While their country of tax residence may have different rules in attributing this tax burden, and may or may not allow for joint filing of income taxes, U.S. citizenship-based taxation means that the implications on U.S. taxes should also be considered:

  • Due to FATCA reporting, the IRS receives information on these foreign accounts directly from the foreign bank, but the U.S. expat spouse does not receive a Form 1099 from a foreign financial institution. Local law will determine the legal attribution of ownership in the country of the account, but the IRS will look further to the underlying facts to determine the division of beneficial ownership of the account based on the specific facts. Accordingly, it may be unclear how much of the income should be reported by the U.S. expat spouse when the U.S. expat spouse files “separately” (or as “head of household”).
  • Should a joint account hold foreign mutual funds, foreign ETFs, hedge funds, private equity (or other “pooled investments”), there will be significant tax reporting and compliance headaches in the United States. Ultimately, these sorts of investments should never be owned by the U.S. tax resident family member. For more detail on the perils of owning passive foreign investment companies (PFICs), see our article on the topic here.
  • In addition to reporting tax on the income from the account that is beneficially attributed to the U.S. spouse, the U.S. spouse will have to include joint foreign accounts (if the aggregate value of this account and other foreign financial accounts exceeds $10,000 at any time during the year) on the FBAR (FinCen 114) form, even if the U.S. spouse merely has signatory authority on the account(s) and is not a beneficial owner. Where the U.S. spouse owns substantial foreign financial assets, Form 8938 may have to be filed with the annual return.

 

Joint domestic (U.S.) account ownership

In those cases where a mixed nationality couple co-own a joint bank or brokerage account in the United States, similar questions arise regarding the attribution of interest, dividends and/or capital gains.

  • In the case of a domestic U.S. account, the U.S. spouse has supplied a Social Security number on the account, and the bank or brokerage is providing a 1099 to that spouse (and to the IRS). Once again, local (i.e., state) law may determine the attribution of legal ownership, but from the IRS’s perspective so long as the U.S. spouse is reporting the full income from that account on their 1040 they are the beneficial owner.
  • It may be possible for the U.S. spouse to shift some of the tax responsibility to the non-U.S. spouse by reporting all the income from the account but also showing a deduction for the interest paid to the co-owner non-U.S. spouse, but because this strategy then creates U.S. tax obligations (and complications) for the non-U.S. spouse, and will likely be scrutinized by the IRS, this strategy should not be attempted without careful direction from a U.S. tax professional.

Accordingly, the mixed nationality couple have a choice to make on their U.S. taxable savings and investment accounts:

  1. they can own them jointly (with survivorship rights) and the income therefrom will be attributed to the U.S. spouse for federal tax purposes;
  2. they could own them jointly as tenants in common (with specific percentage ownership attribution between them and without survivorship rights); or
  3. the spouses decide to own separate/individual U.S. accounts.

In the second and third case, the default federal withholding rate on dividends and interest for non-U.S. account holders is 30%.  However, income tax treaty elections made via the non-American spouse’s W-8 form can lower these elections to 15%, 10%, 5% or even 0% in certain cases.

In addition to concerns about taxation, there are estate and incapacity planning considerations regarding joint accounts. For example, joint ownershipwith survivorship rights (JTWROS) can function as a form of Will substitute or method of probate avoidance. If a couple owns a home, a bank account, or a brokerage account in JTWROS, there need be no instructions in the Will for what happens when the first spouse dies. Additionally, should one spouse become debilitated and unable to make financial decisions, the other spouse can continue to access the asset(s) and make decisions regarding the management of assets owned jointly without any legal procedure or need for complicated legal instructions (powers of attorney, etc.). Joint ownership can simplify the transfer of ownership or decision-making and thereby provide considerably cost-effective solutions for the family estate plan.

However, cross-border estate planning issues are rarely simple or straightforward (discussed below and in our Guide to International Estate Planning for Cross-Border Families). Moreover, although joint ownership can prove useful in providing a spouse with access and authority over the family financial assets in the event of death or disability of the other spouse, there may be substantial administrative requirements that must be satisfied when a surviving joint tenant attempts to retitle an account upon the death of another joint tenant. These hurdles may include regulatory/tax requirements (e.g., IRS “transfer certificate” filing requirements for overseas decedents) as well as policies within the financial institution.  Ultimately, the steps that the surviving tenant may take will vary depending on the location of death and the particular financial institution.

 

Gifting and Shifting the Tax Burden to the Non-U.S. Person Spouse

As discussed above, there may be significant benefits to be gained from joint accounts for mixed (U.S./non-U.S. citizen) couples, but there may also be instances where there can be tax advantages to be gained from separated wealth ownership. While there is not an unlimited spousal deduction for gifts to non-citizen spouses as there is for gifts to U.S. citizen spouses, the annual gift tax exclusion for gifts to non-citizen spouses of $149,000 (2017) provides opportunities to lower U.S. taxable income and capital gains tax exposure for the mixed nationality couple that includes a nonresident alien spouse.

If the couple resides in a low-tax or no-tax jurisdiction (e.g., Singapore, the U.A.E., or Switzerland), then moving assets outside of the U.S. government’s tax reach is particularly appealing.  For instance, simply transferring $149,000 cash annually to the non-citizen, non-U.S. tax resident spouse over the course of a lengthy union can allow for meaningful tax savings, but the mixed nationality couple can accomplish even more tax reduction through the gifting of highly appreciated assets. For example, consider a highly valuable stock position that the U.S. citizen spouse purchased at a low price. If the U.S. citizen spouse were to sell these shares, they would be taxed at the relevant capital gains rate, which would lead to a large tax bill.  However, if the couple resides in a low-tax or no-tax jurisdiction, the U.S. tax resident spouse may opt to transfer shares of this stock in kind to the non-U.S. tax resident spouse.  So long as the gifting (based upon current market value of the stock) falls below the $149,000 (2017) threshold, the transaction has no federal gift tax consequences (and can continue gifting more without present taxes due so long as total nonexempt gifting remains below the lifetime exemption amount).  The non-U.S. spouse can then sell the shares and utilize the proceeds to diversify the family’s overall investment portfolio while also not having to pay capital gains taxes in the United States. The assets have also moved outside of the U.S. citizen spouse’s eventual taxable estate. Of course, other issues (e.g., personal preferences, estate tax treaties) may limit the utility of such a strategy, but where such concerns are not present, interspousal transfers between mixed nationality spouses can prove to be a very effective strategy. (For a more detailed discussion of this strategy, see “Gifting Appreciated Assets to Non-resident Spouses”).

 

U.S. Federal Estate and Gift Tax Considerations

There are certain aspects to U.S. federal estate and gift taxes that are particularly unique for mixed nationality families where one spouse is not a U.S. citizen (a non-citizen spouse), and more so if they are also not a U.S. resident (nonresident alien). Additionally, mixed-nationality couples must also consider the implications of any transfer tax treaties (see sidebar below), which can be of critical importance to estate planning.  Leaving aside any such transfer treaty considerations, here are the key tax issues associated with the non-citizen and/or non-U.S. person spouse.

 

Lower Personal Exemption/Unified Credit for Non-U.S. Persons

U.S. federal estate, gift and GST taxes (collectively “transfer taxes”) are of less consequence for couples that are both U.S. domiciliaries (including citizens and most permanent residents or green card holders), because each spouse is entitled to a lifetime exemption from U.S. federal transfer taxes on $5.49 million (2017) of their worldwide wealth. However, if there is a non-citizen spouse that is domiciled abroad (a non-U.S. person), the non-U.S. spouse will have a lifetime exemption from U.S. federal transfer taxes of only $60,000 on the transfer of their U.S. situs assets (including U.S. real estate, U.S. stocks and mutual funds, U.S. Retirement accounts, U.S. business property, and other tangible property located in the U.S.). The U.S. situs components of the non-citizen spouse’s wealth must be carefully monitored and managed due to this scant lifetime exemption and the onerous transfer tax rates in the U.S. (up to 40%, or 80% with GST).

 

Joint Accounts Revisited – Estate Tax Considerations

Unfortunately, the tax attribution rules for estate tax on joint accounts do not follow logically from the attribution rules for income tax on joint accounts for a U.S./Non-U.S. couple. For U.S. couples, the rule is normally that one-half of the value of a joint property is included in the decedent spouse’s estate (I.R.C. Sec. 2040(b)). However, where the surviving spouse of the decedent is not a U.S. citizen, ALL of the value of the joint property will be included in the estate of the first-to-die citizen spouse’s estate, except to the extent that the personal representative/executor can substantiate the contributions of the noncitizen spouse in acquiring the property.

A Florida vacation home owned jointly with rights of survivorship by a U.S. citizen wife and her nonresident alien husband is an effective example.  Barring a separate estate tax treaty, if the wife dies, the entire $1 million value will be included in the wife’s taxable estate, unless (a) the surviving husband can substantiate his individual financial contribution to the purchase of the home, or (b) the property is transferred to a QDOT in order for the wife’s portion of the property (again, 100% unless contribution proven) to qualify for the spousal deduction.  If the non-resident alien husband dies first, there will be no tax owed or exemption used in this instance even if the husband provided 100% of the funds contributed to the acquisition of the home, because the citizen wife automatically receives the property though survivorship and the estate can claim the unlimited spousal deduction, as further discussed below.

 

Unlimited Spousal Deduction

 Not only may the U.S. citizen give or bequeath $5.49 million (2017) of their wealth to others during their lifetime and upon death, they may transfer unlimited wealth to their spouse free of any estate or gift taxes, with one major caveat – the unlimited spousal deduction applies only where the recipient spouse is a U.S. citizen (not merely a U.S. resident/domiciliary).  For example, a U.S. citizen husband and a noncitizen wife each have amassed impressive $10 million estates, and the entirety of the couple’s wealth consists of U.S. situs assets. They have a very simple estate plan:  the surviving spouse will inherit 100% of the assets of the first-to-die spouse, and their only child shall inherit the remaining family wealth from the second-to-die spouse. If the wife predeceases the husband, there is no present estate tax due because the U.S. citizen husband’s inheritance from his non-U.S. wife is fully deducted on the wife’s federal estate tax return.

However, if the husband (the U.S. citizen) dies first, and unless a QDOT election is made, as discussed below), the spousal deduction is not available and there will be substantial estate taxes owed on the $4.51 million dollars of his estate beyond his personal lifetime exemption (approximately $1.8 million tax due in 2017).  After his death, the wife would have roughly $18.2 million in U.S. situs assets.  If she does no further estate planning and later dies, there will be an even larger federal estate tax bill due before the family wealth passes to their child.  If she is a U.S. domiciliary (permanent resident), there will be estate tax owed on the estate that is in excess of $5.49 million exclusion (a taxable estate potentially as large as $12.7 million if ten or more years have elapsed since estate tax was paid at the husband’s death).  The tax situation is worse if she is a non-U.S. person: as little as $60,000 will transfer to their child free of estate tax, and taxes could be owed on as much as $18.1 million of the estate for a potential tax bill as high as $7.25 million!

 

The Qualified Domestic Trust (QDOT) (IRC Sec. 2056A)

One way to manage the issues identified above is the QDOT.  A QDOT allows the first-to-die spouse’s property to be transferred to a trust to support the surviving spouse with income, and, if necessary for health, maintenance, and welfare, with trust principal.  Upon the death of the surviving spouse or other termination of the trust, the remaining property passes to the remainder beneficiaries via the estate of the first-to-die spouse after any estate taxes owed have been paid by the first-to-die spouse’s estate (after taking advantage of the first-to-die spouse’s $5.49 million lifetime transfer tax exemption).

The rules and nuances of the QDOT in operation are quite extensive, but there a few key issues for which most mixed nationality couples should be aware:

  • The QDOT election can be made well after the death of the first-to-die spouse, as the election is made on the estate tax return (Form 706) and can be filed up to one year after the estate tax return due date, including extensions.
  • The QDOT must have at least one U.S. trustee (citizen individual or domestic corporate trustee). Larger trusts (over $2 mil.) require a domestic bank as trustee and the trust will have special bond or letter of credit requirements to show that the trust can meet its tax obligations.
  • If principal is paid from the trust, the U.S. trustee must pay the U.S. estate taxes that will be owed.
  • Estate taxes may be owed and Form 706-QDOT must be filed when the QDOT makes distributions to the surviving spouse, except (a) trust income; and (b) hardship distributions.
  • When a QDOT is terminated after the surviving spouse dies or become a U.S. citizen, there may be estate taxes owed when the assets are distributed to beneficiaries. Again, Form 706-QDOT must be filed.
  • A QDOT may have adverse tax consequences if the decedent, the surviving spouse and/or beneficiaries are tax residents of a foreign country.

 

Gifting as an Estate Planning Strategy

As discussed above (and in our specific article on this topic), the lack of an unlimited marital deduction is a significant planning obstacle for the high net worth mixed nationality couple (above $5.5 million). However, a solution can be available through the annual gift tax exclusion for gifts to non-citizen spouses of $149,000 (2017).  This annual exemption can allow the U.S. citizen spouse to lower estate and other transfer taxes in much the same fashion as it can lower capital gains taxes (see above) by reducing the size of their eventual taxable estate. If the annual gifting exceeds the $149,000 threshold, then the excess value must be reported on the citizen spouse’s annual federal gift tax return (Form 709) and will reduce the citizen spouse’s remaining lifetime unified credit. However, no tax is owed until the lifetime unified credit is exhausted.  While simply gifting U.S. dollars in a bank account (a non-U.S. situs asset) can lower the exposure to U.S. transfer taxes, additional planning benefits can be achieved through gifting appreciated assets, including stock, real estate, collectibles, etc. (the income tax benefits of such a gift were discussed above). If the non-U.S. citizen spouse is gifted highly appreciated assets, they can thereafter sell them free of federal capital gains tax and can then diversify the portfolio into non-U.S. situs assets.  Subsequent monitoring should continue to keep the U.S. situs assets of the non-U.S. spouse to a minimum.

 

Estate  and Gift Tax Treaties

The United States has estate and/or gift tax treaties or protocols with 18 Countries:  Australia, Austria, Belgium, Canada, Denmark, Finland, France, Germany, Greece, Ireland, Italy, Japan, Netherlands, Norway, South Africa, Sweden, Switzerland and the United Kingdom.  Such agreements may effect one or more of the general guidelines discussed in this section. For example, these treaties may narrow the definition of a U.S. situs asset for the non-resident, raise the nonresident’s federal exemption, and/or provide for a significant spousal deduction for gifts and/or bequests to a non-citizen spouse. Consequently, if a couple resides in one of these countries, they should examine the applicable treaty and incorporate any benefits or exceptions into their estate planning strategies.

 

Conclusion: The U.S. legal/tax implications are Only one layer

There are numerous complex considerations that factor into the financial planning decisions for cross-border families that include U.S. and non-U.S. members, and the discussion above is by no means exhaustive. A couple navigating the opportunities and pitfalls inherent in such a complex cross-border environment should find advisers who can identify the key issues and formulate a strategic framework from which to develop comprehensive financial planning and wealth management solutions. It is imperative for the planner to consider all the individual factors that are relevant to developing a cogent strategy, including the applicable tax regimes that may apply (now and in the future), the overall financial position of the family, the relative financial position of individual family members, and the personality characteristics and goals of those family members.

Ultimately, there is no “one strategy fits all” solution or formula to follow. Therefore, it is crucial for mixed-nationality couples to find advisers who can identify and work with other international experts in the legal and accounting fields that can help formulate and implement the necessary legal and tax strategies required to protect and build the family’s international wealth for current and future generations. Finally, it is imperative to maintain communication with the family’s trusted advisers, because changes in the family’s circumstances or in the legal/regulatory environment may demand adjustments to planning strategies.