Fifty-Fifty Forever Or Until Death Do Us Part: U.S. Estate Tax Surprises For Community Property Couples

INTRODUCTION

When a married couple resides in a civil law jurisdiction, their marital property is typically governed by community property principles – rules that automatically characterize most assets acquired during marriage as jointly owned, regardless of title.¹ While these regimes provide clarity domestically, they can create significant uncertainty when the couple has cross-border ties, particularly involving the U.S. The challenges become especially pronounced where one spouse is a U.S. citizen subject to U.S. Federal income, estate, and gift taxation on worldwide assets, while the other spouse is a nonresident, noncitizen ("N.R.N.C.") individual for U.S. Federal estate and gift tax purposes whose U.S. estate and gift tax exposure is limited to U.S.-situs property.

COMMUNITY PROPERTY LAW IN GENERAL

Community property law is a marital property regime used primarily in civil law jurisdictions and a few U.S. states. It provides in general that most income recognized during marriage and most assets acquired during marriage are treated as jointly owned by both spouses, regardless of which spouse earned the income or which spouse's name is on the title. The outliers to the general rule are assets owned before marriage and assets acquired by gift or inheritance. They remain individually owned in the entirety unless commingled.

LIFE INSURANCE PROCEEDS IN CROSS-BORDER COMMUNITY PROPERTY MARRIAGES

A common question concerns the U.S. Federal estate tax treatment of a life insurance policy on the life of a spouse who is neither a U.S. citizen nor a U.S. domiciled individual for U.S. Federal estate tax purposes. In general, the policy is treated as community property under foreign law.

Under U.S. tax law, the proceeds of insurance on the life of a decedent and payable to a named beneficiary are includible in the decedent's gross estate if the decedent possessed any incidents of ownership in the policy at the time of death.² The term "incidents of ownership" is not limited to ownership of the policy in a legal sense.

Rather, incidents of ownership include the following powers retained by the decedent at the time of death:

• The power to change the beneficiary
• The power to surrender or cancel the policy
• The power to assign the policy
• The power to revoke an assignment
• The power to pledge the policy for a loan
• The power to obtain from the insurer a loan against the surrender value of the policy³

For N.R.N.C. individuals, U.S. Federal estate tax applies only to U.S.-situs property. Insurance on the life of an N.R.N.C. is not an item of U.S.-situs property.⁴ Therefore, the estate of the N.R.N.C. decedent is not subject to U.S. Federal estate tax on the life insurance proceeds even if the N.R.N.C. held all incidents of ownership in the policy or the proceeds are payable to the decedent's estate.

As mentioned above, assets acquired during marriage by individual domiciled in a community property jurisdiction are typically considered to be jointly owned by both spouses. Each spouse holds an undivided one-half interest in community assets. In a strictly domestic setting, if (i) life insurance is acquired during marriage by a spouse domiciled in a community property state and (ii) premiums are paid from community funds, the incidents of ownership and the rights to proceeds constitute community property rights.⁵ Under such circumstances, only one-half of the death benefit received is includible in the decedent's gross estate.⁶

The U.S. generally respects foreign property classifications for estate tax purposes provided they are consistent with U.S. principles. Thus, the U.S. would acknowledge that the U.S. citizen spouse owns a one-half community interest in the foreign policy even if the proceeds are payable to the decedent's estate. Because the decedent was an N.R.N.C. individual, the policy is treated as non-U.S.-situs property, and the decedent's one-half of the proceeds is not includible in his U.S. gross estate. The U.S. citizen surviving spouse's one-half community interest is recognized as an ownership interest, however, no U.S. Federal estate tax consequences arise on such portion.

A strange result may occur when community funds are used to purchase a policy, and the surviving spouse is not made the beneficiary of the full proceeds. In this case, the surviving spouse is treated as having made a gift of their 50% interest in insurance proceeds to the named beneficiary.⁷

COMMUNITY PROPERTY – F.B.A.R. REPORTING

A common question arises as to whether a spouse residing in a community property state such as Texas or Nevada ("Spouse 1") has a separate F.B.A.R. filing obligation solely because community property laws attribute an interest in a foreign financial account owned or controlled by the other spouse ("Spouse 2").

If Spouse 2 holds a financial interest in, or signature authority over, a foreign account and files the required F.B.A.R., Spouse 1 is not required to file a separate F.B.A.R. solely by virtue of community property laws, provided that the account is not jointly titled and Spouse 1 does not have signature authority or any comparable authority over the account. Similarly, if Spouse 2 maintains a foreign financial account in his or her own name while residing in a community property state, the account should not be reported on the F.B.A.R. as jointly owned unless Spouse 1 is, in fact, a joint owner. In other words, community property status, standing alone, does not create joint ownership for F.B.A.R. reporting purposes.⁸ The guidance implies that a community property interest in funds in a foreign account is not a "financial interest" in an account which would require separate reporting.

COMMUNITY PROPERTY – STATUS OF A SINGLE MEMBER ELIGIBLE ENTITY

The I.R.S. recognizes that many taxpayers may be uncertain about how to classify an eligible entity owned solely by one spouse when the married couple are resident in a community property state. To reduce confusion and promote administrative simplicity, the I.R.S. issued Rev. Proc. 2002-69, confirming that it will respect the couple's choice to treat such an entity either as a disregarded entity (a "D.R.E.") or a partnership for U.S. Federal tax purposes.⁹

The revenue procedure is applicable for U.S. Federal tax purposes, which includes U.S. Federal income and estate taxes. While the flexibility to treat an entity as a D.R.E. or a partnership simplifies income tax reporting, it creates meaningful differences in how U.S.-situs assets are attributed for estate tax purposes when one spouse is a U.S. person and the other is an N.R.N.C. individual.

If the entity is treated as a D.R.E., each spouse is treated as directly owning his or her share of the underlying assets. In a community property jurisdiction, this means the N.R.N.C. spouse is considered to own a one-half interest in all community property – including U.S.-situs assets held through the entity. As a result, that portion of the assets becomes includible in the N.R.N.C. spouse's U.S. gross estate and will be subject to U.S. Federal estate tax as provided by U.S. tax law.

The analysis becomes more complex when the entity is treated as a partnership. The N.R.N.C. spouse is treated as owning a partnership interest, which is an intangible property right. Unlike corporate stock, for which tax situs is well established as the place of incorporation, the situs of a partnership interest is not definitively settled under U.S. estate tax law. Three potential approaches appear to have evolved judicially and administratively:

• Situs is determined by the partnership's place of business.
• Situs is determined by the partnership's country of formation.
• Situs is determined by the location of the partnership's assets.

In a 1955 ruling, the I.R.S. held that the situs of a partnership interest is where the partnership conducts business.10 As a result, a position exists under which an interest in a partnership that is not engaged in a U.S. trade or business is exempt from U.S. estate tax even if formed in the U.S. However, this revenue ruling involved an estate tax treaty, rather than domestic estate tax law, and is thus not clearly dispositive with respect to U.S. Federal estate tax.

Relatively recent authority treats an interest in an L.L.C. treated as a partnership as an asset separate from the partnership's assets for gift and estate tax purposes, not income tax purposes. As discussed below, that is a material difference. This is generally referred to as the "entity approach" to partnerships, in comparison to the "aggregate approach." In Pierre, 11 the U.S. Tax Court ruled that an interest in a single-member L.L.C., while disregarded from its owner for purposes of U.S. Federal income tax, is not disregarded for gift-tax valuation purposes. However, Pierre involved gift tax for which the principles are similar, but not identical, to the estate tax. Moreover, the issue before the court involved valuation rather than situs. The opinion of the court addressed whether the property to be valued was the underlying assets or the interest in the entity.

This contrasting treatment demonstrates how entity classification – without altering underlying economic ownership – can produce vastly different U.S. Federal gift and estate tax results.

No discussion of the application of the aggregate approach or the entity approach to partnership is considered to be complete without mentioning Code §864(c)(8), regarding gains and losses of a partnership interest. In pertinent part, it provides as follows:

864(c)(8) Gain Or Loss Of Foreign Persons From Sale Or Exchange Of Certain Partnership Interests

(A) In General — Notwithstanding any other provision of this subtitle, if a nonresident alien individual or foreign corporation owns, directly or indirectly, an interest in a partnership which is engaged in any trade or business within the United States, gain or loss on the sale or exchange of all (or any portion of) such interest shall be treated as effectively connected with the conduct of such trade or business to the extent such gain or loss does not exceed the amount determined under subparagraph (B).

Clearly, Code §864(c)(8) adopts the aggregate approach to partnerships. The balance of the provision explains the way the aggregate approach is to be implemented. Note, however, that by its express terms, Code §864(c)(8) relates to tax rules under "this Subtitle," which is Subtitle A, embodying income tax provisions that cover Code §§1 through 1564. The estate and gift provisions of the Code appear in Subtitle B of the Code. For estate and gift tax purposes, the entity approach adopted in the Pierre cases continues to be relevant.

Finally, Rev. Proc. 2002-69 states that a change in classification constitutes an entity conversion for U.S. Federal tax purposes, which may trigger additional U.S. Federal tax consequences at various points in times by a community property couple.

COMMUNITY PROPERTY – DOUBLE STEP-UP IN BASIS FOR MIXED-RESIDENCY COUPLES

Generally, a person who receives property by inheritance or bequest from a decedent, takes a basis in the property that is equal to its fair market value on the date of the decedent's death.¹² A special basis adjustment rule exists for community property. When one spouse dies, both the decedent's one-half interest and the surviving spouse's one-half interest in community property take a fair market value basis as of the date of death. This treatment is significantly more favorable than the result in common-law jurisdictions, where only the decedent's share of jointly owned property receives a basis adjustment while the basis of the surviving spouse remains unchanged.

One key condition for the full step-up in basis under Code §1014(b)(6) is that it applies (i) on a property-by-property basis, (ii) only with regard to community property included in the U.S. gross estate, and (iii) with regard to each such item of U.S. community property, only if at least one-half is included in the decedent spouse's U.S. gross estate. The provision was written in the domestic context, looking only to the U.S. states that adopted the community property regime. When the deceased spouse is an N.R.N.C. individual, the provision may prove to have limited application. Because the estate of an N.R.N.C. is subject to U.S. Federal estate tax only with respect to U.S. situs assets, the decedent's one-half share in the foreign community property generally would not be includible in the decedent's U.S. estate. At first glance, this seems to preclude a full step-up in basis for community property located abroad.

However, the application of Code §1014(b)(6) in the context of a mixed residency marriage under a community property regime arguably requires deeper analysis as the provision doesn't reach the results apparently anticipated by Congress. Code §1014(b)(6) was designed to equalize the incidence of taxation between community property and common law states, not to provide a special benefit to community property taxpayers.¹³

In a community property state, a taxpayer is not permitted to claim any benefit under the provision for his or her half of the property unless the other half – which passes from the deceased spouse – gets a stepped-up basis under Code §1014(b) (1)-(5), (8), or (9).¹⁴ Therefore, a question could be asked as to how the basis adjustment would occur if the non-U.S. situs asset were held by the couple in a common law jurisdiction, such as the B.V.I.¹⁵ The legal title to the property is respected in a common law jurisdiction regardless of who furnished the consideration. Thus, if the N.R.N.C. decedent were the sole owner of property located outside the U.S. and the property were to be inherited by the U.S. citizen surviving spouse, the surviving spouse would be entitled to receive a stepped-up basis even if the property were not includible in the U.S. gross estate of the N.R.N.C. decedent. This is because property would be viewed to have been acquired by bequest, devise, or inheritance. As a result, the U.S. surviving spouse receives a step-up in basis even if the property is not includible in the U.S. gross estate.¹⁶

Alternatively, a catch-all provision, Code §1014(b)(9) allows a step-up in basis with respect to property not otherwise covered in the section and includes (i) property held in a joint tenancy with a right of survivorship or (ii) a tenancy by the entirety that passes to the other owner by operation of law. However, it only applies to property that is required to be included in determining the value of the decedent's gross estate. While community property would pass to the U.S. citizen surviving spouse by operation of law, the decedent's share in the non-U.S. situs property would not be included in U.S. gross estate and would likely not receive a step-up in basis.

The U.S. surviving spouse of an N.R.N.C. decedent domiciled in a community property jurisdiction receives a less favorable basis outcome than a similarly situated U.S. surviving spouse of an N.R.N.C. decedent domiciled in a common-law jurisdiction. Code §1014(b)(6) as drafted may leave a U.S. surviving spouse in a mixed residency couple with inequitable and counterintuitive results. While a transmutation agreement between the couple can convert the character of community property to separate property, such techniques often do not achieve the intended result in the foreign community property jurisdiction.

CONCLUSION

When two individual brought up in different countries marry, they each need to take significant steps to understand the culture and expectations of the marital partner. Also to be learned are the property regimes that control beneficial ownership of income and assets as well a marital rights and tax rules that are in effect in the country of domicile of the marital partner. This is especially so when one party grew up in the U.S. and the other party grew up in Europe or Latin America. As this article demonstrates, items such as estate taxation of life insurance payouts, F.B.A.R. reporting, entity classification rules, and step-up of asset bases for the survivor should be mastered in advance in order to avoid unpleasant surprises later on.

Footnotes

1 See for example, Delphine Eskenazi and Maria Valentin, "Prenuptial Agreements in the Context of an International Couple – Views from France and Spain," Vol. 12. No. 2 Insights, page 3 (March 2025).

2 Code §2042.

3 Treas. Reg. §20.2042-1(c)(2).

4 Section 2105(a).

5 Freedman v. U.S., 382 F.2d 742 (5th Cir. 1957); Davis v. Prudential Insurance Co. of America, 331 F.2d 346 (5th Cir. 1964).

6 Treas. Reg. §20.2042-1(c)(5).

7 Treas. Reg. §25.2511-1(h)(9); Rev. Rul.79-303; Cox v. U.S., 286 F. Supp. 761 (W.D. Louisiana, 1968).

8 On June 20, 2007, the I.R.S. held a National Phone Forum to disseminate information to the public regarding F.B.A.R. filing obligations. The I.R.S. provided an overview of (i) the F.B.A.R.'s purpose, (ii) reporting requirements, (iii) penalties, and (iv) compliance initiatives. As part of the program, the tax community was offered the opportunity to submit questions. In what proved to be a valuable component to the Forum, the I.R.S. disseminated in writing the questions and answers from the Program. The F.B.A.R. Questions and Answers that were disseminated indicate that they were approved by Counsel on October 22, 2007.

9 Rev. Proc. 2002-69, 2002-2 C.B. 831.

10 Rev. Rul 55-701, 1955-2 C.B. 836.

11 Pierre v. Commr., 133 T.C. 24 (2009). The decision was reaffirmed in Pierre v. Commr., T.C. Memo 2010-106.

12 Code §1014(a).

13 Stanley v. Commr., 338 F.2d 434 (9th Cir. 1964); Bath v. U.S., 211 F. Supp. 368, 370 (S.D. Tex. 1962), aff'd per curiam, 323 F.2d 980 (5th Cir. 1963).

14 Collins v. U.S., 318 F. Supp 382, (C.D. Cal.)1970.

15 Ibid.

16 Code §1014(b)(1); Rev Rul 84-139, 1984-2 CB 168.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.