Client Memo: International Tax Practice -- U.S. Citizens Married to Foreign Spouses: Foreign Personal Holding Company Rules
It is generally understood that the United States taxes the worldwide income of all U.S. citizens, regardless of marital status or domicile. Accordingly, a U.S. citizen who is married to a non-U.S. citizen spouse is required to file U.S. income tax returns and pay U.S. taxes on his or her own personal income, regardless of whether the U.S. citizen lives in the United States or abroad.
What is not generally known is that the U.S. spouse in this situation is required to file certain additional information returns with the U.S. Internal Revenue Service, if the foreign spouse owns a "foreign personal holding company" ("FPHC"), either directly or indirectly through other legal entities such as a foreign trust. The returns must be filed even though the U.S. spouse receives no income from the FPHC and thus no U.S. tax is currently due. Failure to file the returns may subject the U.S. spouse to civil and/or criminal penalties.
Further, if the foreign spouse dies and the surviving U.S. spouse inherits the FPHC stock, the foreign spouse's tax basis in the stock will "carry over" to the U.S. spouse - i.e., there is no "step up" in basis to the value of the stock on the date of death, as is generally the case for other inherited assets. Therefore, the U.S. spouse may incur large U.S. capital gain taxes on sale of the stock, with respect to appreciation in value which occurred while the stock was owned by the decedent foreign spouse.
These U.S. income tax issues should be addressed for any U.S. citizen who is married to a foreign person, especially for those who live abroad. Actions to restructure the ownership of the FPHC may be desirable. U.S. estate tax planning and related advice should also be given.
Definition of FPHC
Any foreign corporation is an FPHC if (i) at any time during the tax year, more than 50% of the corporation's stock, by vote or value, is owned directly or indirectly (see below) by not more than 5 individual U.S. citizens or residents, and (ii) at least 60% of the corporation's gross income is "FPHC income". FPHC income generally includes various kinds of passive income, including dividends, interest, royalties, annuities, capital gains on stock and securities, gains from futures transactions in any commodity, income from estates and trusts and income from certain personal service contracts.
If a foreign corporation is an FPHC, then its undistributed income is taxed currently to its actual U.S. shareholders as deemed dividends ("phantom income"). See Section 551 of the U.S. Internal Revenue Code. As noted, on the death of a U.S. or foreign shareholder in the FPHC, there is no step-up in tax basis of the FPHC stock in the hands of an heir. Code Section 1014(b)(5).
For purposes of the stock ownership test, ownership of the stock of a foreign corporation is attributed from a foreign, non-citizen spouse (even if not a resident of the United States) to his or her U.S. citizen spouse (whether or not a resident of the United States). Code section 554(c).
Although this situation causes the foreign corporation to be classified as an FPHC, the U.S. citizen spouse is not currently taxable on the FPHC income because the citizen is not an actual shareholder.*
FPHC Information Filing Requirements
If the foreign corporation is an FPHC, the U.S. citizen spouse is required to file with the IRS an annual information return, providing detailed information on the FPHC's business and income (including type of business, gross income, deductions, taxable income, etc.) and its shareholders (including the foreign spouse). As noted, there are civil ($1,000 per return) and criminal penalties for failure to file. Imposition of criminal penalties requires a determination that the failure to file was "willful". Civil penalties can be imposed, unless it is shown that the failure was "due to reasonable cause".
U.S. citizen spouse who find themselves in this situation should be advised to make the required information filings, including any late filings for prior years. If late filings are properly presented to the IRS, the risk of penalties may be minimized.
* * *
If you have any questions or comments on the above, please contact Kenneth J. Krupsky (202-942-5689).
* The U.S. citizen spouse may receive tax-free gifts from the foreign spouse. However, pending legislation would require information reporting by any U.S. person who receives more than $10,000 in gifts from foreign sources in any year.