Trusts, holding companies, limited liability companies and various other forms of ownership are the norm for offshore clients and assets. In many jurisdictions, even personal residences are rarely held directly by those who live in them. Yet in the midst of considering offshore income and assets, the age-old joint bank account is often still present. Around the world, joint bank accounts are common between spouses, siblings, parent and child, and in many other situations.
Indeed, even unrelated people may share investment or property accounts. Across myriad situations, joint accounts allow equal access to funds but often have unclear ownership. Since joint account status may be allowed not only for bank accounts but brokerage and other financial accounts, the stakes can be larger than one might assume.
Whose funds are they? And who must pay tax on the interest income? The money may all be beneficially owned by one holder, 50/50, or in some other ratio.
Much of the worry today is about non-U.S. accounts. If a U.S. person child and a non-U.S. parent have a joint account, who must declare it? U.S. persons must report their worldwide income and worldwide assets on tax returns and FBARs. The potential penalties can be enormous.
FBARs
Before turning to income tax, consider FBARs. Non-U.S. accounts over the $10,000 threshold carry an FBAR filing requirement. But in what category? If you have a mere signature interest, it goes in one category on the FBAR.
If you are an owner, it goes on another. Yet for income tax purposes, joint accounts are inherently unclear. Equal access to the funds is not the same as beneficial ownership. Thus, before one can fully answer the FBAR question, one should consider ownership for tax purposes.
Local Law and Exceptions
Federal income tax liability is generally allocated based on entitlements under local law. However, the IRS may seek to impose income tax liability on the beneficial owner of an account regardless of that person’s rights under local law. For example, if you hold legal title as an agent, then income is taxed to the principal, even though the agent may appear as a joint signatory.
In Bollinger, the Supreme Court enunciated a three-part test for agency:
- A written agency agreement must be entered into with the agent contemporaneously with the acquisition of the asset;
- The agent must function exclusively as an agent with respect to the asset at all times; and
- The agent must be held out as merely an agent in all dealings with third-parties relating to the asset.
Assuming a true agency, the agent should not face taxes on the income.
Beneficial Owners Taxed
The courts generally look beyond local law ownership to impose income tax liability on the party with beneficial ownership of the income-producing asset. Courts define beneficial ownership as the “freedom to dispose of the accounts’ funds at will.” Courts may consider such factors as: (1) who enjoys the economic benefit of the property; (2) who has possession and control; and (3) the intent of the parties.
For example, in CHEM, Inc., a father opened four bank accounts in the names of his four children. He deposited money into the accounts but later withdrew it to facilitate his own business ventures. He claimed that his children owned the four accounts so he did not report any of the income.
He claimed his withdrawals were mere loans and would be repaid. Nonetheless, the Tax Court determined that the father was the beneficial owner and was taxable.
Community Property Income
There is a special statutory rule for married couples earning “community income,” under the laws of a state or foreign country, where one or both spouses are non-resident aliens. In that case:
- Earned income is allocated to the spouse who rendered the personal services.
- Trade or business income, and a partner’s distributive share of partnership income, is allocated to the person participating in the business.
- Community income derived from the separate property of one spouse is allocated to that spouse only.
- All other community income shall be treated as provided under the local community property laws.
Examples
Example 1: Tom is a U.S. taxpayer with a foreign joint bank account with his brother Bill, who is foreign. Tom deposited all of the funds and intended them as gifts to Bill. Bill controls them and withdraws funds for his own benefit. Tom does not exercise control over the funds, nor does he withdraw or benefit from the account.
Q1: Can federal income tax be imposed on Tom on the interest?
A1: Yes. As a joint owner, Tom may be taxed according to his ownership interest under local law. However, Tom may be able to avoid income tax liability if the IRS or courts are satisfied that he lacks beneficial ownership of the funds. Tom deposited the funds to benefit his brother Bill and never operated the account or withdrew money.
Example 2: Same as Example1, except that Tom and Bill have agreed to share control over the foreign account and benefit equally. Under the law of the prevailing foreign jurisdiction, Tom owns all of the account assets.
Q2: Can federal income tax be imposed on Tom?
A2: Yes. As Tom owns all of the account assets under local law, he is presumptively liable for all income. However, he arguably has beneficial ownership of only one-half of the account assets and one-half of the tax liability.
Example 3: Tom is a U.S. citizen and his wife Wilma is a non-resident alien. Wilma has no obligation to file U.S. tax returns, and Tom files his U.S. tax returns separately. They live in a foreign country with community property laws and hold a joint bank account in that country. Tom and Wilma agreed to share control over the account and benefit equally.
Q3: Can federal income tax be imposed on Tom in connection with the interest earned in this foreign account?
A3: Yes. Although Wilma is not a U.S. taxpayer, Tom is still required to report his worldwide income. There is a statutory rule for married couples that earn “community income,” where one or both spouses are non-resident aliens. Tom’s federal income tax liability may depend on many factors, including whether the account assets are considered separate or community property under the community property laws of the foreign jurisdiction.
Example 4: Same as Example 3, except that Tom and Wilma have divorced. They have decided to continue the foreign account as joint holders.
Q4: Can federal income tax be imposed on Tom in connection with the interest earned in this foreign account?
A4: Yes. Tom and Wilma divorced but retained the joint account. Tom’s federal income tax liability would presumptively be allocated in proportion to his ownership of the account assets under local law in the foreign jurisdiction. However, Wilma is arguably the beneficial owner of one-half of the account, so Tom might only be taxed on only one-half. Tom could support his position with bank statements, agreements with Wilma, declarations, income tax filings, gift tax returns and FBAR forms, or other documents demonstrating shared control and benefits.
Example 5: Tom is a U.S. taxpayer and is sole signatory on a foreign bank account. Tom’s parents, who are not U.S. taxpayers, deposited all of the funds for the support of Tom’s daughter Daisy. Tom only withdraws and uses the funds pursuant to his parents’ instructions.
Q5: Can federal income tax be imposed on Tom in connection with the interest earned in this foreign account?
A5: Yes. As Tom is the only account holder, the IRS may seek to tax Tom on all income. However, Tom may be able to avoid income tax liability under the beneficial ownership analysis. The funds were deposited by Tom’s parents, Tom never operated the account without explicit instructions, and it was understood that the funds were solely for Daisy’s benefit.
These facts may even suggest that Tom’s parents, rather than Tom, remained the beneficial owners. It would help if there were proof of an agreement that Tom lacked any authority over his parents’ deposits and complied with their instructions. Written agreements, declarations, estate planning documents, and purchase receipts may help, as may income tax returns and/or FBARs filed by Tom’s parents.
Example 6: Same as Example 5, except that Tom did not use the funds to benefit his daughter Daisy. Instead, Tom invested the account assets in a business venture. Although this was against his parents’ wishes, Tom plans on repaying the money.
Q6: Can federal income tax be imposed on Tom in connection with the interest earned in this foreign account?
A6: Yes. Tom appears to have local law ownership. It will be difficult for Tom to avoid this income tax liability through a beneficial ownership analysis. Tom used account assets for his own benefit, something not authorized by his parents. The fact that Tom acted outside the scope of his parents’ explicit instructions weakens the likelihood of meeting the agency safe harbor.
Moreover, beneficial ownership often turns on control and benefits derived from an asset. Tom withdrew funds at his own discretion and used them for his business venture. This freedom over the funds may suggest beneficial ownership and thus tax liability.
Example 7: Same as Example 5, except that Tom’s parents passed away last year. Before passing, they expressed their hope that Tom continue to use the account for his daughter Daisy’s benefit. Although not legally obligated, Tom withdraws the funds solely for the benefit of Daisy.
Q7: Can federal income tax be imposed on Tom in connection with the interest earned in this foreign account?
A7: Yes. Tom’s parents did not legally bequeath the funds to Daisy, so Tom is probably the owner of the funds under prevailing local law. His local law ownership may result in federal income tax liability on all income earned in the account. Tom could argue that he was acting as a non-taxable agent at the time his parents were living.
However, agency generally terminates on the death of the principal, in this case Tom’s parents. Therefore, it is possible that the IRS and courts could view Tom’s unilateral authority over the account as indicative of beneficial ownership. It may be difficult for Tom to overcome the presumptive income tax liability on all income earned in the account.
Example 8: Tom is a U.S. taxpayer and is sole signatory on a foreign account. Tom controls the account and he alone benefits. Recently, however, Tom’s brother Bill, who is not a U.S. taxpayer, deposited money into Tom’s foreign account. Bill made it clear that Tom must return the deposited funds or use them only at Bill’s request and pursuant to Bill’s instructions. Tom agreed, and later transferred the funds out of his foreign account to a third-party at Bill’s request.
Q8: Can federal income tax be imposed on Tom in connection with the interest earned on the funds deposited by Bill?
A8: Yes. Tom was the only account holder, so he will probably be liable for all income generated by the account, including the money deposited by Bill. However, Tom arguably should not be taxed on the temporary funds deposited by his brother because he may have lacked beneficial ownership of those funds. Tom did not benefit from the funds and transferred the money at the time and in the manner requested by Bill.
On these transitory deposits Tom had no beneficial right and no control. Nevertheless, the funds were co-mingled and solely in Tom’s name. Tom could assemble a written agreement with Bill, declarations, and bank statements. It would be helpful if Bill continued to pay income tax on the deposited funds and filed FBARs reflecting his financial interest.
Conclusion
Joint accounts are often established by people who know each other well, are related, or have a high degree of mutual trust. It is only natural that who really owns what may not be clear. When it comes to taxes and reporting, joint and other combined ownership is confusing.
Local law and beneficial ownership are both relevant. With foreign accounts, multiple legal regimes may be relevant, and the situation is complicated if joint account holders have differing citizenships or residencies. When significant penalties and even criminal liability may be at stake, the issues can take on enormous significance.
Be mindful of your facts and be wary of taking inconsistent positions. And since proving something after the fact can be difficult, consider good and timely documentation.
Robert W. Wood practices law with Wood LLP, in San Francisco(www.WoodLLP.com), and is the author of Taxation of Damage Awards and Settlement Payments (4th Ed. 2009 with 2012 Supplement), Qualified Settlement Funds and Section 468B (2009), and Legal Guide to Independent Contractor Status
(5th Ed. 2010), all available at www.taxinstitute.com. This discussion is not intended as legal advice, and cannot be relied upon for any purpose without the services of a qualified professional.
