United States Estate, Gift and Income Tax Planning for International Families Part I: Primer on U.S. Tax Rules
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Cross-border tax issues add an extra layer of complexity to estate and wealth-transfer planning. This article is the first in a series that addresses United States estate, gift and income tax planning for international families.
1. Differences in Estate, Gift and GST Tax Rules Mean Different Planning for
U.S. Citizens and U.S. Residents Than for U.S. Nonresidents
Introduction. After applicable exemption amounts, the United States imposes the following wealth-transfer taxes:
(1) estate tax on the net value of a decedent’s estate;
(2) gift tax on gifts made during lifetime (including funding of irrevocable trusts); and
(3) generation skipping tax (“GST”) on gifts and trust transfers to grandchildren or others two or more generations below the donor.
The top tax rate on any of these taxable donative transfers is now 40% of the amount of cash or fair market value of the property transferred, regardless of whether the transferor is U.S. or non-U.S. But there are two key differences between other U.S. estate, gift and GST tax rules applicable to U.S. citizens and U.S. residents, versus those applicable to U.S. nonresidents:
Worldwide assets vs. U.S.-situs assets. U.S. citizens and U.S. residents are subject to U.S. estate, gift and GST tax on worldwide assets, but U.S. nonresidents are subject to these taxes only on U.S. situs assets.
Exemption Amount. In 2013, U.S. citizens and U.S. residents have no liability for U.S. estate, gift and GST tax on estates and lifetime gifts totaling less than $5.25 million ($10.5 million for a U.S. married couple) under the “unified” transfer tax exemption. (The $5.25 million is indexed for inflation from a base of $5 million). But U.S. nonresidents have an estate and GST tax exemption of only $60,000 (on their U.S.-situs transfers) and zero “lifetime” exemption on U.S. situs gifts.
These two key differences (as well as other differences) make for different tax planning strategies for U.S. citizens and U.S. residents than for U.S. nonresidents. This article addresses many of the basic rules that account for these different strategies. (Special rules apply to expatriates — former U.S. citizens and former U.S. long-term green card holders. “Covered expatriate” provisions are not addressed in this article.)
U.S. Tax Residency. U.S. income tax residency is based on days of presence in the U.S. each year and the two preceding years or whether a person has a U.S. permanent residence visa (a “green card”), but U.S. estate and gift tax residency is based on all of the facts and circumstances of whether a person is “domiciled” in the U.S. That, in turn, looks to whether the person has made the U.S. his permanent home. Possession of a U.S. green card would be a key factor for U.S. estate and gift tax residency.
If a person qualifies for benefits under an applicable income tax treaty or estate and gift tax treaty between the United States and another country, the treaty may override tax residency rules under U.S. domestic law and may provide additional benefits, such as, exemption of certain categories of income or assets from U.S. tax or larger exemption amounts than that provided under U.S. domestic law to non-residents. Most U.S. tax treaties contain a “savings clause” that prohibits U.S. citizens from claiming non-U.S. residency or other benefits against the U.S. under the treaty.
Other Estate and Gift Tax Exemptions. Besides the unified $5,250,000 unified exemption for U.S. citizens and U.S. residents and the zero or near-zero exemption for U.S. nonresidents, there are the following exemptions:
• Small Annual Gifts. U.S. citizens and U.S. residents and U.S. nonresidents are exempt from gift tax or GST on gifts of “present interests” of up to $14,000 per donee per year, and these small gifts are not counted against the applicable unified exemption amount. Husbands and wives each can make tax-free $14,000 gifts to the same donee.
• Direct Payment of Tuition and Medical Expenses of Others. U.S. citizens and U.S. residents and U.S. nonresidents can make gift-tax-free direct payments of tuition and direct payments of medical expenses in an unlimited amount.
• Gifts and Estate Transfers to Spouses.
U.S. citizens and U.S. residents can make unlimited lifetime gifts and estate transfers to a spouse that is a U.S. citizen without triggering tax and without being charged against the unified exemption.
But gifts to a non-citizen spouse are exempt from U.S. tax only if less than an inflation-adjusted $100,000 in any year (currently $143,000). Any excess is charged against the applicable unified exemption (currently $5.25 million for U.S. citizen or U.S. resident donors) and is taxable if in excess of that amount.
Special qualifying testamentary trusts called “QDOTs” (qualified domestic trusts) can obtain the unlimited “marital deduction” applicable to U.S. citizen spouses, but this results in a mere deferral of estate tax because the remaining QDOT assets are subject to U.S. estate tax upon the non-citizen spouse’s death.
Situs Rules. Rules for U.S. situs and non-U.S. situs assets (which are critical for U.S. nonresidents) are not intuitive and are not consistent for estate and gift tax purposes. To cite a few examples:
• Stock in U.S. corporation. Shares of a corporation organized in the U.S. are U.S. situs assets for estate tax purposes (regardless of what assets the corporation owns) but are non-U.S. situs for gift tax purposes because “intangibles” are treated as non-U.S. situs for gift tax purposes.
• Stock in foreign corporation. Shares of a foreign corporation are non-U.S. situs for estate and gift tax purposes even if the foreign corporation owns assets solely located in the U.S. However, there may be U.S. estate tax issues if U.S.-situs assets that are owned directly are later transferred to the foreign corporation.
• Debt instruments. Debt instruments issued by U.S. borrowers (including U.S. corporations and U.S. citizens or residents) are U.S. situs assets for estate tax purposes under the general rule, but are non-U.S. situs under certain special rules, such as, if the debt instrument provides “portfolio interest” (which is the case with practically all publicly traded bonds and debentures). Debt instruments generally are non-U.S. situs intangibles for gift tax purposes. It may be possible to structure personal promissory notes to provide for portfolio interest.
• Partnership and LLC Interests. There is no clear guidance from the U.S. Internal Revenue Service (“IRS”) on the situs of partnership or LLC interests. Unlike shares of a foreign corporation, membership interests in a foreign LLC that owns U.S. real estate may be deemed by the IRS to be U.S. situs for estate tax purposes (under a “look-through” or aggregate ownership theory) whereas a U.S. or foreign LLC membership interest logically may be respected as a non-U.S. situs intangible for gift tax purposes even if the LLC owns U.S. real estate (just as with shares of a corporation).
• Checks and Wire Transfers. There is incomplete IRS guidance on the situs of transfers of checks and wire transfers from non-U.S. residents to U.S. residents. Substantive analysis of what constitutes an “intangible” and informal IRS guidance supports the view that a check drawn by a non-U.S. resident from a foreign bank and paid to a U.S. donee is a non-U.S. situs transfer. This view logically also would extend to a gift by wire transfer from a foreign bank to the account of a U.S. resident at a U.S. bank. But this treatment is not certain.
• U.S. citizens and U.S. residents should optimize use of $5.25 million per donor unified exemption and other exemptions:
- Since U.S. citizens and U.S. residents are subject to U.S. estate, gift and GST tax on worldwide assets, but U.S. citizens and U.S. residents qualify for a large exemption amount (currently $5.25 million), planning for U.S. citizens and U.S. residents generally involves transferring as much value as possible within exemption amounts, such as, by:
• Making lifetime gifts of property that is expected to appreciate in value after the transfer, and
• Using techniques to qualify for “discounted” valuations of property, such as, family partnerships or partial undivided interests in property.
- The current $5.25 million unified exemption and the low interest-rate environment may provide an opportunity for large estates to “leverage” this tax- free amount with sales or other transactions with trusts or family members.
• U.S. nonresidents should optimize use of non-U.S. situs assets and applicable exclusions:
- For U.S. nonresidents, the basic strategy is planning for non-U.S. situs property, such as, by:
• Holding U.S. real estate, U.S. stocks and U.S. business interests in foreign corporations as an estate tax “blocker” (so as to qualify as owning only the shares of the foreign corporation — a non-U.S. situs asset — and not the corporation’s underlying U.S. situs assets), and
• Making lifetime gifts (including funding of trusts) with intangibles and other non-U.S. situs assets.
- Other techniques involve use of “discounting” and perhaps further diminishing the net value of U.S. situs property by encumbering the U.S. property with debt and investing the proceeds of that borrowing in non-U.S. situs assets.
- With regard to trusts, it is possible for a U.S. nonresident to fund a “dynasty” trust for the benefit of multiple generations of U.S. descendants with non-U.S. situs property and to escape GST (generation skipping tax) on distributions to grandchildren and more remote U.S. descendants.
- Revocable trusts or irrevocable trusts that qualify as disregarded entities for U.S. income tax purposes are other vehicles that may be used in connection with other non-U.S-situs holding structures.
(A later installment in this series will address some of the myriad issues relating trusts for international families.)
2. U.S. Nonresident Estate, Gift and GST Tax Planning Needs to Be Coordinated with Income Tax Planning and with Any Applicable Foreign Taxes
Often, there is a trade-off of higher income tax cost from use of entities that achieve gift or estate tax savings, but there can be means of mitigating these trade-offs. The U.S. and foreign income tax costs of an estate and gift tax structure need to be evaluated as part of the planning, as do any foreign tax issues.
• Lifetime Gifts Take “Carryover” Income Tax Basis. If a U.S. nonresident makes a lifetime gift (such as, of a non-U.S. situs “intangible” interest), the gifted property takes an income tax basis equal to the donor’s basis in the property (or a fair market value basis if the property has depreciated in value). Property obtained upon death generally acquires a “stepped up” basis equal to fair market value.
• Gifts of Encumbered Property May Trigger Income Tax. If there is a gift of property subject to debt in excess of the donor’s basis in the property, this triggers a deemed sale for income tax purposes, which may be subject to U.S. income tax if the gain is deemed to be U.S. source income (such as with U.S. real estate or interests in partnerships that own U.S. real estate).
• Foreign Corporation Loses Capital Gain Benefit and Provides No “Inside Basis” Step-Up at Death. If U.S. real estate is held inside a foreign corporation (as an estate tax “blocker”), gain on the sale of the real estate is taxable at full U.S. corporate rates (currently, 35% maximum) and is not eligible for the 15% rate that currently applies to long-term capital gains of individuals. Furthermore, since the real estate is held inside a corporation, it would not qualify for a “step-up” in basis to fair market value at the time of the holder’s death (as occurs when property is held directly by a decedent).
Note: Under so-called “FIRPTA” provisions, a withholding tax based on gross values is imposed when there is a disposition of U.S. real property that is owned by a non-U.S. entity or non-U.S. person. If tax owned on net gain is less than the amount withheld, this excess is recovered by filing a U.S. tax return and claiming a refund of the excess.
• Foreign Corporation With U.S. Business Subject to U.S. “Branch Profits” Tax. If U.S. rental real estate or other U.S. business property is held directly by a foreign corporation (rather than by a U.S. corporate subsidiary of a foreign corporation), the foreign corporation can be subject to a second-level U.S. “branch profits” tax (a deemed dividend tax) on earnings accumulated inside the foreign corporation.
• Foreign Corporation May Be Income-Tax-Efficient For Holding U.S. and Non-U.S. Portfolio Type Investments. As with a nonresident individual, a foreign corporation generally is not subject to U.S. tax on capital gains on portfolio-type investments and is not subject to U.S. tax on “portfolio interest” from qualifying U.S. debt instruments, but is subject to a 30% withholding tax (perhaps reduced under a Treaty) on other investment income (so-called “FDAP” or fixed and determinable annual or periodic income), such as U.S. source dividends, rents and royalties. A lower withholding rate may apply if the recipient of the U.S. source income qualifies for benefits under an income tax treaty between the U.S. and another country. As with a nonresident individual, a foreign corporation is not subject to U.S. tax on non-U.S. source investment income.
• U.S. Shareholders of CFCs and PFICs. If a foreign corporation is used as a blocker to hold U.S. situs assets and the shares in the foreign corporation are inherited by U.S. descendants or inside a trust for the benefit of U.S. beneficiaries, then these “U.S. shareholders” may find themselves subject to special U.S. income tax “anti-deferral” regimes applicable to “controlled foreign corporations” (CFCs) or “passive foreign investment companies” (PFICs).
A U.S. person’s ownership of shares in a CFC or PFIC that owns U.S. assets is a tax -inefficient structure (sometimes referred to as a “CFC sandwich”). At minimum, the structure could have the detrimental effect of converting capital gain income into higher taxed ordinary income. Potentially, the structure could involve an extra layer of U.S. withholding tax or income tax imposed on the foreign corporation and U.S. ordinary income tax on distributions or deemed distributions from the foreign corporation. PFIC rules can cause a tax interest charge to be imposed on delayed distributions from the foreign corporation to a U.S. shareholder.
• “FATCA” (Foreign Account Tax Compliance Act) Issues.
Starting with returns filed for the 2011 tax year, U.S. citizens and U.S. residents must report interests in foreign financial assets (including interests in foreign trusts and foreign estates that have a known value) if these assets exceed a threshold amount (at minimum, $50,000). This report is filed on IRS Form 8938 with the U.S. person’s tax return. These rules will extend in the future to certain domestic entities that own foreign financial assets.
Form 8938 supplements, and does not precisely correspond to, so-called “FBARs” (foreign bank account reports on Treasury Form TD F 90-22.1) that are required to be filed with the Treasury on June 30 of each year with respect to foreign financial accounts held during the preceding year.
Foreign financial institutions must now comply with new U.S. tax rules (enacted as part of the FATCA provisions that were enacted in 2010) that require identification of U.S. account holders and imposition of a 30% withholding tax on U.S. source income of accounts whose non-U.S. ownership cannot be ascertained.
• It is best to develop an integrated plan that considers all estate, gift, GST and income tax ramifications and the trade-offs among them, as well as U.S. tax- reporting issues.
• There should be a plan in place for addressing CFC and PFIC issues at the time of death. Some U.S. tax rules require action within 30 days of death in order to obtain beneficial treatment. There also needs to be a plan in place for succession to accounts with foreign financial institutions.
• With regard to U.S. real estate and other taxable U.S. situs property, a decision needs to be made regarding the trade-off between U.S. income-tax-efficient structures and U.S. estate and gift tax-efficient structures. The time horizon for holding a particular U.S. real estate or U.S. business is a key factor in this decision. If a short time frame is expected, perhaps estate tax risk could be addressed through the use of term life insurance.
• All U.S. planning must be coordinated with foreign income, gift and estate tax issues.
IRS CIRCULAR 230: This article is intended for general informational purposes only and not as tax or legal advice. It is not provided or intended by this firm to be used for (i) the purpose of avoiding federal tax penalties that may be imposed, or (ii) promoting, marketing or recommending any entity, investment, plan or arrangement to any person.