Estate Planning for Non-Citizens
PLANNED GIVING & ENDOWMENTS
ESTATE PLANNING FOR NON-CITIZENS
MAY 23, 2011
Outline and Presentation by
Howell Bramson, Esq.
McCarthy Fingar LLP.
11 Martine Avenue
White Plains, New York 10606
High net-worth nonresident non-citizens (“NRAs”) often invest in U.S. situs investments to maintain a diversified international portfolio. Taxation of foreign investors, both with respect to income taxes and transfer taxes, is a very important topic. The U.S. authorities have historically tried to strike a balance between taxing NRAs and attracting their investment. For example, the Code contains several exemptions from U.S. transfer taxes for certain types of domestic investments that are held directly at death (such as proceeds of a life insurance contract issued by a U.S. insurer). Proper planning can avoid most transfer taxes on U.S. investments.
- Assets Subject to U.S. Estate and Gift Tax
a. Persons who are U.S. citizens at the time of their death, or who are domiciled in the U.S. at the time of their death, are subject to U.S. estate tax on all of their worldwide property and receive a foreign death tax credit for any foreign death taxes paid (limited to the amount of U.S. tax imposed on the property subject to foreign death tax). Sections 2001 and 2014 of the Internal Revenue Code of 1986, as amended (the “Code”).
b. Persons who are U.S. citizens or who are domiciled in the U.S. are also subject to U.S. gift tax on lifetime gifts they make. Code § 2501(a)(1). There is no U.S. gift tax credit for foreign gift taxes paid unless allowed by treaty.
c. NRAs are subject to U.S. estate tax only on “U.S.-situs” property, with no credit for foreign death taxes paid. Code §§ 2101, 2103, and 2106. (Usually the foreign country will allow a credit against its death taxes for U.S. estate tax paid.
(i) “U.S.-situs property” includes:
(A) Real property and tangible personal property located in the U.S., except for certain works of art on loan for exhibition. See Treas. Reg. §§ 20.2104-1 and 25.2511-3(b)(4)(iv); Rev. Rul. 55-143, 1955-1 C.B. 465; Blodgett v. Silberman, 277 U.S. 1 (1928); PLR 8138103; and PLR 7737063. Currency is likely tangible personal property even though technically a piece of currency is a demand note on the issuing government. L See Rev. Rul. 55-143, 1955-1 C.B. 465.
(B) Shares of stock issued by a U.S. corporation. Code § 2104.
(C) Subject to significant exceptions (set forth below), any debt obligation, the primary obligor of which is a U.S. person or the U.S., a state or any political subdivision of the U.S., or the District of Columbia, or any agency or instrumentality of any such government. Treas. Reg. § 20.2104-1.
(D) Property that is gratuitously transferred by an NRA decedent while he or she is alive, by trust or otherwise, if (i) the NRA decedent retained for his or her life (or for a period that cannot be ascertained without reference to his or her death) some type of possession, control, or enjoyment of said property or its income, (ii) said property was, on the date of the NRA decedent’s death, subject to his or her right to alter or revoke the transfer (or if such a power was relinquished by the NRA decedent within three years of the date of his or her death), or (iii) the transferee must survive the NRA decedent in order to possess the property and the decedent retained a right.
(E) An interest in a partnership, if (i) the partnership does not qualify as a separate legal entity under the law of the jurisdiction where it was established or is dissolved on the death of one partner, and the underlying assets of the partnership are situated in the U.S. (see Sanchez v. Bowers, 70 F.2d 715 (2d Cir 1934)) or (ii) if the partnership is a separate legal entity under the laws of the jurisdiction where it was established and it survives the death of a partner and the partnership carries out its business in the U.S. (see Rev. Rul. 55-701, 1955-2 C. B. 836 and GCM 18718, 1937-2 C. B. 476).
(ii) Non U.S. Situs Property includes:
(A) Shares of stock issued by a foreign corporation. Code § 2104 and Treas. Reg. §20.2105-1(f).
(B) Deposits with persons carrying on the banking business, deposits or withdrawable accounts with a federal or state chartered savings institution (if the interest on such accounts is withdrawable on demand subject only to customary notice requirements), and amounts held by an insurance company under an agreement to pay interest thereon, as long as, in each case, the interest on such deposits or amounts is not effectively connected with the conduct of a trade or business in the U.S. by the recipient thereof. Code § 2105(b) and Treas. Reg. § 20.2105-1(h) and (i).
(C) Deposits with a foreign branch of a domestic corporation or partnership engaged in the Treas. Reg. § 20.2105-1(j).
(D) “Portfolio Debt Obligations”, as long as the decedent was an NRA for income tax purposes. Portfolio Debt Obligations are bonds, debentures, notes or other forms of debt which meet specific requirements, such as non-registered obligations available only to non U.S. persons or registered obligations if the payor is advised that the owner is not a U.S. person. Code § 2105(b).
(E) Proceeds from a life insurance policy on the NRA decedent’s life. Code § 2105(a).
d. Persons who are neither U.S. citizens nor domiciled in the U.S. are also subject to U.S. gift tax on lifetime gifts of U.S.-situs property, but not gifts of intangible property. See Code §§ 2501(a)(1) and (2) and 2511(a). The intangibles exception is not available to certain former long-term green card holders. See Code § 2501(a)(3).
(i) Property which is not considered intangible property and is therefore subject to U.S. gift tax includes:
(A) Real property situated within the U.S. Treas. Reg. § 25.2511-3(a)(1) and (b)(1).
(B) Tangible personal property situated within the U.S. at the time of the gift. Treas. Reg. § 25.2511-3(a)(1) and (b).
(C) U.S. or foreign currency or cash situated within the U.S. at the time of the gift. Treas.Reg. § 25.2511-3(b)(4)(iv).
(ii) Property which is considered intangible personal property and is therefore not subject to U.S. gift tax:
(A) Shares of stock issued by a U.S. or foreign corporation. Code § 2511(b)(1) and Treas. Reg. §25.2511-3(b)(3).
(B) Debt obligations, including a bank deposit, the primary obligor of which is a U.S. person, the U.S., a State, or any political subdivision thereof, the District of Columbia, or any agency or instrumentality of any such government. Code § 2511(b)(2) and Treas. Reg. § 5.2511-3(b)(4).
(C) Interests in U.S. or foreign partnerships (although there is some debate on whether such interests are intangible personal property). For authorities and commentaries that support this proposition see Blodgett v. Silberman, 277 U.S. 1, 11 (1928), PLR 7737063 (6/17/1977); 2 Rhoades and Langer, U.S. International Taxation and Tax Treaties, § 33.01[iii] (1998); Stafford Smiley, Dispositions of U.S. Partnership Interests by Nonresident Aliens, Business Entities, Summer 1991; Robert F. Hudson, Jr., The Tax Effects of Choice of Entities for Foreign Investment in U.S. Real Estate and U.S. Businesses, Business Entities, March/April 2002. For authority that take a contrary position see Rev. Proc. 2004-7, 4.01(25), 2004-1 I. R. B. 237.
e. Planning Opportunity. Since the estate taxation of persons who are neither U.S. citizens or residents is based on the situs of their assets, regardless of whether the assets are tangible or intangible, while the gift taxation of such persons is based upon whether the assets that they are giving away are tangible personal property or real property situated in the U.S., by taking advantage of the intangibles exception to the gift tax, such persons can give away property which would be subject to U.S. estate tax (such as shares of stock in a U.S. corporation or an interest in a partnership that holds U.S. situs assets), without incurring a gift tax.
- Estate and Gift Tax Exemptions
As a result of the estate and gift tax unified credit (also referred to as the applicable credit amount) each U.S. citizen and domiciliary has an estate and gift tax exemption which can be applied either against gifts made during life or property owned at the time of death. The exemptions are as follows:
a. For the year 2013, the exemption for lifetime gifts of U.S. citizens and domiciliaries is $5.25 million. See Code § 2505(a). Prior to 2011 the gift tax exemption was $1 million.
b. For bequests at death for U.S. citizens and domiciliaries the estate exemption is $5.25 million for those dying in 2013.
C. The estate tax exemption for bequests at death for persons who are NRAs is $60,000 (such persons do not receive a lifetime gift tax exemption). See Code § 2107(c)(1). Even if the NRA is the surviving spouse of a U.S. citizen or resident, the NRA cannot utilize the deceased spouse’s $5,000,000 exemption, since the “portability” provisions only apply to U.S. citizens and residents. See Code § 2010(a) and (c).
Gift Tax Annual Exclusion
In addition to the estate and gift tax exemption, as of January 1, 2013, each taxpayer, whether or not he or she is a U.S. citizen or resident, can give up to $14,000 (indexed for inflation) a year ($28,000 for a married couple together) to anyone in the world without paying U.S. gift tax or using up any part of his or her estate and gift tax exemption. See Code § 2503(b).
Estate and Gift Tax Marital Deduction
a. Property passing to a spouse, outright or in certain kinds of trusts, is generally not subject to U.S. estate or gift tax because of the U.S. estate and gift tax “marital deduction.” See Code §§ 2056(a) and (b) and 2523(a) – (f).
b. However, the estate tax marital deduction is generally not allowed for property passing to a spouse who is not a U.S. citizen unless the spouse becomes a U.S. citizen before the estate tax return is filed, see Code § 2056(d), or the property that would otherwise pass to the surviving spouse passes, instead, to a “qualified domestic trust“ (“QDOT”). See Code §§ 2056(d)(2) and 2056A.
c. In addition, the gift tax marital deduction is generally not allowed for property passing to a spouse who is not a U.S. citizen, except that a donor can give his or her non-U.S. citizen spouse up to $143,000 per year in 2013 (as indexed for inflation) without the imposition of any gift tax. See Code § 2523(i).
Estate and Gift Tax Charitable Deduction
a. Property passing from a U.S. citizen or domiciliary to a U.S. or foreign corporation that is organized exclusively for religious, charitable, scientific, literary or educational purposes, is generally not subject to U.S. estate or gift tax because of the U.S. estate and gift tax “charitable deduction.” See Code §§ 2055(a)(2) and 2522(a)(2). Compare this to the income tax charitable deduction, which is only available for gifts to U.S. charities. See Code § 170(c)(2).
b. In contrast, the estate and gift tax charitable deductions are only available for property passing from a person who is not a U.S. citizen or domiciliary if the recipient charity is a U.S. corporation. See Code §§ 2106(a)(2)(A)(ii) and 2522(b)(2).
a. For purposes of the U.S. estate and gift taxes, an alien is considered a U.S. resident for if he or she is domiciled in the U.S. at the time of his or her death or at the time of a gift. If an alien enters the U.S. for even a brief period of time, with no definite present intention of later leaving the U.S., he or she is deemed to be domiciled in the U.S. and, therefore, is considered a U.S. resident for estate and gift tax purposes. See Treas. Reg. §§ 20.0-1(b) and 25.2501-1(b). Thus, an alien may be considered an NRA for estate tax purposes and a U.S. resident for income tax purposes, or vice versa, since the estate tax residency test is the more subjective domicile test just described, while the income tax residency test is met if the alien satisfies an objective day count test known as the “substantial presence test” or holds a green card.
b. Under the aforementioned regulations, a person acquires a domicile in a place by living there, for even a brief period of time, with no definite present intention of later removing therefrom.
c. The determination of domicile for estate and gift tax purposes is a factual issue that focuses on the following factors (No one factor is determinative of whether an alien is domiciled in the U.S. for estate tax purposes. In each case all of the facts and circumstances are examined.):
(i) The length of time spent in the U.S. and abroad and the amount of travel to and from the U.S. and between other countries. See Paquette Est. v. Comr., T.C. Memo. 1983-571.
(ii) The value and size of the donor’s or decedent’s homes and whether he or she owned or rented them. See Fokker Est. v. Commr., 10 T.C. 1225 (1948). If the home owned abroad is worth substantially more than the home owned in the U.S., this could be an indication that the alien was not domiciled in the U.S. If the alien owned a home abroad and only rented a residence in the U.S., this could also be an indication that he or she was not domiciled in the U.S. Nevertheless, under certain circumstances renting a residence in the U.S. may also indicate intent to stay.
(iii) The locations of houses and other residences, since a house in a vacation area is less of an indication to remain indefinitely than in other areas. See Nienhuys Est.V. Comr., 17 T.C. 1149 (1952).
(iv) The situs of valuable or meaningful tangible personal property. See Farmers’ Loan & Trust Co. v. U.S., 60 F.2d 618 (S.D.N.Y. 1932).
(v) Where the alien’s close friends and family are situated. See Nienhuys.
(vi) The locales in which the alien has religious and social affiliations or in which he or she partakes in civic affairs. See Farmers’ Loan and Nienhuys.
(vii) The locales in which the alien’s business interests are situated. See Fokker.
(viii) Visa status.
(ix) The places where the alien states that he or she resides in legal documents, such as deeds, wills, trusts, letters, etc, or in verbal communications. See Fokker and Farmers’ Loan.
(x) Whether the alien spends time in a locale due to poor health, for pleasure, to avoid political problems in another country, etc. See Nienhuys and Fokker.
(xi) The jurisdiction where the alien is registered to vote.
(xii) The jurisdiction that issued the alien’s driver’s license.
(xiii) Income tax filing status (although income tax filing status or residency status does not necessarily determine that an alien is a resident for estate and gift tax purposes, the chances are significantly greater that an alien will be considered a U.S. resident for estate tax purposes if he or she is a U.S. resident for income tax purposes).
Estate of Gift Tax Treaties
a. Treaty Countries – The U.S. has estate tax treaties with the following countries: Australia, Austria, Denmark, Finland, France, Germany, Ireland, Italy, Japan, Netherlands, Norway, South Africa, Sweden, Switzerland, and the United Kingdom. Each of these treaties alters in some respect the rules discussed above with respect to the application of the estate and gift taxes to NRAs who reside in these countries and should, therefore, be reviewed before rendering any estate or gift tax advice for such persons. By way of example, this discussion will focus on the estate and gift tax treaty between the U.S. and Germany.
b. Domicile –
(i) German Treaty –
(A) A person is deemed to be domiciled in the U.S. if he or she is a resident or citizen of the U.S., and he or she is deemed to be domiciled in Germany if he has his domicile or habitual abode in Germany, or if he is deemed for other reasons to be subject to unlimited tax liability for the purposes of the German inheritance and gift tax.
(B) If the individual is deemed to be domiciled in both countries under the above rules, the treaty “tie-breaker” provisions will apply. Under these rules, the individual who has dual domicile, will be deemed to be domiciled in the country where he or she has a permanent home, or if he or she has a permanent home in both countries or neither country, in the country where his or her personal and economic relations are the closest (“center of vital interests”). If it cannot be determined where his or her center of vital interests is the closest, he or she will be deemed to be domiciled in the country in which he or she has a habitual abode and if he or she has habitual abodes in both countries or neither country, he or she will be deemed to be domiciled in the country of which he or she is a citizen.
(C) Notwithstanding the general tie-breaker rules, if an individual, at the time of his or her death or at the time of making a gift was a citizen of Germany and not a citizen of the U.S. and, under the respective laws of each jurisdiction, is deemed to be domiciled in both countries, but the individual has not been domiciled in the U.S. for more than 10 years, he or she will be deemed to be domiciled in Germany for purposes of the treaty. After 10 years, the traditional tie-breaker rules discussed above become applicable but only if both jurisdictions claim domicile under their respective internal.
c. Property subject to estate and gift tax under the German treaty
Real property and business property situated in the U.S. and owned by a German NRA and an interest owned by a German NRA in a partnership that owns such property may be subjected to U.S. estate and gift tax. Any other property of a German NRA, including cash, tangible personal property, and debt obligations situated in the U.S. and shares of stock in U.S. corporations may only be taxed by Germany.
d. Deductions –
(i) Debts – Each of the treaties allows for direct deductions of certain debts that relate to the property that may be taxed by the U.S. (ii) Marital Deduction – Unlike the Austrian treaty, the German and French treaties (see recent protocol) provide that property of an NRA decedent or donor which may be taxed by the U.S. under the treaties and which passes to the decedent’s or donor’s spouse shall only be included in the taxable base to the extent its value exceeds 50% of all property that may be taxed by the U.S. In addition, the 2000 protocol to the German treaty and the 2004 protocol to the French treaty provide for a marital deduction (in addition to the 50% deduction) for the estate of an German NRA equal to the lesser of the property passing to the surviving spouse (after the 50% deduction) or the applicable exclusion amount in effect on the date of the decedent’s death ($5 million in 2010, 2011, and 2012 and $1 million thereafter). This additional deduction is available only if the estate elects to forego the QDOT election.
(ii) Charitable Deduction – Under the German and French treaties, property transferred to a German or French charity by a German NRA or French NRA, respectively, is exempt from the U.S. estate and gift taxes, thereby overriding general U.S. law. The Austrian treaty does not have a comparable provision.
e. Pro-Rata Unified Credit – Under the protocols to the German and French treaties, there is aprovision for an estate tax exemption of up to $5 million in 2010, 2011, and 2012 and $1 million thereafter (it may be less depending upon the ratio of the value U.S. situs property to that of worldwide property), rather than the $60,000 exemption for NRAs who are not covered by the treaties.
a. Use of Intangibles exception for gift tax purposes – An NRA who owns intangible assets that will be subject to U.S. estate tax because the assets are situated in the U.S., such as shares of stock in U.S. corporations or interests in partnerships that carry on businesses in the U.S., should consider giving the assets away prior to his or her death, since the gift will not be subject to gift tax or estate tax due to the intangibles exception. This can be a particularly powerful tool for an NRA who has a spouse or child who is a U.S. citizen. If the spouse or child receives the intangible property outright, the property will be subject to U.S. estate tax upon the spouse’s or child’s subsequent death. If, however, the NRA transfers the property to a trust for the benefit of his or her spouse or child over which the spouse or child does not have a general power of appointment, the assets in the trust will not be subject to gift tax or estate tax with respect to the NRA and will escape estate and generation skipping tax with respect to the spouse and child (and younger generations as well, if the trust is a so-called “dynasty” trust).
b. Citizens of treaty countries, like France, Germany, or Austria – They may safely invest in shares of stock in U.S. corporations, hold cash in the U.S., or invest in U.S. situs debt obligations, without any concern that the property will be subject to U.S. estate tax.
c. NRAs who want to invest in a U.S. business or in U.S. real property for business purposes–
(i) Utilizing a U.S. or foreign partnership or limited liability company (taxed as a partnership) – This form of business is attractive because there is only one level of taxation. In addition, interests in the business should be able to be given away gift tax free as a result of the intangibles exception. The downside of this form of operation is that if the partnership conducts business in the U.S., the interests in the partnership will be subject to estate tax since the interests are deemed to be situated in the U.S.
(ii) Utilizing a foreign corporation – Shares of stock that are given away or bequeathed at death will avoid U.S. estate tax and gift tax. However, the downside of this form of business ownership is that its income is subject to double taxation. In addition to U.S. corporate income tax, a foreign corporation engaged (or treated as engaged) in a U.S. trade or business is subject to a 30% ranch profits tax on earnings of the U.S. business that are deemed repatriated offshore. Finally, if a foreign corporation owns U.S. real property and sells that property it is subject to FIRPTA withholding and generally subject to branch profits tax. Therefore, a foreign corporation is not the ideal entity through which to do business.
(iii) Owning U.S. property through a U.S. subsidiary corporation of a foreign corporation that is owned by the NRA – This avoids gift and estate tax and the branch profits tax. In the case of a NRA who can take advantage of the German, Austrian, or French treaty, or a similar treaty, he or she can own the interest in the U.S. corporation directly, since shares of stock in a U.S. corporation are not subject to estate tax under those treaties. Nevertheless, there will still be double taxation if dividends are paid. In addition, the entity may be considered a “personal holding company” (“PHC”). The PHC rules are generally intended to prevent the avoidance of shareholder level taxes by the accumulation of certain types of earnings by certain closely-held corporations (this is beyond the scope of this outline). The rules impose a penalty tax at the corporate level on the “undistributed personal holding company income” of a PHC. The downside of double taxation must be weighed against the possible estate tax if the underlying assets were owned through a partnership or limited liability company.
NRAs who want to own residential real property in the U.S.
(i) Individual ownership – Will result in U.S. estate tax. However, this can be mitigated if the NRA acquires a life insurance policy that has a face value that will cover the estate tax. Since the life insurance policy is not included in the decedent NRA’s estate, this is an easy way to own U.S. residential real estate and “avoid” the estate tax. Another possibility is to obtain a mortgage on the property for which the NRA is not personally responsible, since, in such a case the entire mortgage is in effect deductible (a recourse mortgage would not be deductible in full, as discussed above).
(ii) Ownership through a partnership – This will not shelter the real property from U.S. estate tax, except perhaps under the Austrian treaty, but if the NRA plans to give the property away before he or she dies, it will shelter the property from U.S. gift tax.
(iii) Ownership through a corporation – If the NRA owns the real property through a foreign corporation, this will avoid U.S. estate and gift tax, but there will be FIRPTA withholding when the property is sold. An NRA who can take advantage of one of the treaties discussed above, can own the property through a U.S. corporation without U.S. gift or estate tax exposure. In either case, since the NRA will use the property for personal purposes the “use” could be deemed income to him or her for U.S. income tax purposes. Nevertheless, this potential income tax exposure may be outweighed by the potential estate tax savings.
e. Word of caution – When using any of the planning techniques discussed above, it is best if the entity that will hold the U.S. situs assets does so from inception, rather than having the NRA acquire the property in his or her individual name and then transfers the property to the entity in which he or she may be the sole owner, since this may cause the underlying property to be included in his or her estate under the Retained Power Rule of Code § 2104(b) (although there are authorities that provide that this will not be the case because the NRA received adequate consideration in return for his or her contribution to the entity in the form of an interest in the entity).