International Issues in Estate Planning: Part 1 - Estate Planning for Nonresident Aliens

By Lewis J. Saret[1]

 

1)    Introduction.

The world that we live in, as well as the world economy, is becoming increasingly global. To illustrate, an estimated four to ten million US nationals live abroad.[2]  In this increasingly global environment, there are an increasing number of migratory families and other nonresident aliens who have substantial contacts with the US.

These individuals include foreign executives moving to the US to run US companies or US subsidiaries of foreign companies, wealthy aliens who acquire homes in the US for retirement or vacation purposes, and young aliens with substantial wealth.  They also include migratory families or family members, what the media once called "jet setters," who have homes and substantial assets in various parts of the world, including the US, and who constantly move from one locale to another. Many of these individuals come from countries with very different tax systems than ours.  They typically would be shocked to learn that their contacts with the US may cause them to be treated as US resident aliens for tax purposes, thereby subjecting them to US income taxation on their worldwide income, and US estate and gift taxation on their worldwide assets.

The US also continues to be one of the most desirable destination countries for immigrating families and individuals. Despite the September 11 terrorist attacks, the US continues to have the most stable political system in the world, and it remains one of the safest countries to live in.  It also has one of the highest standards of living in the world, and it remains the sole "superpower" today. 

In addition, the character of individuals immigrating into the US today differs from the historical character of immigrants into the US.  Today, many immigrants come to the US with substantial assets and either a high level of income, or a high probability of receiving a high level of future income. This is in stark contrast to the huddled masses that once immigrated to the US.

Based on the foregoing, we believe that international issues in estate and tax planning, which have always been important, will become even more important as time goes by. This is also the clear historical trend. In this regard, estate and tax planners can provide substantial tax and estate planning benefits to such individuals, frequently, by using very simple techniques.

2)    Federal estate and gift taxation of nonresident aliens ("NRAs")

a)    Generally.

NRAs are subject to federal estate taxes at the same rates applicable to US citizens and residents - but only on assets situated in the US at the time of their deaths.[3] They are subject to federal gift taxes only with respect to transfers (by trust or otherwise) of real or tangible property (but generally not intangible property) situated in the US, after taking into consideration the annual gift tax exclusion, which is currently $11,000 per year, per donee.[4]

b)    Who is an NRA?

i)     Generally / Significance of issue.

If an individual is a US citizen or resident alien, the US subjects that individual to US estate and gift taxation on his/her worldwide assets. In contrast, if an individual is an NRA, then: (a) the US subjects him/her to US estate and gift taxation only on assets situated in the US; and (b) with proper planning, that person may avoid virtually all US estate and gift tax.

To be an NRA, an individual must be neither a US citizen, nor a US resident.

ii)   Citizenship.

Citizenship is generally an objective factual issue. Most individuals know, with a high level of confidence, whether they are US citizens.  In cases of doubt, it is prudent for tax practitioners to consult with immigration lawyers.

Occasionally, individuals may mistakenly believe that they have lost their US citizenship for US tax purposes by the commission of certain acts. However, not only must a person commit one of the several acts set out by statute, but he/she must do so voluntarily and with the intent to surrender his/her US nationality.[5]  Therefore, when presented with a client who was once a citizen, the practitioner must carefully review that client's citizenship status.

If client is in fact a US citizen, then he/she is subject to estate and gift taxation on his/her worldwide assets, just as any other citizen would be, regardless of the location of his/her residence or domicile.  Example 1 illustrates the situation where an estate planner is most likely to encounter this type of situation.

Example 1.            Carl, a US citizen and resident, retains Edith Estate-Planner to prepare his estate plan.  In the course of the initial client interview, Edith asks Carl if he expects to inherit any substantial wealth. Edith learns that Carl expects to inherit several million dollars from his father, Frank, who lives in Switzerland, where Frank has lived for the past fifty years. Upon further inquiry, Edith learns that Frank was born in the US and holds a US passport, even though he has not stepped foot in the US for more than forty years. Edith also learns that Frank has just assumed that he is not a US citizen for US tax purposes, since he does not live in the US. More precisely, because frank has intended to remain outside the US for his remaining life, he has not even thought about whether he is a US citizen for tax purposes, and has just assumed that he is not treated as a US citizen for US tax purposes. Therefore, Frank has not filed any US income or other tax returns for the past fifty years.

Caution.            The facts illustrated by Example 1, which are more common than one would expect, raise significant and serious tax issues.  Estate planners must tread very carefully in such situations because, in certain circumstances, they may inadvertently both (1) expose themselves to civil and criminal tax liability, and (2) expose their clients to additional civil and criminal tax liability.  A full discussion of the issues raised by such situations exceeds the scope of this article.  However, in such cases estate planners, unless they are familiar with these issues, should immediately contact tax counsel who has previously dealt with these issues.

(1)  Special treatment for citizens/residents of US possessions.           

The IRC treats US citizens and residents of US possessions differently in certain respects than other US citizens and residents for estate and gift tax purposes. Specifically, the IRC treats US citizens as NRAs for estate and gift tax purposes if both:

·      They acquire US citizenship solely by reason of their (a) being a citizen of such US possession, or (b) birth or residence within such possession, and

·      They are both a citizen and resident of such possession at their death or at the time of the gift in question.[6]

If this context, if a US citizen acquires citizenship by birth in one possession and dies in a different possession, he/she is also treated as NRA.[7]  In addition, where a US citizen acquires citizenship by virtue of his/her parent's residence in one possession and then dies in a different possession, he/she is also treated as NRA.[8]

Example 2.            Paul is born in Texas.  When Paul is two years old, his parents move to Puerto Rico, where Paul lives until his death, at the age of 43.  Here, this special rule does not apply, and Paul is treated as any other citizen for estate tax purposes.

Example 3.            Same facts as Example 2, except that Paul is born in Puerto Rico, and his parents move to Texas when Paul is two years old.  When Paul is 40 years old, he moves to Puerto Rico, where he dies three years later.  Here, Paul is treated as an NRA for estate tax purposes.

iii) Residence.

(1)  Domicile is test.

For estate tax purposes, a nonresident decedent is a decedent who, at the time of his death, had his domicile outside the US.[9] Consistent with the above discussion, the term "United States" means only the fifty states and the District of Columbia.  It does not include US possessions.

Caution.            Many accountants and attorneys mistakenly confuse the estate and gift tax residence test with the US income tax residence test. The estate and gift tax residence test differs from the income tax residence test.  Consequently, an individual can be a resident for income tax purposes but not for transfer tax purposes, and vice versa.

(2)  Domicile Defined.

Treasury regulations provide that a person acquires a domicile in a place by living there, even for a brief period of time, with no definite intention of later removing therefrom. Residence without the requisite intention to remain indefinitely will not suffice to constitute domicile, nor will intention to change domicile effect such a change unless accompanied by actual removal.[10]

Whether a person is domiciled in the US is a fact issue.  Proof of the required intent to remain depends on all of the relevant facts and circumstances.  Relevant factors include the following:[11]

·      Immigration status of the individual.

Note.            The US issues two types of visas, immigrant and nonimmigrant visas.  Most non-immigrant visas limit visa-holders to a specified time period during which they may remain in the US.  All other things being equal, holding a non-immigrant visa would seem to indicate nonresident status, since such a visa does not allow the holder to legally remain in the US. However, this is not always the case.[12]  Conversely, all other things being equal, if a person holds an immigrant visa, this would seem to indicate intent to remain in the US indefinitely. Having said this, a green card holder is not necessarily an ipso facto resident. Again however, a green card would appear to be strong evidence of residence.[13]

·      Presence within the US, including duration of stay in the US and elsewhere, the frequency and nature of travel, etc.

·      Nature, extent, and reasons for temporary absence from the foreign home.

·      Individual's own statements, including statements made to immigration authorities, and contained within legal documents (e.g., wills, deeds, divorce petitions, etc.).[14]

·      The size, cost, location, and nature of the individual's home or other dwelling places, and whether such home is owned or rented.[15]

·      Marital status and residence of individual's family. To illustrate, if a person moves his/her family to the US and places his/her children in US schools, this would indicate an intent to remain in the US.[16]

·      Situs of clothing and personal belongings.

·      Participation in community activities.[17]  To illustrate, if an individual becomes active within the community within which he lives in the US by joining a Rotary or Lions club, this would seem to indicate an intent to remain in the US indefinitely.  On the other hand, if a foreign business executive joins a private social club for business entertainment purposes, this would appear to be irrelevant with respect to the executive's intent concerning establishing a new domicile in the US.

·      Phone listing, US driver's license, and auto registration.

·      US bank accounts and investments.

·      Participation in US business ventures.[18]

·      Payment of taxes.

·      Voting.

·      Return ticket.

·      Registration.

·      Stationary.

·      Mail.

Example 4.[19]                       

Facts.            D was an illegal alien who entered the US in 1959.  Two years later, D's wife illegally immigrated into the US. D remained in the US until his death, in 1978. Between 1959 and 1978, D purchased a home in the US, and remained there until his death.  He was a member of several local clubs and an active participant in the community.  In 1964 and in 1972, D purchased rental real property in his native country, which he rented out.  At his death, D's estate took the position that D was an NRA, and therefore, that the real property located in D's native country was not includible in his federal gross estate.

Ruling.            The IRS ruled that an illegal alien who lived in the US for 19 years with his family, purchased a residence, and established strong community ties was domiciled in the US at his death. Therefore, his taxable estate is subject to the estate tax imposed by IRC § 2001, including estate tax on the real property located in D's native country.

Example 5.[20]

Facts.            D, a citizen of a foreign country, was an employee of an international organization at his death. In 1965, D entered and remained in the US with a "G-4" visa. A "G-4" visa is a non-immigrant visa granted to employees of international organizations. After arrival, D formed the intent to remain in the US indefinitely, and the intent persisted until D's death in 1978.

Ruling.            At date of death, D was a US resident. Therefore, the transfer of D's taxable estate, both situated inside and outside the US, is subject to federal estate tax under IRC § 2001.

c)     Gross Estate And Situs Rules.

i)     Generally.

The issue of situs is extremely important because only an NRA's US situs property is subject to estate, gift, and GST tax.[21] The appropriate analysis is as follows:

·      Determine the gross estate of the NRA.

·      Determine if any treaties apply.  This is because treaties may modify the situs rules applicable to an NRA's property. As of the date of this article, countries with which the US has estate tax treaties include the following:

Ø  Australia,

Ø  Austria

Ø  Denmark

Ø  Finland

Ø  France

Ø  Germany

Ø  Greece

Ø  Ireland

Ø  Italy

Ø  Japan

Ø  Netherlands

Ø  Norway

Ø  South Africa

Ø  Sweden

Ø  Switzerland

Ø  United Kingdom

·      Determine the situs of the NRA's property, under an applicable treaty, if one applies, or under the situs rules, discussed below.

ii)   Real Property.

Real property is deemed to have its situs in the place where it is located.[22]

The issue occasionally arises as to what constitutes real property.  Because neither the IRC nor treasury regulations define "real property," either an applicable treaty or the law of the jurisdiction governs the issue of what property constitutes real or personal property.[23]  To illustrate, generally, real property includes land, buildings, improvement and fixtures, growing crops,[24] timber cutting rights,[25] and mineral rights.[26]  Conversely, real property generally does not include leasehold interests, unless the lease term is sufficiently long,[27] and security interests such as mortgages.[28]

Planning Pointer.            NRAs acquiring real property may do so through a non-US company.  This will effectively convert US real property into non-US intangible personal property for federal estate tax purposes.[29] This analysis assumes, of course, that the non-US company is a valid and bona fide corporation, with all proper corporate formalities maintained.[30]  In this regard, NRAs who already own US real property can also effectively convert US real property into non-US intangible personal property for federal estate tax purposes. However, there may be FIRPTA issues in doing this.  A common structure for this purpose is to have US real property owned by a US company, which in turn is owned by a foreign holding company.

Caution regarding Earnings Stripping Rule.            When using a foreign holding company that owns a US subsidiary to hold US real property, practitioners should examine carefully any debt that the US company uses to finance the acquisition of the real estate.  Specifically, there is an issue of whether such debt triggers the IRC § 163(j) earnings-stripping rule. 

As a general matter, the earnings stripping rule applies to a corporation for tax years where (a) its ratio of debt to equity at the close of the tax year exceeds 1.5 to 1, and (b) it has excess interest expense for the year.[31]  Generally, "excess interest expense" would be the amount by which the US subsidiary's "net interest expense" exceeds 50 percent of its adjusted taxable income.[32]

To the extent the earnings stripping rule applies to a US subsidiary for a taxable year, "disqualified interest" paid or accrued during such tax year would be nondeductible, except to the extent that such interest exceeds the US subsidiary's excess interest expense.  For this purpose, disqualified interest includes (1) interest payable to a related person not subject to US tax on such interest; (2) interest payable to an unrelated person under an obligation guaranteed by a related person that is either tax-exempt or a foreign person; or (3) interest paid or accrued by a taxable real estate investment trust ("REIT) subsidiary to the REIT.[33]

It should be noted that this issue, earnings stripping, is a favorite one for IRS international examiners.  The issue is usually "picked up" as a result of the US company, filing its Form 5472, Information Return of 25% Foreign-Owned U.S. Corporation or a Foreign Corporation Engaged in a U.S. Trade of Business, disclosing the fact that it is more than 25 percent owned by a foreign person and that there is a related-party transaction.

Finally, advisors should note that the earnings stripping issue is not limited to US real estate holding companies.  It can crop up for many types of US subsidiaries of foreign parents.

Caution regarding use of debt to reduce value of real property.                        Sometimes NRAs get creative and try to reduce the value of US real property, particularly US homes, by encumbering such property with a mortgage.  This strategy is problematic in that for it to succeed, the mortgage must be non-recourse debt, secured solely by the real property.  Unless this is the case, the mortgage will not reduce the value of the real property house for purposes of inclusion in the NRA's gross estate.  Instead, such mortgage would constitute a deduction for US estate tax purposes.  More important, as discussed below, it would be only partially deductible. Specifically, the mortgage would be allocated to the US gross estate, for deduction purposes, in proportion to the US gross estate over the worldwide gross estate.  In other words, the mortgage would be multiplied by a fraction, the numerator of which would be assets includable in the NRA's US estate, and the denominator would be the NRA's worldwide assets, even though the entire mortgage relates to US assets.[34]

iii) Tangible Personal Property.

The situs of tangible personal property is determined by its physical location at the time of death or gift.[35]  However, items of personal property accompanying an NRA who dies while temporarily visiting the US are not includible in his/her gross estate.[36]

One type of tangible personal property that is particularly problematic is art. This is because art is portable and highly valuable.  It is not unusual for an NRA to loan art to a US museum or to send art to the US to be cleaned or sold.  Under the general situs rule for tangible personal property, if an NRA who has loaned property to a US museum dies during the period of such loan, that NRA would be subject to estate tax on such art.  Because this is obviously unfair, the IRC provides an exception for this type of situation.  Specifically, works of art owned by an NRA decedent are not included in the NRA's estate if such art was:

·      Imported in the US solely for exhibition purposes;

·      Loaned for exhibition purposes to a public gallery or museum, no part of the net earnings of which inures to the benefit of any private shareholder or individual; and

·      At the time of the NRA decedent's death, on exhibition, or en route to or from exhibition, in such a public gallery or museum.[37]

Caution.            If an NRA sends artwork to the US to be cleaned or sold, and dies in the interim, such artwork will be subject to US estate taxation.

Planning Pointer.            In the facts of private letter ruling 199922038, an NRA loaned 31 works of art to a US museum, which rotated its art so that all 31 works of art were generally not on display continuously. The museum stored those pieces not on current display.  The IRS ruled that none of the 31 works of art, including any in storage, would be subject to US estate tax if the NRA died during the loan period.  It reasoned that the entire collection was "on exhibition for purposes of section 2105(c) even though only part of the collection will actually be on display to the public at any given time on a rotating basis." Based on this rationale, an NRA could enter into a similar arrangement with a museum, loaning several pieces to such museum, and requiring the museum to clean or restore such art as a condition of the loan.  Such arrangements with museums are common. 

Currency or cash.            Currency or cash that an NRA owns is not considered to constitute a debt obligation or intangible property. Currency or cash owned by an NRA, which is located in the US (e.g., in a safe deposit box) constitutes tangible personal property subject to US estate tax.[38]

Personal property of diplomatic personnel.            Personal property of diplomatic personnel in the US is not includible in the NRA's gross estate if such property is used in the conduct of such NRA's official mission and is reasonably required for such purpose.[39]

iv)   Shares Of Stock Of A Corporation.

US tax law deems shares of stock issued by a US corporation that are beneficially owned (or deemed beneficially owned) by an NRA at his death to be situated in the US.[40]  In contrast, US tax law deems shares of stock issued by a foreign corporation that are beneficially owned (or deemed beneficially owned) by an NRA to be situated outside the US.[41]

The location of the stock certificates, evidencing ownership of stock, is completely irrelevant for federal estate tax purposes.The decedent's tangible property situated in the US;

Other non cash-assets acquired by US persons from the decedent with a value in excess of $60,000; and

Appreciated property acquired by a US person from the decedent if that property was acquired by the decedent by gift within three years of the date of gift and a gift tax return for such property was required to be filed by the donor.[108]

i)     Gift Tax.

The US imposes a gift tax on donors, not the donee.[109]  In addition, a donee's citizenship or residence is irrelevant for federal gift tax purposes. Therefore, NRAs can make unlimited gifts to US persons without any liability for US gift tax if the property gifted has a situs located outside of the US.[110]

As an incidental note, the IRC's estate tax provisions for NRAs are contained within a separate subchapter (i.e., Subchapter B, Estates of Nonresidents Not Citizens, of Chapter 11, Estate Tax).  In contrast, the IRC's gift tax provisions for NRAs are not contained in a separate subchapter. Instead, they consist of specific provisions within Chapter 12, Gift Tax.

i)  %Text" style="margin-bottom: 6pt; line-height: 150%;">[55]             IRC § 871(h).