Estate Planning for the International Private Client
 
December 6, 2007
 

The laws governing estate plans of nonresident aliens and non-citizens of the United States are substantially different from those that apply to U.S. citizens. This article highlights many of the important distinctions and notes several estate planning tips (and potential traps) to be considered by non-U.S. persons.

Resident vs. Nonresident Alien

The test for determining whether an individual is a nonresident alien (NRA) for U.S. federal income tax purposes is different than the test for determining whether one is an NRA for transfer (i.e., estate, gift and generation-skipping transfer) tax purposes. As a result, it is possible for an individual to be considered a resident for income tax purposes but not for transfer tax purposes.

U.S. Income Taxation

Generally, a non-U.S. citizen will be considered a resident alien for income tax purposes if (1) he is a lawful permanent resident of the U.S. at any time during the calendar year (i.e., a green card holder), or (2) if he meets the “substantial presence” test. Subject to certain exceptions, an alien meets the substantial presence test for the current calendar year if he is physically present in the U.S. for at least 31 days during the current calendar year and for at least 183 days during the three-year period that includes the current calendar year and the two years immediately before that, counting (1) all the days he was present in the current calendar year, (2) one-third of the days he was present in the first preceding calendar year and (3) one-sixth of the days he was present in the second preceding calendar year. Certain individuals are exempt from the substantial presence test, including G-4 visa holders, diplomats, teachers temporarily present in the U.S. under a J or Q visa, and students temporarily present in the United States under an F, J, M or Q visa.

An individual who is classified as a resident alien for income tax purposes is generally subject to U.S. taxation on his worldwide income in the same manner as a U.S. citizen. In contrast, an NRA is generally subject to U.S. income tax only on his U.S. source income. Income of an NRA that is considered to be “effectively connected” with a U.S. trade or business is generally taxed on a net basis, at the same rates that apply to U.S. persons after allowable deductions. Gains and losses from the sale or exchange of U.S. real property by an NRA are taxed as if the nonresident alien were engaged in a trade or business in the U.S. and are considered effectively connected income. Disposition of U.S. real property by an NRA may also be subject to the Foreign Investment in Real Property Tax Act (FIRPTA), which generally requires that 10 percent of the gross sales price be withheld at closing.

Income of an NRA derived from sources in the U.S. that is not effectively connected with a U.S. trade or business (known as Fixed, Determinable, Annual, or Periodical (FDAP) income) is generally taxed on a gross basis and is required to be withheld by the payor at a flat 30 percent rate (or lower treaty rate). The 15 percent reduced rate for “qualified dividends” is not available to an NRA. Certain items of FDAP income are generally exempt from U.S. taxation, such as interest earned on U.S. bank deposits (including certificates of deposit) and portfolio interest. Capital gains on the sale of intangible property (such as stock in a U.S. company) by an NRA are generally exempt; however, if the NRA is physically present in the U.S. for 183 days or more during the year of sale, gains on the sale of such property are generally taxed on a gross basis at a flat 30 percent rate (or lower treaty rate). This exception typically arises in the context of an exempt individual (such as a G-4 or F-1 visa holder) who is exempt from the substantial presence test but is otherwise present in the U.S. for at least 183 days in the year of sale.

U.S. Transfer Taxation

A non-U.S. citizen will be classified as a resident alien for U.S. transfer tax purposes if his “domicile” is in the United States. This is a mostly subjective test based on one’s intent to remain indefinitely in the United States. Various factors may be considered in determining the location of an alien’s domicile, including:

• the duration of stay in the U.S. and other countries
• the frequency of travel both between the U.S. and other countries and between places abroad
• the size, cost and nature of the alien’s houses or other dwelling places and whether those places were owned or rented
• the area in which the houses and other dwelling places were located (e.g., resort area vs. non-resort area)
• the location of expensive and cherished personal possessions
• the location of the alien’s family and close friends
• the place where the alien maintained church and club memberships and participated in community affairs
• the location of the alien’s business interests
• declarations of residence or intent made in visa applications, wills, deeds of gift, trust instruments, letters and oral statements
• motivation, especially health, pleasure and the avoidance of the miseries of war or political regression
• visa status

An individual who is classified as a resident alien for transfer tax purposes is generally subject to U.S. transfer taxation on his worldwide assets, and is entitled to the same estate, gift and generation-skipping transfer (GST) tax exemptions as a U.S. citizen. Currently, a U.S. person (U.S. citizen or resident alien) is entitled to a $1 million gift tax exemption and $2 million estate and GST tax exemptions. Any taxable gifts made during one’s lifetime will decrease the amount of estate tax exemption available at one’s death.

In comparison, an NRA is subject to U.S. transfer tax only on his U.S. situs assets. However, the estate tax exemption for an NRA is limited to $60,000, unless increased by a treaty. In addition, only a pro rata portion of an NRA’s recourse debts and administration expenses are deductible for estate tax purposes, based on the value of the U.S. property and the value of the NRA’s worldwide estate (which must be disclosed on the NRA’s U.S. estate tax return).

Both NRAs and U.S. persons are permitted to make annual exclusion gifts of up to $12,000 per donee per year under current law (or $24,000 per year, provided both spouses are U.S. persons and the donor’s spouse consents to “gift-splitting”) – as well as unlimited gifts via direct payment of medical and educational expenses – which are gift tax-free and do not utilize any portion of the donor’s gift tax exemption (if applicable). Gifts between spouses are generally non-taxable, provided the donee spouse is a U.S. citizen. An annual exclusion of $125,000 (as indexed annually for inflation) is available for gifts to a non-U.S. citizen spouse in 2007.

Situs Rules Applicable to NRAs for Transfer Tax Purposes

General Rules

As stated above, an NRA is subject to U.S. transfer tax only on U.S. situs assets. The rules for determining what is U.S. situs property are somewhat different for gift tax purposes than they are for estate tax purposes. For gift tax purposes, U.S. situs property is generally comprised only of real property and tangible personal property located in the United States The Internal Revenue Service has previously ruled that a gift of cash from a U.S. bank account is a gift of tangible personal property. Therefore, gifts of cash by an NRA should be made from accounts located outside the United States.

The definition of U.S. situs property for estate tax purposes is further expanded to include U.S. securities and deposits held by U.S. brokerage firms or other financial institutions that are not considered banks (such as money market accounts, but not including certificates of deposit). Generally, amounts on deposit with U.S. banks, savings and loan institutions, and credit unions (or foreign branches of U.S. banks) are exempt. Portfolio debt obligations (which include U.S. government and corporate bonds, debentures and notes issued after July 18, 1984) are also generally exempt. However, bank accounts and portfolio debt will not be exempt from U.S. estate taxation if the decedent was a resident of the U.S. for income tax purposes at his or her death. Proceeds from an insurance policy on the nonresident alien’s life are not considered U.S. situs property, even if the policy is issued by a U.S. insurance company.

Converting U.S. Situs Property to Non-U.S. Situs Property

There are several ways an NRA can convert or remove U.S. situs property from his or her estate. For example, the NRA could sell his U.S. securities and reinvest the proceeds in non-U.S. situs assets prior to his or her death. As stated above, if the NRA is physically present in the United States for fewer than 183 days in the year of sale, any gain realized on the sale would generally be exempt from U.S. income tax. The NRA could also consider gifting his U.S. securities, which could be done without incurring any U.S. gift tax. An NRA might also consider transferring his or her U.S. securities to a foreign corporation, since stock in a foreign corporation is not subject to U.S. estate tax.

With regard to interests in U.S. real property (such as a vacation home or other investment property located in the United States), an NRA should consider acquiring such property via a foreign corporation, which would convert the property to a non-U.S. situs asset for estate tax purposes. However, any gain or rental income from the U.S. real property owned by the foreign corporation would remain subject to taxation for U.S. income tax purposes.

The NRA may also wish to consider purchasing term life insurance on his or her life, in order to cover any estate tax liability with regard to U.S. situs property that may be due at his or her death. As stated above, the proceeds from such a policy would be exempt from U.S. estate tax. Thus, it would not be necessary for the NRA to transfer the policy to an irrevocable life insurance trust (as is typically done by a U.S. person in order to prevent the proceeds from being includible in his or her estate).

Estate Planning for Non-Citizen Spouses

Qualified Domestic Trusts

Generally, the availability of the estate tax marital deduction for both U.S. person and nonresident alien decedents will depend on whether the surviving spouse is a U.S. citizen. Current law generally provides for an unlimited marital estate tax deduction for outright and other qualified transfers to a surviving spouse, provided the surviving spouse is a U.S. citizen. If the surviving spouse is not a U.S. citizen, property passing to the surviving spouse generally will not qualify for the marital deduction, absent applicable treaty relief, unless the property is transferred to a qualified domestic trust (QDOT). One or more QDOTs can be created by the deceased spouse under his or her will, or by the surviving non-citizen spouse within a specified period of time after the deceased spouse’s death. A QDOT cannot be used for gifts made to a non-citizen spouse during the donor’s lifetime.

QDOTs are subject to various limitations and tax reporting requirements. First, a QDOT must qualify as a marital trust for U.S. estate tax purposes. In addition, at least one trustee must be a U.S. citizen or domestic corporation. The trustee may also be required to furnish a bond or other security if the trust assets exceed a certain amount, to ensure collection of tax from the QDOT. Generally, distributions of principal from a QDOT, as well as assets remaining in the QDOT at the surviving spouse’s death, are subject to a special QDOT tax based on marginal estate tax rate of the first deceased spouse. Most clients are surprised to learn that, even if the surviving non-citizen spouse is a U.S. resident, the surviving spouse’s estate tax exemption (and any debts or administration expenses associated with his or her estate) cannot be used to offset the QDOT tax on assets remaining in the QDOT at the surviving spouse’s death. Thus, if the surviving spouse intends to remain in the U.S. indefinitely, it may be advantageous for the spouse to become a U.S. citizen. In such a case, the QDOT will typically terminate without any QDOT tax and the assets will be distributed to the surviving spouse subject to inclusion in his or her estate.

Given the complexities of a QDOT as described above, couples living outside the U.S. where one spouse is a U.S. citizen and the other is a nonresident alien may wish to consider titling a significant portion of their non-U.S. situs property in the nonresident alien spouse’s name. This would generally avoid the necessity of a QDOT if the citizen spouse dies first. However, the spouses should be careful not to trigger any inadvertent gift on the retitling.

Special Rules Regarding Jointly-Owned Property

The estate and gift tax rules that apply with regard to jointly-owned property where either spouse is a non-U.S. citizen are different than the general rules that apply where both spouses are U.S. citizens.

First, jointly-owned (non-community) property passing to a non-citizen spouse is generally 100 percent includible in the deceased spouse’s estate; whereas, if the surviving spouse is a U.S. citizen, only one-half of the property would be includible. This presumption can be rebutted if the surviving spouse can trace the consideration provided by him or her toward the property; therefore, it is important that the couple maintain complete and accurate records in order to substantiate this information.

Second, the gift tax rules that apply with regard to the creation and severance of joint tenancies where either spouse is a non-U.S. citizen are different than the general rules applicable to U.S. citizen spouses, which can often lead to unintended tax results. Generally, the creation of a joint tenancy (including tenancy by the entirety) in real property by a couple where either spouse is a non-U.S. citizen will not constitute a taxable gift. However, if the property is later severed into tenants in common, or is sold and the non-U.S. citizen spouse receives more than his or her pro rata share of the proceeds attributable to the consideration provided by the non-citizen spouse, a taxable gift to the non-citizen spouse will generally result. Thus, it is important to maintain accurate records tracing the consideration provided by each spouse. Similarly, the creation of a joint bank or investment account by a couple where either spouse is a non-U.S. citizen will not constitute a taxable gift. However, if the account is terminated or if one spouse withdraws or receives more than the pro rata portion of the account that he or she contributed, a taxable gift to the non-citizen spouse will generally result.

Other Special Rules

As stated above, an unlimited gift tax marital deduction is not available for gifts to a non-citizen spouse. Instead, an annual exclusion of $125,000 in 2007 (as indexed annually for inflation) is available for such gifts. In addition, if either spouse is an NRA, the couple cannot elect to “gift-split” (i.e., treat all gifts made by one spouse during the calendar year as having been made one-half by each spouse, provided a qualified election is made on the donor spouse’s gift tax return).

Other Potential Estate Planning Traps

Forced Heirship Rules

NRAs, as well as U.S. persons who own property outside of the United States, should be mindful of the forced heirship rules that apply in most civil law countries (such as France). Generally, these rules require a portion of the estate to pass to the decedent’s children at his or her death, regardless of the provisions contained in his or her will. This can frustrate the decedent’s estate plan and can also prevent such property from qualifying for the estate tax marital deduction. Therefore, it is imperative to consult with legal counsel in the foreign country in order to confirm the potential effect of such rules on the overall estate plan.

U.S. persons who own real property outside of the United States may avoid application of the forced heirship rules, and obtain additional asset protection and estate planning benefits, by contributing the foreign property to a domestic partnership or limited liability company. However, because the law of the foreign jurisdiction may look-through the entity for purposes of the forced heirship rules, one should seek advice from foreign counsel.

Revocable Trusts

Revocable trusts are commonly used in the U.S. to avoid probate and to provide for effective management of one’s property in the event of incapacity. However, the use of a revocable trust by an NRA may result in unintended estate tax consequences. Specifically, if the nonresident alien transfers U.S. situs property (such as a vacation home located in the United States) to a revocable trust, the assets of the trust will generally be includible in the NRA’s estate, even if the U.S. property is sold and converted to non-U.S. situs property (e.g., cash in a U.S. bank account) before the NRA’s death. In order to avoid this result, the U.S. real property should be removed from the revocable trust before it is sold, and the proceeds should be contributed to a newly-created revocable trust.

Conclusion

Planning to take advantage of unique opportunities afforded the international private client and, at the same time, avoid the many potential pitfalls that may befall such plans requires the assistance of professionals who regularly practice in this arena and who can (and will) coordinate with foreign counsel as needed. When identifying such professional advisors, take special care to inquire about their background and experience, not just in the area of estate planning, but also in the specialized world of international estate planning.

For more information, email Melinda Merk at melinda.merk@hklaw.com or call toll free, 1-888-688-8500.