Estate Planning for the Non-Resident Alien with U.S. Assets
By: Adam Kirwan
The Kirwan Law Firm
301 N. Ferncreek Avenue, Suite C
Orlando, Florida 32803
When a Non-U.S. Citizen purchases property in the United States or spends a portion of the year within U.S. borders they become subject to a myriad of complex U.S. tax laws. These laws tax the individual with respect to (i) income earned within the United States and sometime abroad, (ii) certain transfers made with respect to U.S. Situs Property (the definition of which can be complex and is described in greater detail below) and even Non-U.S. Situs Property in certain circumstances, and (iii) property owned by a Non-U.S. Citizen at death. In addition, U.S. tax laws exist that tax property held in corporations, partnerships, limited liability companies, and trusts. These laws present many pitfalls for the unweary, however, the individual who plans properly can reduce or avoid taxation to a significant degree. This memo provides a brief overview of the United States estate and gift tax laws (sometimes called “transfer tax” laws) as they apply to Non-U.S. Residents and how proper planning can reduce estate taxes as well provide many non-tax benefits.
Overview of U.S. Estate and Gift Taxation of Non-Resident Aliens
U.S. transfer taxes (estate, gift, and generation skipping taxes) are triggered by one of two things (1) jurisdiction over the person or (2) jurisdiction over the property. Each of these are explained below.
Jurisdiction Over the Person
Transfer tax jurisdiction over the person arises where an individual is either (1) a U.S. citizen or (2) a U.S. resident. An individual is a U.S. citizen if he or she was either born in the U.S. or naturalized in the U.S. In addition, if an individual was born outside the U.S. but has any U.S. citizen parents or grandparents that may confer upon that person the right to U.S. citizenship, such a person may be treated as a citizen.
If an individual is not a U.S. citizen, the IRS will only have jurisdiction over the person for estate tax purposes if he or she is a resident of the US. For estate tax purposes, the term “resident” is NOT defined using the “substantial presence” test used for income tax purposes (i.e., a foreign individual is classified as a US resident alien if he or she spends 183 days or more in the United States during the taxable year or as determined under a special “lookback” formula). Instead, whether someone is a US resident for estate tax purposes hinges on whether that person is “domiciled” in the U.S. Domicile is generally determined by a two-part test. The first part of the test asks whether the person is living in the US If they are living in the US, the second part of the test asks whether they intend to remain living in the US If both of these questions are answered in the affirmative, the person is a resident for US estate tax purposes. It is interesting to note that under this test, an individual may be a resident of the US for estate tax purposes even if the taxpayer does not have the legal right to live in the US Likewise, an individual may be a resident of income tax purposes, but not estate tax purposes.
Jurisdiction Over the Property
If a person is not subject to estate tax due to their status as a US citizen or a US resident, the US estate tax will only apply to that person’s “US Situs Property.” Not surprisingly, US Situs Property is a property that has “situs” in the United States; however, as you will see in the explanation set forth below, the term “situs” does not simply refer to property physically located in the United States. In fact, some property that is physically located in the US is not US Situs Property for estate tax purposes. Below are several examples of “US Situs Property.” Please understand that this list is not exhaustive and that under different fact patterns, a property that would normally be classified as U.S. Situs Property may be classified as Non-US Situs Property and vice-versa.
Examples of U.S. Situs Property include the following:
- Real Estate: Real property located within the United States. This includes buildings, improvements and fixtures. A harder question is whether US Situs Property includes interests in real property, such as leases, mortgages, or other interests secured by real property located within the United States. A determination of whether a lease, mortgage, or other similar interest would be classified as US Situs Property would require an examination of legal documents and the specific facts and circumstances surrounding the creation of the interest.
- Debt: The general rule is that a debt of a US person or US government has a US situs. A US person means an individual who resides in the US or a corporation incorporated in the US These rules apply whether the debt is in the form of a bond, debenture, promissory note, trade payable or otherwise and whether written or oral. An exception to this rule is deposits with US banks, which are generally treated as having a situs outside the US There is also an exception for certain “tax-free” bonds issued by specific governmental agencies.
- Life Insurance: Life insurance proceeds paid by and amounts left on deposit with US insurance companies, while clearly US situs under the general rules, are generally treated as Non-US Situs Property.
- Interests in Corporations: The general rule is simple – shares of a US corporation are deemed situate within the U.S. and shares of a foreign corporation are deemed situate outside the US The location of the stock certificates and the location of the transfer agent are irrelevant. However, where a foreign corporation owns property that has a US situs, for the shares of the corporation to be treated as foreign situs, the corporation must be recognized for tax purposes. The leading case in this area is Moline Properties v. Commissioner. That decision has been interpreted to mean that a corporation’s separate existence (and, therefore, its status as Non-US Situs Property) would be recognized if (1) there is a real non-tax business reason for the existence of the corporation, or (2) the corporation conducts the actual business activity.
- Interests in Trusts and Estates: If an individual taxpayer has control over trust assets, whether through a right to revoke the trust or through certain powers conferred upon a trust beneficiary (such as a general power of appointment or reversionary interest), that person will be deemed to own the trust assets directly. In that case, the situs of the trust assets becomes the deciding factor.
- Interests in Partnerships: The situs of a partnership interest requires an examination of where the partnership does business, the jurisdiction under whose laws the partnership is organized, and the jurisdiction where the general partner is located.
- Tangible Personal Property: The physical location of tangible personal property determines its situs. However, there is some authority that mere physical presence in the U.S. at the time of death is not determinative where the taxpayer was in transit such that the property had not actually come to rest in the U.S. There is also an exception for works of art that are on exhibit in the United States.
Overview of U.S. Estate and Gift Taxes
The U.S. estate tax is imposed by Internal Revenue Code and collected by the Internal Revenue Service. It is imposed on (i) the worldwide property of U.S. citizens or residents, (ii) certain U.S. property of nonresident former citizens, and (iii) certain U.S. property of other nonresident aliens. In each case, the property subject to estate taxation (called the “gross estate”) includes property owned by the deceased at death as well as certain property that was either used or formerly owned by the deceased. Once the estate tax is calculated, the estate of the deceased is entitled to various deductions and credits to reduce the gross tax liability. While this topic is too broad to discuss in any detail, the principal credit allowed a non-resident alien is a tax credit (called the “Unified Credit”) which shelters $60,000 from U.S. estate tax. The Unified Credit for a citizen or resident alien currently (i.e., as of 2018) allows $1,180,000 to be sheltered from U.S. estate tax. Significant differences in the marital deduction also exist when property is left to a non-U.S. citizen.
Assume that you and your spouse purchase a residence worth $800,000 and title it in your joint names. Assuming you are both non-resident aliens, when you die, roughly $121,800 is due in estate tax despite the fact that it is passing to your spouse. When your spouse then dies owning the same property years later, another $121,800 is due (assuming you didn’t have to sell the house to pay the estate tax). As you can see, in this very common situation, the estate tax can be significant (in this example, $243,600.00 or over 30% of the property’s value). Note that the highest estate tax rate is a full 40%!
The U.S. also has a gift tax. You will be happy to learn that the definition of what constitutes U.S. Situs Property (and, therefore, the property subject to the gift tax) for gift tax purposes is narrower than the definition for estate tax purposes. The gift tax applies only to gifts by nonresident aliens of real property or tangible personal property located in the United States. Gifts of intangible personalty (such as interests in corporations) are not subject to gift tax (but are subject to the estate tax). As of 2018, nonresident aliens are entitled to an exemption for gifts of $15,000 per year for each recipient. With respect to gifts to a non-resident spouse, however, an exemption of $152,000 per year is allowed (again, as of 2018).
There is another U.S. transfer tax called the Generation Skipping Tax which taxes certain transfers made to grandchildren and other more remote beneficiaries. This tax can be quite complex and presents many traps for the unwary when drafting trusts even when children (not grandchildren) are the intended beneficiaries. A discussion of the Generation Skipping Tax is beyond the scope of this letter, but you should be aware of its existence.
Basic planning begins by implementing a revocable trust to hold US Situs Property. The revocable trust provides many benefits including:
(i) Basic Tax Planning: A revocable trust can be used to ensure that both spouse’s tax credits are fully used and that property passing to a Non-US Citizen spouse qualifies for the marital deduction so that no estate tax will be payable on the death of the first spouse to die.
(ii) Probate Avoidance: Probate is a costly, time-consuming process where the disposition of your US Situs Property is supervised by a United States court. The process becomes an even larger burden on your family when they are not present in the United States to oversee the process. Since assets held in a revocable trust are not subject to probate, your children and/or other family members are saved the time, inconvenience, and expense of having to deal with this process at a time when they have just lost a parent.
(iii) Proper Disposition of Your Assets: The use of a revocable trust ensures your assets pass to the people, and in the manner, you desire.
(iv) Privacy: Since you act as both a trustee and the beneficiary of the trust, you gain increased privacy with respect to the nature and extent of your US assets, while still maintaining complete control. The trust is never filed with any court or state or federal agency to make it effective.
(v) Guardianship Avoidance: Absent proper planning, in the event you become disabled while owning property in the United States, your family members will not be able to manage that property for you without establishing a formal guardianship. Guardianship, like probate, is a costly, time-consuming process where a US court first determines who should manage your assets (called a “Guardian”) and then supervises the Guardian by requiring him or her to report to the court on an ongoing basis. Assets held in a revocable trust are instead managed by the people you name as your successors with no involvement of a U.S. court.
(vi) Reducing Future Taxes: Gifts of US Situs Property left to your descendants when you die can be structured so that your children will not have to pay estate tax with respect to the gifted property when they pass on.
(vii) Increased Asset Protection: Gifts of US Situs Property left to your descendants when you die can be structured to protect those assets from the reach of your children’s creditors, including divorcing spouses.
In addition to a revocable trust, your basic estate plan should also include creating a Durable Power of Attorney, a Health Care Power of Attorney, and a Living Will, all drafted under the laws of the United States. A Durable Power of Attorney provides for another person (usually your spouse, a family member, or trusted friend), called an “Attorney-in-Fact,” to be able to act on your behalf in the event you become disabled. In addition to powers to manage assets, a durable power of attorney grants your Attorney-in-Fact the right to exercise your legal rights including the power to sign contracts and tax returns.
A Health Care Power of Attorney allows you to name someone to make health care decisions on your behalf in the event you are unable. A Living Will allows you to state whether you would want life support removed in the event two doctors determine you have not a medical probability of recovery. Both of these documents are recognized by United States hospitals and health care providers and ensure that your wishes are respected and carried out and that people you trust are legally able to make important health care decisions for you in the event you are disabled or injured.
While the use of a revocable trust does provide some tax planning, its use alone will not significantly reduce estate taxes. There are many tools to facilitate planning by non-resident aliens to eliminate or reduce estate taxation; however, the planning requires (i) a thorough examination of your assets both here and abroad, and (ii) a clear understanding of your overall estate plan including any plan established under the laws of your country of origin.
One of the principal planning techniques is to restructure US Situs Property in order to convert it to Non-US Situs Property. This often involves creating both US and foreign situs limited liability companies to hold property and/or using equity stripping techniques to remove equity from certain assets which are then converted to Non-US Situs. Oftentimes, property located within US borders will qualify as Non-US Situs Property. If possible, it is best to establish your estate planning structure before you purchase US property as the cost of transferring interests in real property often time trigger Florida Documentary Stamp Tax.
Since advanced tax planning of this nature is complex and highly fact-specific, it is impossible to go into great detail without discussing your particular situation and goals. Please understand that the information contained in this memo is merely an overview of a complex area of law and that you should not rely on this information without first seeking my advice or the advice of another attorney qualified in this area of the law. If you are interested in implementing additional planning to avoid U.S. estate tax, please let me know at your earliest convenience. I can be reached at (407) 210-6622.