Estates, Trusts & Gifts
With increasing globalization of the world’s economies, the pitfalls for wealthy clients with international business interests and assets have increased. It is essential for these clients with multiple citizenship or residency to understand that the timing and manner of cross-border wealth transfers fundamentally affect their ability to minimize tax burdens.
Is the Donor a U.S. Citizen or Domiciled in the U.S.?
If a donor or decedent is a U.S. citizen or domiciled in the United States, all gifts made and assets owned worldwide at death are subject to U.S. transfer tax in the absence of a relevant gift or estate tax treaty (Sec. 2001(a)). In addition, even if a taxpayer has no connection with the United States (i.e., is not a citizen or domiciliary) but passes away with certain types of property located in the United States, the estate tax applies to the U.S. situs property regardless of the taxpayer’s citizenship or residency, as long as an estate tax treaty does not supersede (Sec. 2103).
What Creates U.S. Domicile for Estate and Gift Tax Purposes?
Treasury regulations explain that a person can establish domicile by living in a place for even a brief period with no definite, present intention of moving (Regs. Sec. 20.0-1(b)(1)). “Residence without the requisite intention to remain indefinitely,” on the other hand, “will not suffice to constitute domicile, nor will intention to change domicile effect such a change unless accompanied by actual removal” (Regs. Sec. 20.0-1(b)(1)). This test requires a facts-and-circumstances analysis that looks into a variety of factors, such as citizenship in another country and the location of investment assets, driver’s registration, bank accounts, homes, etc. Domicile is presumed to continue in a foreign jurisdiction until it is established in the United States (In re Estate of Paquette, T.C. Memo. 1983-571). For example, in Paquette, a Canadian citizen spent the last 25 winters of his life in Florida, where he owned a home. He was deemed not to have created domicile in the United States because his numerous contacts with Canada, such as citizenship, maintaining a home and conducting his banking there, and holding a valid Canadian driver’s license, supported the presumption of continued domicile there.
Domicile Is Separate from Income Tax Residency
Because estate and gift tax domicile in the United States is not necessarily the same as income tax residency, it is possible to acquire income tax residence without becoming domiciled in the United States for estate and gift tax purposes. Income tax residency is based on meeting one of two criteria. Under the first criterion, the “substantial presence test,” a person is a resident who has been present in the United States for at least 183 days over a three-year period, counted as the sum of days in the current year (which must number at least 31), plus one-third of the days in the first preceding year, plus one-sixth of the days in the second preceding year (Sec. 7701(b)(3)). Under the second criterion, a person who holds a U.S. Green Card—i.e., is a U.S. permanent resident—is considered a resident for income tax purposes.
U.S. Beneficiaries and Transfer Tax
If gift or bequest beneficiaries are located in the United States and the donor or testator is not a U.S. citizen or domiciliary, must U.S. transfer taxes be paid? In almost all cases, the answer depends on the location of the transferred assets, not the location of the beneficiary. For instance, a citizen of France whose children live in the United States need not worry about U.S. estate tax on testamentary transfers to his or her children as long as the assets transferred are not U.S. situs property (real or business property in the United States, stock traded on a U.S. exchange, etc.). Gifts made under the same facts are not subject to U.S. gift tax unless the gift consists of U.S. real property or tangible personal property located in the United States (Sec. 2501(a)(2)). Gifts of intangible property are not subject to gift tax if the donor is not a citizen or domiciled in the United States, and under a special rule U.S. stock is treated as an intangible asset for this purpose (Sec. 2511(b)). This exception is unique to U.S. gift tax and does not apply to the estate tax.
Nonresident aliens who make gifts subject to U.S. transfer tax are not entitled to any gift tax unified credit. The annual exclusion of $13,000 (tax year 2012) generally is allowed on these gifts. For estate tax transfers, a nonresident alien is allowed only the equivalent of a $60,000 lifetime exclusion from tax (Sec. 2102(b)(1)). Compare this with the $5 million exclusion for U.S. citizens and domiciled residents dying in 2011, increasing to $5.12 million for 2012.
Estate/Inheritance and Gift Tax Treaties May Provide Relief to Domiciled, Non-U.S. Citizens
Unless an estate/inheritance or gift tax treaty applies, lifetime transfers and all assets owned at death by a person domiciled in the United States who is a citizen of another country are subject to tax by the United States and his or her country of citizenship. This happens because the U.S. tax system is set up with what has been called a “super jurisdiction.” For a U.S. citizen or domiciliary, all lifetime transfers of property and estate assets are subject to U.S. transfer tax unless a treaty provides relief.
Currently, 16 countries have an estate tax treaty or a combined estate and gift tax treaty with the United States: Australia, Austria, Denmark, Finland, France, Germany, Greece, Ireland, Italy, Japan, Netherlands, Norway, South Africa, Switzerland, and the United Kingdom. In addition, Article XXIX B of the U.S.-Canada Income and Capital Tax Treaty provides estate tax relief for U.S. citizens with Canadian property and vice versa.
Is the Treaty Based on Situs or Domicile?
The general purpose of these estate and inheritance tax treaties is to avoid double taxation. However, depending when the treaty was negotiated, the application of taxing authority under the treaty can be substantially different. Treaties signed before 1966 apply the estate tax based on the situs of the property, by giving the situs state the primary right to tax, i.e., a situs approach. Post-1966 treaties, for the most part, apply the estate tax based on the domicile of the taxpayer, i.e., a domicile approach. Domicile-based estate tax treaties contain a number of exceptions so that property interests outside the United States are not subject to double taxation solely as a result of a taxpayer’s having domicile in the United States.
Under the applicable treaties, immovable property (which includes property accessory to immovable property, such as livestock, equipment, usufructs, and mineral rights) is taxed only in the country where the property is located. As another exception, business property of a permanent establishment is taxed only by the country in which the establishment is located. Furthermore, some estate tax treaties allow for tiebreaker rules for a person considered domiciled in both countries. This may allow the estate to circumvent U.S. domicile treatment and avoid a large U.S. estate tax bill. Specifically, the estate of a U.S.-domiciled person may avoid estate taxes on investment accounts held outside the United States that would otherwise be included.
Loss of Treaty Rights
An estate or inheritance tax treaty can provide significant benefit to a taxpayer who has assets scattered in numerous countries throughout the world. Unfortunately, there is a limit to the use of a treaty for preferential treatment if a person has lived for a significant period in the United States. Longer-term residents will be treated like U.S. citizens and thus will not be eligible for relief under the terms of the treaty. Advisers should examine the domicile article in the treaty to determine whether any tiebreaker rule still applies and what rights may be reserved.
Are Multiple Estate Plans Necessary?
For clients worried about subjecting some or all of their assets to U.S. transfer tax, treaties may be only half the equation. Depending on the client’s original country of citizenship, an additional plan should be developed to deal with estate and asset transfers in the client’s “home” country, both during life and in anticipation of death. A qualified legal expert from the country of citizenship should be consulted to protect the interests of the client adequately. Coordination between U.S. and international advisers is beneficial in developing an all-encompassing estate plan.
Comparison of Estate Tax Rates: Reasons to Avoid U.S. Treatment
Through December 31, 2012, the gift and estate tax unified credit and tax rates are the most favorable they have been for taxpayers since the 1930s. Each taxpayer subject to the estate and gift tax, as a citizen or domiciled resident, is allowed a $5.12 million lifetime exemption, with any transfers above that amount subject to a 35% tax rate. If these provisions sunset back to the 2001 rates at the end of 2012 as scheduled, the unified credit amount will decrease to $1 million, with a 55% tax rate on any transfers exceeding that amount.
The potential for a large decrease in tax-free lifetime transfers creates a substantial planning opportunity through the end of 2012 for all individuals with estates exceeding $5.12 million. President Barack Obama’s administration has indicated that a unified credit of $3.5 million and a 45% tax rate (the 2009 tax structure) would be acceptable. Given the politically charged nature of the estate and gift tax, as well as the current U.S. budget deficit, this matter is far from settled.
Transfers to a Non-U.S.-Citizen Spouse
Even if U.S. domicile has been established and the taxpayer is allowed the full unified credit, Sec. 2056(d)(1) dis-allows the unlimited marital deduction for spouses who are not U.S. citizens, with some exceptions. So, in addition to potentially all assets of a U.S.-domiciled foreign person being subjected to U.S. estate tax, if there is no applicable estate tax treaty, the taxpayer will not be afforded a full marital deduction unless the taxpayer’s spouse is a U.S. citizen, becomes a U.S. citizen before the return is filed, or puts the property into a qualified domestic trust (Sec. 2056(d)(2)). Considering the number of populous countries that currently have no estate tax (e.g., Australia, Brazil, and China) or have tax rates substantially lower than those of the United States (e.g., Italy: 4% to 8%; Turkey: 10%; and Venezuela and Chile, for spouses and certain other beneficiaries: 25%), establishing domicile in the United States can be costly.
Forced heirship: Many European Union signatory countries that follow a civil law system have an inheritance system called “forced heirship,” which requires a certain percentage of estate assets upon the death of a family member to pass to children, the surviving spouse, and possibly some other specified ancestors. Therefore, when crafting the non-U.S. portion of the estate plan for citizens of these countries, advisers should consider that some transfers may be restricted or subject to litigation as a result of forced heirship rules. Making transfers during life may avoid the issue, but this, too, may be problematic, as some European countries do not recognize a trust as a legal entity (e.g., France, Germany, and Greece). This can make it harder to achieve a client’s planning goals and, again, highlights the need for expert legal advice in the international realm.
Community property: Many continental European countries, as well as most Latin American countries, follow a community property law system. Each system has slight variations, but for the most part, the spouses own all property of the marriage, or in some cases all property acquired after marriage, 50/50, with some possible exceptions for bequeathed property or property actively kept separate from the marriage. This type of ownership has a favorable result for assets passing at death, as the surviving spouse’s one-half interest is not transferred but is already treated as his or her property. This may allow for a significant decrease in estate tax if an international client’s estate is subject to U.S. estate tax. International treatment of community property can bring up a variety of conflicts of laws, however.
Conservative countries: An integral part of a well-rounded estate plan is to have both a financial and medical power of attorney. This will allow for the client’s wishes to be adhered to if he or she becomes incapacitated. However, in some locales throughout the world, medical powers of attorney will not be followed in the event of incapacity, and it is up to the state to decide the treatment of a terminally ill person in a hospital.
Cultural issues: As a result of the possibly significant transfer tax issues for wealthy international clients who interact with the United States through visiting, purchasing a home, sending children to U.S. universities, or other scenarios, it is important to apprise them of gift and estate tax rules. Clients from countries with no estate or gift tax, such as China or Brazil, may not realize that giving a large sum of money to their children can have transfer tax consequences. Therefore, whenever possible, advisers should fully inform international clients of tax laws governing transfers and gifts.
Mindy Tyson Cozewith is a director, Washington National Tax in Atlanta, and Sean Fox is a director, Washington National Tax in Washington, DC, for McGladrey & Pullen LLP.
For additional information about these items, contact Ms. Cozewith at (404) 751-9089 or firstname.lastname@example.org.
Unless otherwise noted, contributors are members of or associated with McGladrey & Pullen LLP.