Advising Nonresidents and Recent U.S. Residents on Estate Tax Issues

In this age of global mobility, foreign individuals may own property in the United States or become U.S. residents without understanding the transfer tax ramifications of those actions. The 2010 Tax Relief Act1 revived the estate tax and provided a top federal tax rate of 35% and a $5 million exclusion (credit of $1.73 million).2 An estate of a nonresident who is not a citizen is entitled to an exclusion of $60,000 (credit of $13,000).3 Citizens and residents of the United States and nonresident aliens may be affected by this legislation.

Tax practitioners should understand that when a nonresident becomes a resident for U.S. tax purposes, that individual will be taxed on worldwide income and will be subject to U.S. estate and gift taxes, called transfer taxes in this article. What is less known are the intricacies of how a nonresident becomes a resident for U.S. income tax purposes, which may be quite different from becoming a legal U.S. resident. And those who know the definition of a U.S. resident for income tax purposes might not realize that it differs from the definition of residency for transfer tax purposes, although the operation of these definitions may overlap. There is a window of opportunity for planning prior to an individual’s being considered as having established residency in the United States. The purpose of this article is to summarize important rules so that practitioners can advise clients before the planning window closes.

Sec. 2001(a) states that a tax is imposed on the transfer of the taxable estate of every decedent who is a citizen or resident of the United States. The regulations define a resident for these purposes as a decedent who had his or her domicile in the United States at the time of death.4 If the decedent was domiciled in the United States at the time of death, the total value of all real or personal, tangible or intangible property wherever situated must be included in the decedent’s gross estate.5 If the decedent was a nonresident and noncitizen, his or her taxable estate is subject to the estate tax under Sec. 2101. In this case, the value of the gross estate is that part of the gross estate that at the time of death is situated in the United States.6

Definition of a U.S. Resident for Federal Income Tax Purposes

It is important to review the definition of resident for income tax purposes because, in many cases, a person who is a resident of the United States will also likely be considered to be domiciled in the United States. The definition of a resident alien and nonresident alien is contained in Sec. 7701(b). An alien individual will be treated as a U.S. resident if he or she meets one of three requirements: the “green card” test, the substantial presence test, or the first-year election test. Provisions in tax treaties discussed below may override these tests. An individual may meet the residency requirements under the Code, but may nonetheless be considered a nonresident under an income tax treaty.

The “Green Card” Test

Any lawfully permanent resident at any time during the calendar year will be considered a U.S. resident. A lawful permanent resident is an individual who has been lawfully granted the privilege of residing permanently in the United States as an immigrant in accordance with immigration laws.7 In other words, he or she holds a U.S. Permanent Resident Card or green card. This residency status is deemed to continue unless it is rescinded or administratively or judicially determined to be abandoned. For the first year of residency, if the individual does not meet the substantial presence test discussed below, the residency starting date is the first day in the year he or she was present in the United States while a lawful permanent resident.8

The Substantial Presence Test

An individual satisfies the substantial presence test for any calendar year if he or she has been present in the United States on at least 183 days during a three-calendar-year period and 31 days during the current calendar year.9 The 183 days is determined from the sum of the days present in the current year plus one-third of the days present in the first preceding year plus one-sixth of the days present in the second preceding year. There is an exception to this treatment if the individual is present in the United States less than 183 days during the current year and has a tax home in a foreign country to which he or she has a closer connection than to the United States.10 If he or she has applied for a change in status or took other steps to apply for permanent residency, then the foregoing exception does not apply. Days in the above formula do not count if the individual has a medical condition that arose while the individual was present in the United States that prevents him or her from leaving.11

Example 1: N, citizen and resident of Country Q, which does not have an income tax treaty with the United States, travels frequently to the United States on business. In 2008, N was present in the United States for 144 days; in 2009, N was present in the United States for 135 days; and in 2010, N was present in the United States for 117 days. N could be considered a U.S. resident for tax purposes under the substantial presence test as follows: 117 + (1/3 × 135) + (1/6 × 144) = 186. If N continued to have a tax home in Country Q, then she will not be considered a U.S. resident for tax purposes in 2010.

Under the substantial presence test, an individual is deemed to become a resident on the first day he or she is present in the United States during the calendar year the test is first met. Certain nominal presence is disregarded. For purposes of determining when an individual’s residency begins, the individual is not treated as present in the United States for up to 10 days during which the individual establishes that he or she has a closer connection to a foreign country than to the United States.12

Certain individuals are exempt from the substantial presence test. These include a foreign-government-related individual, a teacher or trainee, a student, or a professional athlete who is temporarily in the United States to compete in a charitable sporting event.13 A foreign-government-related individual includes any individual temporarily present in the United States on diplomatic status or a visa determined to represent full-time diplomatic or consular status (and his or her immediate family) and a full-time employee of an international organization (and his or her immediate family). A teacher or trainee is an individual who is temporarily present in the United States under the Immigration and Nationality Act14 and who substantially complies with those requirements. A student is an individual who is temporarily present in the United States under the Immigration and Nationality Act15 and who substantially complies with those requirements.

The days spent in the United States by regular commuters for employment or self-employment in the United States from Canada or Mexico are not counted as days present in the United States on any day they commute.16 Also, a person traveling between two foreign points will not be treated as present in the United States if the person is in the United States for less than 24 hours.17 Days regular crewmembers on a foreign vessel (boat or ship) engaged in transportation between the United States and a foreign country or a U.S. possession spend in the United States are not counted as U.S. presence unless the individuals engage in any trade or business in the United States on those days.18

The First-Year Election Test

An individual may also elect to be treated as a resident of the United States provided certain conditions are satisfied. First, he or she cannot have met the green card test or the substantial presence test for the election year or the immediately preceding year but must meet the substantial presence test in the following year. Second, he or she must be present in the United States for at least 31 days during the year of the election and be present in the United States at least 75% of the number of days in the testing period. The testing period begins the first day of the 31-day period and ends on the last day of the election year. In applying the 75% test, an individual will be treated as present in the United States for up to five days during which he or she was actually absent from the country. Once the individual makes the election, he or she will be treated as a resident for that portion of the election year that begins on the first day of the earliest presence period that satisfies both the 31-day and 75% tests.19

The individual makes the election on his or her tax return for the election year. The individual may not make the election before he or she has met the substantial presence test for the calendar year following the election year.20 Once made, the individual can revoke the election only with the IRS’s consent.21

Income Tax Treaties

Provisions in income tax treaties between the United States and a treaty partner may override the previously discussed rules under the Code, possibly treating an apparent resident under the Code as a nonresident. The tax practitioner must ask the client the right questions about his or her tax status in his or her home country and also examine the relevant treaty to determine residency status. Treaties contain so-called tiebreaker provisions to settle the question of residency when both countries claim that the individual is a resident of that country. For example, Article 4 of the U.S.–France Income Tax Treaty contains the definition of resident. This treaty provides that a green card holder will be considered a resident of the United States only if he or she has substantial presence in the United States or would be a resident of the United States and not of a third country under the tiebreaker provisions.

The first in the list of the provisions, which come into play when both France and the United States claim a person as a resident, states that the person is deemed to be a resident of the country in which he or she has a permanent home available. Next, if there is a permanent home available in both countries, then the person will be deemed to be a resident of the country with which his or her personal or economic relations are closer (called the center of vital interests). Next, if the center of vital interests cannot be determined, or if a permanent home is unavailable in either country, then he or she will be deemed to be a resident of the country in which he or she has a habitual abode. Next, if the individual has a habitual abode in both countries or in neither, then the person will be deemed a resident of the country in which he or she is a national. Finally, if the person is a national of both countries or of neither, then the competent authorities of the two countries will settle the residency question by mutual agreement.

In other words, the fact that a French national holds a green card does not mean that the individual automatically is deemed a U.S. resident, even though that is true under the Code. To determine residency, additional factors must be considered, such as the time the individual spends in the United States as well as the treaty’s tiebreaker provisions.

Definition of Domicile

As mentioned above, transfer taxes are imposed on certain property located in the United States by a nonresident alien and for those with domicile in the United States. The regulations define domicile as follows:

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. 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.22

Under these provisions, it is possible for a person to be domiciled in the United States and not be considered a resident. Also, it is possible for a person to be a resident in one place (United States) and have a domicile in another.23 For transfer tax purposes, a person is considered a nonresident alien domiciliary of the United States if that person has no intention of residing here. This is essentially a factual issue. The Supreme Court stated, “Domicile has been thus defined: ‘A residence at a particular place accompanied with positive and presumptive proof of an intention to remain there for an unlimited time.’”24

In Vlandis v. Kline,25 a reasonable standard for determining domicile included relevant criteria such as year-round residence, voter registration, place of filing tax returns, property ownership, driver’s license, car registration, marital status, vacation, employment, etc.

Visa status may affect an alien’s ability to establish domicile. In Elkins v. Moreno,26 the Supreme Court held that a certain class of temporary nonimmigrant aliens could establish domicile by looking at the intent of Congress when it established the particular visa classification. The Court stated, “were a G-4 [nonimmigrant] alien to develop a subjective intent to stay indefinitely in the United States, he would be able to do so without violating [the law or the regulations] or the term of his visa . . . and would not necessarily be subject to deportation . . . or to have to leave and re-enter the country in order to become an immigrant.”

In the case of TN/TD professional visas (for nonimmigrant citizens of Canada and Mexico), the Ninth Circuit in Carlson v. Reed27 held that admission to the United States for TN/TD nonimmigrant aliens is expressly conditioned on intent not to establish permanent residency in the United States. Thus, TN/TD visa holders are precluded from establishing domicile in the United States. On the other hand, Rev. Rul. 80-20928 determined that an immigrant can establish domicile in the United States for estate tax purposes even though he or she is not a legal resident.

Estate Tax Treaties

The United States has entered into a number of estate tax treaties. When a person dies and is a citizen of, or domiciled in, one of the countries party to an estate tax convention, then that convention must be consulted to determine the treatment of items the convention specifies in order to avoid double taxation or to prevent tax evasion. These treaties deal with domicile, inclusion of property in the estate, deductions, tax credits, exchange of information, and other definitions and administrative matters. The current treaties in force are shown in the exhibit.

Canada does not have a dedicated estate tax treaty with the United States. Instead, many estate tax issues are covered in the U.S.–Canada Income Tax Treaty.

Domicile Under Estate Tax Treaties

Treaties vary on the question of domicile for estate tax purposes. For example, in the U.S.–Australia Estate Tax Convention, the question of whether a decedent was a citizen or was domiciled in the United States or Australia at the time of death is determined in accordance with the law in force in the country where the person was at the time of death. This provision is similar to that found in estate tax treaties with Finland (Article III(1)), Greece (Article IV(1)), Ireland (Article III(1)), Italy (Article III(2)), Japan (Article II(3)), Norway (Article III(1)), South Africa (Article III(1)), Switzerland (Article II(3)), and the United Kingdom (Article III(1)). Thus, the treaty provides some guidance, but the answer of the ultimate questions as to taxation of the decedent’s estate depends on the decedent’s citizenship or domicile in the country at the time of death.

The U.S.–Netherlands Estate Tax Convention has a similar provision regarding domicile but has a number of additional tiebreaker provisions (Article 4). These tiebreaking provisions somewhat resemble the tiebreaking provisions described above in the U.S.–France Income Tax Treaty. There are similar provisions in the U.S.–Denmark Estate and Gift Tax Treaty (Article 4(b)), U.S.–France Estate Tax Treaty (Article 4), and U.S.–Germany Estates, Inheritances and Gifts Treaty (Article 4).

Treatment of a Nonresident Alien Domiciliary

A person considered a nonresident alien domiciliary is subject to U.S. estate tax on U.S. situs assets owned at the time of death.29 Assets with U.S. situs include U.S. real property, tangible personal property located in the United States, stock in domestic corporations, and debt obligations of U.S. persons or governmental units. Also included are lifetime transfers of U.S. situs property within the meaning of Secs. 2035–2038 and transfers within three years of death.30 Property not included in the gross estate of a nonresident includes real and personal property located outside the United States; bank deposits (regardless of whether within or without the United States) not effectively connected with a U.S. trade or business; foreign stocks and debt obligations, including those of U.S. obligors if the interest is eligible for exemption under Sec. 871(h)(1); and proceeds of an insurance policy on the life of a nonresident alien domiciliary. Also not included are works of art on loan for exhibition.31

A nonresident alien domiciliary is entitled to an estate tax credit of $13,000 (which excludes the first $60,000 of the taxable estate) instead of the $5 million exclusion available to a citizen or resident alien domiciliary. A nonresident alien domiciliary is entitled to deductions for funeral and administrative expenses, debts allocated to the U.S. gross estate, donations to U.S. charities, and a marital deduction for property passing to a surviving spouse who is a U.S. citizen.

A tentative tax is computed on the sum of the taxable estate plus adjusted taxable lifetime gifts of U.S. property made by the decedent after 1976 that were not included in the gross estate. A tentative tax is also calculated on the post-1976 lifetime gifts. The gross estate tax before credits is the first tentative tax amount less the second amount. The net estate tax is the gross estate tax less the unified credit and any other applicable credits.

Preresidency Planning for the Nonresident Alien Domiciliary

Before establishing domicile in the United States, an alien should review assets owned in the context of the person’s estate plan. If the review enables a plan to be put into effect before establishing domicile, there may be significant savings of U.S. transfer taxes. A nonresident alien domiciliary incurs gift taxes only on gifts of real or tangible personal property located in the United States. Gifts of other U.S. property, such as U.S. stocks, mutual fund shares, and debt instruments, are not subject to U.S. gift treatment. Therefore, the nonresident alien client should consider making gifts of real and tangible personal property located outside the United States.

Also, the client should consider selling real and tangible personal property located outside the United States with a gift of the sales proceeds if this is part of the overall plan. If these gifts are to a U.S. citizen or resident, care should be taken by the recipient to report these gifts on Form 3520, Annual Return to Report Transactions With Foreign Trusts and Receipt of Certain Foreign Gifts, if they exceed $100,000.

Marital Deduction and Qualified Domestic Trusts Exception

After an alien individual has established domicile in the United States, all property owned, regardless of its situs, will be subject to transfer taxes without regard to the recipient’s citizenship or residency. In addition, Sec. 2056(d)(1) prohibits a marital deduction for property passing to a noncitizen spouse, even if the transferor is treated as a resident for U.S. income tax and is domiciled in the United States for transfer tax purposes.

The exception to this rule allows a marital deduction for property passing to the surviving spouse in a qualified domestic trust (QDOT).32 A QDOT is defined as any trust that satisfies the following:

• The trust instrument requires that at least one trustee of the trust be a citizen or a domestic corporation;
• No nonincome distributions may be made from the trust unless the U.S. trustee has the right to withhold any required taxes;
• The trust meets prescribed requirements to ensure the collection of any required taxes; and
• An election to apply these provisions is made by the executor.33

Property passing to a QDOT is eligible for the marital deduction. In effect, the QDOT postpones the estate tax until the property is distributed to the surviving spouse, when the trust ceases to exist,34 or until the surviving spouse’s death. The tax imposed is the amount that would have been due on the death of the first spouse to die.35 Certain lifetime distributions are exempt from tax if they are distributions of income or on account of hardship.36

If the surviving spouse does not intend to remain domiciled in the United States, a decision may be made to forgo a QDOT and pay the death taxes. The surviving spouse may wish to take possession of the estate’s assets (less estate taxes) and leave the United States to avoid future income tax and transfer tax issues on non-U.S. situs property. On the other hand, if the surviving spouse plans to continue residing in the United States, the inherited assets in the QDOT will be subject to U.S. transfer taxes when the surviving spouse dies.

If the surviving spouse becomes a U.S. citizen, then no tax is imposed on any distribution from a QDOT if the surviving spouse was a resident of the United States between the date of the decedent’s death and the date of citizenship and either no tax was imposed, or, if a tax was imposed on any transfer, the surviving spouse elects to treat any distribution on which tax was imposed as a taxable gift, and to treat any reduction in tax as a credit under Sec. 2010.37

Expatriation to Avoid Tax

Sec. 2107 provides that the nonresident estate tax provisions apply to any nonresident alien who dies during the 10-year period in which he or she is subject to income tax under Sec. 877. What this means is that a person domiciled in the United States for more than five years who ceases to be a lawful resident may still be subject to the estate tax. Under Sec. 877, former citizens and long-term residents who cease to be lawful residents of the United States are subject to an alternative tax under Sec. 877(b) if they meet an average net income tax test or a net-worth test; fail to certify compliance with the tax laws for the five preceding years; or fail to submit required evidence of compliance.

The expatriated individual’s gross estate includes the value of property that at the time of death is situated in the United States. Also, the stock in a foreign corporation may be required to be considered. If the decedent owns at death directly or indirectly 10% or more of the combined voting power of all of the voting stock in a foreign corporation and directly, indirectly, or constructively more than 50% of the total combined voting power of all the voting stock or more than 50% of the total value of all stock of the corporation, then a portion of the decedent’s stock is included under a lookthrough rule.38 This portion is calculated from the ratio of the fair market value of the U.S. situs assets owned by the corporation over the total assets.

Conclusion

In this age of global mobility, it is not unusual for nonresident individuals to own property in the United States. It is also not unusual for individuals to live in the United States for varying periods of time. A nonresident who owns certain property in the United States or becomes a resident or domiciliary of the United States may be unaware of the U.S. estate tax consequences of such activities. A decedent who is a nonresident and noncitizen may be subject to tax on property in the gross estate that has situs in the United States. A decedent domiciled in the United States on his or her date of death is subject to estate tax on the total value of all property wherever situated.

Understanding the intricacies of residency and domicile is necessary to understand what will be included in a decedent’s estate for U.S. estate tax purposes. Also, it is important to understand the potential estate tax consequences for the former citizen or long-term resident who ceases to be a lawful resident of the United States and is considered under Sec. 877 to have expatriated to avoid tax. Not carefully taking into account the special estate tax rules that apply to nonresidents when performing estate planning for a nonresident individual can lead to unpleasant surprises for the estate and heirs.

Footnotes

¹ Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010, P.L. 111-312.

² These provisions are scheduled to sunset on Dec. 31, 2012. As of this writing, the top federal estate tax rate will revert to 55% in 2013, and the exclusion amount will be $1 million.

³ Sec. 2102(b)(1).

⁴ Regs. Sec. 20.0-1(b).

⁵ Regs. Sec. 20.2033-1(a).

⁶ Sec. 2103.

⁷ Sec. 7701(b)(1)(A)(i).

⁸ Sec. 7701(b)(2)(A).

⁹ Sec. 7701(b)(3).

¹⁰ Sec. 7701(b)(3)(B).

¹¹ Sec. 7701(b)(3)(D).

¹² Sec. 7701(b)(3)(B).

¹³ Sec. 7701(b)(5).

¹⁴ Immigration and Nationality Act, §101(15)(J) or (Q) (8 U.S.C. §1101(15)(J) or (Q)).

¹⁵ Immigration and Nationality Act, §101(15)(F), (J), (M), or (Q) (8 U.S.C. §1101(15)(F), (J), (M), or (Q)).

¹⁶ Sec. 7701(b)(7)(B).

¹⁷ Sec. 7701(b)(7)(C).

¹⁸ Sec. 7701(b)(7)(D).

¹⁹ Sec. 7701(b)(4).

²⁰ Sec. 7701(b)(4)(E).

²¹ Sec. 7701(b)(4)(F).

²² Regs. Secs. 20.0-1(b) and 25.2501-1(b).

²³ District of Columbia v. Murphy, 314 U.S. 441 (1941).

²⁴ Mitchell, 88 U.S. 350 (1874).

²⁵ Vlandis v. Kline, 412 U.S. 441 (1973).

²⁶ Elkins v. Moreno, 435 U.S. 647 (1978).

²⁷ Carlson v. Reed, 249 F.2d 876 (9th Cir. 2001).

²⁸ Rev. Rul. 80-209, 1980-2 C.B. 248.

²⁹ Sec. 2103.

³⁰ Sec. 2104(b).

³¹ Sec. 2105(c).

³² Sec. 2056(d)(2).

³³ Sec. 2056A(a).

³⁴ Sec. 2056A(b)(4).

³⁵ Sec. 2056A(b)(2).

³⁶ Sec. 2056A(b)(3).

³⁷ Sec. 2056A(b)(12).

³⁸ Sec. 2107(b).