For generations, the Statue of Liberty has welcomed immigrants with this most famous of quotes: "Give me your tired, your poor, your huddled masses yearning to breathe free" (Emma Lazarus, "The New Colossus"). However, Lady Liberty does not warn of the huge tax costs associated with immigrating to the United States. Foreign high-net-worth individuals immigrating to the United States should seek advice to minimize exposure to the U.S. income, gift, and estate tax system. This item articulates some considerations for those taxpayers.
How Residency and Domicile Are Established
A person is not subject to U.S. income tax unless he or she is a U.S. citizen or U.S. resident (Sec. 7701(a)(30)) and is not subject to gift or estate tax unless he or she is a U.S. citizen or domiciliary (Regs. Sec. 20.0-1(b)(1)). Residency for federal income tax purposes is different from domiciliary status for federal gift and estate tax purposes, and this distinction can often result in a person's having residency for income tax but not for estate or gift tax purposes (or vice versa). This distinction can make pre-immigration planning challenging but can create opportunities as well.
Income tax: The United States taxes the worldwide income of its citizens and residents (Sec. 7701(a)(30)). Thus, U.S. citizens and residents, even when living abroad, are subject to the full brunt of the U.S. tax system. U.S. federal income tax rates can be as high as 43.4% on U.S. residents. For income tax purposes, noncitizen individuals are U.S. residents if they meet either the green card test or the substantial-presence test, as described below.
Green card test: Individuals who hold a permanent resident card (a "green card") are taxable residents of the United States for income tax purposes, and, as a result, their worldwide income is subject to U.S. income tax (Sec. 7701(b)(1)(A)).Possession of a green card is the only relevant fact under this test (although there are special rules for the first and last year of lawful residence).
Substantial-presence test: In addition, individuals qualify as U.S. tax residents if they are present in the United States for 183 days or more in any given calendar year (Sec. 7701(b)(3)(A)). If the individual is not present in the United States for 183 days or more in any given year, but is present for at least 31 days, and the individual's days present in that year and the two preceding years, based on a weighted formula, equals 183 days or more, then the individual also qualifies as a resident for that year (id.). An individual is subject to U.S. income tax on the first day of the year in which the individual meets the 183-day test. As a general rule, an individual who does not spend more than 121 days in the United States in any given year will not meet the substantial-presence test.
Some key exceptions present planning opportunities:
1. An individual present in the United States for fewer than 183 days in a given year may be able to avoid U.S. resident status by establishing a tax home in a foreign country and a closer connection to that foreign country than to the United States (Sec. 7701(b)(3)(B)).
2. A person holding a full-time student, teacher, or trainee visa, or who is an employee of an international organization, will not qualify as a U.S. resident, regardless of the number of days spent in the United States (Secs. 7701(b)(5)(A) and (B)).
3. Treaties with some countries include "tie-breaker" provisions to determine residency status for a person who could otherwise be treated as a resident of both of the treaty countries.
Domiciliary status for gift/estate tax: Unlike the mostly clear and objective variables used to determine residency status for income tax purposes, determination of a person's domicile for gift and estate tax purposes is based on a facts-and-circumstances analysis, which is subjective. Even the presumption that a green card holder has a U.S. domicile is rebuttable. Domiciliary status is acquired when one lives in the United States, even for a brief period, with no definite present intention of moving from the United States (Regs. Sec. 20.0-1(b)(1)). One can see that avoiding residency for U.S. income tax purposes does not rule out becoming a U.S. domiciliary for U.S. gift and estate tax purposes.
A person who is a U.S. domiciliary for estate and gift tax purposes is subject to gift tax at rates as high as 40% on that person's worldwide gratuitous lifetime transfers of property. In addition, U.S. domicile status could result in the person's worldwide assets' being exposed to federal estate tax upon death at rates as high as 40%. However, a non-U.S. domiciliary's estate and gift tax exposure extends only to gifts, bequests, and estate holdings of U.S. situs property (Sec. 2106).
Pre-immigration options: Given the worldwide reach of the U.S. income and transfer-tax systems, timing an immigrant's status as either a resident or domiciliary is essential. With a systematic and disciplined approach, a high-net-worth individual's exposure to these taxes can be minimized.
Minimizing Income Taxation
Step up basis: Under the U.S. check-the-box regime, a business entity may elect to be treated either as a corporation, a partnership taxed to its owners directly, or, for an entity with a single owner, as a disregarded entity (see Regs. Secs. 301.7701-1et seq.). A foreign corporation whose owners elect partnership or disregarded-entity status will be treated as making a liquidating distribution of its underlying assets to its owners on the effective date of the election. As a result, the basis of assets held by the foreign corporation is stepped up (or down) in the hands of the entity's owners to its fair market value (FMV) on the date of the election.
Under current rules, this liquidating distribution is not taxable since gain realized on non-U.S. assets is not subject to U.S. income tax when realized by a nonresident (see Sec. 871; U.S. tax generally not imposed on capital gains of nonresident aliens). However, for U.S. tax purposes, any step-up in the basis of the assets can reduce future realization of capital gain after the foreigner becomes a U.S. income tax resident.
Sell appreciated assets: Some countries, such as Mexico, allow for an inflation adjustment to the basis of assets, while the United States does not. The result is that gain in the United States could be significantly more than in the taxpayer's current home country. As a result, taxpayers coming from those jurisdictions should consider selling those assets before immigrating. This could result in little tax in the taxpayer's home country while allowing the taxpayer to purchase new assets and enter the United States with an FMV basis in the new assets.
Dispose of foreign corporations with passive income: A U.S. shareholder owning more than 10% (taking into account attribution and constructive ownership principles) of a foreign corporation may need to include in taxable income his or her pro rata share of the foreign corporation's "Subpart F" income, even if the shareholder receives no actual distributions (Sec. 951(a)). Even if Subpart F does not apply, a U.S. shareholder who recognizes gain from the sale of shares in a foreign corporation that has passive income as the majority of its income (or where the majority of its assets produce passive income) may be subject to an extremely punitive tax regime under which any such gain may be taxed at ordinary rates (the passive foreign investment company rules, Sec. 1291(a) et seq.). To avoid these regimes, a pre-immigrant taxpayer should consider disposing of those investments before entering the United States.
Plan with trusts: Before becoming a U.S. resident, a taxpayer can make irrevocable gifts to non-U.S. persons in trust where (1) the trust document indicates that it is not permitted to have U.S. beneficiaries, and (2) the trust is not otherwise considered a U.S. grantor trust. By doing so, the taxpayer may avoid U.S. income taxes on future income earned by the gifted assets and may also avoid later U.S. gift and estate taxes on the transfer of those assets, simply because the now-U.S. resident no longer owns the income-producing assets for U.S. tax purposes.
As a precautionary note, nonresidents who create foreign grantor trusts that have (or may have) a U.S. beneficiary are subject to U.S. income tax on that foreign trust's income if the nonresidents themselves become U.S. taxpayers within five years of transferring property to the trust (Regs. Sec. 1.679-5(a)). Thus, a nonresident alien who intends to immigrate to the United States should create and fund the foreign trusts at least five years before becoming a U.S. person, in order to avoid being taxed on trust income.
Alternatively, a taxpayer can, before immigrating to the United States, transfer a portion of his or her assets to an irrevocable discretionary trust of which the taxpayer and other family members are permissible discretionary beneficiaries. While this will become a grantor trust for U.S. income tax purposes, subjecting its income to U.S. income tax in the hands of the grantor after the grantor becomes a U.S. resident (Secs. 671-677), the assets should not be subject to U.S. estate tax on the taxpayer's death (Sec. 679). Moreover, life insurance can be used to cut off the accumulation of any undistributed net trust income (thereby minimizing the income tax liability to the grantor) by using trust assets to purchase a life insurance policy.
Invest in an annuity or a life insurance policy: Before immigrating, a taxpayer can purchase an annuity or a life insurance policy. A life insurance policy that is not a modified endowment contract can provide funds under its terms (e.g., loans) to the taxpayer, even when the taxpayer becomes a U.S. tax resident, without payment of U.S. income tax, because a loan from the taxpayer's insurance policy is generally not taxable (Sec. 72(e)(5)(A)).
Minimizing Exposure to Gift and Estate Taxation
Foreign irrevocable trust: Even if the five-year waiting period, discussed above, cannot be met, contributing foreign property to a trust before immigrating to the United States still has significant transfer tax advantages. As stated above, the nonresident's non-U.S. assets that are in the trust will not be subject to any U.S. estate tax.
Gifts to U.S. persons: Assuming a desire to so do, it is advisable to make gifts to U.S. persons before becoming a U.S. domiciliary because nonresidents are subject to U.S. gift tax only on gratuitous lifetime transfers of U.S. situs property (including U.S. real estate and tangible property located in the United States, such as cars, art, jewelry, and furnishings) (Sec. 2101(a)). However, a U.S. person who receives a gift from a foreign person may need to report the gift to the IRS, and penalties may result from failure to do so (Sec. 6039F).
Gifts between spouses: If spouses become U.S. residents but not U.S. citizens, any gifts between them in excess of $148,000 per year (2016 amount) will be subject to gift tax. Thus, any gifts between spouses should be made before entering the United States with non-U.S. situs assets (Sec. 2523(i)).
Anomalous treatment of U.S. shares: Shares of a U.S. corporation are intangible property and therefore are not considered taxable as U.S. situs property for gift tax purposes, similar to debt instruments issued by U.S. issuers and Treasury securities. However, shares of a U.S. corporation are considered U.S. situs property for estate tax purposes (Secs. 2104(a), 2501(a)(3), and 2511(b)). Thus, nonresidents who own U.S. shares and intend to immigrate to the United States should consider making gifts of their U.S. shares. Those gifts may achieve two tax-saving goals. The gifts will be exempt from U.S. gift tax and will also reduce the U.S. estate for estate tax purposes.
Through advanced and disciplined planning before becoming a U.S. resident, a taxpayer can significantly reduce exposure to U.S. income, gift, and estate taxes. At a minimum, individuals considering a move to the United States should seek advice long before establishing U.S. resident or domiciliary status.
Mindy Tyson Weber is a senior director, Washington National Tax, for RSM US LLP.
For additional information about these items, contact Ms. Weber at 404-373-9605 or email@example.com.
Unless otherwise noted, contributors are members of or associated with RSM US LLP.