US estate tax: Not just for US citizens

Editor: Kevin Anderson, CPA, J.D.

The U.S. tax system is based on a citizenship model rather than a residency model, so its reach is potentially worldwide. Domicile and residence are irrelevant for U.S. citizens, who are subject to income tax on their worldwide income, to gift tax on their worldwide gifts, and to estate tax on their worldwide estate. So how do non.U.S. citizens become subject to U.S. estate tax on all or a portion of their worldwide estate? The application of U.S. estate tax laws to a non.U.S. citizen depends on domicile, situs of assets, and application of a treaty.

Domicile matters

A non.U.S. citizen who is domiciled in the United States (a U.S. domiciliary) has the same lifetime exemption amount as a U.S. citizen and is similarly subject to estate tax on his or her worldwide estate (Sec. 2031(a); Regs. Sec. 20.2031-1(a)). So how is domicile determined for a non.U.S. citizen?

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. [Regs. Sec. 20.0-1(b) (1) ; Regs. Sec. 25.2501-1(b) contains nearly the same language]

Domicile requires both physical presence in a specific location and the intent to make that physical location one’s home. Intent may be established by the presence of numerous factors, including but not limited to the following:

• Location and duration of current residence;
• Location of medical providers, civic organizations, and employment;
• Driver’s license, voter registration, and vehicle registration;
• Place of business;
• Green card or visa;
• Declarations of intent;
• Bank accounts;
• Motives of changing residence; and
• Renting versus owning a home.

No single factor is necessarily determinative, but obtaining a green card (permanent residence visa) generally would lead to the conclusion that a non.U.S. citizen is domiciled in the United States. The determination of a non.U.S. citizen’s domicile is a facts-and-circumstances analysis, subjective and unique to the individual. The substantial-presence test, which is applied for federal income tax purposes, is not relevant in the determination of a non.U.S. citizen’s domicile for estate tax purposes.

If it is determined that a non.U.S. citizen is not domiciled in the United States, the analysis shifts to the situs of the assets. Non.U.S. citizens not domiciled in the United States generally are subject to U.S. estate tax only on their assets “situated in the United States” (Sec. 2103).

Situs matters, too

A non.U.S. citizen who is not domiciled in the United States (a non.U.S. domiciliary) has an exemption amount limited to $60,000, which translates to a $13,000 credit against the U.S. estate tax. While the allowed exemption is small, a non.U.S. domiciliary estate will include only the U.S.-situated assets owned at death (Sec. 6018(a)(2)).

Any asset that has a situs in the United States constitutes a U.S.-situated asset. The most straightforward example of a U.S.-situated asset is real property within any of the 50 states or the District of Columbia. In general, personal property located within the United States has a U.S. situs. Personal effects and merchandise of a non. U.S. citizen not domiciled in the United States who dies while traveling in the United States, however, are not subject to U.S. estate tax laws (Delaney v. Murchie, 177 F. 2d 444, 447 (1st Cir. 1949)). Similarly, works of art owned by a non.U.S. citizen not domiciled in the United States do not constitute property within the United States, as long as the art was (1) imported into the United States solely for exhibition purposes; (2) loaned to a public gallery or museum; and (3) at the time of death, on exhibit or in transit to or from an exhibition (Sec. 2105(c)).

Corporate stock is situated in the United States if it is issued by a domestic corporation (Sec. 2104(a)). The location of the stock certificates or corporate assets of the domestic corporation is irrelevant. Ordinary debt obligations (e.g., promissory notes and bonds) owned and held by non.U.S. citizens not domiciled in the United States constitute property within the United States if the principal debtor is a “United States person, or the United States, a State or any political subdivision thereof, or the District of Columbia” (Sec. 2104(c)).

Conversely, life insurance policies on the life of a non.U.S. citizen not domiciled in the United States are deemed not to be situated in the United States, thereby avoiding the U.S. estate tax (Sec. 2105(a)). Bank deposits lack a U.S. situs as long as they are not effectively connected with a U.S. trade or business (Sec. 2105(b)). The situs of a partnership interest is uncertain; however, the IRS’s position is that partnership interests generally are situated where the partnership’s predominant business is conducted. Authority on the topic, however, is sparse (see Rev. Rul. 55-701).

If a non.U.S. domiciliary’s estate is subject to U.S. estate tax, an estate tax treaty, if available, may mitigate its impact.

Tax treaties matter more

A non–U.S. domiciliary with ties to the United States and a foreign country may be subject to more than one estate tax and may benefit from tax treaties, which can mitigate or eliminate a requirement to pay estate tax to two or more countries.

Estate tax treaties generally are categorized by reference to situs or domicile. Situs treaties usually bestow the authority to impose an estate tax on the country in which the assets are located, thereby overriding the domestic tax rules of the other countries that are party to the treaty. The United States is a party to situs-type treaties with Australia, Finland, Greece, Ireland, Italy, Japan, Norway, South Africa, and Switzerland.

Domicile treaties assign a single fiscal domicile to an individual who is claimed as a domiciliary of more than one country. The country to which the treaty assigns the fiscal domicile usually has the primary right to impose the estate tax. Domicile treaties may carve out exceptions, thereby reserving the right of the nondomiciliary country to tax certain assets located within its territory. The United States is a party to domicile-type treaties with Austria, Denmark, France, Germany, the Netherlands, and the United Kingdom.

The United States and Canada terminated their estate tax treaty on Jan. 1, 1985, but in 1995 they implemented a protocol amending the U.S.-Canada income tax treaty to address double taxation and other issues concerning the U.S. estate tax and the Canadian tax on capital gains at death.

Estate tax treaties generally are used to determine the assets includible in the estate of a non–U.S. domiciliary that would come within the scope of the treaties. An applicable treaty also may increase the exemption amount above the statutory $60,000.

Planning

Planning before purchasing U.S.- situated assets can potentially reduce the uncertainty associated with a non– U.S. domiciliary estate. Who will use the asset and who will inherit it may dictate the manner of ownership. Here are a few planning options involving the acquisition of U.S. real property (USRP).

If the non–U.S. domiciliary does not intend to hold the USRP for the long term, they could own it outright and manage the U.S. estate tax risk by purchasing sufficient life insurance — which is not deemed to be a U.S.-situated asset — on their own life to cover the future U.S. estate tax cost that might be incurred. They also could take out nonrecourse loans on the USRP, which will reduce its value dollar for dollar in the non–U.S. domiciliary estate.

If no U.S. beneficiaries will be associated with the USRP, a foreign corporation could own it. There would be no U.S. estate tax liability because the stock in the foreign corporation is not considered a U.S.-situated asset. Alternatively, a foreign corporation could own a U.S. corporation that owns the USRP. Again, there would be no U.S. estate tax because the foreign holding company is not considered a U.S.-situated asset.

If there will be U.S. beneficiaries, a domestic nongrantor irrevocable trust could own the USRP; however, the trust would have to be specifically designed to exclude provisions that might cause inclusion in the grantor’s gross estate. A foreign nongrantor trust may work if there are no U.S. beneficiaries; otherwise, the throwback tax rules under Secs. 666–668 apply, and an accumulation distribution tax may kick in for U.S. beneficiaries of the foreign trust.

A foreign partnership could own the USRP, such that an interest in the foreign partnership may be treated as an intangible and not considered situated in the United States. However, U.S. estate tax law is unclear on this point. There is some risk that the IRS could take a lookthrough approach based on the aggregate approach to the treatment of sales and exchanges of partnership interests in Secs. 864(c)(8) and 1446(f) and look to the situs of the underlying partnership assets to determine the location of the USRP.

These planning suggestions demonstrate a few ownership structures that could reduce or eliminate U.S. estate tax liability on USRP for a non–U.S. domiciliary. Planning, of course, should not be done in a vacuum and would require assessing the effect of other factors, such as U.S. income taxes, taxes in the home country, creditor protection, privacy, legal compliance and maintenance of the entities, and administrative costs.

Editor notes

Kevin Anderson, CPA, J.D., is a managing director, National Tax Office, with BDO USA LLP in Washington, D.C.Contributors are members of or associated with BDO USA LLP. For additional information about these items, contact Anderson at 202-644-5413 or kdanderson@bdo.com.