With the tremendous amount of wealth transferring into and out of the United States, more and more CPAs are encountering clients with international ties. Whether it is a U.S. citizen with international ties to family, business, or real property, or a U.S. nonresident seeking to immigrate to the United States or acquire U.S. property, these clients bring with them a host of international questions, issues, and potential liability for their advisers.
Although working with these clients can become quite complicated, many of the most crucial issues in the transfer tax arena (i.e., gift, estate, and generation-skipping transfer (GST) taxes) are basic issues that are often overlooked. When advising a client with international ties, the CPA should ask introductory questions to be able to provide comprehensive tax planning advice.
The following is a list of questions that will assist CPAs in spotting the transfer tax planning opportunities that their international clients may have now or in the future. These questions focus on planning, not reporting requirements or compliance, which have been thoroughly discussed in past JofA articles.
1. Is the client a U.S. citizen? If the client is not a U.S. citizen, is he or she currently living in the United States with no present intention to leave?
This question introduces the client to the concept of U.S. residency for U.S. transfer tax purposes. One issue that is often misunderstood is that the test applied to determine if an individual is a U.S. resident for transfer tax purposes is different from the test applied to determine if an individual is a U.S. resident for income tax purposes. As a result, an individual could simultaneously be “domiciled” in the United States and subject to U.S. transfer taxes while also being a U.S. nonresident who is not subject to U.S. income taxes. Clients and their advisers must understand the distinction between the two residency tests before any other planning is considered.
For income tax purposes, the test for whether an individual is a U.S. resident is found in Sec. 7701(b). In brief, an individual is a U.S. resident for income tax purposes if he or she meets one of three requirements: the “green card” test, the substantial presence test, or the first-year election test. While an in-depth analysis of each test is outside the scope of this article, these tests are bright-line tests based on specific requirements for days present in the United States and legal residency status.
For transfer tax purposes, however, the residency test is a facts-and-circumstances test based on the concept of domicile. An individual is subject to transfer taxes if he or she is a U.S. citizen or is domiciled in the United States at the time of the transfer (i.e., at death for estate tax purposes or at the time of the gift for gift tax purposes). An individual is domiciled in the United States if he or she “acquires a domicile in [the United States] by living there, for even a brief period of time with no definite present intention of moving therefrom” (Regs. Sec. 25.2501-1(b) (gift tax regulations)).
Since the question of domicile is a facts-and-circumstances test, the CPA should inquire about the client’s intention to remain in the United States, as well as about other facts that suggest domicile, such as the client’s employment history, the situs of real property owned, and the extended family’s country of residence. (The remainder of this article refers to an individual who is a noncitizen and a nondomiciliary as a “nonresident” and an individual who is a U.S. citizen or U.S. domiciliary as a “resident.”)
2. If the client is a nonresident for transfer tax purposes, does he or she plan to acquire U.S.-sitused property in the future?
Most nonresidents who seek a CPA’s advice plan to acquire U.S. assets. While residents are subject to U.S. transfer taxes on their worldwide assets, the rules for nonresidents are based on the “situs” of their assets under Sec. 2103. Examples of U.S.-sitused assets are real property and tangible personal property located in the United States.
For nonresidents, the estate and gift tax exemptions are much smaller than the exemptions for residents. The exemption for residents is currently a unified amount of $5,430,000 for estate and gift taxes, with amounts in excess taxed at 40%. For nonresidents, the estate tax is assessed at the same 40% rate, but with only a $60,000 exemption under Sec. 2102(b). For gift tax purposes, there is only the $14,000 annual exclusion for gifts of a present interest.
Because of the modest $60,000 estate tax exemption for nonresidents, preparation is paramount for the nonresident seeking to acquire U.S.-sitused property. If the nonresident client intends to purchase property in the United States, the adviser should analyze whether the asset can be acquired in a form of ownership that is not deemed sitused in the United States and thus not subject to U.S. transfer taxes.
For example, consider a nonresident who plans to purchase a vacation home in the United States. Since this individual is a nonresident for transfer tax purposes, U.S. transfer taxes will generally not apply to the estate, but since this vacation property is sitused in the United States, it will be subject to U.S. transfer taxes. However, this client could purchase the U.S. real property through a foreign corporation. An interest in a foreign corporation is not “U.S. sitused” property, and, as a result, the property would not be subject to U.S. transfer taxes upon death. Even here, though, the CPA must consider the income tax, withholding requirements, and other planning issues associated with owning U.S. real estate through a foreign corporation.
3. If the client is a resident for transfer tax purposes, are his or her parents residents and, if not, do they plan to transfer significant wealth to the client by gift or inheritance?
A number of recent immigrants who are residents have parents living overseas with a significant amount of wealth that they intend to transfer to their children. Because U.S. transfer taxes do not apply to the nonresident parents, certain techniques should be used in the parents’ estate plan to significantly reduce the U.S. transfer taxes that will be due when the client dies.
As discussed above, nonresidents are not subject to U.S. transfer taxes unless the assets are in the United States. Therefore, a nonresident parent who owns considerable property outside the United States could transfer those assets to the child with no U.S. transfer tax implications. However, if these assets are transferred directly to the child, then, when the child dies, they will be subject to U.S. transfer taxes.
To avoid this result, the parents could establish and fund a trust for the child’s benefit with the parents’ non-U.S. assets. This trust would not be subject to U.S. gift, estate, and, most importantly, GST taxes. Because the parents are nonresidents, they could transfer an unlimited amount of assets to a trust for the benefit of the child, and those assets could pass from generation to generation free from U.S. transfer taxes. Of course, transfer tax implications for the parents that may arise in their home country will also need to be evaluated and may require the assistance of a tax adviser in that country.
4. Does the client have a noncitizen spouse?
A marriage between a U.S. citizen and a non-U.S. citizen (regardless of whether the spouse is a U.S. domiciliary) creates a host of transfer tax issues that are not present in marriages between U.S. citizens. In a marriage between U.S. citizens, one spouse can make unlimited tax-free transfers during life or at death to the other spouse as a result of the marital deduction that applies to transfers between spouses. Unlike the treatment in marriages between U.S. citizens, however, the marital deduction does not apply to transfers from a resident spouse to a noncitizen spouse.
For estate tax purposes, the lack of a marital deduction for transfers to a noncitizen spouse means that all of the assets in the resident spouse’s estate that pass to the noncitizen spouse will be taxable. In addition, the full value of assets that are jointly held with the noncitizen spouse is included in the resident spouse’s estate if the resident spouse dies first and contributed all of the assets to the jointly held property. For example, in 2015, if the resident spouse plans to leave assets of more than the estate tax exemption of $5,430,000 to the noncitizen spouse, then the amount in excess of $5,430,000 will be subject to federal estate taxes at a rate of 40%.
To avoid this result, the resident spouse can establish a qualified domestic trust (QDOT) under Sec. 2056A in the estate plan for the benefit of the surviving spouse. Assets that pass to a QDOT qualify for the marital deduction under Sec. 2056(d)(2)(A); however, the assets will ultimately be subject to U.S. estate taxes at the survivor’s death. A QDOT can be quite cumbersome to administer and may place greater restrictions on the survivor’s access to the assets than the couple would otherwise prefer.
For a client who prefers the surviving spouse to have greater access to his or her assets, a CPA should consider the following options. First, the surviving spouse will qualify for the marital deduction (and eliminate the need for the QDOT) by becoming a U.S. citizen before filing the estate tax return. This may be difficult to accomplish unless the naturalization process began before the resident spouse died. More practically, however, the QDOT can be terminated and all assets paid to the surviving spouse if he or she becomes a U.S. citizen at any time after the estate tax return is filed.
A second option for the resident spouse is to consider purchasing a life insurance policy through an irrevocable life insurance trust for the benefit of the surviving noncitizen spouse. If the life insurance policy is structured properly, the death benefit will not be included in the resident spouse’s estate, and the surviving spouse would have full access to the funds without the need for a QDOT.
The third option for the resident spouse is to transfer wealth to the noncitizen spouse through annual exclusion gifts. Under Sec. 2523(i), in 2015, a resident spouse can make annual gifts of up to $147,000 to a noncitizen spouse, exempt from transfer taxes.
5. Are the client’s parents or any other family members planning to immigrate to the United States?
Many recent U.S. immigrants have family members overseas who also plan to immigrate to the United States. Because U.S. transfer taxes likely do not apply to a significant amount of the family members’ assets, a tremendous amount of planning can be accomplished before their immigration to the United States, to reduce U.S. transfer taxes. Again, preparation is the key here.
Similar to the parents of a resident making gifts to irrevocable trusts for the resident’s benefit, people planning to immigrate to the United States should consider making large gifts to family members in trust before they establish domicile and are subject to U.S. transfer taxes. A person planning to immigrate to the United States who does not want to lose access to assets should consider establishing an irrevocable trust in a jurisdiction that has an “asset protection” statute and name himself or herself and the family members as discretionary beneficiaries of the trust. That structure will give the immigrant access to the assets while also removing him or her from the estate for U.S. estate tax purposes.
In an increasingly global world, more and more practitioners have clients with dealings both inside and outside the United States. It is important to ask these clients the right questions to be able to help them plan to minimize U.S. income and transfer taxes. Asking the above questions early on in the engagement is the best practice.