The U.S Gift and Estate Tax
We previously wrote about determining status for estate and gift taxes - http://www.mooresrowland.tax/2019/12/determining-status-for-estate-tax.html
There's a great chart in this article here - http://www.mooresrowland.tax/2015/01/lets-talk-about-gifts.html
The U.S Estate Tax is imposed on the “Gross Estate” of U.S Citizens and U.S residents.
This phrase, “wherever situated”, imposes the Estate and Gift Tax on “worldwide assets “. The Estate Tax and the Gift Tax attach to all assets regardless of the location of U.S citizens or resident (or his property) at the time of gift or death. Citizens and non-citizens residents are afforded a unified credit against Estate and Gift Tax, which currently “shields” assets. No Gift Tax or Estate Tax is actually payable by U.S citizens and residents until the value of lifetime gifts and bequests exceed the unified credit.
Transfers Between U.S. Citizens Spouses
U.S citizens may delay the imposition of either the Gift Tax or the Estate Tax transfer between citizens spouses.
Such transfers may be accomplished during life or at death and either by outright gift or through gifts in trust (for the benefit of the other spouse).
The first spouse to die may leave his or her entire estate to the surviving U.S citizen spouse without triggering the Estate Tax (payable on the death of the second spouse). Thus, any Estate Tax owed by the first spouse to die may be delayed (by devising the deceased’s estate to the surviving spouse). This concept is known as the “unlimited” marital deduction.
A U.S citizen or resident may also “port” his or her individual exclusion amount to the surviving spouse. Any exclusion amount not used by the first spouse to die (by lifetime and testamentary non-spousal gifts) may therefore be transferred (or “ported”) to the qualifying surviving spouse. The total amount of property excluded from the Estate tax may therefore be “pooled” by the U.S spouses (and applied against the taxable estate of the second spouse to die).
Certain limitations are, however, imposed on the marital deduction for property transferred to a non-U.S citizen spouse (even if the recipient spouse is a U.S resident).
TESTAMENTARY TRANSFERS TO NON-CITIZEN SPOUSES
Marital Deduction For Bequests
The marital deduction on testamentary transfers to non-citizen spouses is restricted. If the surviving spouse is not a U.S is not a U.S citizen, the survivor may not generally receive a bequest (of the deceased spouse’s estate) tax-free. The restriction is intended to limit the risk that the surviving (even if a U.S. resident) leaves the U.S. with a taxable estate. A shift in domicile would allow for avoidance of Estate tax, as the survivor (with the assets) could permanently leave the U.S. and elude Estate Tax on “worldwide” assets.
Qualified Domestic Trusts
Any U.S. citizen or U.S resident with a U.S. estate may defer Estate tax on testamentary transfers to a non-citizen spouse through a special trust. The grantor spouse must leave his or her estate to a “Qualified Domestic Trust” (“QDOT”), as a condition to a receiving the marital deduction. Only through the QDOT may Estate Tax be deferred until the death of the non-citizen surviving spouse.
If the non-citizen surviving spouse becomes a U.S citizen before the deceased’s Estate Tax return is filed, direct bequests to the survivor will qualify for the marital deduction. If the surviving spouse later becomes a U.S. citizen, all QDOT assets may then be distributed directly to the survivor (free of tax, through the marital deduction).
To qualify for the marital deduction, the QDOT must
(i) be executed under the U.S. law,
(ii) have at least one trustee that is a U.S. corporation, and
(iii) not allow distributions unless the trustee has the right to withhold tax on transfer from the trust to the surviving (non-citizen) spouse.
The executor of the first spouse to die must elect to treat the trust as a QDOT and pass property directly to the QDOT.
Any distribution of principal from the QDOT to the non-citizen surviving spouse are subject to the Estate tax at the time of distribution. Any principal remaining upon the death of the non-citizen spouse will also be subject to Estate Tax (as part of the estate of the first spouse to die).
Treasury regulations permit a modified “portability” election to be made (to allow a surviving non-citizen spouse to utilize the deceased’s unused Estate Tax exemption). Estates of non residents non citizens (or NRNCs) may not, however, elect portability.
The modified portability credit (applied through the QDOT) delays imposition of Estate Tax until the death of the second (non-citizen) spouse. Upon the death of the non-citizen spouse, the first spouse’s unused Estate Tax exemption is applied. The determination of the amount of exemption (left by the first spouse to die) available to the non-citizen spouse involves a series of valuation procedures. The formula is influences by the appreciation or depreciation of assets in the QDOT.
Rules of administration exempt the QDOT from “foreign trust" (and the associated onerous reporting requirements).
LIFETIME GIFTS TO CITIZEN AND NON-CITIZEN SPOUSE
Only citizens enjoy an unlimited deduction (i.e., no tax imposed) for lifetime spousal gifts. Similar to the restriction on tax-free testamentary gifts to non-citizen spouses, tax-free lifetime gifts are also limited.
If the spouse receiving a lifetime gift is not a U.S. citizen, the gifting spouse may only deduct $147,000 in tax-free spousal gifts during any calendar year.
The limitation on lifetime gift applies even if both spouses are domiciled in the U.S. the time of the gift. The domicile of both the donor and done is irrelevant. Annual lifetime gifts to non-citizen spouses are taxed on value exceeding $147,000. Interestingly, the limitation on gifts ton non-citizen spouses does not limit tax-free gifts by non-citizen spouses to a U.S. citizen spouse.
A NRNC considering U.S. residency should make any intended large spousal gifts of foreign property and U.S. intangible property before moving to the U.S. Once domiciled in the U.S. (with a non-citizen spouse), the (now U.S.) grantor is subject to the Gift Tax on all assets held worldwide. The U.S. grantor spouse then faces the $147,000 limitation on tax-free spousal gifts. This leaves the U.S. spouse the options of
(i) applying his or her remaining Estate Tax and Gift Tax exclusion (against gifts exceeding the limitation) or
(ii) deferring the gift until death.
Deferral until death of the U.S. spouse will potentially avoid Gift and Estate Tax entirely through either
(i) a testamentary QDOT trust or
(ii) applying the grantor’s Estate Tax Credit (to the extent sufficient to cover the value of the gift).
ESTATE TAX IMPOSED ON NON-RESIDENT NON CITIZENS
Property “Situated in the United States”
The Estate Tax imposed on NRNCs is limited to property owned “which at the time of the NRNC’s death is situated in the United States”. The U.S. taxable estate of a NRNC also includes U.S. assets held in a foreign or U.S. trust generally controlled by or accessible to the NRNC.
To avoid the Estate Tax, the NRNC should avoid having assets “situated” in the United States.
To determine where an asset is “situated”, one must first look to the U.S Treasury Regulation which deem certain assets U.S “situs” property. Such assets (deemed located in the U.S.) include U.S. real estate, stock in U.S, corporations and certain tangible personal property. Determining the “situs” of other assets is a more factual inquiry. Factors include the owner’s rights to the assets and the connections between the asset and a given country.
Rate of Estate tax and Credit
The rate of Estate Tax imposed on NRNCs is identical to that imposed on U.S. citizens and U.S residents. The Estate Tax credit for NRNCs is significantly lower than the credit allowed U.S. citizens and residents.
NRNCs are allowed only a $13,000 credit against the Estate Tax (which shields $60,000 of U.S. situs property). The credit may not be applied against taxable gifts.
Marital bequests are not taxable but non-citizen spouses must receive testamentary gifts through a QDOT trust. The estate of a NRNC may not elect portability of any unused Estate tax credit to the surviving spouse.
GIFT TAX ON NON-RESIDENT NON-CITIZENS
NRNCs are subject to U.S. Gift Tax on U.S. assets. Intangible assets are, however, excluded.
A non-resident non-citizen may therefore make unlimited gifts to U.S. stocks and bonds free of Gift Tax.
Although neither Congress nor the IRS has defined “intangible property”, case law allows for certain generalizations. Assets whose value is derived from contract law or a cause of action similar to contract law are considered intangible property. Such assets include annuities, shares of stock, membership interests and other entity ownership rights. Life insurance policies and bank deposits also qualify as intangible property.
Interestingly, if U.S. securities (or other intangible U.S. assets) are not given away (before death), they become subject to Estate Tax upon the NRNC owner’s death. To minimize Estate Tax (ultimately payable on death), NRNCs should make lifetime transfer of U.S. intangible property.
NRNC gifts of tangible U.S. property are taxed to the extent of value exceeding $14,000 (per donee per year). Smaller gifts fall within the annual Gift Tax exclusion. Unlike gifts made by U.S. residents or citizens, Gift Tax incurred by NRNCs may not be avoided y offset against the Estate Tax credit.
There are also significant restrictions on tax-free lifetime gifts to non-citizen spouses. The most significant is the absence of the “unlimited” lifetime marital deduction.
UNIQUE ASSET CONSIDERATIONS FOR NON-RESIDENT NON CITIZENS
Transfers of Intangible Property
As noted above, U.S. Gift Tax does not apply to lifetime transfers of “intangible property’ by NRNCs. The rule allows for avoidance of Estate Tax through lifetime gifts of U.S. intangible property (otherwise subject to Estate tax upon the death of the NRNC). NRNCs may therefore reduce their taxable estate by making lifetime transfers of U.S intangibles. Certain U.S. intangible assets are, however, excluded from Estate Tax (even if owned by the NRNC at death). These exclusions are integral to U.S. Estate Tax planning for NRNCs.
Cash deposits by NRNCs in U.S. banks are not subject to Estate Tax, provided the deposits are “not effectively connected with the conduct of trade or business in the United States”65. Deposits connected with a U.S. trade or business are excluded from Estate Tax if held in foreign or offshore branches of domestic banks. Deposits at a U.S. branch of a foreign bank are, however, subject to Estate Tax. To quality as a bank “deposit”, the account must be maintained “in behalf of or ‘for’ the decedent”, meaning that the decedent must have had a direct and enforceable claim on the account”.
This direct and enforceable claim concept is address in the case of Estate of Ogarrio v. C.I.R. In that case, the decedent, a non-resident Mexican citizen, was owned money by a brokerage house (from a stock sale). The brokerage house put the proceeds of the sale into a general account, from which the broker could pay a variety of obligations (not merely its obligation to disburse proceeds to the decedent). The decedent’s estate argued that the “cash account” constituted an excluded “deposit” (not subject to Estate Tax).
The Tax Court ruled that the brokerage house was not a bank, concluding that the “cash account” was not a deposit account but rather a general liability of the brokerage to the decedent. The decedent had only a general claim against the debtor for non-payment (rather than an enforceable claim against a specific account).
To establish an exempt bank account, the decedent must own or control the account (i.e., have the right to unfettered demand of funds held in the account).
This position is supported by the case of Estate of Gade v. C.I.R which expanded the meaning of “deposit” from conventional savings and checking accounts to custodial accounts. The decedents in Gade opened an account with a trust company and executed an agreement which made the trust company both the agent and custodian of the account. The court concluded that, although the trust company managed the funds, the decedent’s directives (in the agency agreement) qualified the account as a “deposit”.
Note that a “deposit” is distinct from dollar bills on hand in a physical location. Money is generally treated as a tangible assets which (if transferred by a NRNC in the U.S.) is subject to Gift Tax (on transfer) and Estate Tax (on death). Gifts of paper currency by a NRNC should therefore be made outside the U.S.
U.S. bonds considered so-called “portfolio debt” are excluded from Estate Tax. Although the definition of portfolio debt is somewhat ambiguous, bond issued by the U.S. entities are not generally included in the taxable estate of a NRNC.
Life insurance proceeds received by the estate of NRNC are not subject to Estate Tax. The Internal Revenue Code explicitly states that life insurance proceeds insuring the life of a NRNC “shall not be deemed property within the United States”. Proceeds are therefore not included in the estate of the NRNC owner/insured .This makes life insurance a very attractive asset.
The life insurance exclusion does not apply to the cash surrender value of insurance. If a NRNC owns a U.S. situs policy on the life of another person (even a family member), the value of the policy forms part of the owner’s taxable U.S. estate. Life insurance policies are treated as U.S. situs property if issued by a U.S. insurers outside the U.S. (to avoid owning a taxable U.S. situs asset at death).
Direct ownership of U.S. life insurance on another person may be avoided by holding the policy in a foreign entity.
If life insurance is owned by (and benefits) a foreign corporation, neither the cash value nor the payment of proceeds to the owner (upon the death of the insured) creates a taxable event.
This is the case because life insurance proceeds are not subject to income tax and the foreign entity (owning valuable life insurance) has no taxable estate.
SHIFTING ASSETS FROM U.S. SITUS
Although lifetime gifts of U.S intangibles by NRNCs are exempt from Gift Tax, all U.S. situs assets (both tangible and intangible) are taxable upon the death of a NRNC owner.
Those same assets held in a foreign corporation are, however, excluded from Estate Tax.
Shares of corporate stock in a foreign entity held by a NRNC are subject to neither Gift Tax nor Estate Tax.
Treasury Regulation indicate that the “situs” of an entity is determined by looking at the place where the entity is created or organized. The regulations further state that this test applies “irrespective of the location of the (ownership) certificates”. Consequently, shares of stock owned by the decedent in a U.S. entity are subject to Estate Tax. Conversely, ownership by a NRNC in foreign corporate entity (if properly organized) is not subject to Estate Tax.
Real property has situs in the jurisdiction in which it is located. Consequently, U.S. real estate (a tangible asset) is included in the taxable estate of a NRNC.
If real estate is instead owned by a foreign corporation (itself owned by the NRNC), the property is excluded from the Gift Tax and Estate Tax.
The NRNC acquiring U.S. real estate should initially do so through a foreign corporation. If U.S. real estate is initially purchased directly by the NRNC, later transfer of the property to an offshore corporation could have tax consequences. Appreciated U.S. real estate held by a NRNC will trigger taxable gain upon transfer to a foreign corporation.
Unlike the rules regarding corporate stock, the situs rules for a foreign entities taxed as partnership are ambiguous. The limited case law suggests that a factual examination of the partnership’s assets and business activities is necessary to determine the situs of the partnership. The IRS will not rule the issue of how foreign partnership interests will be characterized in the hands of NRNCs.
The clarity of the situs rule on “corporate” stock makes the use of foreign limited liability companies (“LLCs”) an attractive option. The LLC is generally more protective of owner equity than the corporation. Although LLC membership interests are not identical to corporate stock, Treasury Regulations treat foreign LLCs as corporations for tax purposes (unless the LLC elects otherwise) if all members have limited liability. If any of the members do not have limited liability, the default rules treat the LLC as a tax partnership. Establishing limited liability is typically not difficult.
If a foreign LLC is treated as a corporation for tax purposes, ownership interests in the LLC are not U.S. situs property and may be transferred tax-free by NRNCs during life or at death. One planning technique is to own real estate through a foreign LLC (itself owned by the NRNC or a foreign entity). Such structure moves the situs of ultimate ownership offshore (avoiding Estate and Gift Tax). In the case of appreciated real estate (and other U.S. assets subject to gain tax), no tax is payable on appreciation until the property itself (irrespective of the entity owner) is sold.
Here's something else we wrote on investing in the US –