INTRODUCTION

U.S. estate tax planning is said to be among the most complicated aspect of tax planning because of the numerous moving parts and the changing needs and objectives of the family. The exercise becomes complicated when the client is not a U.S. person, but the heirs live in the U.S. and have started families in the U.S.

This article is intended to guide an adviser in dealing with the specific issues that arise when a client has roots outside the U.S. and heirs in the U.S. It does so by setting up a typical fact pattern and then identifying 15 issues that are unique to this type of client. It is based on U.S. tax law currently in effect. The reader is cautioned that many provisions may change, possibly with retroactive effect.

FACT PATTERN

Mrs. Smith walks into your office. She advises that she is not a U.S. citizen and lives permanently outside the U.S. She does not hold a green card. Mrs. Smith has two adult children and several grandchildren. One child qualifies as a U.S. resident and the other is a citizen of the U.S. by naturalization.

Mrs. Smith seeks advice on how to structure her estate in order to reduce or eliminate U.S. Federal estate tax. Her assets include the following:

  • All the issued and outstanding shares of a corporation formed in her home country
  • A term life insurance policy issued by a U.S. insurance company
  • A house in a foreign country
  • All issued and outstanding shares of a U.S. corporation. The principal asset of the corporation is a condominium apartment located within the U.S.
  • All the furnishings for the condominium apartment that were purchased by Mrs. Smith and which have never been contributed to the U.S. corporation
  • A portfolio of publicly traded shares of U.S. corporations
  • A portfolio of publicly traded bonds
  • An automobile owned and registered in her name in the state where her resident child resides, which is used by that child

She has many concerns about U.S. estate tax, but does not know where to begin. Her daughters will inherit, but she wishes to provide for them during her lifetime.

She asks for your advice. Below are the 15 most important questions that should be asked and answered in fashioning a plan for her to minimize U.S. estate tax exposure - as it exists under current law - and to plan for tax issues she and her two daughters may face in the U.S.

15 ESTATE PLANNING QUESTIONS AND ANSWERS

  1. What properties listed above will be subject to U.S. estate tax for a foreign individual such as Mrs. Smith?

For an individual that is neither a U.S. citizen nor a U.S. resident for estate tax purposes ("an N.R.N.C. individual"), such as Mrs. Smith, the only assets that are subject to U.S. estate tax are assets having a situs in the U.S.1 This includes shares of a U.S. corporation, debt instruments issued by a U.S. person, unless specifically exempt, tangible personal property physically located in the U.S., and U.S. real property.

If an N.R.N.C. individual were to own U.S. situs property, the first $1,000,000 of taxable value will be taxed at graduated rates totaling in $345,800. Thereafter, the estate tax is imposed at a flat 40% rate at Federal level. A benefit can be claimed for a portion of global administration expenses and claims against the estate. However, direct tracing of expenses to various countries is not allowed for U.S. tax purpose. Rather, the percentage of the global estate that is situated in the U.S. controls the portion of global administration expenses and claims that reduce the gross U.S. estate. Note that deductions are allowed only if the executor files a true and accurate U.S. estate tax return that lists all of the gross estate situated outside of the U.S. There is no unlimited marital deduction for bequests to a surviving spouse. However, the estate tax can be deferred through the establishment of a Qualified Domestic Trust ("Q.D.O.T.") until a triggering event occurs. Finally, the unified credit that may be claimed by U.S. persons to eliminate estate tax on $11.7 million in 2021 is reduced to $60,000.

For Mrs. Smith, the shares of the U.S. corporation owning an apartment, the portfolio of publicly traded shares, the automobile, and the furnishings in the apartment are U.S. situs assets. Certain other assets owned are specifically treated as foreign situs assets, as discussed in the answer to the following question. For those assets that are considered to be U.S. situs assets, the estate tax in the U.S. can be burdensome.

  1. Are certain assets generally thought to be U.S. situs assets exempt from U.S. estate tax at the time of Mrs. Smith's death?

As a matter of tax policy, certain assets that would be considered to be U.S. situs assets under the general rule discussed in the answer to the preceding question are treated as foreign situs assets and for that reason are not subject to U.S. estate tax. These assets include the following:

  • Account balances in domestic U.S. banks and foreign branches of U.S. banks that are not connected to the conduct of a U.S. business by the N.R.N.C. individual2
  • Portfolio debt obligations for which interest income is not subject to U.S. tax under Code 871(h) for an N.R.N.C. individual, such as publicly traded debt instruments or privately issued debt obligations that meet certain conditions, of which the most important are that the instrument cannot be freely transferred by endorsement, the creditor cannot be related to the U.S. debtor as defined in the statute, and the rate of interest cannot be contingent because it is based, inter alia, on profits, cash flow, value of assets, and like items3
  • Short-term O.I.D. obligations, generally commercial paper or Treasury instruments having a term of 183 days or less from the date of original issue4
  • Insurance proceeds on the life of an N.R.N.C. individual5
  • Works of art on loan to a not-for-profit public gallery or museum in the U.S.6

For Mrs. Smith, the U.S. situs assets that are treated as foreign situs assets are the portfolio of publicly traded bonds and life insurance policy. While Mrs. Smith's taxable estate will not include the foregoing items, so that nothing need be done during Mrs. Smith's lifetime to restructure ownership, her executor may face a practical problem for account balances with banks and investment portfolios held in street name by financial institutions. These institutions may refuse to release assets to Mrs. Smith's executor until such time as a closing letter is issued by the I.R.S. regarding satisfaction of estate tax liability, if any. Anecdotally, advisers have complained that the I.R.S. has taken up to two years to issue a closing letter even when the estate of an N.R.N.C. individual is involved, and the assets have a foreign situs. Consequently, it may be prudent for Mrs. Smith to raise the matter with all banks and financial institutions she uses. If written assurances are not received, it would be prudent to move the investments.

  1. Are all items of U.S. situs property that are subject to U.S. estate tax at the time of Mrs. Smith's death subject to gift tax if given away during her lifetime?

No. In comparison to estate tax which covers all U.S. situs assets other than those treated as foreign situs assets, U.S. situs intangible property is not subject to gift tax when given away during life.7 For purposes of the U.S. Federal gift tax, intangible property is not defined in the Internal Revenue Code. Over the years, various rules have developed. Some of these are as follows:

  • Cash money and currency in physical form are items of tangible property, and gift tax will be due if gratuitously transferred in the U.S. by an N.R.N.C. individual.8
  • Treasury Regulations discussing the situs of property in the context of gifts or bequests by foreign individuals state that intangible personal property consists of a "property right," and includes stocks, bonds, and debt obligations, including bank deposits.9
  • In Private Letter Ruling 7737063, the I.R.S. stated that intangible property refers to choses in action10 such as corporate stock, bonds, notes, bank deposits, patents, partnership interests, goodwill, but not to physical cash.

Note that no unified credit is allowed for gifts made by an N.R.N.C. individual. However, the $15,000 annual exclusion for gifts to each recipient remains applicable to an N.R.N.C. individual. There is no unlimited marital deduction for an N.R.N.C. individual in connection with gift tax. However, the $15,000 annual exclusion for an interspousal gift is increased more than tenfold. In 2021, the amount is $157,000.

For Mrs. Smith, the shares of the U.S. corporation owning the apartment, the portfolio of publicly traded shares of U.S. corporations, the portfolio of publicly traded bonds, and the life insurance contract can be given away without triggering the obligation to pay U.S. gift tax.

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Footnotes

1. Code §2103.

2. Code §2105(b)(1).

3. Code §2105(b)(3).

4. Code §2105(b)(4).

5. Code §2105(a).

6. Code §2105(c).

7. Code §2501(a)(2).

8. Blodgett v. Silberman, 277 U.S. 1 (1928). Rev. Rul. 55-143.

9. Treas. Reg. §§25.2511-3(b)(3), (4).

10. A chose in action is a right to sue. It is an intangible property right recognized and protected by the law, that has no existence apart from the recognition given by the law, and that confers no present possession of a tangible object.

Originally Published 27 May 2021

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.