By Patrick J. McCormick
Clients increasingly have international ties of some kind, whether (for example) from international holdings, dual citizenships, or overseas family members. International connections can create complications for practitioners when it comes to compliance and planning, as they must remember to consider ramifications that might arise in other jurisdictions.
This blog provides an overview of transfer tax rules for those in the United States with international ties, and discusses factors to consider when implementing a plan. It is critical to stress the care required, as plans that are optimal from a U.S. perspective can lead to disastrous results in other jurisdictions.
As an initial step when designing a transfer tax plan, a practitioner must determine the client’s level of tax exposure from a U.S. perspective. Citizens and residents are taxed on the transfer of their worldwide estate, whether by gift or bequest. An estate tax credit is available; for 2017, the estate tax exclusion is $5,490,000. After application of the exclusion, the estate is taxed federally at a rate of 40 percent.
An unlimited marital deduction usually is applicable on death, whereby a decedent can pass assets to his or her surviving spouse free of any tax. However, this is only available when the surviving spouse is a U.S. citizen. Where bequests are made to a noncitizen spouse, the aforementioned $5,490,000 exclusion is instead used (subject to estate tax treaty provisions, as discussed below).
A tax is also imposed for each calendar year on the transfer by citizens and residents of gifts of assets. Generally, the gift tax exclusion is unlimited for gifts between spouses, but as with the estate tax, this exclusion is inapplicable where the donee spouse is not a U.S. citizen. If the donee spouse is a noncitizen, an annual exclusion amount (not cutting into the aforementioned $5,490,000 exclusion amount) is available, with such amount set at $149,000 for 2017.
It is usually easy to determine whether an individual is a U.S. citizen, but ambiguity can exist regarding whether or not a noncitizen is classified as a U.S. resident. “Residency” for transfer tax purposes is not defined the same as “residency” for income tax purposes. For transfer taxes, an individual is treated as a U.S. resident decedent (for estate tax purposes) or resident donor (under gift tax rules) when the individual establishes his or her domicile in the United States. Factors considered include whether the individual held a green card, the length of stay in the United States, and the remaining connections to any prior country of residence.
Unlike citizens and residents, nonresident aliens of the United States are not subject to estate tax on worldwide assets, only on specified assets in the United States. However, the estate of a nonresident alien receives only a $60,000 exemption from taxation, with a maximum 40 percent rate of tax applicable. The estate tax is assessable on U.S. real estate, tangible personal property, securities of U.S. companies, and accounts with brokerage firms.
For gift tax purposes, nonresident aliens normally are subject to tax on lifetime gifts of tangible property located in the United States. Tangible property includes real property situated within the country, tangible personal property within the United States, and U.S. currency or cash situated within the United States. A nonresident alien (like a U.S. resident or citizen) can make gifts of up to $14,000 per donee per year without tax ramifications.
For nonresidents of the United States, a narrower scope is applicable for transfer tax purposes. Appropriate planning in this context (particularly when done before asset acquisition) can minimize transfer tax implications.
When planning, it is vital to obtain information on a client’s worldwide assets and worldwide connections. Clients often do not realize that worldwide assets can be subject to U.S. estate and gift tax. Additionally, the location of assets can have significant effects on their ultimate disposition.
As noted above, tax rules regarding transfers to a spouse are different based on the spouse’s citizenship. Where bequests are made to noncitizen spouses, the approach often advised is the use of a qualified domestic trust (QDOT). While the QDOT is beneficial in many instances, note that estate and gift tax treaty provisions can sometimes provide treatment to noncitizen spouses that gives better results from a U.S. perspective than usage of a QDOT.
Outside of treaties, for marital property to be passed to a surviving noncitizen spouse free of tax, a QDOT must be used, unless the surviving spouse was a resident of the United States at all times after the decedent’s death and becomes a U.S. citizen prior to the filing of the estate tax return. A QDOT trustee must be a citizen of the United States (or a U.S. corporation), the trust instrument must provide that principal distribution cannot be made unless the trustee withholds the estate tax amount imposable on the distribution, the trust must meet regulatory requirements for collection of tax, and the executor of the estate must elect to treat the trust as a QDOT.
Distribution of principal from the QDOT is subject to QDOT taxation unless an exception applies; when a taxable principal distribution occurs, the decedent’s estate tax is increased. Thus, the QDOT normally functions only as a method to defer estate taxes.
If a surviving spouse becomes a U.S. citizen then no QDOT estate tax is imposed on any distribution from a QDOT after the spouse becomes a citizen.
The QDOT functions to ensure payment of U.S. estate tax. From a planning perspective, it is advantageous to use the $149,000 annual exclusion for gifts to noncitizen spouses in planning during a client’s lifetime, as it allows for transfers between spouses without transfer tax ramifications.
Consultation of applicable estate and gift tax treaties is of great importance because of the potential benefits available.
One dramatic example in the noncitizen spouse context is contained in the estate and gift tax treaty between the United States and Germany. The treaty provides a marital deduction for qualifying spouses, even when the surviving spouse is not a U.S. citizen. Under the terms, the value of a decedent’s taxable estate is determined by deducting from the value of the gross estate an amount equal to the value of any interest in property that passes to the decedent’s surviving spouse and which would qualify for the estate tax marital deduction if the surviving spouse were a U.S. citizen. Such deduction is equal to the lesser of the value of the qualifying property or the applicable exclusion amount. Qualification depends on four factors:
Treaty benefits are not limited to nonresident spouses, and can provide relief under a multitude of circumstances. Consultation of treaty terms is, thus, vital for discovery of the best available results.
Numerous issues must be addressed in implementation of any plan, which must be evaluated in the context of the laws of all applicable jurisdictions. When assets held overseas are transferred, both the laws of the United States and of the country in which the assets are maintained are relevant. For example, in many countries the ability of a testator to transfer assets to persons of his or her choosing is severely restricted by statutory provisions, forcing the allotment of a certain share to designated parties (such as a spouse or a child). These rules can minimize the options a client has in making dispositions, altering the flexibility a client would have in disposing of other assets under U.S. rules.
From both a tax and functional perspective, a significant issue can exist regarding using trusts. In many countries (particularly those operating under civil law systems), trusts are not recognized. When transfers are made to trusts, these can sometimes be taxed at the highest rates for transfers. This can limit a trust’s utility and, in many cases, make usage entirely inappropriate.
Consideration of transfer tax rules in other relevant countries is also required. For example, in many countries inheritance taxes – rather than estate taxes – form the primary method of collecting tax on bequests. The residence of the testator may determine whether inheritance taxes are due only on property owned within the country or on worldwide bequests (including from persons with no connection to the country). Additionally, countries may have estate taxes but no gift taxes – an important consideration when devising a planning strategy.
The overarching issue is a need to customize the client’s plan to account for worldwide ramifications. Consultation with foreign counsel is of enormous benefit, as they are most familiar with their country’s laws and can best assess the impact of a plan formulated by U.S. advisers.
It is absolutely critical to evaluate any estate planning client on a worldwide basis to ensure results are optimized, both under the laws of the United States and those of all relevant jurisdictions. Strategies that are appropriate in the United States can create harsh results under the laws of other countries. Assessing a client on a global basis and involving outside counsel specializing in laws of relevant countries ensures that the best results from a worldwide perspective are obtained.
Patrick J. McCormick is an associate with Kulzer & DiPadova PA in Haddonfield, N.J. He can be reached at pmccormick@kulzerdipadova.com.
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