The Nassau Lawyer
ESTATE PLANNING FOR NON-CITIZENS
BY FRED J. COHEN
Attorneys practicing in the area of estate planning are ever more likely to confront clients who are either non-citizens or of ambiguous status, given the increasing pace of globalization, with New York serving as a major international center for business and a magnet for immigrants. It is important to be aware of the myriad of special rules and exceptions that significantly impact planning strategies for such clients. While this article focuses on matters affecting estate planning and transfer taxation, the estate planner should also take into account the income tax effects of any proposed strategy for such clients, perhaps with the aid of a qualified tax professional.
While income taxes are generally imposed on citizens and residents alike, the United States is one of the few industrialized nations that imposes transfer taxes (estate, gift and generation skipping) on the basis of citizenship. Because of the important transfer tax consequences of citizenship status, it is imperative to inquire into this area before proceeding with any planning strategy. It is not unusual to find that a client who speaks impeccable English, without a trace of an accent, to in fact be a resident alien from Canada or South Africa. It is advisable to always take note of the citizenship status of clients to prevent malpractice.
A person is a citizen if he or she was born in the United States, Guam, Puerto Rico, or the U.S. Virgin Islands or within 12 nautical miles from shores thereof. The major exception to this rule applies to embassies, consulates or anywhere else outside the jurisdiction of the United States.
Persons born outside the United States to parents who are both U.S. citizens, (at least one of whom has resided the in the U.S. prior to the child's birth) are also US citizens. 8 USC §1401. Lastly, a person may also attain U.S. citizenship by undergoing the naturalization process. Once the client's citizenship status is ascertained, it is important to determine whether the client holds citizenship under the laws of another country.
International Tax Conventions
If the client is a resident or citizen of another country, an inquiry needs to be made to determine whether the United States has a tax convention or treaty with that country. The United States has estate tax treaties with Australia, Austria, Canada, Denmark, Finland, France, Germany, Greece, Ireland, Italy, Japan, Netherlands, Norway, South Africa, Sweden, Switzerland and United Kingdom. While each of these treaties have their own peculiarities reflecting local sensitivities and the prevailing status of geopolitics, their primary purpose is the establishment of a domicile for the prevention or mitigation of double taxation. Such treaties should be studied carefully to ascertain the level of tax relief which may be afforded to the client. You will recall from your Constitutional Law class that the terms of such treaties are overriding to the extent they conflict with federal, state or local law.
If a person is a citizen or permanent resident alien (PRA or "green card holder") of the United States, he or she is subject to estate and gift tax on their worldwide assets. If the client is neither a citizen or PRA, he or she is considered a non-resident alien (NRA). Even NRAs may be subject to U.S. transfer taxation on their worldwide assets if they are U.S. domiciliaries with physical presence in the U.S. and intent to remain herein. While determination of such "residence" based on domicile can be subjective, there are a number of objective factors that may be considered including the location of the client's residence, family and employment. Once residence is established on the basis of domicile, it no longer matters if the person actually continues to remain in the United States. U.S. transfer taxes will apply to transfers made by such domiciliaries regardless of where they live (or die) and regardless of the fact that all of the assets are situated outside the United States. Note that this is an entirely different "residency" test than the "count the days" test used for income tax purposes.
Non-resident aliens who do not otherwise qualify for transfer tax "residence" cannot qualify for the full estate tax applicable exclusion ($2M in 2007) and instead enjoy a relatively meager $60,000 exclusion. There are a number of important rules with respect to assets that have significant transfer tax consequences for NRAs. Specifically, NRAs are subject to federal gift and estate tax only on U.S. property they directly own, not on property they own through foreign corporations. Furthermore, NRAs enjoy an exemption on life insurance proceeds, U.S. bank deposits and U.S. debt obligations. IRC §2105. Perhaps most importantly from a planning perspective, NRAs can shelter virtually all their assets from federal estate taxation by transferring their U.S. assets, including real property, to non-U.S. corporations. It is advisable that such non-U.S. corporations engage in various other business transactions to preclude the Service from disregarding such entities as shams. Lastly, income and potential foreign tax consequences of such transfers should be evaluated, preferably with the aid of local counsel to assure the most tax efficient outcome for the client.
NRAs are subject to gift taxation only to the extent that such property is tangible and situated within the United States, such as real property and physical currency. IRC §2501. Otherwise, they can make unlimited gifts of U.S. financial assets completely free of gift and GST taxes. Interestingly, if the NRA, prior to making a gift of such currency, converts it to an intangible form, such as a checking account, such transfer is no longer technically subject to taxation, though the Service may disregard it as a step transaction. NRAs do qualify for the annual exclusion.
Transfers to non-citizen Spouses
Unlike citizen spouses, spouses who are non-citizens (PRAs and NRAs) cannot qualify for the unlimited marital deduction which allows married couples to leave an unlimited amount of assets to one another upon the death of the first spouse without the imposition of estate taxes.
There are two primary strategies can be implemented to eliminate or minimize estate taxes depending on the value of assets owned by the spouses.
The first strategy involves gifting. The estate of a non-citizen spouse can be increased by having the citizen spouse gift property, with an annual maximum of $120,000 (in 2007), until both spouses have less than the applicable exclusion amount. Assume the citizen wife owns $2,200,000 in assets and non-citizen husband owns $300,000. If the wife gifts $120,000 this year and next year to her non-citizen husband, her estate would be reduced to $1,960,000, an amount less than the $2,000,000 exemption, thereby allowing the full value of her estate to pass tax free to her intended beneficiaries. Without such planning, her estate could have been subject to over $80,000 in federal estate taxes.
Another strategy involves the use of a Qualified Domestic Trust, or QDOT. Congress was concerned that a non-citizen spouse could receive a tax-free bequest from a deceased spouse through the marital deduction and whisk away that wealth to foreign lands, avoiding estate taxes on the deceased spouse's property. To prevent such an occurrence, Congress authorized the use of QDOTs which preserve the unlimited marital deduction for bequests to a non-citizen spouse, with some restrictions, resulting in a deferral of the estate taxes until the death of the surviving spouse. The mechanics of the QDOT and the options available to such couples are complex and dependent upon a number of factors, including the size of the estate and the country of citizenship of the non-resident spouse. Specifically, at least one of the trustees of the QDOT must be a U.S. citizen living in the U.S. or a domestic corporation. No distributions from the corpus of the trust can be made without the approval of such trustee. Furthermore, the trustee is required to withhold potential estate taxes.
If no QDOT planning is implemented prior to death, the surviving spouse must irrevocably assign his or her assets to a trust meeting the QDOT requirements prior to the due date of the estate tax return. Without QDOT planning in place, in order to take advantage of the unlimited marital deduction a surviving spouse may also opt to become a U.S. citizen within nine months following the death of the first spouse. It is important to point out that the only time a QDOT should be used is when there is a need for a marital deduction, and the decedent's spouse is a non-citizen.
Joint Tenancy Creation
As a general rule, the establishment of joint property constitutes a completed gift to the extent of the difference contributed by the joint owners. This situation does not cause concern where both co-owners are citizen spouses because of the unlimited marital deduction for gift and estate taxes. To avoid potentially significant tax liabilities for couples of mixed citizenship, Congress modified the rule such that the creation of joint tenancy when one spouse is not a citizen is no longer deemed a completed gift.
Like citizens and residents of the United States, NRAs can get an unlimited estate tax or gift tax charitable deduction. The deduction is allowed even if the charitable bequest is made from assets that are not within the United States. IRC §2106(a)(2)(D). However, unlike citizens and residents, NRAs cannot take estate and gift tax charitable deductions for contributions to foreign corporate charities. The rules for income tax deduction of charitable bequests are significantly different and beyond the scope of this article.
Pitfalls to consider
Planning for the international client can be quite complex and should be handled with a heightened level of diligence. Here are some pitfalls that the planner should be aware of when developing a strategy for the international client. Transferring property to a trust fund, even if it's a intervivos grantor trust is typically a recognition event in most foreign jurisdictions, triggering capital gains, or other taxes in those countries. Additionally, the planner should be aware of statutory heirship laws which prohibit the complete disinheritance of spouse and/or issue in many civil law jurisdictions. Again, it is prudent to consult with foreign counsel whenever working with an international client to see whether planning strategies contradict foreign laws or trigger foreign tax liabilities.
Fred J. Cohen is a trusts and estates attorney with the law firm of Cohen & Schwartz LLP in Manhasset, NY.