U.S. estate tax exposure for foreign nationals.

Foreign nationals who live and/or work in the U.S. should be aware of the particular rules that may apply to their estates. Certain tax-saving provisions applicable to U.S. estates, such as the marital deduction and inclusion of only half the value of jointly owned property, may not be available to the estates of foreign nationals or may be severely limited. This article examines these issues and offers planning strategies.

The U.S. generally taxes its citizens on their worldwide income under Regs. Sec. 1.1-1(b), regardless of their country of residence or source of income. Additionally, U.S. citizens pay Federal estate tax on their worldwide assets, without regard to the location of such assets.

A foreign national (i.e., a non-U.S. citizen) who qualifies as a U.S. resident for income tax purposes and is classified as a resident alien under U.S. tax law, is taxed virtually the same as a U.S. citizen. Once so classified, the foreign national becomes subject to income tax on his worldwide income. Many foreign nationals planning an extended stay in the U.S. often address the income tax issues through tax treaties with their home country or tax equalization or compensatory bonuses. However, the estate tax rules, which operate in a similar fashion, are often overlooked and can provide a trap for the unwary.

Background

The estate of a foreign national who dies while a U.S. resident may be subject to substantial U.S. estate tax on worldwide assets, including assets not accumulated during his stay in the U.S. or which otherwise had no connection with his presence in the U.S.

For 2000, the Sec. 2010(c) unified credit is $675,000 (and is scheduled to increase to $1 million by 2006). This constitutes a $675,000 exemption on both lifetime and post mortem transfers. Net assets in excess of $675,000 are subject to transfer taxes at rates varying from 37%-55%.

Most married U.S. citizens can avoid the imposition of the estate tax by leaving assets to their spouse. Assuming the assets qualify for the Sec. 2056 marital deduction, they will pass to the surviving spouse untaxed and will be subject to tax only on the surviving spouse's death. Thus, the effect of a premature or unexpected death can be mitigated by leaving $675,000 (i.e., the lifetime exemption) to children or other relatives, and the balance to the spouse.

Unfortunately, the same strategy is not available to a decedent whose spouse is not a U.S. citizen. Under Sec. 2056(d)(1)(A), the marital deduction is not allowed for bequests to noncitizen spouses; thus, the estate may be subject to substantial transfer taxes, despite the fact that the assets pass to the surviving spouse. Further, the treatment of jointly held property is also disadvantageous in the case of noncitizen spouses. For two U.S. citizen spouses, under Sec. 2040(b),jointly owned property is deemed to be owned 50% by each, regardless of who provided the funds for the property's acquisition. Thus, only 50% of the value of such property is includible in the decedent's gross estate. Because of the surviving spouse's right of survivorship, the asset transfer is generally eligible for the marital deduction. If the surviving spouse is not a U.S. citizen, Sec. 2056(d)(1)(B) provides that Sec. 2040(a), not Sec. 2040(b), applies; thus, the entire value of jointly owned property is included in the estate, unless it can be proven that the surviving spouse furnished a portion of the asset's acquisition cost. Moreover, the marital deduction does not apply.

Thus, an estate may be subject to tax on the entire value of jointly held assets, even though such assets were (1) accumulated prior to arrival in the U.S. and (2) acquired with the surviving spouse's personal funds, unless Sec. 2040(a) documentation requirements are met.

Accordingly, when a foreign national establishes a residence pursuant to a long-term tour of duty and both he and his spouse become U.S. residents, but not citizens, a significant transfer tax exposure results. Exhibit 1 illustrates the dramatic difference in estate tax consequences, depending on whether the surviving spouse is a U.S. citizen.

Exhibit 1: Estate tax comparison--citizen vs. noncitizen surviving spouse (death occurs in 2000)

Decedent's estate:                                Citizen

Assets not jointly held                        $2,000,000
Assets jointly held with surviving spouse:      1,000,000
  Reductions permissible under Sec. 2040(b)     (500,000)
  Reductions meeting Sec. 2020(a)
    documentation requirements                         --
Administrative cost and other deductions        (100,000)
Maximum marital deduction                     (1,725,000)

Taxable estate                                   $675,000

Tax                                              $220,550
Unified credit                                  (220,550)

Net tax                                                $0

Decedent's estate:                            Noncitizen

Assets not jointly held                       $2,000,000
Assets jointly held with surviving spouse:     1,000,000
  Reductions permissible under Sec. 2040(b)           --
  Reductions meeting Sec. 2020(a)
    documentation requirements                         0
Administrative cost and other deductions       (100,000)
Maximum marital deduction                              0

Taxable estate                                $2,900,000

Tax                                           $1,237,800
Unified credit                                 (220,550)

Net tax                                       $1,017,250

Concept of Residency

From Exhibit 1, it can be seen that classification as a U.S. resident is critical. The residency test for transfer tax purposes differs from the Sec. 7701(b) residency test for income tax purposes, which is based largely on physical presence. For transfer tax purposes, residency relies on the concept of domicile, which requires a physical presence and an intention to remain in the U.S., under Regs. Sec. 20.0-1(b).

While physical presence is relatively easy to determine, intent to remain is somewhat less clear and, thus, introduces an element of uncertainty. The following factors are normally used to determine intent to remain in the U.S.:

* Length of stay.

* Visa and other immigration representations and documents.

* Representations made to tax and governmental officials, both in the U.S. and the home country.

* The nature of U.S. housing (rental versus ownership).

* Location of family members.

* Location of principal business interests, social club affiliations, religious affiliations, etc.

* Extenuating circumstances regarding health, war or political repression in the home country, and similar issues that may indicate intent.

Planning Considerations

Checklist

The following is a checklist of considerations for foreign nationals to avoid U.S. estate tax:

Pre-residency planning: Before a foreign national becomes a U.S. resident, transfer tax planning options in conjunction with his home country should be considered. This is often accomplished in conjunction with income tax planning techniques (e.g., selling/reacquiring assets to obtain a stepped-up basis, or making classification (i.e., check-the-box) elections or taking other actions to address controlled foreign corporation (Sec. 951 et seq.), foreign personal holding company (Sec. 551 et seq.) or passive foreign investment company (Sec. 1291 et seq.) issues). Clearly, this should include consideration of lifetime transfers that might otherwise be subject to U.S. gift or generation-skipping tax if made by a resident. Caution should be exercised if these activities involve the use of foreign trusts. Under Sec. 679(a)(4), if a nonresident alien grantor creates a trust, then becomes a U.S. resident within five years of the transfer, the trust may be a grantor trust if it has U.S. beneficiaries (e.g., the grantor's resident alien children). This could result in the trust grantor being taxed currently on trust income, even though he does not receive trust distributions and otherwise has no power or control over trust assets.

Abandoning U.S. residency: Obviously, a taxpayer may not have sufficient advance notice to consider this option; however, those diagnosed as terminally ill or having time for advance planning may wish to terminate qualification as a U.S. resident. Secs. 2107 and 2501(a)(3) make this option unavailable to a long-term resident alien, defined by Sec. 877(e)(2) as a non-U.S, citizen who is a permanent legal resident of the U.S. (i.e., a "green card" holder) for at least eight of the 15 tax years before departure.

Surviving spouse becomes citizen: If the surviving spouse becomes a U.S. citizen before the estate tax return is filed and was a U.S. resident or domicile since the decedent's death, the estate can claim the marital deduction for bequests to that spouse. Regs. Sec. 20.2056A-1(b) provides that the testing date (i.e., the date the estate tax return is deemed filed) is the date of actual filing, even if the return is filed untimely. This is a relatively simple solution, assuming that the surviving spouse is emotionally willing and legally able to become a U.S. citizen.

Transferring assets to a QDOT: Under 2056A(a), a qualified domestic trust (QDOT) is a trust established under U.S. law, having at least one U.S. trustee. Generally, it must pay income to the surviving spouse annually and meet certain other legal requirements. Although qualifying asset transfers into the mast are transfer tax-free, transfers of principal from the mast to the surviving spouse generate transfer tax, subject to certain hardship exceptions. Any undistributed assets remaining at the surviving spouse's death will be taxed at that time. However, under Sec. 2013, a credit is permitted for prior transfers to the surviving spouse, to avoid taxing both spouses on the same assets.

A major benefit of a QDOT is the ability to defer (rather than avoid) estate tax. Paying taxes later is always preferable to paying them currently, particularly if an immediate tax burden might require a forced sale or liquidation of assets. Also, a surviving spouse maintaining continuous residence after the decedent's death, who is unable to obtain citizen status by the estate tax filing date, may use a QDOT to acquire more time. Sec. 2056A(b)(12) exempts a distribution to the spouse (otherwise taxable) from transfer taxes if the spouse has become a U.S. citizen. Thus, if the marital deduction is unavailable due to citizenship application processing delays, the surviving spouse can transfer assets to a QDOT until they can be received tax-free.

In addition to tax deferral, however, a QDOT may also result in absolute savings. When the first spouse dies, a QDOT allows for deferred tax on his assets; the surviving spouse's estate will incur tax on her assets at her death. This allows both estates to take advantage of the graduated transfer tax brackets in both estates. This contrasts with the normal unlimited marital deduction, which allows for deferral only in the first spouse's estate; all assets not otherwise disposed of are eventually taxed in the surviving spouse's estate.

Although QDOTs have certain other technical advantages, there are a number of disadvantages, such as:

* They are complicated, and difficult and costly to establish and administer.

* It may be difficult (if not impossible) to make the requisite transfer of assets into a QDOT. This may occur, for example, in the case of foreign real estate, assets held in countries in which there are exchange restrictions or other prohibitions on asset withdrawals, or privately held securities that may not be transferred without a third party's consent.

* Although providing the estate tax benefits described above, under U.S. tax law, the transfer of certain assets into a QDOT (e.g., retirement plan benefits, S corporation stock, certain life insurance policies and personal residences) may have significant adverse income tax consequences.

Using treaty benefits: Any relief available to a resident by virtue of an estate tax treaty between the U.S. and his home country can provide substantial benefits. Although treaties generally do not relieve resident aliens of transfer tax burdens, they often clarify the uncertainty surrounding residency determination, particularly if the taxpayer may be considered domiciled in both countries. Also, some treaties provide for liberalized credits to avoid double taxation in the U.S. and the home country.

Making inter vivos gifts: Beyond the current $675,000 lifetime exclusion, a person can make annual gifts of $10,000 per donee at no transfer tax cost, as long as the gift is of a present interest. In addition, for a taxpayer with a noncitizen spouse, although no marital deduction is allowed, Sec. 2523(i)(2) allows a $100,000 annual exclusion on gifts to a spouse.

Using life insurance: The basic concept is that if estate tax is unavoidable, the assets used to pay it can be replenished by life insurance proceeds. Generally, the insurance policy is held either in trust or by the insured's spouse or other family member, such that the death benefit is not included in the gross estate under Sec. 2042.

Conclusion

Foreign nationals and their families anticipating extended residency in the U.S. should be aware that transfer tax issues may exist, and address them on a proactive basis. This would include examining residency and domicile; comparing U.S. tax considerations to those of the home country; revisiting the potential effect these factors may have on overall lifetime and post mortem family financial planning; and taking necessary action.

EXECUTIVE SUMMARY

* While many foreign nationals planning an extended stay in the U.S. often address income tax issues through tax treaties with their home country or tax equalization or compensatory bonuses, they often overlook the estate tax rules.

* If a surviving spouse is not a U.S. citizen, the entire value of jointly owned property is generally included in the decedent's estate; there is no marital deduction on direct bequests to the surviving spouse.

* The residency test for transfer tax purposes differs from that for income tax purposes.

For more information about this article, contact Mr. Schaefer at [e-mail].

Michael K. Schaefer, CPA Principal Michael K. Schaefer, Certified Public Accountant Boston, MA