As more foreign nationals relocate to the United States for education, training, and employment, more estate planners must apply the U.S. tax rules to transfers to or from foreign national individuals. Different estate and gift tax laws can apply to transfers by foreign nationals. "U.S. Tax Rules Can Apply to Inheritances, Gifts from Abroad", Massachusetts Bar Association Section Review, Volume 1, Number 1, discusses the US tax rules related to transfers from abroad. This article discusses the special estate tax rules that can apply to transfers by foreign decedents and their application to their assets and nonresident beneficiaries.
Resident or Nonresident Status
Whether a foreign national's estate will be taxed under the U.S. rules that apply to estates of U.S. citizens and residents or under the rules for nonresident estates will depend on the decedent's status, resident or nonresident. For U.S. estate and gift tax purposes, the regulations define a "resident" as a person domiciled in the United States. This is a different rule than the income tax rule that bases residency status on the "green card" or "substantial presence" test of section 7701 (b) of the Internal Revenue Code. The income tax rules on residency, however, determine the residency of trust or estate beneficiaries and the resulting withholding and income reporting rules that apply to payment to these individuals.
Whether a decedent was domiciled in the United States depends on the client's intent as evidenced by facts and circumstances. Was the decedent on a temporary assignment of a definite term for a foreign employer or employed by an American employer? Was the decedent included in foreign employer benefit programs? Was the decedent in the U.S. under a temporary assignment as defined by an applicable social security agreement? Did the decedent's immigration status require an intention to return to his or her home country following a temporary stay as for a students or scholar? Did the decedent have U.S. lawful permanent resident status (a "green card') indicating an "intention to reside permanently in the United States" under the U.S. immigration laws? Did the decedent maintain a home in the home country? Did the decedent purchase a home in the United States? Where are the decedent's family, personal ties and business connections?
A decedent who was domiciled in the United States may nevertheless be a nonresident under an estate tax treaty. The United States has estate tax treaties with Austria, Australia, Denmark, France, Germany, Greece, Finland, the Netherlands, Ireland, Italy, Japan, Norway, Sweden, Switzerland, South Africa, and the United Kingdom. Under the treaties, a decedent who was domiciled in both countries will be treated as a resident for estate tax purposes in the country in which the individual resided for a specified number of years. Some treaties use seven out of ten years; others use five out of seven years.
Estates of Residents
Estates of foreign national decedents domiciled in the United states are taxed in a similar manner to estates of U.S. citizens with two exceptions. The unlimited marital deduction does not apply to transfers to non-U.S. citizen spouses. A marital deduction is allowed for property that passes to a non-citizen spouse in a Qualified Domestic Trust (QDOT). The marital deduction is also allowed if the non-citizens spouse transfers the assets to a QDOT following the death of the transferor. A marital trust meets the requirement of being a QDOT if:
á. The trust has at least one trustee that is an U.S. citizen or domestic corporation;á. No distribution can be made without the required withholding;á. The executor elects to treat the marital trust as a QDOT.
Special rules apply to QDOT if the trust's assets exceed $2,000,000. The appointment of a foreign person co-trustee may cause the trust to be classified as a foreign trust and subject to the U.S. tax and procedural rules related to foreign trusts.
In addition to the limitation on the marital deduction, the rule valuing a decedent's property held jointly with a spouse at 50 percent of the value of the property does not apply to assets held jointly with a non-citizen spouse. Property held jointly with a non-citizen spouse must be valued using the rules of contribution.
Estates of Nonresidents
A Form 706-NA, Nonresident Estate Tax Return must be submitted for estates of nonresident decedents whose gross estate exceeds $60,000 with adjustments made for certain taxable gifts and gift taxes claimed before January 1, 1977. The gross estate of a nonresident decedent includes only property that is situated in the United States at the time of the decedent's death. Sections 2104 and 2105 define whether an asset is situated in the United States (called "U.S. situs") for purposes of these rules. U.S. situs property includes:
* Real estate located in the United States;
* Tangible personal property located in the United States (including cash or other currency) at the time of the decedent's death unless the presence of the property in the United States is for a transitory purpose, such as works of art on loan to a museum;
* Debt obligations of persons, including U.S. corporations and U.S. government agencies, states and subdivisions;
* Intangible personal property that is enforceable against a U.S. resident or U.S. entity or governmental agency;
* Stock of U.S. corporations;
* Situs of partnership interests including interest in LLCs treated as partnerships for income tax purposes is not entirely clear;
* Trust interests in which the nonresident transferor retained an interest if the assets were situated in the U.S. either at the time of transfer or at the time of death:
* The U.S. situs assets of a trust interest which is vested or over which the decedent has a power that would cause estate inclusion.
The U.S. situs definitions include important exceptions enacted to encourage foreign nationals to make certain investments in the United States. For example, U.S. situs property does not include:
* Insurance proceeds on the life of a nonresident even if the insurance is with a U.S. insurance company;
* Certain deposits in U.S. banks;
* Portfolio debt obligations under section 2105(b)(3).
An estate tax treaty may change the situs of assets for foreign nationals domiciled in the treaty country. Domicile-type treaties grant the right to tax to the country of domicile except for real property and property associated with a permanent business establishment in the situs country. The estate tax treaties with Austria, Denmark, France, Germany, the Netherlands, Sweden, and the United Kingdom are domicile-type treaties. Other estate tax treaties grant the right to tax to the country of situs of the asset. These include the treaties with Australia, Greece, Finland, Ireland, Italy, Japan, Norway, Switzerland, and South Africa.
Deductions, Rates and Credits
A nonresident estate is allowed a marital deduction for property transferred to a U.S. citizen spouse or to a non-U.S. citizen spouse in a qualified domestic trust (QDOT). An estate tax treaty that allows marital deduction may reduce value of the marital deduction by referring to old law. For example, the treaty with France limits the marital deduction to $250,000 or one half the value of the property transferred to a spouse. The estate can claim a deduction for bequests to U.S. charities but only if the decedent's worldwide assets are disclosed with the return.
A nonresident estate is entitled to claim the same kinds of deductions and expenses as the estates of U.S. citizens or residents. However, the deductions must be apportioned pro rata based on the value of the U.S. estate to the worldwide estate. Many nonresident estate administrators choose to forego deductions rather than disclose worldwide assets on the return. An estate tax treaty may allow deduction for expenses directly related to property included in the gross estate.
Estates of nonresidents are subject to the same rates as estates of U.S. citizens and non-U.S. citizens domiciled in the United States. The estate is allowed a credit of $13,000 to shelter an estate of $60,000 from tax. This credit is decreased dollar for dollar by any unified credit used by the decedent to offset taxable gifts made when the decedent was domiciled in the United States. An estate tax treaty may increase the amount of the credit. Although the treaties refer to the specific exemption, this has been interpreted to include the new terms for the credit.
A nonresident estate may also claim credits for state death taxes paid, gift tax on gifts made before January 1, 1977, and tax on prior transfers included in the decedent's gross estate. The amount of the credit is computed with reference to the lower credit for nonresident estates. Estates of nonresidents are not allowed a credit for foreign death taxes. Under the estate tax treaties and estate tax provisions of the income tax treaty with Canada, the treaty country must allow a credit for death taxes paid to the United States to avoid double taxation.
Transfers of U.S. situs property by nonresidents are also subject to the generation skipping tax if the property is also subject to estate tax and the generation skipping conditions are met by the transfer. The residency of the skip person is not relevant in determining the application of the tax. A nonresident estate is entitled to the $1 million exemption.
Nonresident Estate Income Taxes
The estate of a nonresident is treated like a nonresident alien for income tax purposes as long as the administrator's activities are limited to paying debts and distributing the estate assets. A nonresident estate with income submits a Form 1040NR tax return instead of a Form 1041 fiduciary tax return, with certain exceptions. Net income that is effectively connected with a U.S. trade or business is taxed at graduated rates using the rates for trusts. Other income that is considered U.S. source under the income-sourcing rules of the Internal Revenue Code is subject to a 30 percent withholding tax at source unless a lower income tax treaty rate applies.
Many foreign countries do not recognize an estate as a separate entity and consider the estate income to belong to the beneficiary. If the estate pays an income tax, the income may be subject to double tax if the beneficiary's country of tax residence imposes an income tax on the beneficiary. The double tax occurs if the foreign tax authority does not allow an individual a credit for taxes paid by the entity rather than by the individual.
An administrator who makes income payments to individuals who are nonresidents must comply with the withholding and reporting rules on payments to nonresidents. For purposes of these rules, residence is determined under the section 7701(b) "green card" test or substantial presence test. A non-U.S. citizen who is not a U.S. lawful permanent resident ("green card" holder) and who does not satisfy the 183-day substantial presence test is a nonresident alien for income tax purposes. An individual satisfies the substantial presence test by being physically present in the United States for more than 30 days in the calendar year and for 183 days or more based on the following formula: all of the days of U.S. presence in the current calendar year plus one third of the days of U.S. presence in the prior year plus one sixth of the days of U.S. presence in the second preceding year.
The 30 percent withholding tax may be reduced based on a tax treaty if the beneficiary presents to the administrator prior to payment a completed Form W-8BEN with adequate documentation supporting tax residency in the treaty country. For payments on or after January 1, 2000 a person claiming a reduced rate under a tax treaty must also have a taxpayer identification number (TIN), either a social security number or an individual taxpayer identification number (ITIN). If the nonresident has applied for but has not yet received a number, the administrator can reduce the tax if a copy of the nonresident's Form SS-5 or W-7 application is attached to the W-8BEN. Income payments to nonresidents must be reported on Form 1042S. The estate must also submit a Form 1042 tax return.
These same considerations apply to payments to nonresident beneficiaries by U.S. estates. Generally, an administrator who does not know the income tax rules in a beneficiary's country of tax residence should pay out income currently to the beneficiary to avoid the double tax situation noted above. This is particularly the case with capital gains which when paid out to a nonresident beneficiary avoid U.S. income tax and may avoid foreign income tax as well. If the income is taxed at the estate level rather than distributed to the beneficiary, the withholding and reporting rules for income payments to nonresidents are avoided. Distributions of estate assets are not income and are not subject to withhold and are not required to be reported on Form 1042S.
Different U.S. tax rules, forms, and procedures apply to estates of foreign national decedents who are not domiciled in the United States and to transfers to non-U.S. citizen spouses, regardless of the domicile of the decedent. In addition, different income tax rules and forms apply to income of nonresident estates and income payments to beneficiaries who are neither citizens nor residents of the United States. Because of the global mobility of individuals, estate planners need to be aware of these different rules and procedures as they will be required to apply these rules and procedures more frequently.