DURING THE PAST 10 years, investments in the United States by foreign investors have risen dramatically, and attorneys are frequently asked to prepare estate plans or to give planning advice, to aliens. These plans raise difficult issue involving state, federal, and foreign gift and inheritance taxes, problems of jurisdictional administration, and conflict of law questions regarding the situs of real and personal property.
Misconceptions sometimes exist among practitioners concerning the tax treatment of resident, as opposed to non-resident, aliens. Even those attorneys who represent only United States citizens frequently encounter jurisdictional difficulties when faced with the administration of property located in several states.
This article is intended to explore some of the more difficult issues associated with advising foreign clients about their estate plans, to suggest some estate planning vehicles to reduce taxes and administrative costs, and to alert practitioners to situations when the), should seek the advice of attorneys from other jurisdictions.
FEDERAL ESTATE TAXES
The federal government imposes taxes on the estate of any deceased person who is a resident of the United States or who leaves property located within the United States. The estates of United States citizens and alien residents are taxed identically under the Internal Revenue Code ("Code") -- to which all section references. unless otherwise indicated, will be made. §2001(a).
After appropriate deductions and credits are taken, the tax is imposed effectively in 1984 upon estates greater than $325,000, at progressive rates beginning at 34%, up to a phased-in maximum by 1985 of 50% on the value of estates over $2.5 million. The size of the smallest estate subject to this tax is scheduled to increase progressively from $325,000 to $600,000, in the case of decedents dying in 1987 or thereafter, but this increase is a matter of legislative grace and should be reviewed annually. The estates of residents and citizens include all property held throughout the world, but a federal estate tax credit is allowed, with limitations, for any tax paid to a foreign country on property located in that country. §2014.
The United States also imposes a tax on the gross estates of non-resident aliens. §2101(a). After appropriate deductions and credits are taken, this tax is imposed on estates larger than approximately $50,000, at rates that begin at six percent and reach a maximum of 30 percent for that portion of the estate in excess of $2 million. §2101(d). The tax is reported on Form 706NA.
The "gross estate" of a non-resident alien decedent is defined by section 2103 as all property located within the United States. "Properly located within the United States" is further defined by section 2104 and a number of federal regulations to include:
- Real property located within the United States. Treas. Reg. §202104-1(a)(1).
- Stock held in United States corporations. §2104(a).
- Debts held from United States obligors. §2104(c).
- Tangible personal property located within the United States. Treas. Reg. §20.2104-1(a)(2).
Property held in trust, if it would be defined as property within the United States at the time of transfer to the trust or at the date of death of the non-resident alien decedent. §2104(b).
A number of tax treaties modify the definition of what constitutes property located within the United States for the purpose of non-resident alien decedents who are citizens or residents of certain foreign countries, and practitioners should check the applicability and terms of these treaties. Estate tax treaties currentlv exist between the United States and Australia, Austria, Canada, Finland, France, Greece, Ireland, Japan, the Netherlands, Norway, Switzerland, the Union of South Africa, and the United Kingdom. In addition, separate gift tax treaties with Australia and Japan are in effect. Since the federal estate tax imposed on the estates of non-resident alien decedents covers only property within the United States, no foreign death tax credit is available for these estates.
STATE INHERITANCE TAXES
As of 1983, 21 states -- including Arizona, California, Florida, Massachusetts, Nevada, Texas, and Washington -- do not impose a tax on the gift or inheritance of any person or estate. To the extent that the federal estate tax is paid and a credit for state death taxes is allowed under section 2011, all 21 states, except Nevada, impose a tax in an amount equivalent to the state death tax credit, called a "pick-up" tax. When property is located in more than one state, state laws provide a formula for prorating the single state death tax credit, usually by dividing the credit by the fraction of the decedent's estate situated for tax purposes within the state. All states have enacted legislation that generally parallels the federal rules for determining the taxable situs of property within each state.
Although 29 states - including Delaware, Maryland, Michigan, New Jersey, New York, Ohio, and Pennsylvania - continue to impose inheritance taxes at varying rates, the trend is toward abolishing inheritance taxes. The list of states following this trend includes Minnesota and Virginia, which abolished their inheritance taxes effective January 1, 1980, Washington (January 1, 1982), California (June 9, 1982), Illinois (December 31, 1982), Wyoming (January 1, 1983), Hawaii (June 30, 1983), and Texas (September 1, 1983). Maine is phasing out its inheritance tax until June 30, 1986, when it will be abolished altogether. The tax laws of each state in which a decedent owns property must be checked regularly, often with the aid of an attorney from that jurisdiction. In addition to real property, stock held in corporations located in various states must be reviewed, since many states do not follow the federal rule that the tax situs of corporate stock is determined by the state of incorporation.
In addition to insuring that all required inheritance or estate taxes are paid, the attorney must see that all of the estate's property is transferred to the recipients pursuant to the terms of the decedent's estate plan and according to the laws of the appropriate jurisdictions. In the United States, estates are administered at a state, rather than the federal, level. State laws provide universally that a decedent's property will be administered primarily in the county or judicial district of the state where he was domiciled, and that secondary -- "ancillary" -- proceedings are to be initiated in the states where the decedent's property is located. See Cal. Prob. Code §301 (West 1956); N.Y. Surr. Ct. Proc. Act §§206, et seq. (McKinney 1967); 111. Rev. Stat. ch. 11-1/2, §206, et seq. (Smith-Huro 1978); 20 Pa. Cons. Stat. Ann. §3151 (Purdon 1975).
When a decedent is not a resident of the United States, the principal administrative proceeding will be begun in his country of domicile, and ancillary proceedings need only be instituted in those states in the United States where he has left property.
Situs of Property
The situs of a decedent's property is determined by the nature of the property and the laws of the state in which the property is physically located. The situs of property for the purpose of probate administration often differs from the property's situs for purposes of federal and state death taxes. As a general rule, real property is deemed to be located in the jurisdiction in which it is physically situated; personal property, stocks, bonds, cash, automobiles, and other personal effects is deemed to follow the decedent and to be located in the jurisdiction in which he is domiciled at the time of his death. For this reason, some state laws do not require further ancillary Proceedings to transfer effective legal title to personal property. See Hurst v. Mellinger, 73 Tex. 189, 11 S.W. 184 (1889). While most state laws are in accord, an attorney should check carefully every jurisdiction in which the client's personal and real property is located to determine whether those jurisdictions require administration of that property. For example, Missouri requires original administration in the state to transfer personal property located there, while other states, including California and Virginia, allow transfer of title to personal property -- even stock in domestic corporations -- without ancillary Probate if certain conditions are met.
The Uniform Probate Code sets forth certain more restrictive situs rules for the administration of property. Its section 3-201(d) provides that commercial paper, investment paper, and other instruments are located where the instrument is situated; all other debts are deemed located where the debtor resides or maintains its principal office.
Interest in a Trust
Under most state laws, real property transferred to a trust eliminates the need for primary or ancillary administration in the state where the property is located, not because the property ceases to be classified as real property, but because the decedent has exchanged an interest in real property for an interest in a trust, which is classified as personal property. Under California law, for instance, personal property is governed by the administration of the domicile of the decedent, and real property that is held in trust by a decedent who is not a resident of California does not require administration in that state. Estate of Tutules, 204 Cal. App. 2d 481, 22 Cal. Rptr. 427 (1962); cf. Unif. Probate Code §3-201(d) (property held in trust is deemed located where the trustee may be sued).
TAX PLANNING VEHICLES
Attorneys who do not practice extensively in estate planning traditionally build an estate plan upon a Will. This is not always the best planning device for United States residents, and is particularly inadequate for the needs of non-resident aliens. If a decedent does not reside in the state where the drafting attorney practices, the attorney should not prepare an estate plan to reflect the laws of the state where he practices, because the plan eventually will be governed by the laws of the state where the decedent is domiciled.
Transferring real property to a trust often avoids the administration of property by ancillary probate in the state where the property is situated. The trust may be revocable or irrevocable and may include any dispositive provisions desired by the client. In many states, including California and Virginia, personal property does not have to be transferred to the trust, since this property is not subject to administration in those states. The prudent attorney will check the laws of every state where the client's real property is located, since each state's laws govern the situs of the property. A single trust should be sufficient, and most states will honor a trust provision that requires the instrument to be construed according to the laws of another state.
Each state's laws may differ regarding the administration of trusts, and the attorney should research the trust laws of every jurisdiction in which the client's property is located. Some states, for example, Connecticut and Georgia, restrict the rights of a non-resident of the state or a corporation not authorized to do business in the state to serve as a trustee, and various states have widely disparate rules concerning the validity of a trust, the qualifications of a trustee, the exercise of discretionary powers, and other matters relating to the administration of trusts.
Real property placed in a trust is still subject to federal estate taxes if the trust is covered under sections 2036 to 2038, which apply to any trust in which the grantor retains an interest, reversion, or power. Therefore, unless the trust is irrevocable and the grantor retains no interest in it, the trust, while avoiding probate administration, will not avoid the imposition of the federal estate tax. State inheritance taxes on trust property located in each state depend, of course, on the laws of that state with regard to situs.
Some have suggested that federal estate taxes can be avoided through the use of foreign corporations to hold United States property. D.C. Troxell, Aliens - Estate and Gift Taxation, 201-2nd Tax Management Portfolios (BINA 1980). Stock in a foreign corporation is deemed to be situated outside the United States and therefore is not includable in the gross estate of a non-resident decedent. A foreign corporation should hold property located only in the United States unless the tax laws of the domiciliary nation suggest similar advantages.
Note, however, that section 2038 provides for the inclusion of property transferred by a decedent during his lifetime by trust or otherwise when the decedent has retained, alone or in conjunction with any other person, the power to revoke the transfer. If the decedent has the power to cause the United States property to be distributed to him by dividend, liquidation, or otherwise, the property may have to be included in his estate. See Estate of Sivan v. Commissioner, 247/ F. 2d 144 (2d Cir. 1957).
Practitioners called upon to prepare estate plans for non-resident aliens should familiarize themselves with the federal estate tax laws that impose a tax on property left in this country by their clients, as well as the inheritance tax imposed by every state in which the property is located. In addition, attorneys should become familiar with the administrative and situs rules of each jurisdiction. Steps should be taken to remove personal property from any state that requires the administration of that property, and a new form of property ownership, such as a trust, should be set up to hold real property.
Counsel may wish to recommend a foreign corporation to hold United States property, so long as he understands the potential estate tax and income tax problems inherent in holding property in this manner.