What Every Estate Planner Should Know About Planning for Non-US Citizens
Pablo and Lena Rodriguez are wealthy South Americans who have three children, ages 18, 17, and 15, who will be attending college in Southern California in the not-too-distant future. Rather than have their children live in student housing, Pablo and Lena have decided to purchase a home in the Los Angeles area that their children will live in while attending college on student visas. Neither Pablo nor Lena is a resident or citizen of the US, and at this time, neither intends to become a US resident. However, it is unclear whether one or more of their children will remain in the US after college or graduate school.
Since neither Pablo nor Lena is a US citizen or other lawful permanent resident, the gift and estate tax rules are potentially very different for them. Let’s consider how the gift, estate, and generation-skipping transfer tax (collectively, the “transfer tax”) rules apply to Pablo and Lena—individuals who are neither US citizens nor long-term lawful residents.
Non-US Residents for US Tax Purposes
If an individual is a citizen or long-term permanent resident of the United States, the US subjects all of that person’s property worldwide to transfer tax and income tax. In other words, all property of US citizens and long-term permanent residents (defined as a green card holder for at least 8 of the preceding 15 tax years), no matter where the property is located, is subject to US income and transfer tax.
Alternatively, if that individual is not a US citizen or long-term permanent resident, as in Pablo and Lena’s case, subject to a tax treaty with their native country, income taxation, and transfer taxation depends upon their legal residency.
Interestingly, the test to determine residency for transfer tax purposes is not the same as the test to determine residency for income tax purposes. For income tax purposes, a green card holder or other lawful permanent resident who is present in the US for at least one day is a US resident for income tax purposes. Alternatively, an individual can be a resident for US income tax purposes if: (1) he or she is present in the US for 183 days or more in the current year (i.e., more than one-half of the year) or (2) he or she is “substantially present” in the US, meaning more than 31 but less than 183 days in the current year and the total number of days present in the US in the current and two immediately preceding years equals or exceeds 183 days under the following formula:
– The number of days present in the US in the current year;
– 1/3 of the number of days present in the US in the immediately preceding year
– 1/6 of the number of days present in the US in the second immediately preceding year
If the sum of the above equals or exceeds 183 days, he or she is a US resident for US income tax purposes.
For example, suppose Pablo and Lena are present in the US. 115 days in 2016. If they were present 135 days in 2015, and 120 days in 2014, the substantial presence calculation is 180 days (115 + 45 (135/3) + 20 (120/6) days), and thus they are not US residents for US income tax purposes.
For income tax purposes, non-US residents like Pablo and Lena are generally taxed only on US-source income. Thus, if their only US property is a second residence, and they do not collect rent, they have no US-source income. However, if they rent the property or have other US property that produces income, the rate they pay depends on the type of income:
– Wages, salaries, trade and business income, gains from the disposition of real property, and other “effectively connected to a trade or business income,” or ECI, is subject to standard US graduated income tax rates up to 39.6%.- Passive or portfolio-type income—including interest, dividends, rents and royalties—is taxed at a flat 30% (typically withheld at source), though this rate may be reduced by
– Passive or portfolio-type income—including interest, dividends, rents and royalties—is taxed at a flat 30% (typically withheld at source), though this rate may be reduced by tax treaty.
For transfer tax purposes, legal residency is determined by a person’s domicile or residency with the intent to remain indefinitely. In other words, for transfer tax purposes only, a non-citizen is a US resident if he or she currently lives in the US and intends to remain there indefinitely. Conversely, living in the US with the intent to return home to one’s native country means that individual is not a resident of the US for transfer tax purposes (a non-US resident). Here, Pablo and Lena are clearly not domiciled in the US, and thus, they are not residents for transfer tax purposes.
For those who are residents of the US, intent to remain in the US indefinitely is determined by the facts and circumstances for each individual. Some of the factors considered include:
– Duration of stay in the US and other countries and frequency of travel between countries
– Size, cost, and nature of homes (vacation home, owned, rented, etc.)
– Location of business and social contacts
– Membership in religious and other organizations
– Location of expensive/cherished personal possessions
– Registration to vote
– Place of driver’s license and vehicle registration
– Location of bank and investment accounts
– Reasons for residency (temporary employment, etc.)
– Declarations of residency or intent made in visa applications, estate planning documents, letters, and oral statements
Table 1, Residency Requirements for US Transfer Tax, showing the residency requirements for US gift and estate tax purposes.
Based on these very different tests, it is possible for an individual to be a resident for transfer tax purposes but not a resident for income tax purposes, and vice versa.
This matters because, unlike US citizens, a non-US resident is only subject to transfer tax on US situs property. Situs is a technical term meaning the legal location of the property. Unfortunately, the rules are different for gift and estate tax purposes, so we will look at each separately.
For gift tax purposes, non-US residents like Pablo and Lena are subject to tax only on gifts of real property or tangible personal property located in the US. Tangible personal property includes jewelry, art, antiques, cars, and other tangible possessions. Significantly, cash and checks cashed in the US are tangible personal property located in the US, and thus subject to gift tax. Intangibles—such as shares in a US corporation or debt obligations of US corporations or the US or state governments—are not subject to gift tax. Gifts of partnership and LLC interests are treated as gifts of intangible personal property and thus are not subject to gift tax.
A US citizen or permanent resident has a $5 million (indexed for inflation) unified credit against the federal gift and estate tax. Thus, if a US citizen makes a gift of more than $14,000 to one individual in any tax year, he or she must file a gift tax return (Form 709) that uses up some of his or her $5 million exemption. A non-US resident, on the other hand, is only allowed the $14,000 gift tax annual exclusion and a $60,000 estate tax exemption for transfers to a non-spouse. In other words, if Pablo or Lena transfers more than $14,000 of US situs property to any one individual other than each other (their spouse), they will have to pay gift tax at a rate of 40% of the amount over $14,000.
Furthermore, US citizen spouses have the unlimited marital deduction—meaning they can transfer an unlimited amount of property to their spouse free of gift or estate tax. Alternatively, when the recipient spouse is a non-US citizen, he or she can only receive $148,000 per year from his or her spouse free of gift tax or estate tax.
It is worth noting that the unlimited exclusion for transfers made directly to a medical or educational provider also applies to non-US residents. Therefore, non-US residents can transfer an unlimited amount for educational or medical expenses, free of gift tax, as long as the payment is made directly to the medical or educational provider. A potential trap for the unwary, payments made to a non-spouse family member (who then pays for medical or educational expenses) will be subject to gift tax if over $14,000, and payments made to non-US citizen spouses will be subject to gift tax if greater than $148,000. Thus, while some transfers are exempt from transfer tax (e.g., direct payments to educational and medical providers), transfers from non-US residents are generally subject to a 40% tax beginning at very low thresholds. Table 2, US Gift Tax Exemptions, shows the exemptions from US gift tax.
A non-US resident is subject to estate tax only on her US situs property; debts on the property (such as a mortgage on real property) help reduce the value of the property subject to tax. For estate tax purposes, US situs property subject to the tax includes:
Life insurance on the life of a non-US resident is not US situs property. However, if an individual owns life insurance on the life of someone else, a policy issued by a US insurer will be US situs property whereas a policy issued by a foreign insurance company will be non-US situs property.
At death, a non-US resident can transfer to a non-spouse only $60,000 worth of US situs property without having to pay estate tax; anything above $60,000 will also be subject to a 40% tax. Perhaps more surprisingly, a non-US resident can transfer to a spouse only $148,000 worth of US situs property without having to pay estate tax; anything above $148,000 will also be subject to a 40% tax unless it is left in a Qualified Domestic Trust (QDOT). A QDOT for a non-citizen spouse essentially replaces the unlimited marital deduction for transfers to that non-citizen spouse, regardless of their residency. Thus, if the assets transferring to the non-citizen spouse exceed the federal estate tax exemption (either $148,000 or $5,450,000, as the case, may be), absent a QDOT, those assets above the applicable exemption amount will be subject to a 40% US estate tax, which is due within 9 months of the death of the first spouse to die.
Moreover, if the transfer is subject to gift or estate tax and is left to a person two generations or more below the transferor, the generation-skipping transfer tax will also apply, subjecting the transfer to an additional 40% tax! Thus, just like with gift tax, transfers from non-US residents at death are generally subject to a 40% tax beginning at very low thresholds. For families like those of Pablo and Lena, if they don’t plan around this tax, they will be very unpleasantly surprised when the IRS asks for nearly 40% of the value of the transfer nine months after Pablo or Lena’s death.
Table 3, US Estate Tax Exemptions, shows the exemptions from US estate tax. Note that these are different from the US gift tax exemptions.
Purchasing Real Property
It is very common for non-US residents like Pablo and Lena to purchase real property in the US—often as an investment or as a residence for family members who are studying or otherwise living in the US. As discussed above, if a non-US resident purchases US real property in his or her name, that property will be subject to potentially both gift and estate tax.
Thus, if Pablo and Lena purchase real property located in the US in their personal names, since US real property owned by a non-US resident is subject to both gift and estate tax, they cannot give it away without paying gift tax to the extent the value of the gift exceeds $14,000. What can they do? Ideally, they would convert the real property ownership to intangible personal property, such as through a corporation, LLC, or partnership. Once converted, Pablo and Lena could—after a period of time elapses—decide for estate planning purposes to transfer the corporate shares (or LLC or partnership interests) free of gift tax. Let’s assume Pablo and Lena’s goal is to benefit one or more of their children by letting them live on the property while they go to school. Under these circumstances, the transfer will ideally be to a trust for the benefit of their children; if established in a state or foreign jurisdiction that permits self-settled trusts, the trust can include the power to add Pablo or Lena as a discretionary trust beneficiary. The decision as to whether to establish this as a foreign or US trust will depend on many factors, including whether the beneficiaries are or will become US residents/citizens.
Ideally, Pablo and Lena will consult with a qualified attorney before buying the property. If so, they will learn that they have significantly more options. If they buy the property in the name of a corporation, partnership, or LLC, they can transfer the corporate shares or partnership/LLC interests without incurring gift tax. Even smarter, if they establish a trust for the benefit of their children or other beneficiaries and transfer to that trust the interests in the entity owning the real property, those entity interests (and the underlying real property) will be out of their estate for gift and estate tax purposes. If they set up the trust in a foreign jurisdiction—or a US state that permits such trusts, as discussed above—they can even be a discretionary beneficiary of the trust. If it is set up in a foreign jurisdiction, the foreign trust will frequently own a foreign entity that in turn owns the domestic entity.
The key, of course, is to have the conversation before purchasing the property so they still have all of their options.
Investing in a US Business
An investment in a US business is very similar to an investment in US real property. If the business is a US corporation, the corporation’s shares can be transferred free of gift tax, but ownership of the shares will result in estate tax at an investor’s death. If the business is a US partnership or LLC, those interests also can be transferred free of gift tax, and ownership at death will subject the business interests to estate tax.
As with real property, if an individual’s goal is to benefit his or her children, having a trust own the property (with the children as beneficiaries) would be ideal. This would remove the business interests from the estate for estate tax purposes. Again, the key is that an individual should discuss this with a qualified attorney before purchasing the business interest.
Migrating to the US
If Pablo and Lena ever chose to migrate to the US themselves (rather than just purchasing a home for their children), they should take steps now, before they migrate, to reduce the overall taxation on their property worldwide. Here are some of the steps they could take now, before migrating to the US, to minimize US tax:
- Make irrevocable gifts to non-US persons.
- Make irrevocable gifts to long-term trusts for US beneficiaries. These can be either US trusts or foreign trusts. However, if it is a foreign trust, it will become a grantor trust if the trustee becomes a US person within 5 years of the trust’s creation, which would subject all of the trust’s assets to US income tax.
- Consider transferring a portion of their assets to a discretionary trust for theirs and their children’s benefit, either offshore or in a state that permits self-settled trusts.
- Sell appreciated assets.
- Dispose of any interests in foreign businesses.
- Make gifts to a spouse (these should be made before becoming US residents).
- Consider the investment in a specific type of US insurance policy that allows access to the policy’s cash value tax-free (a non-MEC policy), possibly Private Placement Life Insurance (PPLI) owned by a domestic or foreign asset protection trust. This will significantly reduce US income tax going forward.
One important consideration, however, is that if Pablo and Lena migrate to the US within 5 years of establishing an offshore trust, the trust will become a grantor trust for US income tax purposes. In that case, all of the trust income will be subject to US income tax. Should this occur, Pablo and Lena would be well served to work with an adviser team that can minimize taxable income, either through investment in tax-efficient investments or through the purchase of life insurance, or both.
Common Planning Mistakes
This area is rife with traps for the unwary. As just one common example, suppose Karl is a Canadian who recently moved to the US; he has lived here for less than five years. Karl’s adult children from a prior marriage live in Canada, having stayed close to where they grew up. After meeting with the couple, their attorney decides they need a fully-funded revocable trust to avoid probate of their US assets. Knowing nothing about Canadian law, however, their attorney tells the clients that Karl’s Canadian assets (Canadian real estate and a Canadian retirement account) should be handled by a Canadian attorney, and she encourages him to contact counsel in Canada. Their attorney then funds all of the couple’s US assets into separate revocable trusts, given that it’s the second marriage for both. Their attorney carefully clarifies in the husband’s Will that it only addresses US-based property, and not property located anywhere else in the world.
This is totally safe planning, right? Maybe! Are his children from the proper marriage – or any other Canadians for that matter – beneficiaries of this trust? If the answer is yes, the Canadian non-resident trust rules will apply and the trust may be considered a foreign trust in Canada. If so, all of the trust assets may be subject to tax in Canada! Alternatively, if there are no Canadian beneficiaries these rules do not apply, and the revocable trust will not be subject to tax in Canada.
Assuming Karl’s children are beneficiaries of his trust, what could their attorney have done to avoid the Canadian foreign trust rules? When we handle similar cases, we create a revocable trust for the non-Canadian (frequently they are an American), and we create a Will for the Canadian client. (We also encourage them to seek counsel in Canada to address their Canadian property.) Once the Canadian has lived in the US for 5 years, we can then create a fully funded revocable trust for that individual, without fear of application of the Canadian foreign trust rules.
Back to Pablo and Lena Rodriguez
Fortunately, Pablo and Lena contacted an American international planning attorney before purchasing the $1 million home for their children. As a result, Pablo and Lena established a Nevada LLC to own the California rental property, with the Nevada LLC owned by an offshore LLC. The offshore LLC is, in turn, owned by an offshore asset protection trust, which also owns many of their other investments. While it is subject to income tax (the fair market value rent is income to the children), the home is not subject to gift, estate, or generation-skipping transfer tax in the US. Thus, Pablo and Lena saved upwards of $400,000 or more of potential gift tax and more than $375,000 of estate tax in a transfer of the home to their children, either during their lifetimes or at death.
This article is a modified version of what was originally published in a book co-authored by Jeffrey R. Matsen, Timothy Voorhees and Jonathan A. Mintz, titled WISDOM FOR THE WEALTH: SOLVING THE HIGH NET WORTH PLANNING PUZZLE (Crescendo Publishing, LLC, 2015), available online at http://www.amazon.com/Wisdom-Wealthy-Solving-Planing-Puzzle-ebook/dp/B0193WJQ8C/ref=sr_1_1?.
We used the example of Pablo and Lena throughout the article, but our clients could be from any foreign country, and they could be investing in US businesses or real property for countless reasons. As you’ve seen, the varying reasons often only impact the details of their overall planning structure.
This article provides the general US tax rules for non-US persons for gift, estate, and income tax purposes. It is important to note, however, that one or more gift, estate, or income tax treaties with the client’s native country may alter these rules significantly.