It is a fact that the phenomenon of human migration has been a major force in the history of the world.[i]
Indeed, among the themes that have remained constant during my years of practice, there are two that may be described, semi-facetiously, as modern manifestations of humanity’s migratory tendencies.
Bound for the U.S.
The first is the desire of many people from all over the world to move to the U.S.[ii]
I am certain that, for many of us, the only reason we are here is because our parents or grandparents accepted the risk of leaving their homelands – or were forced to do so – and headed to America in search of a better life.
However, I discovered as a young lawyer that the foreign individuals seeking to reside in the U.S. are not limited to the uneducated, non-English speaking, lower-middle class folks around whom I was raised but also include many wealthy individuals.[iii] Very clearly, these folks aren’t worried about identifying someone to sponsor them, to find them a job, and to provide them with shelter.
Still, these affluent individuals have many concerns related to their change of residence, some of which will be addressed here; specifically, the imposition of U.S. gift and estate taxes upon the transfer of their wealth.
The second constant, which confounded me when I first became aware of it many years ago, was the desire of many well-to-do New Yorkers to leave the State.[iv] This post is not about them.
Today’s post will take a look at some of the tax-related factors with which nonresidents noncitizens[v] (“NRNC”) should concern themselves, and for which they should plan, before moving to the U.S.
Before reviewing some pre-immigration planning options that may reduce or even eliminate a NRNC’s exposure to U.S. transfer taxes, and in order to give these strategies some context, we will consider from a high level the U.S. federal transfer (estate and gift) tax rules that apply to these individuals and their assets.
In order to properly advise an individual who informs you they are a “foreigner” with respect to the U.S. you first have to confirm their “residency.”
The concept of residency for federal tax purposes depends upon which federal tax you are considering.
For income tax purposes, a U.S. resident is someone who (i) is a citizen[vi] of the U.S., (ii) is a permanent resident[vii] of the U.S., or (iii) meets the “substantial presence” test.[viii]
Estate and Gift Tax Residence
Except in the case of a U.S. citizen – who is treated as a U.S. resident for purposes of both the U.S. income tax and the U.S. transfer taxes – the manner in which the residency of a noncitizen is determined for purposes of the U.S. estate and gift taxes is very different from the approach used in the case of the income tax.
Whereas the income tax relies upon one’s green card (permanent resident) status or upon the number of days one has spent in the U.S., the transfer taxes treat a foreign individual as a U.S. resident for purposes of such taxes if the individual is “domiciled” in the U.S.
Specifically, for purposes of the estate tax, a “resident” decedent is one who, at the time of their death, had their domicile in the U.S.[ix]
Similarly, for purposes of the gift tax, a “resident” is one who has their domicile in the U.S. at the time of the gift.[x] All other individuals are treated as nonresidents.
Intention to Remain Indefinitely
According to IRS regulations, a person acquires a domicile in a place by living there, for even a brief period of time, with no definite present intention of later leaving that place.
Residence without the requisite intention to remain indefinitely will not suffice to constitute domicile, nor will one’s intention to change domicile to another place effect such a change of domicile unless it is accompanied by the individual’s actually moving to such place – in other words, actions speak louder than words.[xi]
(Sounds a lot like New York’s definition of domicile for both income tax and estate tax purposes, doesn’t it? Keep reading.)
According to the IRS, the requirements for acquiring a domicile in a particular place are an individual’s legal capacity to do so, the individual’s physical presence in the place, and the individual’s current intention to make a home in the place.[xii] There is a presumption that an existing domicile continues in the absence of contrary evidence.[xiii]
Factors to Consider
Of these requirements, the most difficult to address is that of a noncitizen’s intention to make a home in the U.S. The process of ascertaining an individual’s intentions regarding domicile is a subjective inquiry, which means it can be difficult.
It is important, therefore, to focus on what may be described as objective manifestations of such intent. For example, the fact the noncitizen has a green card that entitles them to “permanent” residence in the U.S. provides some evidence of the noncitizen’s intentions; however, it may not be determinative in the face of other factors.[xiv]
Among the other factors to be considered in determining whether a noncitizen is domiciled in the U.S. for transfer tax purposes are the following:
- Where is the individual’s “permanent” home located?
- How about their family?
- Where do they keep important personal items?
- In what location does the noncitizen engage in business activities?
- Where do they spend their time?
- From what jurisdictions have they obtained various licenses?
- How have they identified their home on official documents (such as tax returns)?
- What about visa applications?
- Have they maintained ties to their country of origin?
In other words, very much an exercise in examining facts and circumstances for indications of intent. For that reason, if the NRNC is not interested in becoming a U.S. domiciliary, they will have to monitor these factors closely to ensure they weigh in favor of the foreign jurisdiction.
Why Does It Matter?
Insofar as the U.S. transfer tax regime is concerned, a lot depends upon whether a noncitizen is or is not domiciled in the U.S.
In general, a U.S. domiciliary[xv] is subject to U.S. gift tax, at a maximum rate of 40 percent, on the transfer of any kind of property regardless of its situs.[xvi]
That said, a U.S. domiciliary is allowed an unified-gift-estate tax exclusion of $12.06 million. In other words, between their lifetime gifts and transfers occurring at their death, the U.S. domiciliary may transfer up to $12.06 million’s worth of property in the aggregate without incurring U.S. gift tax or estate tax.
A nonresident, on the other hand, is subject to U.S. gift tax only if the property transferred is tangible property located in the U.S.; for example, U.S. real property, artwork that is located in the U.S. at the time of the gift, cash that is kept in the U.S.
The transfer of intangible property by a nonresident is not subject to U.S. gift tax[xvii] even if the property would have been included in the nonresident’s gross estate as U.S.-situs property for purposes of the U.S. estate tax.
For example, a gift of stock in a U.S. corporation is not subject to the U.S. gift tax. This is the case even if the corporation owns U.S. real property or owns and operates a U.S. trade or business.
However, a testamentary transfer of that same stock would be subject to U.S. estate tax.
The gift tax treatment of a nonresident’s transfer of an interest in a U.S. partnership is not as clear as it should be, though most advisers would probably treat such a transfer as subject to U.S. gift tax if the partnership is engaged in a U.S. trade or business or if it owns U.S. real property, to the extent the value of the partnership interest is attributable to such property.[xviii]
A few estate and gift tax treaties provide that an interest in a partnership with such assets will be treated as U.S. property.[xix]
However, in a somewhat dated published ruling, the IRS rejected the notion that the situs of a partnership interest is determined by reference to the situs of its assets.[xx]
Then there is the question of a nonresident’s interest in an LLC. Of course, the U.S. will treat an LLC as a partnership for tax purposes if that is consistent with its status under the check-the-box regulations.[xxi]
However, the U.S. Tax Court has held that the transfer of a membership interest in a single member LLC that held cash and marketable securities and that has not elected to be treated as an “association” (i.e., corporation) for tax purposes – i.e., that is disregarded for purposes of the U.S. federal income tax – should be respected as a transfer of such membership interest (an intangible) and should not be treated as a transfer of a proportionate share of the LLC’s assets.[xxii]
Query whether the outcome would be different where the LLC holds real property or the assets of a U.S. trade or business.
Unless both spouses are U.S. citizens or residents, they will not be able to split gifts.[xxiii]
A nonresident who makes an otherwise taxable gift of U.S.-situs property to a spouse who is a U.S. citizen will be entitled to a marital deduction for purposes of determining their U.S. gift tax liability.
However, if the donee-spouse is not a U.S. citizen – and even though the donee-spouse may be domiciled in the U.S. – the nonresident donor is not allowed to claim the marital deduction.[xxiv]
Instead, the nonresident donor may transfer up to $164,000 to such a spouse every year without incurring U.S. gift tax.[xxv]
In contrast to the $12.06 million exclusion enjoyed by a U.S. domiciliary, a nonresident is not granted any exclusion amount other than the annual exclusion from gifts, the annual exclusion for gifts to a noncitizen spouse, and the exclusion for certain transfers to cover educational or medical expenses.[xxvi]
Thus, a nonresident who makes a gift that is subject to U.S. gift tax is not allowed any exclusion beyond the annual exclusion amount (currently $16,000) and the special annual exclusion for gifts to spouses who are not U.S. citizens.[xxvii]
The estate of a decedent who was domiciled in the U.S. at the time of death is subject to U.S. estate tax with respect to the decedent’s worldwide assets.[xxviii]
U.S. Situs Property
A nonresident decedent, however, is subject to U.S. estate only with respect to their U.S. situs property.[xxix]
Of course, this would include U.S. real property and other tangible assets located in the U.S. at the time of death.[xxx] (There is an exception for artwork that is on loan to a public museum for an exhibition.[xxxi])
It should include an interest in a partnership that is engaged in a U.S. trade or business or that owns U.S. real property, to the extent the value of the partnership interest is attributable to such assets.
Shares of stock issued by a U.S. corporation, and debt obligations issued by a U.S. person, are deemed to be U.S. situs property for purposes of the estate tax.[xxxii]
In other words, the nonresident decedent’s U.S. estate may include properties that would not have been subject to the U.S. gift tax if the decedent had transferred them prior to their death (for example, shares of stock in a U.S. corporation).
It will also include any property of which the decedent made a gift transfer, but with respect to which they retained an interest[xxxiii] (or released such interest within three years of their death[xxxiv]) that would cause such property to be included in their gross estate if such property was situated in the U.S. at the time of the gift transfer or at the time of the decedent’s death.[xxxv]
Deemed Non-U.S. Situs
Significantly, the life insurance proceeds payable on the life of a NRNC is not deemed to be U.S.-situs property.[xxxvi]
In addition, debt obligations that generate portfolio interest[xxxvii] are also not treated as U.S. property.[xxxviii]
Finally, amounts on deposit at a U.S. bank are not treated as U.S.-situs property if the interest thereon would not be treated as income that is effectively connected with the decedent’s conduct of a U.S. trade or business.[xxxix]
For purposes of determining their U.S. estate tax liability,[xl] a donor-spouse is entitled to a deduction for the value of property passing outright to the U.S. citizen spouse or in trust for the spouse’s benefit provided the trust meets certain requirements.
If the surviving spouse is not a U.S. citizen, the NRNC decedent’s estate may claim a marital deduction only to the extent that the decedent’s property passes into a qualified domestic trust (“QDOT”) for such spouse’s benefit. Distributions of principal from such a trust are subject to transfer tax which must be withheld by the trustee.[xli]
In contrast to the $12.06 million aggregate unified estate-gift tax exclusion enjoyed by a U.S. domiciliary, a nonresident decedent whose estate is subject to U.S. estate tax is allowed an exclusion of only $60,000.[xlii]
The situation may be quite different for a NRNC who resides in a foreign country with which the U.S. has an estate (or an estate and gift) tax treaty.
For one thing, a treaty may change the situs of certain property. Thus, for example, “real property” may be defined to include shares in a U.S. corporation the assets of which consist at least 50 percent of U.S. real property. These shares are deemed to be situated in the U.S. for purposes of the U.DS. gift tax.[xliii]
A NRNC decedent who was domiciled in a treaty country may be allowed an exclusion that bears the same ratio to the $12.06 million exclusion allowed a U.S. decedent as the nonresident’s U.S. estate bears to their total estate.[xliv]
Likewise, a treaty may allow a deduction for the value of property that passes to a nonresident decedent’s surviving spouse and that would qualify for the marital deduction if the surviving spouse were a U.S. citizen, provided certain criteria are satisfied (for example, the surviving spouse is domiciled in the treaty country or in the U.S. at the time of the decedent’s death).[xlv]
If ever there was a situation in which an individual taxpayer should be especially attentive to the saying “forewarned is forearmed,” it is that of an affluent NRNC who is considering a move to the U.S.
A NRNC who knowingly seeks to change their tax status with respect to the U.S., and who expects to be subject to U.S. transfer taxes, should consider the implementation of some basic “pre-immigration” tax planning strategies that may significantly reduce their exposure to U.S. transfer tax.
The following measures are based upon the applicable “default” rules under U.S. tax law, as described above.
Any NRNC who is a resident of a foreign country with which the U.S. has an estate and/or gift tax treaty should determine how such a treaty may affect the appropriateness of these and other measures.
Moreover, it is important to consider the U.S. and foreign income tax consequences of these strategies, with respect to both the NRNC and the individuals to whom the NRNC plans to transfer their wealth; after all, a large income tax bill can substantially reduce the benefit of any transfer tax savings.[xlvi]
Gifts of Intangibles
The NRNC may transfer shares of stock and other securities to family members or to trusts for their benefit before the NRNC becomes a U.S. resident for purposes of the U.S. gift tax.
As explained earlier, a gift of such assets by a NRNC is not subject to U.S. gift tax, even if the asset gifted is stock or securities issued by U.S. corporations.
The use of a trust may also reduce the beneficiaries’ estate tax exposure.
Because the sale of such investment assets would usually not be subject to U.S. income tax in the hands of a NRNC,[xlvii] a gift of such assets to a family member who is also a NRNC would not burden the recipient with a deferred U.S. income tax liability,[xlviii] assuming the recipient does not move to the U.S.
By the same token, the NRNC may consider retaining, for inclusion in their U.S. gross estate – in order to step up the basis of such assets to fair market value[xlix] – certain intangibles that are to be transferred to U.S. individuals.
Gift of Foreign/Non-U.S. Situs Assets
The NRNC should consider gifts of non-U.S. assets because the transfer of such assets is not subject to U.S. gift tax.
For example, a gift of cash from a foreign bank account is not subject to U.S. gift tax – even when the gift is made to a U.S. beneficiary[l] – whereas a gift of cash that is on deposit with a U.S. bank would be.
A gift of foreign real estate would also escape U.S. gift tax; at the same time, the property would be removed from the NRNC’s future U.S. estate.
Instead of a direct transfer to NRNC individuals, the NRNC donor may gift the securities to a trust for the benefit of such individuals. Ideally, a foreign trust[li] would be used because it would escape U.S. income tax on any capital gains realized.
The assets of the trust would escape the U.S. transfer taxes, provided the grantor did not retain any rights or powers with respect to the trust that would prevent the transfer from being a completed gift,[lii] or that would cause the inclusion of the trust in the gross estate of the grantor for U.S. estate tax purposes.
A trust is a foreign trust if no court within the U.S. is able to exercise primary supervision over the administration of the trust.[liii] A trust may also be a foreign trust if no U.S. person has the authority to control all substantial decisions of the trust.
There is a scenario, however, in which, the use of a foreign trust may be problematic for a NRNC grantor who may be moving to the U.S. shortly after the gift.
Specifically, if the NRNC makes a gift transfer of property to a foreign trust, the trust has or is treated[liv] as having a U.S. beneficiary, and the NRNC grantor becomes a U.S. resident within five years after the transfer, then the grantor (now a U.S. person) will be treated as the owner of the property and of its income under the grantor trust rules.[lv]
Even where the NRNC manages to avoid the grantor trust rules by becoming a U.S. resident only after the fifth anniversary of establishing the foreign trust, any U.S. beneficiary of the trust may have to contend with the application of the so-called “throwback rules” with respect to certain distributions from the trust.[lvi]
The direct transfer of any intangibles that are used or held for use in a U.S. trade or business should be avoided. However, if such property is held by a U.S. or foreign corporation,[lvii] the shares of such corporation’s stock may be gifted by the NRNC without incurring U.S. gift tax.
With respect to the transfer of U.S. real property and of tangible personal property located in the U.S. that is already owned by the NRNC, the NRNC should consider contributing such asset to a corporation, the equity in which may then be gifted without triggering U.S. gift tax,[lviii] while also removing the property and its subsequent appreciation from the soon-to-be-former NRNC’s future U.S. gross estate.[lix]
Of course, it is imperative that the corporation have a bona fide business purpose and that it be respected as a separate legal entity; that includes transacting with the corporation on an arm’s length basis.[lx]
If the IRS determines that the corporation should be disregarded as a sham, the NRNC donor would be treated as having made a direct and taxable gift of the underlying U.S.-situs tangible property.
It is equally imperative that the NRNC determine the U.S. and foreign income tax consequences of contributing the property to a corporation. If the contribution cannot be accomplished on a tax-deferred basis, the NRNC may have to reconsider their strategy.[lxi]
Even if the NRNC implements any or all of the strategies outlined above, it may be prudent to acquire life insurance on the NRNC’s life to provide their beneficiaries with liquidity to satisfy any potential U.S. estate tax liability.
Moving to the U.S. and becoming a U.S. domiciliary for purposes of the transfer taxes should not be undertaken without first planning for the reduction of such taxes, including the implementation of the measures described herein.
Such planning takes time. Thus, it would behoove the NRNC who is considering a move to the U.S. to consult their U.S. and foreign tax advisers as soon as practicable.
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The opinions expressed herein are solely those of the author(s) and do not necessarily represent the views of the Firm.
[i] Just think of the Huns forcing the Germanic tribes into southern and western Europe. The Yankees forcing the Giants and the Dodgers to California.
[ii] That said, there are a number of foreign individuals who inadvertently become U.S. persons because they are ignorant of the rules described herein.
[iii] Talk about culture shock.
[iv] Well, I can tell you that, after many bouts with the Department of Taxation and Finance, and after observing the “process” by which Albany taxes its constituents, I am no longer taken aback by the number of well-to-do New Yorkers who have shared with me their plans to depart New York for a jurisdiction with a friendlier tax environment.
In fact, these days I am pleasantly surprised to encounter a wealthy New Yorker who does not want to remove themselves to another state.
However, I am impressed by the number of these people who are thinking about moving overseas. Mind you, I’m not talking about individuals who want to give up their U.S. citizenship. Thankfully, the vast majority of wealthy Americans still recognizes the privilege of being a U.S. citizen and the attendant benefits. No, I’m referring to folks who just want to stop being New Yorkers.
[v] Years ago, we referred to these individuals as “aliens”; apparently, that term is now reserved for extraterrestrials.
[vi] Among the benefits bestowed on citizens: voting right, one’s children become citizens, U.S. passport and assistance outside the U.S., elected office, priority to bring family to the U.S., etc.
[vii] A permanent resident, or green card holder, is a noncitizen who has been granted the right to work and live permanently in the U.S. There are several categories of eligibility; for example, some focus on one’s relationship to a U.S. citizen, or on one’s special educational qualifications or work skills.
A green card holder must maintain residency in the U.S. – if a permanent resident remains outside the U.S. for 180 days or more, their Green Card will be revoked. If a permanent resident needs to travel outside the U.S. for an extended period, they will need to obtain an authorization that proves they do not intend to abandon their status.
[viii] A noncitizen nonresident may also be treated as a U.S. resident for a particular tax year if they are present in the U.S. for at least 31 days during that year, and if they are present in the U.S. for more than 183 days (determined on a weighted basis; see below) during the three-year period ending with (and including) the tax year in question. IRC Sec. 7701(b)(3).
For purposes of counting days, each day of presence in the current year counts as a full day, every day of presence in the immediately preceding year is counted as a one-third of a day, and every day of presence in the next immediately preceding year counts as one-sixth of a day.
[ix] Reg. Sec. 20.0-1(b)(1).
[x] Reg. Sec. 25.2501-1(b).
[xi] Reg. Sec. 20.0-1(b)(1); Reg. Sec. 25.2501-1(b).
[xii] Rev. Rul. 80-209.
[xiii] Mitchell v. United States, 88 U.S. 350 (1875); Estate of Nienhuys v. Commissioner, 17 T.C. 1149 (1952).
[xiv] Est. of Khan, T.C. Memo 1998-22 (1998).
[xv] The same applies to a U.S. citizen.
[xvi] IRC Sec. 2501(a)(1); Reg. Sec. 25.2501-1(a)(1).
[xvii] IRC Sec. 2501(a)(2).
[xviii] If the partnership owns only intangible investment assets, a gift of an interest therein should escape U.S. gift tax.
[xix] For example, Article 8 of the U.S. estate and gift tax treaty with Germany.
[xx] Rev. Rul. 55-701.
[xxi] Reg. Sec. 301.7701-3.
[xxii] Pierre v. Comm’r, 133 T.C. 24 (2009). Of course, Rev. Rul. 99-5 treats the transfer of an interest in a single member LLC that is disregarded for tax purposes as the transfer of a proportionate part of the LLC’s assets, followed by a contribution of such assets by both the original member and the new member as a contribution to the LLC described in IRC Sec. 721.
[xxiii] IRC Sec. 2513(a)(1).
[xxiv] IRC Sec. 2523(a) and Sec. 2523(i).
[xxv] IRC Sec. 2523(i). This amount is subject to adjustment every year.
[xxvi] IRC Sec. 2503(b) and (e), respectively.
[xxvii] A gift to a spouse who is a U.S. citizen is allowed to claim a marital deduction for such transfer.
[xxviii] IRC Sec. 2001; Reg. Sec. 20.0-2(b); Reg. Sec. 20.2031-1(a).
[xxix] IRC Sec. 2101, Sec. 2103, and Sec. 2106.
[xxx] IRC Sec. 2104; Reg. Sec. 20.2014-1(a).
[xxxi] IRC Sec. 2105(c).
[xxxii] IRC Sec. 2104(a) and (c).
[xxxiii] IRC Sec. 2036, 2037, and 2038.
[xxxiv] IRC Sec. 2035.
[xxxv] IRC Sec. 2104(b); Reg. Sec. 20.2104-1(b).
[xxxvi] IRC Sec. 2105(a). More on this later.
[xxxvii] See IRC Sec. 871(h).
[xxxviii] IRC Sec. 2105(b)(3).
[xxxix] IRC Sec. 2105(b)(1).
[xl] IRC Sec. 2056 and Sec. 2056(d).
[xli] IRC Sec. 2056A.
[xlii] IRC Sec. 2102(b).
[xliii] For example, Article III of the Protocol to the U.S. estate and gift tax treaty with France.
[xliv] For example, Art. 3 of the Protocol amending the U.S. estate and gift tax treaty with Germany.
[xlv] For example, Art 3 of the Protocol amending the U.S. estate and gift tax treaty with Germany.
[xlvi] A subject for a later post.
[xlvii] IRC Sec. 871(a). Of course, there are exceptions. For example, the sale of stock in a U.S. real property holding corporation under IRC Sec. 897(c), and the sale of property used or held for use in a U.S. trade or business under IRC Sec. 864(c)(2).
[xlviii] Tied to the carry-over basis of the donor’s basis. IRC Sec. 1015.
[xlix] IRC Sec. 1014.
[l] Note that U.S. beneficiaries of foreign donors or foreign estates may have to report such gifts or bequests. See IRS Form 3520.
[li] Preferably, in a low-tax jurisdiction.
[lii] Such as a testamentary limited power of appointment.
[liii] IRC Sec. 7701(a)(31)(B).
[liv] To avoid being treated as having a U.S. beneficiary, the trust must provide that no part of the trust’s income or principal may be paid to or held for a U.S. person. IRC Sec. 679(c)(2)(C).
[lv] IRC Sec. 679. Of course, if the grantor can afford the resulting income tax, the trust will not be reduced by U.S. income taxes.
[lvi] IRC Sec. 665 to Sec. 668. These rules seek to negate any deferral benefit enjoyed by a U.S. beneficiary of a foreign trust that does not make current distributions of its income on a current basis. When the trust distributes income that has been accumulated, the rules first allocate such income to the years of the trust in which it had undistributed income. The distributee-beneficiary is then required to report the income for the year the beneficiary received the distribution, except the tax is based upon the beneficiary’s tax rate during the years the income was accumulated by the trust, and an interest charge is imposed based upon of the underpayment rate.
[lvii] Including an entity that is treated as a corporation under the check-the-box rules of Reg. Sec. 301.7701-3.
[lviii] In order to avoid the step transaction doctrine, under which the transfer of the property to the corporation may be disregarded for tax purposes, with the result that the NRNC is treated as having gifted U.S. situs property, the NRNC should not make the gift of stock immediately after contributing the property to the corporation.
[lix] Ideally, the NRNC would not have acquired the property directly in the first place. Instead, they would have used a corporation or trust as the purchaser.
[lx] IRC Sec. 482 is a good place to start.
[lxi] For example, see IRC Sec. 367(b) and the regulations promulgated thereunder.