United States: U.S. Tax Planning For Non-U.S. Persons And Trusts: An Introductory Outline

Last Updated: January 17 2012
Article by G. Warren Whitaker

Estate planning for non-U.S. persons differs from domestic planning not only in the specific rules that apply, but in the mental outlook that the planner must bring to the process. To put it simply, in planning for a U.S. person we begin with the assumption that all income and assets are subject to U.S. income, estate and gift tax, and we then hunt for exceptions (a.k.a. "loopholes") that will shelter some income and assets from these taxes, i.e., municipal bond interest, charitable deductions, the estate tax marital deduction. Non-U.S. persons, on the other hand, start out in an environment in which no U.S. income or estate taxes are payable, and the planner's job is to keep an eye out for pitfalls (U.S. residence, U.S. source income and U.S. situs assets) that may produce such taxes.

The following is an outline of the rules that apply in estate and tax planning for non-U.S. persons and trusts. It is not intended to be the exhaustive word on the subject—volumes are required for that task—but is meant to serve as a general guide to the subject.

I. BASIC RULES

The following are the basic rules of international estate planning:

  • U.S. persons are subject to U.S. income taxation on their worldwide income. (I.R.C. §§ 1, 61)
  • Individuals who are U.S. persons are also subject to gift, estate and generation-skipping transfer taxation on their worldwide assets. (I.R.C. §§ 2001, 2031-2046, 2601).
  • Non-U.S. persons are subject to U.S. income tax only on their U.S. source income.
  • Individuals who are non-U.S. persons are subject to estate, gift and generation-skipping transfer tax only on U.S. situs assets.

These rules are elaborated upon on the following sections of this outline.

II. WHO IS A U.S. PERSON?

A. Individuals, Corporations and Trusts. The term "U.S. person" includes U.S. individuals as well as domestic corporations and U.S. trusts. (I.R.C. § 7701(a)(30))

B. When is an Individual a U.S. Person? An individual is a U.S. person if he or she is either:

  • A U.S. citizen, regardless of residence, and including a dual citizen of the U.S. and one or more other countries; or
  • A U.S. resident, regardless of citizenship.

C. Who is a U.S. Resident?

1. Income Tax Resident: A resident for income tax purposes is:

  1. A green card holder (or other lawful permanent resident) who is present in the United States for at least one day of a calendar year. (I.R.C. § 7701 (b)(1)(A)) There are special rules for the first and last year of lawful residence. For the first year, if the individual was not a resident in the prior calendar year, the individual is treated as a resident only for the portion of the year starting when the residence began. (I.R.C. § 7701(B)(2)(A)) For the final year, if an individual turns in his green card and leaves the U.S., is not a U.S. resident in the following year and has a closer connection to another tax jurisdiction, he or she will only be a U.S. income tax resident for the portion of the year that he or she was a card holder. (I.R.C. § 7701(B)(2)(B)) (As to departing residents, however, there are special rules for Long-Term Residents, discussed infra)
  2. Under the "substantial presence" test, a person is a U.S. resident for a given calendar year if he or she either (a) is present in the United States for 183 days in that year, or (b) is present in the U.S. for at least 31 days of that year and has been present in the U.S. for an average of more than 121 days per year over that year and the two prior years. (I.R.C. § 7701 (b)(3)(A))

Exceptions:

  1. A person holding a diplomatic visa or a full-time student, teacher or trainee visa, or an employee of an international organization, is not a U.S. resident, regardless of the number of days spent in the U.S. (I.R.C. § 7701 (b)(5)(A) and (B))
  2. A person who is present in the U.S. for less than 183 days in the calendar year, but whose 3-year average is greater than 121 days, can avoid U.S. resident status by demonstrating that he or she has a tax home in and a "closer connection" to a foreign country. (I.R.C. § 7701(b)(3)(B))
  3. Treaties with some countries contain "tie-breaker" provisions to resolve the issue of residence for a person who would otherwise be treated as a resident of both of the treaty countries.

2. Estate and Gift Tax Resident: A U.S. resident for estate and gift tax purposes is a person whose primary residence, or domicile, is in the United States. This means that the person lives in the United States and has no definite present intent to leave, as shown by the surrounding facts and circumstances. (Treas. Reg. § 20.0-1(b)(1); Treas. Reg. § 25.2501-(1)(b)).

Because a "bright line" test applies for income tax purposes and a "facts and circumstances" test for estate tax purposes, it is possible for an individual to be a U.S. resident for purposes of one tax and not for the other.

D. What Constitutes a Domestic Corporation? A corporation that is organized or created in the United States. I.R.C. § 7701(a)(3)

E. What Constitutes a Domestic Trust? Under the law in effect as of 1996 (I.R.C. §§ 7701(a)(30)(E) and (31)(B)), every trust is a foreign trust unless both of the following are true:

  1. A United States court can exercise primary supervision over the administration of the trust; and
  2. One or more U.S. persons have the power to control all substantial decisions of the trust.

Under Reg. § 301.7701-7, the "United States" refers only to the fifty states and the District of Columbia. A safe harbor is created whereby a trust is a domestic trust if it is administered exclusively in the U.S., has no provision directing administration outside the U.S., and has no automatic change of situs clause (except in case of foreign invasion or widespread confiscation of assets in the U.S.) If a person other than a trustee (such as a Protector) has the power to control substantial decisions, that person will be treated as a fiduciary for purposes of the control test. Powers exercisable by a grantor or a beneficiary, such as a power to revoke or a power of appointment, will also be considered in determining "substantial control."

Under the Regulation, "substantial decisions" include:

  1. Whether and when to distribute income or corpus.
  2. The amount of any distribution.
  3. The selection of a beneficiary.
  4. The power to make investment decisions. (However, if a trust has a foreign investment advisor who can be removed by the U.S. trustee at any time, this will not make the trust foreign.)
  5. Whether a receipt is allocable to income or principal.
  6. Whether to terminate the trust.
  7. Whether to compromise, arbitrate or abandon claims of the trust.
  8. Whether to sue on behalf of the trust or to defend suits against the trust.
  9. Whether to remove, add or name a successor to a trustee.

If a vacancy occurs through the death or sudden resignation of a trustee which would shift control of a substantial decision out of the hands of U.S. trustees, the trust has twelve months to reassert U.S. control by either a change of fiduciaries or a change of residence of a fiduciary. If such a change is made within twelve months, the trust will be treated as having remained a U.S. trust; if no such change is made, the trust will have become a foreign trust on the date the vacancy occurred.

This new definition makes it easier to determine whether a trust is U.S. or foreign. It also is heavily tilted towards a conclusion that a trust is foreign. For instance, if a New York resident creates a testamentary trust for his New York resident children by his will probated in New York, with a New York bank and an Irish cousin as trustees, and if principal distributions to the children can only be made by majority vote of the trustees, the trust is a foreign trust under the new law since a substantial decision is not controlled by a U.S. fiduciary.

III. TAXATION OF NON-U.S. PERSONS

Persons who are neither U.S. citizens nor U.S. residents ("Non-Resident Aliens" or "NRAs") are subject to U.S. taxes as follows:

A. Income Tax: NRAs are subject to U.S. income tax only on U.S. source income, generally at a 30% withholding rate. (I.R.C. § 871(a)(1))

U.S. Source Income for Income Tax Purposes (I.R.C. § 871(a)):

  • Dividends from U.S. corporations, but not the proceeds of sale of U.S. securities.
  • Rent from U.S. real property, and capital gains on the sale of U.S. real property or real property holding companies.
  • Interest on debts of U.S. obligors. However, interest on most publicly traded bonds issued after July 18, 1984 constitutes "portfolio interest" and therefore qualifies for the portfolio exemption and is not taxed as U.S. source income (I.R.C. § 871(h)).
  • Salaries paid by U.S. and non-U.S. entities for services performed by the recipient in the United States.
  • U.S. royalties.

NRAs are also subject to income tax at the same graduated rates as U.S. persons on their income in connection with the conduct of a trade or business in the U. S. (I.R.C. § 871(b))

Interest on U.S. bank accounts, including time deposits and certificates of deposit, is not U.S. source income.

Income tax treaties between the U.S. and other countries can alter these rules, particularly the withholding rate.

B. Estate Tax: Estates of NRA individuals are subject to U.S. estate tax only on U.S. situs assets. The tax is assessed at the same rates as for U.S. citizens, up to 35% for 2011 and 2012, but with only a $60,000 exemption (as opposed to the current exemption of $5,000,000 for a U.S. person). (I.R.C. § 2106 (b)) Worldwide debts and administration expenses may be deducted, but only in the proportion that the U.S. assets bears to the decedent's worldwide assets. The unlimited marital deduction is available; however, if the surviving spouse is not a U.S. citizen, only property left to a Qualified Domestic Trust (QDT) will qualify (see Section VIII (B) below). The charitable deduction is available only for bequests to U.S. charities.

U.S. Situs Assets for Estate Tax Purposes: The following is a partial list:

  • U.S. situs real property, including houses and condominiums. (Treasury Reg. §§ 20.2104-1 (a)(2); 20.21051 (a)(2))
  • U.S. situs tangible personal property, such as jewelry, antiques, artworks and cars, unless the items are in transit or on loan for an exhibition. (Treasury Reg. §§ 20.2104-1 (a)(2); 20.21051 (a)(2))
  • Shares of stock of U.S. corporations, including shares of a U.S. co-operative corporation representing a co-op apartment. (I.R.C. § 2104(a)) Shares of non-U.S. corporations are not U.S. situs property. The location of the certificate is immaterial. Mutual funds (including money market funds) organized in corporate form are U.S. situs property if incorporated in the United States. (I.R.C. § 2104(a)) If the fund is structured as a partnership or grantor trust, the situs of the fund depends on the situs of the underlying assets of the fund.
  • Cash deposits with U.S. brokers, money market accounts with U.S. mutual funds and cash in U.S. safe deposit boxes are U.S. situs property. (I.R.C. § 2104 (c))
  • Debts of U.S. obligors. Once again, however, publicly traded bonds issued after July 18, 1984 qualify as "portfolio debt" and therefore are not subject to U.S. estate taxation. (I.R.C. § 2105 (b)(3)) Previously, only bonds with a maturity of more than 6 months qualified for the estate tax portfolio debt exemption, so that short-term Treasury bills, for example, were U.S. situs assets. However, this distinction was eliminated by the Taxpayer Relief Act of 1997, and bonds now qualify for the portfolio debt exemption regardless of maturity.
  • Interests in limited or general partnerships that either do business in the U.S. or own assets in the U.S. will probably be considered U.S. situs assets.
  • Life insurance proceeds paid by a U.S. insurer on the life of a non-U.S. person is not U.S. situs property. However, the cash surrender value of life insurance owned by a non-U.S. person on the life of another person is U.S. situs property if issued by a U.S. insurer. (Treasury Reg. § 20.2105-1 (g))

Bank accounts maintained with U.S. banks are not U.S. situs property: this includes checking and savings accounts, time deposits and certificates of deposit. (I.R.C. § 2104 (c))

Again, treaties with various countries can alter these rules, particularly as to whether U.S. stocks owned by a citizen and resident of another country will be taxed by the U.S.

C. Gift Tax: NRAs are subject to gift tax only on gifts of U.S. situs real property and tangible personal property. The annual exclusion of $13,000 for gifts of a present interest may be applied; however, the $60,000 credit that NRAs have for estate tax purposes may not be applied to gifts. Gifts of shares of stock of U.S. corporations are not subject to U.S. gift tax. However, gifts of cash (possibly including checks) that take place within the United States may be subject to gift tax; therefore, any gifts of cash by a non-U.S. person to a U.S. person should be made outside the United States. (I.R.C. §§ 2501 (a)(3); 2511 (b))

D. Reporting of Gifts by NRAs to U.S. Persons: Any U.S. person who receives "large gifts" (over $100,000) from a foreign person during any calendar year must file a report describing these gifts. (I.R.C. § 6039F; Form 3520) (The recipient must be a U.S. person for income tax purposes, and the foreign person may be either a foreign individual for income tax purposes, or a foreign entity—corporation, partnership, trust or estate). The stated purpose of this reporting requirement is to insure that the purported gift is not really a disguised distribution of income from a foreign trust.

The term "gifts" includes bequests from estates of non-U.S. persons. (I.R.C. § 6039F(b)) Qualified medical or educational payments under I.R.C. § 2503(e) are not considered to be gifts and are not subject to reporting.

In determining whether a U.S. person has received gifts during the taxable year from a particular foreign donor in excess of $100,000, the U.S. donee must aggregate gifts from foreign persons that he knows or has reason to know are related, within the meaning of § 643(i)(2)(B). For instance, if an NRA mother and father each give their U.S. son $60,000, the gifts are aggregated, the $100,000 reporting threshold is exceeded and the son must report both gifts. Once the $100,000 threshold has been met, the donee must separately identify each gift in excess of $5,000.

A U.S. person is required to report the receipt of purported gifts from foreign corporations and foreign partnerships if the aggregate amount of purported gifts from all such entities exceeds $10,000 in any year. (This threshold is indexed for inflation and is presently $12,760.) The use of the word "purported" in the Notice gives an indication of the jaundiced eye with which the I.R.S. will view such "gifts." The I.R.S. may recharacterize those "gifts" as taxable dividends from the corporation.

The form used to report gifts from foreign persons (Form 3520) asks for a brief description of the property received as a gift, whether the foreign donor is an individual, corporation, partnership, or estate, and whether the foreign donor was acting as a nominee or intermediary for another person. The form does not ask for the identity of a foreign individual donor, although the IRS could ask for this information.

While there is no tax on gifts from foreign persons, the penalty for failure to report the gifts is severe. If a gift is not reported on Form 3520, the tax consequences of the receipt of the gift shall be determined by the Secretary. (I.R.C. § 6039F(c)(1)(A)) In addition, the recipient is subject to a penalty equal to 5 percent of the value of the gift for each month in which the gift is not reported, not to exceed 25 percent. (I.R.C. § 6039F(c)(1)(B)) The penalties can be waived if the failure to file was due to reasonable cause and not willful neglect. Ignorance of the law is not reasonable cause.

E. Estate Tax and Generation-Skipping Transfer Taxes: Transfers by a NRA to a U.S. person are not subject to U.S. income, estate or gift tax except as to assets that have U.S. situs for estate or gift tax purposes.

A transfer by a NRA will be subject to GST tax only if it is also subject to U.S. estate or gift tax, which will be the case only if it consists of U.S. situs property. (Treas. Reg. § 26.2663-2)

F. Treaties: Treaties with individual countries may alter some of these rules, particularly as to determination of residence, source of income, situs of assets and income withholding rates. The U.S. generally enters into treaties with countries that have significant taxes of their own, to help avoid double taxation. Therefore, if a treaty allows a NRA to reduce his U.S. tax liability, there will usually be an offsetting tax in the NRA's country of residence.

The United States never enters into a treaty which exempts U.S. citizens from worldwide income, estate, gift, or generation-skipping taxation.

At present the United States has estate tax treaties with the following countries

Australia
Austria
Canada (Third Protocol to Income Tax
Convention)
Denmark
Finland

France
Germany
Greece
Ireland
Italy
Japan

Netherlands
Norway
South Africa
Sweden
Switzerland
United Kingdom

The estate tax treaties with the United Kingdom, France, Germany, Austria, Denmark and Sweden are based on the unified system concept, and in consequence cover taxes on gifts and generation-skipping transfers as well as estate taxes.

The U.S. also has separate gift tax treaties with Australia and Japan.

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