Volume 1, Number 2
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Most U.S. estate planners deal exclusively with domestic clients and assume that they do not need to know anything about cross-border matters. But other countries do exist in the world. Citizens of those countries sometimes move to the United States or own property here, and U.S. citizens occasionally move or own property outside the United States. Estate planners need to be aware of international issues that may arise. This article describes (with apologies to David Letterman) the top ten international estate planning issues that a domestic estate planner is likely to encounter. (QTIP) trust for her benefit. Because Carol is not a U.S. citizen, the marital deduction is available only if certain requirements are met. Code § 2056(d)(2)(A).
The property must be left to the surviving noncitizen spouse in the form of a qualified domestic trust (QDT), which pays all income to the spouse for life, has at least one U.S. trustee, and may make principal distributions only to the surviving spouse. Code § § 2056(d)(2), 2056A. If the trust has more than $2 million in assets, there must be a U.S. corporate trustee, unless a letter of credit or a bond is posted.
If Sam does not create a QDT but leaves his property outright to Carol, she (or the executor of Sam's estate) can create a QDT after his death and add the assets she inherits from him to the QDT she creates. It is preferable, however, for Sam to create the QDT in his will or revocable trust. Among other reasons, this alerts both Sam and Carol to the QDT requirement and allows them to plan to minimize its effect.
The greatest disadvantage to the QDT is that principal distributions to Carol are subject to estate tax. Here are techniques to minimize this disadvantage:
1. You are discussing estate planning with Sam, a U.S. citizen and resident client. Sam tells you that his wife, Carol, is a Canadian citizen with a green card who has resided in the United States for many years.A key element in the estate planning for a married individual is the estate tax marital deduction. Because Carol is not a U.S. citizen, special rules apply to obtain the marital deduction for Sam's estate.
The unlimited marital deduction from U.S. estate taxes will not be available for bequests that Sam makes outright to Carol or in a qualified terminable interest property spouse from a QDT, estate tax is paid out of the distribution at the applicable rate for the estate of the deceased spouse. On the death of the surviving spouse, the balance then remaining in the QDT is also subject to estate tax at the applicable rate for the estate of the deceased spouse. Code § 2056A.
Special arrangements can be entered into with the IRS to obtain the marital deduction for individual retirement accounts, other retirement benefits, and other assets that cannot easily be transferred directly into a QDT. Treas. Reg. § 20.2056A-4(b). These are cumbersome, however, and involve posting a bond and paying a tax on the principal portion of all distributions from the plan to Carol. It may be preferable in some cases to use Sam's applicable exclusion amount of $1.5 million to shelter retirement plans payable to Carol.
• Following Sam's death, Carol may avoid the QDT requirements by becoming a U.S. citizen. Code § § 2056(d)(4), 2056A(b)(12). Any principal distributions made from the QDT to Carol before she becomes a citizen will be taxed (unless she becomes a citizen before Sam's estate tax return is filed), but the remaining principal in the trust can be paid outright to her or converted to a QTIP trust without tax after she becomes a citizen. This may be the easiest solution if Carol does not expect to ever give up U.S. residence.
• Sam can build up Carol's estate to the extent possible, and Carol should not transfer any assets to Sam or to joint names. (But see Issue 3 in this regard for limitations on the amount Sam can give to Carol.)
• Consider the hardship exception, which allows principal distributions to be made to Carol from the QDT without tax if she does not have sufficient income or assets of her own to meet her needs. Code § 2056A(b)(3)(B).
• Consider the use of life insurance. A life insurance policy on Sam's life owned by an insurance trust can provide a source for both income and principal distributions to Carol without estate tax either on Sam's death, at the time of distribution, or on the death of Carol. (The policy could also be owned by Carol; this will avoid the need for the proceeds to be held by a QDT on Sam's death, but the remaining proceeds at Carol's death will be subject to estate tax if she is still a U.S. resident.)
Of course, if Sam's gross estate is under $1.5 million, he can leave his entire estate outright to Carol without using a QDT. Although his assets will not qualify for the marital deduction, they will be sheltered by Sam's unified credit. If Sam has less than $1.5 million but the total assets of Sam and Carol exceed $1.5 million, and if Carol plans to remain in the United States after Sam's death, Sam should leave his estate to a unified credit shelter or bypass trust for Carol to shelter his assets from estate tax at her later death.
2. Carol, a Canadian citizen residing in the United States, now asks you to prepare her estate plan.
The United States subjects both citizens and residents to estate and gift tax on their worldwide assets. Every other country in the world (except for the Philippines) taxes only its residents and not its nonresident citizens. Therefore, it is essential to confirm that Carol is a resident of the United States and not a resident of Canada.
The residence test for U.S. estate tax purposes is a domicile test, based on all the facts and circumstances. Treas. Reg. § 20.0-1(b)(2). Visa status and the number of days spent in the United States are relevant but not determinative. By contrast, the income tax test for residence is a "bright line" test that includes a non-U.S. citizen who either (1) is present in the United States for 183 or more days in a year, (2) is present in the United States for an average of 122 or more days in three or more consecutive years, or (3) has a U.S. green card or permanent work visa. Code § 7701(b); Treas. Reg. § 301.7701(b)-1-(b)-9.
When Carol says that she has lived in the United States for twenty years on her green card with her husband and their children (all of whom are U.S. citizens), that the only property she owns in Canada is a vacation house that she visits for three weeks each year, and that her contacts (clubs, doctors, financial and banking relationships) are overwhelmingly with the United States, it is easy to conclude that she is a U.S. resident. As such, she is fully subject to U.S. estate, gift, and generation-skipping transfer taxes on her worldwide assets and is entitled to a full unified credit. She will not need a QDT in her will because her husband, Sam, is a U.S. citizen.
It seems clear from the facts that Carol is not a Canadian resident, although if the facts were closer it might be a good idea to consult a Canadian attorney to confirm that this is a correct conclusion under Canadian law. Because Canada taxes only its residents, Carol will not be subject to Canadian death taxes on her death, except possibly on the real property that she still owns in Canada. (If Carol had changed her residence from Canada to the United States in the past year, Canadian counsel might have to be consulted on whether this resulted in any Canadian tax consequences; in fact, Canada does charge a capital gains tax on the assets of all departing residents.)
Carol's house in Canada can probably be disposed of by her U.S. will, but administration in Canada may be streamlined if she has a separate Canadian will to dispose of that property. The Canadian house will be subject to U.S. estate tax at Carol's death, but it will also be subject to Canadian death taxes, and a Canadian attorney will need to be consulted on this issue. (The Canadian attorney will explain that Canada does not have an estate tax but has a capital gains tax at death with a rollover available for property passing to a surviving spouse. Under a treaty between the United States and Canada, the United States allows a credit against U.S. estate tax for this Canadian capital gains tax at death.)
3. Because Carol has few assets in her own name, Sam wishes to transfer assets to her to build up her estate.
A person may make unlimited lifetime gifts to his or her U.S. citizen spouse without gift tax consequences because the gifts will qualify for the unlimited gift tax marital deduction. Code § 2523. The unlimited gift tax marital deduction is available even when the spouse making the gifts is neither a U.S. citizen nor a U.S. resident. (Non-U.S. persons are subject to gift tax only on U.S. situs real estate, tangible personal property, and cash.) But because Carol--the donee--is not a U.S. citizen, the marital deduction is not available to Sam. Instead, Sam is allowed an annual exclusion of $114,000 for these gifts. Code § 2523(i). (The amount was originally $100,000, but it is indexed annually for inflation.) These gifts may be made outright or in trust.
If Sam prefers to make the gifts in the form of a trust, the trust must be structured so that it qualifies as a gift of a present interest (Code § 2503(b)) and would also qualify for the gift tax marital deduction under Code § 2523 if the donee spouse were a U.S. citizen. This would include, for instance, a trust in which the spouse receives all income for life and is also granted a general power of appointment at death. It would not include a QTIP trust because such a trust does not qualify for the marital deduction unless an election is made, and, because Carol is not a U.S. citizen, no such election can be made.
Any gifts to Carol in excess of $114,000 will be subject to gift tax, against which Sam must apply the unused portion of his unified credit amount. He cannot create a "lifetime" QDT to qualify these gifts for the gift tax marital deduction.
4. Sam and Carol have a bank account and a house in joint name. The joint bank account was opened in 1992, and the house was purchased in 1995. Sam provided three-quarters and Carol provided one-quarter of the funds for the purchase of the house.
On Sam's death, if he is the first to die, the entire value of all joint property is included in his gross estate, except to the extent that Carol can establish by evidence that she contributed to the acquisition cost of the property. Treas. Reg. § 20.2056A-8. If Carol were to die first, the rules under Code § 2040(b) would apply because Sam is a U.S. citizen and one-half of the value of the property would be includible in Carol's gross estate.
The creation by a husband and wife of a joint tenancy (or a tenancy by the entirety) in real property on or after July 14, 1988, is not treated as a taxable gift. Treas. Reg. § 25.2523(i)-2(b)(1). If, however, the joint tenancy is terminated (for example, by sale of the property or as a change in the form of ownership), a gift is deemed to be made from Sam to Carol, if Carol individually receives any proceeds in excess of her pro rata share of contributions to the purchase price. Treas. Reg. § 25.2523(i)-2(b)(2), (4).
Upon the creation of a joint tenancy in tangible personal property, when consideration is furnished by the U.S. citizen spouse, a gift of one-half of the value of the joint property is deemed to have been made to the noncitizen spouse. Treas. Reg. § 25.2523(i)-2(c)(1). A different rule may apply, however, in the context of a joint bank account or brokerage account that allows either joint tenant to withdraw funds without obligation to repay such amounts. In such a case, there will be a gift not at the time the joint account is funded, but rather at the time the account is terminated or at the time of a withdrawal by Carol to the extent that either spouse receives a greater portion of the account balance than he or she contributed. See Treas. Reg. § 25.2511-1(h)(4).
If, as a result of these rules, all or a portion of the value of a jointly held property interest is includible in Sam's gross estate, the includible portion may be transferred to a QDT by Carol to avoid an immediate estate tax liability. Treas. Reg. § 20.2056A-8.
The federal estate and gift taxation of joint tenancies in the context of noncitizen spouses is an area of difficulty because of an intricate legislative history and an absence of judicial and regulatory interpretation. An estate planner advising clients on these matters should review and apply these rules carefully on a case-by-case basis. The best advice will generally be to avoid joint tenancies for property of any significant value when one spouse is not a U.S. citizen. Any existing joint tenancies should be severed and each party receive his or her pro rata share based on their respective contributions.
5. Sam and Carol want her brother, Wayne, a Canadian citizen and resident, to be co-trustee, together with the surviving spouse, of the credit shelter, QTIP, and QDT trusts they are each creating under their respective wills, and also of Sam's insurance trust.
Having Wayne serve as a co-trustee of the trusts will make each trust a foreign trust for U.S. income tax purposes. A trust is treated as a foreign trust unless (1) a U.S. court can exercise primary supervision over the administration of the trust (the "court test") and (2) one or more U.S. persons have the power to control all substantial decisions of the trust (the "control test"). Code § § 7701(a)(30)(E) and (31)(B); Treas. Reg. § 301.7701- 7(b). This is true even if the trusts are governed by the laws of a U.S. state and even if they are created under wills that are admitted to probate in a U.S. state.
Under the control test, powers held by any person or entity will be considered in determining whether U.S. persons control all substantial decisions--not only by the trustee, but also powers exercisable by a trust protector, the grantor, or even a beneficiary.
Under the Treasury Regulations, "substantial decisions" include:
• whether and when to distribute income or corpus,
• the amount of any distribution,
• the selection of a beneficiary,
• the power to make investment decisions (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),
• whether a receipt is allocable to income or principal,
• whether to terminate the trust,
• whether to compromise, arbitrate, or abandon claims of the trust,
• whether to sue on behalf of the trust or to defend suits against the trust, and
• whether to remove, add, or name a successor to a trustee.
If the trust is a foreign trust, it is subject to U.S. income tax only on its U.S. situs income: generally dividends from U.S. corporations, rents from and gains from the sale of U.S. real estate, and U.S. royalties. (Interest and capital gains on the sale of U.S. stocks are not U.S. source income.) A U.S. beneficiary of a foreign trust, however, is taxed on all income received from the trust (whether the income is from a U.S. or foreign source). There are also negative tax consequences for a U.S. beneficiary who receives a distribution of accumulated income from a foreign trust, including loss of capital gains treatment, an interest charge on the tax going back to the date the income was originally earned, and application of the throwback rules.
If Carol plans to leave the United States after Sam's death, it may be advantageous for the trusts for her benefit to be foreign trusts at that time. If she plans to remain in the United States this will not be advantageous. And it will probably not be advisable for the trusts for Sam and the children, who are U.S. citizens, to be foreign trusts. The best plan will probably be to ensure that the trusts remain U.S. trusts by either taking out Wayne as a trustee or adding two U.S. trustees who can outvote him. (Carol, as a green card holder, is considered to be a U.S. trustee.)
If the trust for Carol is initially a U.S. trust with two U.S. trustees, and then Wayne replaces one of the trustees, the shift of control over substantial decisions out of the hands of U.S. persons will make the trust a foreign trust at that point. The trust then has 12 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 12 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 change in control occurred. This is of particular concern because when a U.S. trust becomes a foreign trust, capital gains recognition is triggered under Code § 684 on all trust assets.
6. Sam was told by a friend at his country club that he can put his assets in a foreign trust or corporation and pay no U.S. taxes.
Sam may obtain some tax advantages by investing in a foreign corporation that engages in an active business outside the United States, particularly if the corporation is controlled by non-U.S. persons. But Sam will not reduce his U.S. taxes by putting his passive investments into a foreign corporation. The foreign corporation will fall into one or more of three categories, each with its own tax disadvantages: a foreign personal holding company (Code § § 551- 558), a passive foreign investment company (Code § 1296), or a controlled foreign corporation (Code § 957). Some of the adverse income tax consequences that result from this categorization are recognition by U.S. shareholders of undistributed income, denial of capital gains treatment on the sale of shares, inability to carry out capital losses, and denial of a step-up in basis of the shares on death.
A foreign trust, like any other non-U.S. person, generally pays no U.S. income tax except for a withholding tax on U.S. source income. The grantor trust rules, however, prevent this result for most foreign trusts created by U.S. persons. Code § § 671-679. If the grantor or the trustee of a trust or the grantor's spouse remains as a beneficiary of the trust or otherwise retains a certain power or interest, the trust will be a grantor trust for income tax purposes and all trust income will be taxed to the grantor (or the person who transferred assets to the trust), regardless of whether the income is accumulated in the trust or distributed to another beneficiary. In addition, a foreign trust will be treated as a grantor trust if the trust permits any U.S. person to be a beneficiary. Code § 679. Therefore, unless Sam is willing to eliminate himself, Carol, and all other U.S. persons as permissible beneficiaries of the trust, as well as give up any power to control or revest himself with the trust assets, the trust will be a grantor trust and all income will be taxed to Sam as it is earned in the trust.
Moreover, a completed gift to a trust, whether foreign or domestic, will result in gift tax (or the application of the grantor's unified credit and annual exclusion for gift taxes). But the trust assets, including future appreciation and income, will not be includible in Sam's estate at death. To make the gift complete, the trust may not be revocable (alone or with the consent of another person), Sam cannot retain the power to control beneficial enjoyment, and he may not have a reversionary interest or retain a testamentary power of appointment (including a limited power of appointment) over the trust. If an incomplete gift is made to the trust, no gift tax will be payable and no credits need to be used. The assets, however, will be fully subject to U.S. estate taxation at Sam's death.
If Sam wants to make a completed gift, one option is available in some foreign jurisdictions that is not generally available in the United States: Sam may remain as one of the permissible beneficiaries of a discretionary trust. Under the laws of most U.S. states, creditors can reach such "self-settled" trusts, and therefore the transfer to the trust is not complete for U.S. gift tax purposes and is subject to U.S. estate tax at Sam's death. But in offshore jurisdictions like the Bahamas, the Cayman Islands, Jersey, Guernsey, the Cook Islands, and a few others, the fact that Sam is a discretionary beneficiary of a trust he has settled does not permit creditors to reach the trust, and therefore a gift to the trust can be a completed gift, even though Sam can receive distributions in case of emergency.
Sam may also structure the irrevocable foreign trust so that transfers to it are incomplete gifts for U.S. gift tax purposes, by retaining a testamentary power of appointment and prohibiting distributions to persons other than Sam without his consent. The transfers will not be subject to gift tax, but the trust assets will be includible in Sam's estate at death.
The primary benefit of an irrevocable foreign trust for a U.S. grantor is asset protection, not tax minimization. If the trust is properly structured, it should be protected from claims of creditors of the grantor that arise after the trust is created, even though the funds are still available for distribution to the grantor in the trustee's discretion. Moreover, creditors of the grantor whose claims arose before the transfer of assets to the trust have a limited period within which to bring those claims (two years in the Bahamas, one year in the Cook Islands, six years in the Cayman Islands).
The creation of or the transfer of assets to a foreign trust by a U.S. person must be reported to the IRS, and all of its transactions must be reported to the IRS annually. The penalties for failure to report are significant--up to 35% of the amount paid to the trust. Code § § 6048, 6677(a). The grantor of the trust is encouraged (but not required) to appoint a U.S. person as "agent" for the trust, whose responsibility is to supply the IRS with information about the trust upon request. If no agent is appointed, the IRS will require additional information regarding the trust and will interpret all information in the manner most adverse to the taxpayer.
7. Carol has received a cash bequest of $200,000 from her father, who is a Canadian citizen and resident.
No U.S. gift or estate tax is due on a gift received from a non-U.S. person or estate unless it consists of U.S. property (U.S. situs real estate, tangible personal property, or cash). Carol should contact a Canadian attorney regarding Canadian taxes that may be due. Many foreign countries impose succession taxes that are payable by the recipient. (Canada is not one of them; as noted, it has replaced its succession duty with a capital gains tax on appreciation in the decedent's assets at death.)
Carol must also be advised that if she receives gifts (including bequests) from a non-U.S. person that exceed $100,000 in a calendar year, she must file Form 3520 reporting receipt of the property together with her income tax return. Although no tax is payable, there is a 25% penalty for failure to file this form. Code § 6039F.
8. Carol's brother, Wayne, a Canadian citizen and resident, wishes to give Carol a cash gift of $3 million.
If Wayne makes the gift to Carol outright, Carol owes no U.S. tax, although she must report gifts from a single non-U.S. person that exceed $100,000 in a calendar year on Form 3520 or face a 25% penalty. Code § 6039F; IRS Notice 97-34.
Instead of making an outright gift to Carol, however, Wayne could transfer the $3 million to a properly structured U.S. or foreign trust for the benefit of Carol and her descendants that qualifies as a foreign trust. Such a trust will not be subject to U.S. estate, gift, or generation-skipping transfer tax for its duration.
In addition, if the trust that Wayne creates qualifies as a grantor trust, Carol can receive distributions from it free of U.S. income tax (except for 30% withholding tax on any U.S. source income such as U.S. corporate dividends). (Carol will still have to report receipt of the income.) Recent legislation, however, has made it difficult for non-U.S. persons to be treated as grantors. Code § 672(f)(1). There are only three ways by which Wayne can be the income tax grantor of a trust for U.S. tax purposes:
1. The grantor has the full power to revoke the trust without the consent of any person, or with the consent of a subservient third party. Code § 672(f)(2)(A)(i). (Upon the grantor's incapacity, his or her guardian must possess the power to revoke for the trust to continue to qualify as a grantor trust.)
2. The grantor (and, if desired, the grantor's spouse) are the sole beneficiaries of the trust during the lifetime of the grantor. In this case, the grantor and the grantor's wife could receive distributions from the trust and could then make gifts to the U.S. relatives. The U.S. person would then have to report the receipt of the gifts if they met the applicable threshold, but they would not be taxable. Code § 672(f)(2)(A)(ii).
3. The trust was created on or before September 19, 1995, but only as to funds already in the trust as of that date, and only if the trust was a grantor trust under either Code § 676 (concerning the grantor's power to revoke with consent of another party) or Code § 677 (concerning the grantor's retained possibility of receiving income in conjunction with other beneficiaries), but excluding Code § 677(a)(3) (income may be used to pay premiums on insurance policies on the grantor's life).
Once the non-U.S. grantor dies, the foreign trust, which previously qualified as a grantor trust under one of the exceptions, is no longer a grantor trust, and all income distributed to the U.S. beneficiary will be taxed to the beneficiary.
9. Carol has received a distribution of $50,000 from an irrevocable Canadian trust created in 1999 by her brother, Wayne, a Canadian citizen and resident.
All distributions to a U.S. person from a foreign trust must be reported to the IRS on Form 3520. Carol must report the name of the trust, the aggregate amount of distributions received from the trust during the taxable year, and indicate how the distribution is characterized, even if it is claimed that the distribution is not taxable because it came from a grantor trust, or from a trust that had no income, or for some other reason. Code § 6048(c). If the distribution is not reported, the U.S. recipient may be subject to a penalty of 35% of the gross amount of the distribution. Code § 6677(a). In addition, the distribution may be recharacterized by the IRS as an income distribution to the recipient, even if it would have qualified for grantor trust treatment.
In this case, because the trust is irrevocable, Carol is a beneficiary, and the trust was created after September 15, 1995, it is not a grantor trust. Therefore, the distribution will carry out taxable distributable net income (DNI). Once DNI is exhausted, the distribution will carry out undistributed net income (UNI) from prior years of the trust, which is taxable with interest going back to the year when the income was received by the trust.
Carol should obtain from the foreign trustee a "Foreign Nongrantor Trust Beneficiary Statement" (or a "Foreign Grantor Trust Beneficiary Statement" if the trust were a foreign grantor trust) for the distribution, which will provide full information about the trust. If she cannot obtain such a beneficiary statement from the trustee (often the case, given the bank secrecy laws of other countries), Carol may avoid having the entire amount treated as an accumulation distribution if she provides information regarding actual distributions from the trust for the prior three years. Under this "default treatment," Carol will be allowed to treat a portion of the distribution as a distribution of current income based on the average distribution from the prior three years, with only the excess amount of the distribution treated as an accumulation distribution (and therefore subject to the interest charge of Code § 668). See IRS Notice 97-34, Form 3520.
10. Sam and Carol tell you that they wish to leave the United States and move permanently to Canada.
If Sam gives up U.S. residence, he will remain fully subject to U.S. estate and income tax on his worldwide income because he is a U.S. citizen. He will also be fully taxed by Canada on his worldwide income and assets (although Canada will tax only his Canadian source income during the first five years that he is a resident). He (and his estate) will obtain a credit against U.S. taxes for Canadian taxes that are paid.
To end his U.S. tax obligations, Sam must not only move his residence to Canada but also give up his U.S. citizenship (expatriate). Even then, he will remain subject to U.S. taxes on a broad list of U.S. income and assets for ten years after expatriating. (This list includes interest on U.S. bond interest and capital gains on sales of U.S. stocks, which are normally not subject to tax when paid to nonresident aliens.) To avoid this ten-year tax problem, Sam may be able to obtain a ruling from the IRS that tax avoidance was not a principal motive for expatriating, or he may simply sell all his U.S. assets and pay a one-time capital gains tax. He may also be refused reentry to the United States for any purpose under the Reed Amendment. These rules are presently being reconsidered by Congress, and changes are possible.
Carol must move to Canada and relinquish her green card (not just allow it to expire) to rid herself of U.S. taxation. Even then, because she has had a green card for at least 8 out of the last 15 calendar years, the special 10-year expatriate rules applicable to Sam will also apply to her. Again, she can seek an IRS ruling or sell all her U.S. assets to avoid this.
Copr. (C) 2004 West, a Thomson business. No claim to orig. U.S. govt. works. This article is reprinted with permission from West, a primary sponsor of the General Practice, Solo and Small Firm Division.