International Estate Planning Taxation and Reporting

Who Does International Estate Planning Apply to?

Globalization has had a tremendous impact on the estate planning industry. The increasing interconnectedness of our world and the movement of family members and property across borders has brought about a greater need for estate planning strategies and solutions. In California it is even more of a necessity to understand the tax implications and reporting obligations if you have foreign connections because the state is home to roughly 10.5M immigrants, which is about a third of the state’s population.

Many foreign persons may own property in the U.S., plan on becoming a U.S. person, and/or have family members permanently residing in the U.S., without first understanding their U.S. tax implications. U.S. persons may be married to an individual who is not a U.S. citizen and/or have foreign assets. U.S. estate planning for non-U.S. persons who have connections in the U.S. and U.S. persons who have foreign connections involve different rules and strategies from domestic estate planning, and foresight is required under these circumstances when creating a U.S. estate plan.

Examples of U.S. estate planning with international considerations include the following:

When a foreign person owns real estate in the U.S., has stock in a U.S. corporation, has a business or even a subsidiary in the U.S.;
When a foreign married couple has children living or studying in the U.S., and their children end up living in the U.S. permanently, they will need to think about how to structure the ownership of assets they may gift to their children who become U.S. residents (or perhaps, eventually become U.S. citizens); or
When a U.S. person is married to a non U.S. citizen.

This article provides a general overview of the U.S. tax rules and reporting obligations that apply to non-U.S. persons who may have connections in the U.S., either through ownership of assets in the U.S. and/or have family members residing in the U.S. It is not intended to serve as a comprehensive summary of the topic but rather an introductory guide to inbound U.S. estate planning for individuals and families with foreign connections.

U.S. Income Taxation

U.S. Income Tax Residents

As a general rule, U.S. citizens (regardless of residence) and U.S. income tax residents (regardless of citizenship) are taxed on their worldwide income for income tax purposes. Non-U.S. income tax residents are taxed only on their U.S. source income. But what exactly determines if someone is a U.S. income tax resident?

Two tests can be applied to determine a U.S. income tax resident:

Green Card Test – If the person is a lawful, permanent resident (i.e., a green-card holder) at any time during the calendar year, then such person is considered a U.S. income tax resident.

Substantial Presence Test – If the person is a non-resident alien (“NRA”) and has spent more than 183 days in the U.S., then such person is considered a U.S. income tax resident. To meet the 183-day requirement of the substantial presence test, such NRA must at least: (1) be physically present in the U.S. on at least 31 days during the current calendar year and (2) the total number of days on which such individual was physically present in the U.S. during the current year and the two preceding calendar years equals or exceeds 183 days. The total days are calculated as follows: (1) all days such individual was physically present during the current calendar year plus (2) one-third of days such individual was physically present during the previous calendar year plus (3) one-sixth of days such individual was physically present during the second-preceding calendar year.

Non-U.S. Income Tax Residents

Non-U.S. income tax residents (meaning, those who did not meet the Green Card Test or Substantial Presence Test) are taxed on what is called “U.S. Source Income.” There are two broad categories of U.S. Source Income: (1) Fixed Determinable Annual or Periodic Income (FDAP) and (2) Effectively Connected Income (ECI).

In general, FDAP income, includes the following categories of passive income: (1) dividends from U.S. corporations; (2) rent from U.S. real properties; (3) interest on debts of U.S. obligors; and (4) U.S. royalties. This income is subject to 30% U.S. withholding tax.

There are a couple of exemptions under FDAP, including capital gain generated from the sale of U.S. securities (though capital gain from the sale of real estate is subject to U.S. withholding tax).

Note further that deductions are generally not allowable against FDAP income.

Effectively Connected Income (ECI), on the other hand, includes income derived from the conduct of a U.S. trade or business, including the following categories of non-passive income: (1) wages and other compensation derived from services performed in the U.S.; (2) rental income from actively managed properties; and (3) income from the sale of goods and products in the U.S. ECI is subject to U.S. tax at graduated rates, and deductions are allowable against ECI.

U.S. Wealth Transfer Taxation

While income tax is tax levied by federal, state and local governments on income generated by businesses and individuals, wealth transfer tax (sometimes referred to as an “inheritance tax,” “estate tax,” “gift tax” or “death tax”) as it relates to the “transfer of assets” during one’s lifetime (also known as a “gift”) or upon death (also known as an “inheritance”) is tax levied by the federal and state governments on the value of assets transferred by a change in ownership of the property, or change in title to the property, from one individual or entity to another. Note, however, that California, as of the published date of this article, does not have a wealth transfer tax; though, other states in the U.S. may have a form of wealth transfer tax, such as New York and Maryland.

A key distinction of U.S. wealth transfer tax rules from U.S. income tax rules as they apply to individuals and families with foreign connections is that U.S. transfer taxation is not so much dependent on one’s physical presence in the U.S. that can be determined by a “bright line test,” such as the “Green Card Test” or the “Substantial Presence Test”; but rather on one’s intent on permanently residing in the U.S., thereby being deemed as a “U.S. Domiciliary” – the determination of which is more subjective based on a “facts and circumstances test”.

As a general rule, U.S. citizens (regardless of residence) and U.S. Domiciliaries (non-U.S. citizens who are deemed “domiciled” in the U.S.) are subject to U.S. gift and estate taxes on the transfer of their worldwide assets. An example of a U.S. Domiciliary is a lawful permanent resident who has no definite present intention of residing outside the U.S.

Non-U.S. Domiciliaries, including lawful permanent residents who have a definite present intention of later residing outside the U.S., and NRAs, are subject to U.S. gift and estate taxes only on the transfer of U.S. situs assets.

U.S. Domiciliary

Under U.S. Treasury Regulation Section 20.0-1(b), the definition of domicile for U.S. wealth transfer tax purposes is as follows:

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 removing therefrom. Residence without the requisite intention to remain indefinitely will not suffice to constitute domicile, nor will intention to change domicile effect such a change unless accompanied by actual removal.

Accordingly, to be a U.S. Domiciliary, who would be subject to U.S. gift and estate taxes on the transfer of his or her worldwide assets, one must establish, through the surrounding facts and circumstances that such individual had no definite present intent of residing outside the U.S.

Examples of facts and circumstances to be considered when determining whether an individual is a “U.S. Domiciliary,” include the following: (1) the domicile of the individual at the time of the gift or at the time of death; (2) the situs of the individual’s estate administration; (3) the location of the individual’s primary residence; (4) the location of the majority of the individual’s assets; and (5) the location of residence of the individual’s immediate family members.

Non-U.S. Domiciliary

As mentioned, Non-U.S. Domiciliaries are those who are non-U.S. citizens who have the definite present intention of residing outside the U.S., and they are subject to U.S. gift and estate taxes only on the transfer of U.S. situs assets.

U.S. Situs Assets

What may be deemed as a U.S. situs asset for gift tax purposes may be different from what may be deemed as a U.S. situs asset for estate tax purposes. Below is a non-exhaustive list of U.S. situs assets for estate tax purposes versus gift tax purposes.

U.S. situs assets that fall under estate tax inclusion are:

Real property located in the U.S.
Tangible personal property located in the U.S.
S. equities: shares of stock in U.S. companies, whether publicly or privately held, and regardless of location of share certificates; and shares in U.S. registered investment funds, including mutual funds
Cash accounts with U.S. brokerage firms are not considered bank deposits and are subject to estate tax
Debt owed by U.S. persons

U.S. situs assets that fall under gift tax inclusion are:

Real property located in the U.S.
Tangible personal property located in the U.S.
S. or foreign currency or cash situated in the U.S. at the time of gift

Non-U.S. situs assets for both U.S. gift and estate tax purposes include:

Securities that generate portfolio interest
Bank deposits not used in connection with a trade or business in the U.S. (generally, cash on deposit with a U.S. bank or insurance company)
Insurance proceeds payable by a U.S. resident insurer
Bonds of U.S. companies, U.S. government, and U.S. government agencies
Stock in foreign corporations
Real property located outside the U.S.
Tangible property located outside the U.S.

U.S. Gift and Estate Tax Rules for U.S. Domiciliaries Versus Non-U.S. Domiciliaries

U.S. Citizen and U.S. Domiciliaries

U.S. citizens and U.S. Domiciliaries are subject to U.S. gift and estate taxes on the transfer of their worldwide assets in excess of their unified gift and estate tax exemption amount. Currently, the unified gift and estate tax exemption amount for U.S. citizens and U.S. Domiciliaries is $12.92 million per person. With inflation adjustments, the exemption will increase to $13.61 million per person for U.S. citizens and U.S. Domiciliaries. Transfers of worldwide assets in the aggregate in excess of this exemption amount during lifetime or upon death will be taxed at 40%.

Additionally, U.S. citizens and U.S. Domiciliaries are afforded a $17,000 annual gift tax exclusion per gift recipient (commonly referred to as “donee”) for lifetime gifts made each tax year as well as unlimited gift tax exclusions for educational and medical gifts paid directly to institutions. As an example, one may pay a donee’s tuition and the gift will not be subject to U.S. gift tax if the payment was made directly to the educational institution.

Non-U.S. Domiciliaries

Non-U.S. Domiciliaries, including non-U.S. citizens who are lawful permanent residents and NRAs with the present intention of residing outside the U.S., are subject to U.S. gift and estate taxes on the transfer of their U.S. situs assets only. They are afforded with a mere $60,000 estate tax exemption. There is no exemption afforded to Non-U.S. Domiciliaries for lifetime transfers. Transfers of U.S. situs assets during the lifetime of a Non-U.S. Domiciliary is subject to a 40% gift tax, and transfers upon death in excess of a $60,000 exemption is subject to a 40% estate tax.

Similar to U.S. citizens and U.S. Domiciliaries, Non-U.S. Domiciliaries are afforded a $17,000 annual gift tax exemption per donee for lifetime gifts made each tax year as well as unlimited gift tax exclusions for educational and medical gifts paid directly to institutions.

Given the onerous U.S. transfer tax rules for Non-U.S. Domiciliaries, planning before purchasing U.S. situs assets by Non-U.S. Domiciliaries is critical.

For example, if a Non-U.S. Domiciliary purchases U.S. real property but does not intend to own it for the long term, he or she may wish to purchase sufficient life insurance coverage to cover the U.S. estate tax liability that may be incurred upon death. Note that life insurance is generally not deemed a U.S. situs asset. They may also wish to take out nonrecourse loans against the U.S. real property, which will offset the value of the asset upon death for estate tax purposes.

If the Non-U.S. Domiciliary intends to own the U.S. situs asset indefinitely and there are no U.S. beneficiaries upon the death of the Non-U.S. Domiciliary, the U.S. situs asset may be held for the long term through a domestic entity that is in turn owned by a foreign entity, in which the Non-U.S. Domiciliary holds an ownership interest. The transfer of the Non-U.S. Domiciliary of his or her interest in the foreign entity would not be subject to U.S. gift and estate taxes because it would then be a transfer of a non-U.S. situs asset.

If the Non-U.S. Domiciliary intends to have U.S. beneficiaries benefit from the U.S. situs asset, then he or she may wish to create a U.S. irrevocable trust funded through a cash gift that could purchase the U.S. situs asset for the benefit of the U.S. beneficiaries. The trustee of such U.S. irrevocable trust must be a U.S. person to avoid the treatment of such U.S. trust as a foreign trust that would result in significant tax consequences.

Note, further, funding the irrevocable U.S. trust with a cash gift by the Non-U.S. Domiciliary must be made outside the U.S. (and not through U.S. bank accounts). Alternatively, the cash may first be converted into U.S. securities or treasury bills, since they are not deemed U.S. situs assets for gift tax purposes, and these assets may then be gifted by the Non-U.S. Domiciliary to the U.S. trust.

Transfers to Non-U.S. Citizen Spouses

Next, we will examine the U.S. gift and estate tax rules when transfers of assets are made to non-U.S. citizen spouses.

First and foremost, transfers of assets to U.S. citizen spouses during lifetime and upon death are afforded an unlimited marital deduction from U.S. gift and estate taxes.

However, there is no unlimited marital deduction for lifetime and testamentary transfers of assets to non-U.S. citizen spouses.

Under U.S. gift tax rules, donor spouses are afforded an increased annual gift tax exclusion ($175,000 in 2023 and $185,000 in 2024) for lifetime transfers of assets to non-U.S. citizen spouses. Any gifts made to a non-U.S. citizen spouse in excess of the increased annual gift tax exclusion is subject to a 40% gift tax.

With regard to U.S. estate taxes, there is no unlimited marital deduction for testamentary transfers to a non-U.S. citizen spouse; though U.S. estate tax deferral may be available for assets passing to, or contributed by the surviving non-U.S. citizen spouse to, a Qualified Domestic Trust (QDOT). A QDOT is an estate tax deferral vehicle as opposed to a marital deduction vehicle because any distributions of principal from the QDOT to the non-U.S. citizen surviving spouse is subject to a 40% estate tax at the time of distribution, with the exception of distributions of principal for hardship. The remaining principal of the QDOT on the death of the non-U.S. surviving spouse will also be included in the surviving spouse’s estate and subject to U.S. estate tax at 40%.

To qualify, a QDOT must meet the following requirements:

All net income must be payable to the non-U.S. citizen surviving spouse at least quarterly or at more frequent intervals.
The non-U.S. citizen spouse can be the only lifetime beneficiary of the trust.
Distributions of principal to the non-U.S. citizen spouse are subject to U.S. estate tax as explained above.
The trust must have at least one U.S. trustee, and the U.S. trustee must have the power to withhold estate tax on any distributions of principal to the non-U.S. citizen spouse.
If the value of QDOT assets exceeds $2M, there must either be a U.S. corporate trustee or the posting of a bond or letter of credit in an amount equal to 65% of the initial value of the QDOT assets.
If the value of QDOT assets is $2M or less, and if more than 65% of the assets are foreign real property, there must be either a U.S. corporate trustee or the posting of a bond or letter of credit in an amount equal to 65% of the initial value of the QDOT assets.

If the non-U.S. citizen surviving spouse becomes a U.S. citizen after a QDOT has been established, the QDOT will no longer be subject to U.S. estate taxes and the QDOT may be terminated with all assets distributed outright to the surviving spouse; but any principal distributions that were made to the surviving spouse prior to becoming a U.S. citizen are subject to U.S. estate tax. Prior to becoming a U.S. citizen, the non-U.S. citizen surviving spouse must be a resident of the U.S. at all times from the decedent spouse’s date of death. The QDOT’s U.S. trustee must certify to the Internal Revenue Service that the surviving spouse has become a U.S. citizen.

Portability Election

Portability election is available for transfers to a non-U.S. citizen surviving spouse if (1) he or she is a U.S. Domiciliary and (2) the transferred assets are held by a QDOT. Portability Election preserves the decedent spouse’s exemption only to the extent the exemption is in excess of the value of the QDOT assets as of the decedent spouse’s date of death.

Tax Treaties and How They Affect Foreign Persons

Non-U.S. Domiciliaries with ties to other countries may benefit from transfer tax treaties that mitigate U.S. gift and estate taxes. These treaties may also increase the exemption amount available to the Non-U.S. Domiciliary in excess of the statutory $60,000.

Understanding the pitfalls in international estate planning may save one from onerous tax reporting obligations and/or significant U.S. gift and estate taxes.

Discuss your international estate planning with an expert. Contact Jacqueline Yu by e-mail at [email protected] or by phone at 310-313-1195.

Understanding Taxation and Reporting for International Estate Planning