Meet Blank Rome: The Non-U.S. Investor: Unforeseen Exposure to U.S. Gift and Estate Taxation for Non-Resident Aliens
Editor’s Note: This article continues a series aimed at introducing some of our other practice groups at Blank Rome. In this article, contributed by our Private Client Group, we discuss gift and estate tax issues as they pertain to non-resident clients.
Often, an individual who is neither a resident nor a citizen of the U.S. (referred to here as a “non-resident alien” or “NRA”) is presented with an opportunity to invest in U.S. real estate, tangible property such as art or collectibles that will be located in this country, stock of a U.S. company, or as a partner in a limited partnership or member of a limited liability company (“LLC”). Typically, the savvy NRA investor knows what he must do to avoid being treated as a U.S. resident for income tax purposes. But, he may not be aware that these investments could attract one of the three federal transfer taxes, namely, the federal gift tax, estate tax, and generation-skipping transfer (“GST”) tax.
Although the federal estate and GST taxes are in a one-year sunset period and technically do not apply in 2010 to U.S. citizens, U.S. residents, or NRAs, the gift tax remains in effect. The estate and GST taxes will, even without passage of new federal legislation, apply again beginning in 2011, so for simplicity we may assume all three taxes to be in effect.1
Gifts by NRAs will trigger current gift taxation if the subject of the gift is real property or tangible personal property that is situated in the U.S. or, as we sometimes say, has a U.S. situs for federal gift tax purposes. Basically, this means real estate and tangible property (like the furniture in a residence, jewelry, art, a car, a boat, or a plane) that is physically located in this country at the time of the gift. Thus, if the NRA who owns a Florida residence decides to transfer it by gift to his son, or if he decides to gift some of the home’s contents to his daughter, the gift tax will be triggered. There is a modest annual exclusion from gift tax generally available for gifts to donees other than a spouse—in 2010 this amount is $13,000 per donee. The exclusion is increased to $134,000 if the gift is to a NRA spouse. (If the spouse is a U.S. citizen, an outright gift to the spouse, as well as certain transfers in trust, would qualify for the marital deduction and would be gift tax-free.) In all cases, the fair market value of the gift in excess of the annual exclusion is taxable, and the maximum tax rate currently in effect is 35%.
In contrast to this rule for real estate and tangibles, shares of stock in a corporation are considered to be intangible personal property and, regardless of situs, are not subject to gift taxation upon lifetime transfer by the NRA (unless the NRA is a covered expatriate, in which case different rules will apply during the 10-year period following expatriation).
The same property that is taxable if given away during the NRA’s life is subject to federal estate tax if owned by the NRA at the time of his death. In addition—and subject to any different rules set forth in a governing estate tax treaty between the U.S. and the NRA’s country of domicile—intangible personal property with a U.S. situs (i.e., intangible personal property situated or deemed situated in the U.S. at the NRA’s death) is taxable under the federal estate tax laws, with only a $13,000 credit against the tax that is due. If the property passes to the NRA’s spouse (who presumably is also a NRA), it is subject to current estate taxation under the above rule unless the marital deduction is obtained by transferring the property into a trust that is held for the lifetime benefit of the spouse. Even in this case, the estate tax is merely deferred and the property held in trust will be estate taxable at the surviving spouse’s death.
As noted above, shares of stock issued by a corporation constitute as intangible property. If the corporation is a U.S. corporation, then the stock has a U.S. situs, and if it is owned by the NRA at the time of his death, then it will be subject to federal estate taxation regardless of where the stock certificate or other physical evidence of ownership is located. A partnership interest and a membership interest in a LLC are also intangible personal property under U.S. laws, but the application of the federal estate tax is not as clear as in the case of a corporation. Generally speaking, however, if the partnership or LLC does not terminate upon the NRA’s death, and is also a valid and continuing entity, then the situs of its underlying assets at the NRA’s death would not be relevant, but the U.S. may seek to assert an estate tax based on either the place where the entity’s business is conducted or the domicile of the NRA partner. Therefore, the NRA should be cognizant of the potential estate tax exposure when investing in partnerships and LLCs.
Other examples of intangible personal property are interests in patents and trademarks, debt instruments, bank accounts, certificates of deposit, and cash on hand in a brokerage account. Accounts held in U.S. banks are deemed non-U.S. situs property so long as these are not effectively connected with the conduct of a U.S. trade or business; but a brokerage firm that is not considered to be a bank, and funds on deposit in the NRA’s name at the time of the NRA’s death, will be deemed U.S.-situs property and subject to federal estate taxation. Debt instruments issued by U.S. persons—the interest on which qualifies as portfolio interest for federal income tax purposes—will be deemed situated outside the U.S. and will not be subject to federal estate taxation. Patents, trademarks, and certain copyright interests issued or licensed in the U.S. are generally property situated in the U.S., but should be reviewed carefully. Life insurance, whether held in a trust or owned outright by the NRA, is not treated as situated in the U.S. even if the policy is issued by a U.S. insurance company. Often, NRAs will invest indirectly through foreign holding companies or other structures. These should be reviewed by counsel in the U.S. to make sure the structure is sound from the U.S. tax perspective. Care must be taken to review trusts as well. A trust that is established by the NRA, or by a family member and benefiting the NRA, may be subject to U.S. estate taxation at the time of the NRA’s death, depending on the interests in, or rights over, the trust property that the NRA held at death; when the transfer occurred; and the type of property that was transferred to the trust.
Perhaps the most common trap for the unwary NRA is investment in U.S. real estate.2 It is preferable for the NRA to avoid direct ownership in U.S. real estate because a transfer during life will attract a gift tax, and ownership at death will subject the property to estate taxation. Therefore, it is generally advisable to consult with counsel before an investment in a U.S. residence is acquired. The laws of the NRA’s domicile must be reviewed and evaluated, but it is often advisable to have a foreign entity rather than the NRA himself make the purchase. Foreign ownership may not be permissible in all cases, the most notable being the cooperative apartment; typically a foreign corporation will not be permitted to be the purchaser of a co-op. However, foreign entity ownership is generally allowed in the case of a condominium, house, or other interest in real property, including undeveloped land. Once real property is owned by the NRA, it can be transferred to a foreign corporation, for example, and if corporate formalities are observed, this should be effective to block federal estate taxation. (Although there are arguments the IRS may assert at the time of the NRA’s death to tax the property if it is still owned by the entity, this strategy is generally offers maximum protection against exposure to federal estate tax.)
This is intended as an overview of general rules. Obviously, each situation’s facts and circumstance must be reviewed for planning opportunities.
Susan Witkin is a partner in the Private Client Group and her practice focuses on estate, trust and tax planning, estate and trust administration, and related litigation. She represents domestic, foreign, and multinational clients in these areas.
- Since most of the transfers that NRAs contemplate tend to be to a spouse or child(ren), and not to grandchildren, and because the GST is more limited in its application to NRAs, we will not discuss its application here. But, one should be aware that if a transfer is gift or estate taxable, and is made to a grandchild or more remote descendant of the NRA, or to a trust that could benefit such an individual, the GST tax may be implicated as well. Also note that various states impose local estate and/or inheritance taxes that apply in addition to the federal estate tax. While these generally follow the federal rules regarding what is taxable, due to the different approaches of the states, we discuss only federal taxes here. Finally, different tests are applied to determine whether one is resident in the U.S. for income tax purposes or for estate and gift tax purposes. The income tax rules are quite clear, while the estate and gift tax meaning of “resident” is actually one who has a “domicile” in the U.S., a much more amorphous concept. We ignore those differences here as we assume that if someone is a non-resident for U.S. income tax purposes, then he or she does not consider the U.S. to be his or her domicile.
- Note also that dispositions of interests in appreciated U.S. real property are subject to special income tax rules under FIRPTA (Foreign Investment in Real Property Tax Act) and generally trigger capital gain, unlike dispositions of most capital assets held by NRAs. These rules are outside the scope of this article.
Notice: The purpose of this newsletter is to identify select developments that may be of interest to readers. The information contained herein is abridged and summarized from various sources, the accuracy and completeness of which cannot be assured. The Advisory should not be construed as legal advice or opinion, and is not a substitute for the advice of counsel. Additional information on Blank Rome may be found on our website www.blankrome.com.