Spring 2010 Newsletter
Estate Planning for the Multinational Couple: A Virginia Perspective
By: Leigh-Alexandra Basha
Author’s Note: This article discusses the planning techniques relevant to when the U.S. estate tax is reinstated in 2011.
Iain and Charlene Burgess come to see you for their estate planning. They proclaim that their situation is simple and straight forward as they have three children together and have had a long and stable marriage. As usual, you embark on your due diligence inquiries from your client questionnaire. You learn that Iain was born in South Africa while his father was working in Johannesburg on a project for his U.K. employer. Iain’s father is a British citizen and his mother is a South African national, and Iain holds both South African and British passports. Iain became a U.S. permanent resident (“green card” holder) in the 1980s shortly after he and Charlene married at St. Joseph’s Church in Paris, France. Charlene is a U.S. citizen and was born in New York to an American father and a French mother. She expects to inherit additional assets in southern France which have been in her mother’s family for generations. Iain and Charlene now reside in McLean, Virginia. They have three adult children who live in three different jurisdictions: Germany, Chicago, and South Korea. Iain’s and Charlene’s net worth is approximately $10 million comprised of real property and other assets in the U.S., the U.K., and France, as set forth on the attached financial statement. During the course of your meeting, Iain mentions that his father established a Guernsey Trust for him when he was a child; however, Iain does not know much about the trust and only received one distribution many years ago to help launch his consulting business. You planned to recommend pour over wills and revocable trusts (with bypass provisions and a qualified domestic trust (“QDOT”) in Charlene’s documents for assets passing to Iain) together with durable general and medical powers of attorney. As Iain and Charlene have foreign assets and Iain is not a U.S. citizen, their estate planning will need to be adjusted from the estate plan recommended for the typical domestic client.
1. Determine Tax Jurisdiction. First, we must determine whether Iain and Charlene will be exposed to estate and inheritance taxation in more than one jurisdiction. Each jurisdiction taxes based on certain connectors. Such connectors include nationality, domicile, residency, situs of property, and religion (e.g., Sharia law). The U.S. taxes based on nationality, domicile, and situs of property. In general, the U.S. federal estate, gift, and generation-skipping transfer taxes apply to U.S. citizens and residents on a worldwide basis.1 On the other hand, nonresidents who are not U.S. citizens are generally subject to these transfer taxes only with respect to transfers of property located or deemed located in the U.S. (“U.S. situs assets”).2 For U.S. federal transfer tax purposes (as distinguished from U.S. federal income tax purposes), a “resident” is an individual who is domiciled in the U.S.3 A “nonresident” is an individual who is not a U.S. citizen and who is not domiciled in the U.S.4 In general, a person acquires a domicile in a jurisdiction by living there, even for a brief period of time, with no definite present intention of later removing therefrom.5 Residence without the requisite intention to remain indefinitely will not suffice to constitute domicile, nor will the intention to relocate to a different jurisdiction change domicile unless accompanied by actual removal.6 It is possible for an individual to be a “resident” of the U.S. for U.S. federal income tax purposes by reason of holding a green card or meeting the substantial presence test, and yet remain a nonresident/non-domiciliary of the U.S. for purposes of the U.S. federal estate, gift, and generation-skipping transfer taxes.7 It is also possible for an individual to be a nonresident of the U.S. for income tax purposes and a resident of the U.S. for transfer tax purposes.8
As a U.S. citizen, Charlene will be subject to U.S. taxation regardless of her domicile or residence. Given that Iain has a green card, there is a strong presumption that he is U.S. domiciled; however, Iain may be able to rebut the U.S. domicile presumption.9 Even if the U.S. considers Iain U.S. domiciled, we must also determine whether Iain may be considered domiciled in another country, i.e., England (as his father was English domiciled) or South Africa (his place of birth).10
England applies a “domicile of origin” test which is based on the domicile of the taxpayer’s father at the time of the taxpayer’s birth.11 In Iain’s case, his father, although living in South Africa, was English domiciled as his intention was to return to England. Iain’s father was in South Africa for a limited period of time due to his employment. Hence, Iain has an English domicile of origin under English law because a person’s domicile of origin is the domicile of his father at the time of his birth. However, an illegitimate child or a child born after the death of his father takes the domicile of his mother.12 Iain could change his domicile of origin to a domicile of choice, e.g., to the U.S. Under English law, if Iain is English domiciled, England will subject him to the equivalent of an estate tax on his worldwide assets.13 If both the U.S. and England claim Iain’s domicile to be in their respective countries, one must look to the U.S.–U.K. Estate and Gift Tax Treaty to examine the treaty tiebreaker rules.14 The U.S. and a number of foreign countries have entered into transfer tax treaties which limit the ability of the U.S. to impose such taxes. The U.S. has a combined gift and/or estate tax treaty with sixteen countries.15 In several of these treaties, the country of domicile (as determined under the treaty) has the primary right to tax transfers by a domiciliary of that particular country on a worldwide basis. In such treaties, the non-domiciliary country retains the right to tax certain property situated within its borders, including real property, assets related to a fixed place of business within the non-domiciliary country, or certain partnership interests located in the non-domiciliary country. In addition, under the saving clause of most treaties, the U.S. retains the right to tax its citizens on a worldwide basis; however, the U.S. is required to grant a credit against U.S. tax for any taxes imposed by the treaty partner country on the basis of situs or domicile under the terms of the treaty.
Similarly, under the U.S.–U.K. Estate and Gift Tax Treaty, the country of domicile generally has the primary right to tax.16 However, the foregoing rule does not apply if the donor or decedent in question is a national of the other country.17 In such cases, double taxation is avoided by means of a credit system set out in the treaty.18 With respect to real property and certain business property of a permanent establishment, however, the property is taxable only by the country in which such property is situated.19
Although more than one jurisdiction may claim to be an individual’s domicile, an individual can only have one domicile and always must have a domicile. Iain may be able to overcome U.K. domicile and only be taxed on his English situs real property (which will be exempt from tax if its value is less than the nil rate band (akin to our applicable exclusion amount) of £325,000 (in 2010). Assuming Iain can overcome the English domicile issue, Iain will be subject to U.S. taxation on his worldwide assets if he is considered U.S. domiciled. As a U.S. domiciliary, Iain will be entitled to the higher $1 million applicable exclusion amount in 2011 (as opposed to the $60,000 applicable to non-U.S. domiciliaries). Thus, from a transfer tax perspective, Iain, undoubtedly, will want to be considered a domiciliary of the U.S.
Based on our facts, Charlene will be taxed by the U.S. on a worldwide basis for estate tax purposes because she is a U.S. citizen. Charlene will also be exposed to French inheritance tax on her French situs real property and subject to U.K. inheritance tax on her U.K. real property. Iain may be able to overcome U.K. claims of domicile and be subject to estate taxation only on his worldwide assets by the U.S. and situs taxation by the U.K. and France (for the real property located in those countries). Based on the treaty tie breaker rules for determining domicile in Article 4 of the U.S.–U.K. Estate and Gift Tax Treaty, it is likely that Iain will be deemed domiciled in the U.S. because that is the center of his vital interests. Iain will not be subject to estate tax in South Africa because he does not have any South African situs assets, and is neither a South African resident nor domiciliary. Iain’s South African nationality will not affect his estate tax exposure as South Africa does not tax based on nationality.20
2. Marital Regime and Spousal Issues. Next, we must determine the couple’s marital regime and its effect on their estate plan. If Iain and Charlene have a prenuptial agreement, we will need to review it to determine their marital regime. Couples married in the U.K. seldom have premarital agreements (e.g., Paul McCartney and Heather Mills, and Madonna and Guy Ritchie). However, couples married in France typically enter into a “contrat de mariage” or marriage contract. The three major marital regimes in France (and in most civil law jurisdictions) are: (i) universal community (“communauté universelle avec attribution de la communauté conjoint au survivant”), (ii) ganancial community property or community property of acquets (“communauté de biens reduite aux acquets”), and (iii) separate property (“separation de biens”). If a couple fails to select a regime, the default regime of ganancial community property (communauté de biens reduite aux acquets) will apply.21
a. Universal Community. The universal community or communauté universelle regime treats all assets as community property. Under the universal community property regime, all assets of the two spouses, including those acquired by gift or inheritance and those acquired prior to marriage (with the possible exception of some personal items), are considered to be jointly held.22 If the assets are characterized as community property, then one-half of all of the community property will be deemed to be owned by each spouse.23 The U.S. income tax advantage of this regime is there will be a one hundred percent (100%) step up in basis for the community property at the death of the first spouse to die.24 In addition, couples under the universal community regime should not have to retitle assets between each other to ensure each spouse is fully utilizing his or her applicable exclusion amount. Thus, the couple is able to avoid the constraints of the marital annual exclusion for assets gifted to a non-U.S. citizen spouse (currently $134,000 in 2010). In addition, community property can be left to a spouse without taking into consideration forced heirship rules applicable in most civil law jurisdictions (such as France, by which it is known as “Reserve Legale”).25 Forced heirship is the entitlement of certain family members to a portion or forced share of a decedent’s estate. A constraint on testamentary freedom, it ensures a minimum share and protection of certain reserved heirs from disinheritance. Forced heirship is prevalent in most civil law jurisdictions and under Islamic law. However, in France, if one has remarried and there are children from a previous marriage, the children from the previous marriage generally would still have a reserve legale and could make a forced heirship claim.26 Finally, only one-half of the assets would be includible in the deceased spouse’s estate for U.S. tax purposes as under the universal community property regime, each spouse is deemed to own one-half of the assets.27 The estate of the first spouse to die would not have to rely on the contribution rules generally applicable to property owned jointly by a husband and wife where one is a non-U.S. citizen.
b. Ganancial Property Community. The ganancial property community or community property of acquets, is the most common community property regime. Under the ganancial property community, assets acquired before marriage or received by gift or inheritance are separately owned, and assets acquired during the marriage (other than by gift or inheritance) are jointly owned.28 This is the more typical regime not only in civil law jurisdictions, but also in the ten U.S. states adopting the community property regime.29
c. Separate Property. The third regime, the separate property regime (or “la separation de biens”) treats all property as separate property for inheritance tax purposes (but not for marital dissolution purposes where one must still determine marital property). With the separate property regime, all assets are individually owned, including assets obtained before the marriage and assets obtained during the marriage.30
It is imperative that we determine the couple’s marital regime and then categorize the assets to distinguish the community property from the separate property. Once we have categorized each asset, one-half of the value of the community property assets and all of the deceased spouse’s separate property will be includible in the estate of the first spouse to die.
Since Iain and Charlene were married in France, it is possible that they entered into such a “contract de mariage.” If they did not, then under French law (the law governing their marriage), one must look to their first country of residency as a married couple and apply the default marital regime of that jurisdiction. If Iain and Charlene fall under the universal community regime, only one-half of their assets will be includible in the estate of the first spouse to die as the surviving spouse is already deemed to own one-half of the assets. Under this scenario, the marital regime could significantly reduce the number of assets that would need to be held in the qualified domestic trust (“QDOT”) if Charlene were to predecease Iain. Given the advantages of the community property regime, it may be appropriate for clients to change their marital regime to accomplish their estate planning objectives. The advisability of changing the marital regime will also depend upon the stability of the marriage and the children of each spouse. Some countries will not permit a couple to change their marital regime if one of the spouses has a child born outside of the marriage, or the laws of the country will provide that the child may still enforce his or her forced heirship claim despite the change in marital regime. In any case, the marital regime analysis and asset categorization between community property and separate property is an integral part of Iain’s and Charlene’s estate planning.
3. Examining the Treaty and Planning for the QDOT. The unlimited marital deduction does not apply to transfers made at death to a surviving spouse who is not a U.S. citizen except to the extent the property is transferred to a QDOT in a timely manner.31 This rule applies regardless of whether the deceased spouse is a U.S. or foreign person. In addition, the rule applies even if the surviving non-U.S. citizen spouse is a permanent resident of the U.S. (as where the spouse holds a valid green card).32
A QDOT is essentially a security device for ensuring that, either upon the distribution of principal from the trust during the surviving spouse’s lifetime, or at the surviving spouse’s death, the trust principal will be subject to U.S. federal estate tax as if it were included in the estate of the transferor spouse. A QDOT can be established by the transferor spouse, by the transferee spouse, or by the executor of the transferor spouse. Only property which passes from the deceased spouse to a QDOT, or which passes to the surviving spouse and is then irrevocably transferred or assigned to the QDOT in a timely manner, qualifies for the estate tax marital deduction.33 Subject to any treaty considerations, if Iain settles assets into a QDOT (as opposed to Charlene creating it under her will) and he is English domiciled, then he will have a liability to U.K. inheritance tax (IHT) if he exceeds the tax allowance because he will be treated as creating a lifetime trust. Thus, it is preferable for Charlene to create the QDOT rather than relying on Iain’s doing so at her death.34
However, before assuming all assets in excess of the decedent’s applicable exclusion amount should be transferred into a QDOT, one should examine the applicable treaty. Given Iain’s British citizenship, the U.S.–U.K. Estate and Gift Tax Treaty may apply to assets passing from Charlene to Iain. Examining the applicable treaty will assist with determining the tax treatment upon Charlene’s death if Iain survives her.
4. Choice of Documents. As Iain and Charlene have foreign assets and Iain is not a U.S. citizen, the choice of estate planning documents could have a significant impact on the ease of managing the assets during their lives, the distribution of their assets at death, and the tax treatment of such transfers. Thus, unlike domestic based clients, it is not initially clear if Iain and Charlene should have a revocable trust with pour over wills.
a. The U.K. There could be disastrous tax results if U.K. situs property is transferred to a revocable trust. Under U.K. law, assets transferred into a revocable trust could incur an entry charge, a maintenance charge, and an exit charge.35 Hence, a will (even with testamentary trust provisions) is usually preferable to using a revocable trust to dispose of the U.K. situs assets. It is not necessary to have a separate U.K. will to dispose of the U.K. situs assets. Generally speaking, the U.S. will can effectively deal with the U.K. situs property since it will be drafted in English and the U.K. is also a common law jurisdiction. If the will is executed with the formalities required under the Washington Convention on Laws and Wills (the International Will Statute),36 then it should be accepted on its face in other jurisdictions that have adopted the convention, one of which is the U.K.37
b. France. The French real property cannot be transferred into a revocable trust because France is a civil law jurisdiction. Many civil law jurisdictions acknowledge the concept of a trust and have signed the 1985 Hague Convention on the Law Applicable to Trusts and on their Recognition (“The Hague Convention on Trusts”), which attempts to coordinate choice of law rules so that one country will recognize a trust that is valid in another country.38 Although a country has adopted the Hague Convention on Trusts, one should not assume that using a trust in such a jurisdiction will be advantageous.39
France, as most civil law countries, does not have the distinction between legal and equitable title in an asset for the benefit of the third party as applies to trusts. Consequently, the actual tax treatment of a trust in a civil law jurisdiction can be confusing. The treatment of a trust under French law depends, in part, on the interpretation of the trust by the notaire.40 The notaire could analyze the trust and decide either that: (i) the assets are actually owned by the ultimate beneficiaries; or (ii) that the trust is a separate entity and the trustee is the owner of the assets. Depending upon the terms of the trust, the analysis could become quite complex and the notaire may need to consult with the Centres for Notarial Research, Information and Documents (the “CRIDON”) for its interpretation of the trust. Not only may a trust cause confusion with respect to the devolution of title, but the tax treatment of the trust may be ambiguous.
Charlene wishes for Iain to own the French real property at her death. However, if their marital regime is not universal community, Charlene will be unable to devise the property to Iain because of the French forced heirship rules. Under the forced heirship rules, title to three-fourths of the real property must pass to their three children even if Charlene wishes for Iain to have sole title to the French real property.41
Currently, each parent has a €156,974 (2010) exemption (or “abatement”) per child in France. Any assets in excess of the exemption amount are subject to the French inheritance tax at a rate ranging from twenty percent (20%) to forty percent (40%). Since the French real property is valued at €2 million ($3.3 million based on an exchange rate of $1.5USD to €1), approximately €1.5 million (or $2.2 million) (3/4th of the property) must pass to the children under the forced heirship rules. Under this scenario, the amount that would pass to each of their three children far exceeds the current French exemption amount per child. After the three exemptions at €156,974, a French inheritance tax will be imposed upon approximately €1.5 million less -€470,922 or €1,029,078 ($1,543,617) -€470,922. Further, the $2.2 million passing to the children exceeds Charlene’s U.S. applicable exclusion amount ($1 million in 2011) and she will be exposed to the U.S. estate tax at 55% (in 2011).
French advisors may recommend the following planning technique for Charlene. Charlene would give the nu propriete or remainder interest in the French real property to her children using the €156,974 exemption per child every six years and retain the usufruit interest or life estate for herself. Following this advice may prove problematic from the U.S. perspective. First, Charlene would exceed her U.S. annual exclusion of $13,000 per person with a gift of €156,974 per child. If Charlene gifts more than $13,000 per year, she would be required to use part of her $1 million lifetime exemption. Second, the retention of the usufruit interest would cause the full value of the French real property to be brought back into her U.S. estate at Charlene’s death under I.R.C. § 2036. Thus, Charlene would not achieve the desired tax goal of a “freeze” using the often recommended French estate plan.
Charlene must circumvent the French forced heirship rules if she wishes to take advantage of the spousal exemption under French law. By changing their marital regime to universal community for their French assets (which is permissible under French law), Charlene could avoid forced heirship and devise the French real property to Iain. The devise of the French real property to Iain would be exempt from French inheritance tax due to the spousal exemption. However, the devise of real property would not qualify for the U.S. marital deduction because (i) Iain is not a U.S. citizen, and (ii) the real property cannot be transferred to a QDOT as French law does not permit real property to be owned by trusts.
Although Charlene should not title the French real property in a trust, there is a way for Charlene to avoid the French forced heirship rules while providing for Iain’s use of the real property at her death. From a U.S. perspective, since the French real property would need to be transferred into a QDOT for assets passing to Iain to qualify for the U.S. marital deduction, Charlene could convert her French real property into intangible property by transferring it into a company. This could be accomplished by transferring the property into a societe civile immobiliere (“SCI”) or other entity. The costs associated with a notaire transferring the real property into the SCI would be approximately seven percent (7%) to ten percent (10%) of the value of the real property. The SCI shares could then be transferred into Charlene’s revocable trust. Under the U.S.–France Estate and Gift Tax Treaty,42 the shares of such company would still be subject to French inheritance tax, if the SCI assets consist of fifty percent (50%) or more French real property. However, Charlene could avoid the French forced heirship rules because her country of domicile (the U.S.) would govern the devolution of title to her intangibles.
Although the French real property would still be subject to French inheritance tax at Charlene’s death, under the U.S.–France Estate and Gift Tax Treaty, the assets passing to the surviving spouse would not be taxed due to the French marital spousal exemption.43 Hence, Charlene could avoid French inheritance tax, but she would still need to use some of her U.S. applicable exclusion amount on the transfer of the company shares to Iain because he is a non-U.S. citizen, or she would need to transfer the shares to a QDOT at her death. Iain could thereafter sell the French real property and avoid French inheritance tax altogether. This technique would accomplish Charlene’s objective of avoiding forced heirship rules (not to disinherit her children, but to minimize the French inheritance tax). Charlene and Iain will still need to balance the objectives accomplished by implementing the SCI against the costs associated with creating the SCI. However, if Charlene desires to maintain the French real property in the family, then this may not be an appropriate solution as Iain would have complete control over the shares. She could consider leaving the shares in a QDOT for Iain, but one would need to ensure it was properly drafted so that it would still qualify for the spousal exemption under French law.
If the real property remains titled in Charlene’s individual name, Charlene should execute a French will specifically addressing the disposition of the French real property. Absent a French will, Charlene should provide for the disposition of the French real property through a foreign assets clause in her U.S. will. If Charlene disposes of the French real property in the residuary clause of her U.S. will (thereby pouring all assets into Charlene’s revocable trust), she may cause unnecessary confusion and expense in France. However, even if the real property is addressed in a foreign assets clause in the U.S. will, France will require the U.S. will to be translated into French and accompanied by an apostille, resulting in additional expense. Given the translation expenses, it may be more appropriate for Charlene to dispose of her French real property through a French will which can be a holographic will registered with the Fichier Central de Dispositions de Dernieres Volontes.
Finally, Charlene should consider minimizing the value of the French property included in her estate. Given that only the net value of the French real property will be includible in Charlene’s estate for French inheritance tax purposes, she could encumber the French real property in order to decrease its net value taxable at her death.
c. Germany. Germany imposes an inheritance tax on the recipient based on the relationship to the decedent. If Iain and Charlene wish to leave assets to their German resident son and his wife (their daughter in law) the distribution may be exposed to German inheritance tax. In the case of a distribution to their daughter in law, such distribution will fall into Class Three.44 Class Three (“Steuerklasse III”) is the “catch-all” class of inheritance (estate) tax covering all other recipients at a personal exemption amount (“Persönlicher Freibetrag”) at €20,000.00 and at inheritance tax rates ranging from 30 through 50 percent. Thus, it would be preferable for the distribution from Iain and Charlene to go only to their son (a Class I distribution and taxed at rates from 7%-30%) rather than to their daughter in law (a Class III distribution and taxed at rates from 30%-50%).45
d. South Korea. It is necessary to examine the South Korean tax implications of Iain’s and Charlene’s estate planning as one of their children lives in South Korea. South Korean inheritance tax is imposed upon (a) all assets (wherever located) of the deceased in case of the death of a person who was domiciled in South Korea or resided in South Korea continuously for at least one year immediately prior to his death (hereinafter referred to as a “South Korean resident”) and (b) all property located in South Korea which passes on death (irrespective of the tax residency of the deceased). South Korean gift tax is imposed upon (x) all assets (wherever located) received, as a donation, by the donee if at the time of donation he is a South Korean resident and (y) all property located in South Korea (irrespective of the tax residency of the donor) if the donee is not a South Korean resident.46 The tax rates under both the gift and inheritance tax are as follows: (i) 10% - the first .1 billion Korean Won; (ii) 20% - the amount between .1 billion Korean Won and .5 billion Korean Won; (iii) 30% -the amount between .5 billion Korean Won and 1 billion Korean Won; (iv) 40% -the amount between 1 billion Korean Won and 3 billion Korean Won; and (v) 50% -the maximum rate on amounts over 3 billion Korean Won. Although South Korea does not offer general gift tax deductions, there is a general inheritance tax deduction of .5 billion Korean Won, which is applicable only to the death of a South Korean resident.47
Thus, given the jurisdictions in which the children of Iain and Charlene reside, great care must be taken to avoid additional inheritance and estate tax considerations.
5. Foreign Trust Issues. With respect to the Guernsey Trust, we will need to review that trust to determine if it is a foreign grantor trust or a foreign non-grantor trust. Once Iain is considered a resident for U.S. income tax purposes, certain adverse U.S. income tax consequences could result with respect to the U.S. taxation of the trust under the foreign trust rules. Generally, the taxation of a trust for U.S. income tax purposes will depend on (i) whether the trust is considered a foreign or domestic trust; (ii) whether the settlor is a nonresident alien or U.S. person; and (iii) whether the trust is considered a grantor or non-grantor trust.
a. Foreign vs. Domestic Trust. Generally, a trust will be treated as a foreign trust unless both of the following conditions are satisfied: (i) a court within the U.S. must be able to exercise primary jurisdiction over the trust’s administration (the “Court Test”), and (ii) one or more U.S. persons must have authority to control all substantial decisions of the trust (the “Control Test”).48 Under these tests, a trust may be a foreign trust even if all of the trust assets are located in the U.S.
The Treasury Regulations create a safe harbor the trust instrument does not direct that the trust be administered outside of the U.S.; (ii) the trust is in fact administered exclusively in the U.S., and (iii) the trust is not subject to an automatic migration provision.49 The Control Test requires one or more U.S. persons (whether acting in the capacity of a fiduciary, grantor, beneficiary or otherwise) have the power to control all “substantial decisions” pertaining to the trust, with no foreign person having authority to veto any such decisions.50
b. Grantor Trust v. Non-Grantor Trust. If the trust is a foreign grantor trust (which may be the case if Iain’s father is still living) then the trust income will be taxed to the grantor (i.e., Iain’s father). However, if the trust is a foreign non-grantor trust, (which, among other conditions, will be the case if Iain’s father, as grantor, is deceased), then the income will be taxed in much the same manner as a nonresident alien individual who is not present in the U.S. at any time during the taxable year. 51 Generally, the trust will be subject to U.S. tax only on its U.S. source income, subject to certain exemptions and any applicable treaty relief. 52 Thus, the foreign non-grantor trust will not be subject to U.S. tax if the foreign non-grantor trust has only foreign source income.
However, if there are U.S. beneficiaries, then four main disadvantages result: (i) to the extent the foreign non-grantor trust accumulates income and has undistributed net income, the U.S. beneficiaries will be subject to throwback rules (a penalty regime); (ii) capital gains will be taxed as ordinary income; (iii) the U.S. beneficiaries will need to comply with more stringent reporting requirements including the filing of a Form 3520 and failure to file will trigger severe penalties; and (iv) if the foreign non-grantor trust holds shares of a controlled foreign corporation (“CFC”) or passive foreign investment company (“PFIC”), there are potential adverse tax consequences even in the absence of a distribution.53
U.S. persons who are beneficiaries of a foreign non-grantor trust may be subject to U.S. income tax on distributions of cash or other property from the trust. Generally, the beneficiary would be subject to tax on such distributions only to the extent of his or her share of the trust’s “distributable net income” (also referred to as “DNI” or “trust accounting income”) for the taxable year, which includes capital gains realized by the trust.54 Therefore, to the extent no distributions are made to the U.S. beneficiary from by providing that a trust satisfies the Court Test if (i) the trust, no U.S. income tax would be payable by the beneficiary. However, with the enactment of the Foreign Account Tax Compliance Act (“FATCA”) there are more stringent provisions impacting foreign trusts, including the characterization of the uncompensated use of trust property by a U.S. grantor, a U.S. beneficiary or any person related thereto as a distribution equal to the fair market value of such use. This provision is effective as of March 18, 2010.55 Failure to disclose a distribution from a foreign trust is subject to increased penalties under FATCA equal to the greater of 35% of the gross reportable amount or $10,000.56
However, if the trust has “undistributed net income” (or “UNI”) from prior years, distributions in excess of the trust’s DNI for the current taxable year may result in a special tax and interest charge to the beneficiary under the so-called “throwback rules.”57 The purpose of these rather complex rules is to produce a rough approximation of the tax the beneficiary would have been required to pay if the foreign non-grantor trust had paid income to the beneficiary in the year it was earned, instead of accumulating it and paying it to the beneficiary in a later year. In making this calculation, generally all accumulated income (except for tax exempt income) is taxed to the beneficiary at ordinary income rates. Thus, the throwback rules and interest charge apply to accumulation distributions and not to non-accumulation distributions.58
Certain distributions to U.S. beneficiaries from foreign non-grantor trusts are not taxable to the beneficiary or subject to the throwback rules. For example, gifts of a specific sum of money or of specific property that are paid as a lump sum or in not more than three installments are not taxable to the beneficiary, provided the distribution is made from trust principal.59 In addition, certain types of investments generally will not create taxable income, such as the tax-free build-up of a whole life or variable life insurance policy. Moreover, the throwback tax and accompanying interest charge generally can be avoided by distributing the current net income of the trust to the U.S. beneficiaries each taxable year, which would effectively allow the trust principal to accumulate tax-free for an indefinite period of time.
To avoid the throwback rules, a trustee should consider domesticating a foreign non-grantor trust if (i) a U.S. person is the sole beneficiary, or (ii) the trust can be divided into separate shares.
In Iain’s case, assuming the Guernsey trust is categorized as a foreign grantor trust during the lifetime of Iain’s father, the trustee should take advantage of this so that non-U.S. source income is generated. We should review the trust to see if can be domesticated upon the grantor’s death.
6. U.S. Filing Requirements for Foreign Assets and Gifts. As Iain and Charlene have assets in Guernsey (through the trusts), the U.K., and France, it is quite probable that they also have foreign assets. It would be appropriate to remind them of the potential filing requirements they may have, not only to report the income generated from such foreign assets on their income tax returns, but also to report the existence of such accounts on the various informational returns required by the U.S.60
a. IRS Form 3520. Any U.S. person who receives gifts from foreign individuals aggregating more than $100,000 during a single taxable year must report such gifts on an IRS Form 3520 (Annual Return to Report Transactions with Foreign Trusts and Receipt of Certain Foreign Gifts).61 In addition, a U.S. person who receives gifts from foreign corporations or foreign partnerships aggregating more than $10,000 during a taxable year (adjusted for inflation in 2010 to $14,165) must file such Form 3520. A taxpayer must also report the distribution from a foreign trust (be it a grantor or non-grantor trust) on Form 3520. Form 3520 is due on the date that the donee’s income tax return is due, including extensions. A U.S. donee who fails to report any such gift is subject to a penalty of up to 25% on the amount of the gift, or the greater of 35% of the amount of trust distribution and $10,000.62 The Service is permitted to waive any penalty if the failure to file was due to reasonable cause and not due to willful neglect. The Service has expressly stated that “reasonable cause” does not include refusal on the part of a foreign trustee to provide information.63
b. Form TD F 90-22.1. In addition, U.S. Treasury Form TD F 90-22.1 (Report of Foreign Bank and Financial Accounts), also known as an “FBAR”, is required to be filed annually by any U.S. person who has a “financial interest” in or “signature authority” or any “other authority” over a financial account located outside the U.S. if the aggregate value of these financial accounts exceeds $10,000 at any point in the taxable year. Foreign financial accounts include bank accounts, investment accounts, debit card or prepaid card accounts, cash value in foreign life insurance policies or any other account maintained with a foreign financial institution. The due date for the FBAR is on or before June 30th of the year following the year to be reported. There are no extensions available with respect to this form. The form is filed with Department of Treasury at the Detroit Service Center, and not with the taxpayer’s federal income tax return. Failure to comply with FBAR reporting requirements may trigger severe penalties. Currently, civil penalties for non-willful violations can range up to $10,000 per violation, while civil penalties for willful violations can range up to the greater of $100,000 or 50% of the account balance at the time of violation.64 Criminal penalties may also apply, and may be imposed together with applicable civil penalties.65
c. FATCA Disclosure. Although the form for filing the FATCA disclosure is not yet released, FATCA creates a new requirement. In addition to the FBAR reporting of foreign accounts, FATCA requires the disclosure of certain “specified foreign financial assets” if their aggregate value exceeds $50,000.66 A foreign entity (e.g., a PFIC or an entity holding title to foreign or domestic real property) falls under this category.
Iain may be required to file a Form 3520 reporting the distribution from the Guernsey trust. In addition, Iain may be required to file an FBAR for his interest in the Guernsey trust if the trust maintains foreign financial accounts. The FBAR instructions provide that a U.S. person has a financial interest in an account if the owner of record or holder of legal title is a trust in which the U.S. person “either has a present beneficial interest, either directly or indirectly, in more than 50% of the assets or receives more than 50% of the current income.”67 Thus, if Iain is a discretionary beneficiary of the Guernsey trust, he may have an FBAR filing obligation. For any actual trust distribution or uncompensated use of foreign trust property, Iain will need to report such direct or indirect distribution or face increased penalties. He and Charlene will also need to report their interests in any specified foreign financial asset if the aggregate value exceeds $50,000.
7. Expatriation Rules. At the end of the initial meeting, Iain requests advice with respect to relinquishing his green card and returning to England. As Iain is currently a permanent resident of the U.S., he could be subject to the exit tax. A U.S. citizen or long term resident (one holding a U.S. green card for at least eight out of the fifteen years prior to his or her date of expatriation) will be a “covered expatriate” if certain conditions apply.68 Under the new rules for expatriations after June 16, 2008, it is likely that Iain would satisfy the tests for being a covered expatriate under the exit tax.
The Heroes Earning Assistance and Relief Act of 2008 (“HEART”) introduced I.R.C. §§ 877A and 2801. Section 877A imposes a mark to market tax on worldwide appreciation of the covered expatriate’s assets and a withholding tax regime on certain other items (e.g., eligible deferred compensation and certain trust distributions), and imposes income tax on certain non-deferred compensation items. Section 2801 imposes a transfer tax on U.S. recipients of a gift or bequest from a covered expatriate at the highest transfer tax rate (currently 35% and increasing to 55% in 2011). Given the harsh nature of Sections 877A and 2801, few clients will consider expatriating under the new rules if they would be covered expatriates, have substantially appreciated assets and/or beneficiaries who are U.S. persons (i.e., U.S. citizens or U.S. income tax residents). There are planning opportunities Iain should consider if he chooses to expatriate.
First, Iain should ensure that he has been fully compliant with his tax reporting obligations. Second, Iain could make lifetime gifts to Charlene (which would be exempt from U.S. gift tax because Charlene is a U.S. citizen) resulting in his net-worth being under $2 million. However, such planning would be imprudent if the stability of their marriage were a concern. If Iain’s assets are under $2 million (and he does not satisfy the other tests), he would avoid the exit tax on his worldwide assets. If Iain’s assets are valued at $2 million or higher, he would be required to file a Form 8854 and report the appreciation of his assets from the time he became a U.S. permanent resident to the date before he expatriates. Iain will be able to exempt $600,000 of gain ($627,000 for 2010, indexed for inflation). Valuing the assets for purposes of the exit tax could prove difficult due to the exchange rates and capital improvements made to assets during the period in question. If Iain is under the $2 million threshold, he should file a Form I-407 and relinquish his green card at a U.S. consulate office outside of the U.S. (e.g., the U.K.). Once Iain expatriates, he could return to the U.S. on a B visa under the visa waiver program with the U.K. In addition, if he desired to regain permanent residency, Iain could reapply for a green card in the future through his wife or one of his adult children.
Iain’s expatriation could become quite problematic for his heirs, in particular, his children. Although gifts and bequests to Charlene will qualify for the unlimited marital deduction to a U.S. citizen spouse, Iain’s children will be subject to the new successions tax imposed by I.R.C. § 2801. Hence, assets received by the children from Iain’s estate would be subject to the maximum transfer tax rate. Iain’s interest in the Guernsey trust may also be counted which he may not be able to give to his wife under the trust terms, so he may not be able to lower the value of all his assets under the $2 million threshold.
Conclusion. Iain’s and Charlene’s estate plan is complicated due to their foreign assets, Iain’s status as a U.S. permanent resident, and the location of their children in foreign jurisdictions. It is necessary to examine their domicile, marital regime, all of their assets, the laws relating to each jurisdiction, and applicable treaties to construct a plan that addresses their concerns while minimizing tax implications. Any time a client is not a U.S. citizen, has a non-U.S. resident heir, and/or has foreign assets, the estate and tax planning analysis becomes more complicated. So, Iain’s and Charlene’s estate plan is not so simple after all.
Leigh–Alexandra Basha is a Partner in Holland & Knight’s Private Wealth Services Group where she focuses her practice in the areas of complex domestic and international estate planning and administration and related tax planning and tax controversy work for high net worth clients and multinational families. Ms. Basha chairs the firm’s International Private Client Practice. She is the current chair of the IBA’s Individual Tax and Private Client Committee and the immediate past chair of the ABA’s International Tax Planning Committee. She is a fellow of the American College of Trusts and Estates Counsel (ACTEC), an Academician of the International Academy of Estate and Trust Lawyers and the secretary of STEP Mid-Atlantic. She received her A.B and LL.M in Taxation from Georgetown University and her J.D. from American University. Ms. Basha is a frequent speaker nationally and internationally including as a visiting professor at L’Ecole de Formation de Barreaux de la Cour d’Appel de Paris and L’Universite de Paris II (Assas). She has been recognized as a Washington Super Lawyer, Virginia Super Lawyer, Leading 100 Counsel in Citywealth (London) and one of Washington’s best by the Washingtonian Magazine. Although her clients are global, she is a member of the Virginia, Maryland and District of Columbia Bars.
Financial Information (.pdf)
1. I.R.C. §§ 2001, 2031. All section references are to the Internal Revenue Code of 1986, as amended, unless noted otherwise.
2. See I.R.C. §§ 2101(a) and 2103 (estate tax); see also §§ 2501(a) and 2511(a) (gift tax).
3. Treas. Reg. § 20.0-1(b)(1).
4. Treas. Reg. § 20.0-1(b)(2).
5. Treas. Reg. § 20.0-1(b)(1).
6. Treas. Reg. § 20.0-1(b)(1).
7. See Estate of Barkat A. Khan, 75 T.C.M. (CCH) 1597 (1998) (where the decedent’s estate was arguing the decedent, who held a U.S. green card and died in Pakistan, was a U.S. domiciliary to benefit from the increased applicable exclusion amount available to U.S. domiciliaries).
8. See Rev. Rul. 80-209, 1980-2 C.B. 248 (holding an illegal alien may be U.S. domiciled).
9. To rebut the presumption of domicile, Iain (in the case of a gift) or his estate would need to prove that Iain had no present intention of remaining indefinitely in the U.S. This may be difficult if all the indicators (center of vital interest, habitual abode, and family) are all located in the U.S.
10. The United Kingdom is a federal state and one is domiciled in England and Wales, Scotland or Northern Ireland.
11. Domicile and Matrimonial Proceedings Act, 1973, § 4 (U.K.).
13. Note: If Iain is a non-resident of England or the U.K., then he will be outside the U.K income and capital gains tax net.
14. Convention for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion with respect to Taxes on Estates of Deceased Persons and on Gifts, Oct. 19, 1978, U.S.-U.K., (hereinafter U.S.-U.K. Estate and Gift Tax Treaty). ARTICLE 4. FISCAL DOMICILE.
(1) For the purposes of this Convention an individual was domiciled: (a) in the United States: if he was a resident (domiciliary) thereof or if he was a national thereof and had been a resident (domiciliary) thereof at any time during the preceding three years; and (b) in the United Kingdom: if he was domiciled in the United Kingdom in accordance with the law of the United Kingdom or is treated as so domiciled for the purposes of a tax which is the subject of this Convention.
(2) Where by reason of the provisions of paragraph (1) an individual was at any time domiciled in both Contracting States, and (a) was a national of the United Kingdom but not of the United States, and (b) had not been resident in the United States for Federal income tax purposes in seven or more of the ten taxable years ending with the year in which that time falls, he shall be deemed to be domiciled in the United Kingdom at that time.
(3) Where by reason of the provisions of paragraph (1) an individual was at any time domiciled in both Contracting States, and (a) was a national of the United States but not of the United Kingdom, and (b) had not been resident in the United Kingdom in seven or more of the ten income tax years of assessment ending with the year in which that time falls, he shall be deemed to be domiciled in the United States at that time. For the purposes of this paragraph, the question of whether a person was so resident shall be determined as for income tax purposes but without regard to any dwelling-house available to him in the United Kingdom for his use.
(4) Where by reason of the provisions of paragraph (1) an individual was domiciled in both Contracting States, then, subject to the provisions of paragraphs (2) and (3), his status shall be determined as follows: (a) the individual shall be deemed to be domiciled in the Contracting State in which he had a permanent home available to him. If he had a permanent home available to him in both Contracting States, or in neither Contracting State, he shall be deemed to be domiciled in the Contracting State with which his personal and economic relations were closest (centre of vital interests); (b) if the Contracting State in which the individual’s centre of vital interests was located cannot be determined, he shall be deemed to be domiciled in the Contracting State in which he had an habitual abode; (c) if the individual had an habitual abode in both Contracting States or in neither of them, he shall be deemed to be domiciled in the Contracting State of which he was a national; and (d) if the individual was a national of both Contracting States or of neither of them, the competent authorities of the Contracting States shall settle the question by mutual agreement.
(5) An individual who was a resident (domiciliary) of a possession of the United States and who became a citizen of the United States solely by reason of his (a) being a citizen of such possession, or (b) birth or residence within such possession, shall be considered as neither domiciled in nor a national of the United States for the purposes of this Convention.
15. These countries include the following: Australia, Austria, Canada, Denmark, Finland, France, Germany, Greece, Ireland, Italy, Japan, the Netherlands, Norway, Republic of South Africa, Switzerland, and the United Kingdom.
16. U.S.-U.K. Estate and Gift Tax Treaty, art. 5.
17. Id. at art. 5, para. (3)-(4).
18. Id. at art. 9, para. (1)(b); para. (2)(b).
19. Id. at art. 6 (real property); art. 7 (business property of a permanend establishment).
20. Estate Duty Act, No. 45 (1955) (S. Afr.).
21. Civil Code [C. Civ.] art. 1400 (Fr.).
22. Id. at art. 1526.
23. Id. at art. 1401.
24. I.R.C. § 1022(d)(1)(B)(iv).
25. C. Civ. arts. 756-758.
27. I.R.C. § 1022 (d)(1)(B)(iv).
28. C. Civ. art. 1405.
29. The community property states are: Arizona, California, Idaho. Louisiana, Nevada, New Mexico, Texas, Washington and Wisconsin (and Alaska by election).
30. Some separate property states have gone so far as to adopt the Uniform Disposition of Community Property Rights at Death Act (“Uniform Disposition Act”), 8A U.L.A. 191 (1993). The adopting states include: Alaska, Arkansas, Colorado, Connecticut, Florida, Hawaii, Kentucky, Michigan, Montana, New York, North Carolina, Oregon, Virginia and Wyoming. The Uniform Disposition Act respects the community property character even if it has been reinvested in separate property assets (e.g., Virginia real property).
31. I.R.C. § 2056(d).
32. Treas. Reg. § 20.2056A-1(b).
33. I.R.C. § 2056A(b). Note that even in 2010, and until January 1, 2021, distributions from a QDOT are still subject to the QDOT tax, which is essentially a recapture tax.
34. Technically, it may be possible for Iain to vary the U.S. will under U.K. principles within 2 years of Charlene’s death to create a QDOT in a more tax efficient way, but it will be more cumbersome than drafting it correctly in the first instance.
35. Finance Act, 2006, § 156 et seq., sched. 20 (U.K.).
36. Uniform International Wills Act, 8 Unif. Laws Ann. at 281 (1998 and 2005 Supp).
37. These countries include the following: Belgium, Bosnia and Herzegovina, Canada (subject to certain restrictions and the non-application in Quebec), Cypress, Ecuador, France, Italy (subject to certain restrictions), Libya, Niger, Portugal, and Slovenia. Several countries have signed the treaty, but it has not yet been ratified or entered into force. These include: the Holy See, Iran, Laos, Russia, Sierra Leone, and the United Kingdom. The adopting US states include: Alaska, California, Colorado, Connecticut, Delaware, District of Columbia, Illinois, Michigan, Minnesota, Montana, Nevada, New Hampshire, New Mexico, North Dakota, Oregon, and Virginia. The Mississippi legislature will consider a bill to adopt the International Wills Act in July of 2010.
38. Convention on the Law Applicable to Trusts and on their Recognition, Jul. 1, 1985.
39. The following countries have ratified The Hague Convention on Trusts: Australia, Canada (subject to certain reservations and the non-application of the convention in Quebec), China (Hong Kong only), Italy, Liechtenstein, Luxembourg, Malta, Monaco, the Netherlands, San Marino, Switzerland, and the United Kingdom (including many of its territories, including Bermuda, Gibraltar, and the Isle of Man). Several countries have signed the treaty but it has not yet been ratified or entered into force. These include Cyprus, France, and the United States.
40. A notaire is a pubic official in most civil law jurisdictions and is responsible for many acts including contracts, deeds and wills. Notaires are the only ones authorized to transfer legal title to real property, effectuate donations and administer estates. In France there are about 8000 notaires who are under the authority of the Minster of Justice (Ministere de la Justice) and appointed by decree.
41. For instance, below is the legal reserve for children, varying according to the number of children: Once the reserve has been calculated, the remaining assets can pass freely to another person, provided there is a will. The rights of the spouse vary according to the marital regime. Note, France has recently introduced provisions that will permit a beneficiary to waive his or her forced heirship rights.
|Number of children||Legal reserve to the children|
|One child||1/2 of the estate|
|Two children||2/3 of the estate (divided between the children)|
|Three children or more||3/4 of the estate (divided among the children)|
42. Convention for the Avoidance of Double Taxation, Nov. 24, 1978, U.S.-Fr.
44. §§ 3(2), 7(1) ErbStG (F.R.G.).
45. Professor Rainer Lorz, Individual Tax and Private Client, IBA Annual Conference (Madrid, 2009).
46. Inheritance Tax & Gift Tax Act, No. 9916 (2010) (S. Korea).
47. Confirmed by In-Hwa Chung, Tax Partner at Shin & Kim (Seoul, S. Korea).
48. I.R.C. § 7701(a)(30)(E).
49. Treas. Reg. § 301.7701-7(c)(1).
50. Treas. Reg. § 301.7701-7(c)(1). Examples of substantial decisions are:
• Whether and when to distribute income or principal;
• The amount of any distributions;
• The selection of a beneficiary;
• 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;
• Whether to remove, add, or replace a trustee;
• Whether to appoint a successor trustee who has died, resigned, or otherwise ceased to act (unless the power to make such decision is limited such that it cannot be exercised in a manner that would change the trust’s residency); and Investment decisions.
51. I.R.C. § 641.
52. For example, capital gains from the sale of U.S. securities, U.S. bank account interest, and U.S. “portfolio interest” earned by the trust would generally be exempt from U.S. tax. Generally, taxable U.S. source income from passive investments (i.e., income not effectively connected to a U.S. trade or business) would be subject to tax at a flat rate of 30%, which would be required to be withheld by the payor. The 15% reduced rate for “qualified dividends” does not apply to income received by a foreign trust or any other nonresident alien. However, there are ways to structure the trust’s investments in U.S. securities to obtain favorable dividend treatment. In addition, most income tax treaties to which the U.S. is a party reduce the tax on such dividends from 30% to 15%.
53. Tech. Adv. Mem. 200733024 (Oct. 26, 2006). The ownership of PFIC shares is reportable. I.R.C. § 1298 was amended by the Foreign Account Tax Compliance Act (“FATCA”) which became effective on March 18, 2010, requiring the disclosure of PFIC shares by U.S taxpayers.
54. I.R.C. § 643(a).
55. I.R.C. § 643(i)(1).
56. FATCA amends § 6677.
57. I.R.C. §§ 665(a), 667.
58. I.R.C. § 661(a).
59. Treas. Reg. § 1.665(b)-1A(a).
60. Some forms to consider include: Form 5471, Information Return of U.S. Person with Respect to Certain Foreign Corporations; Form 926, Return by a U.S. Transferor of Property to a Foreign Corporation; and Form 8865 Return of U.S. Persons with Respect to Certain Foreign Partnerships.
61. I.R.C. § 6039F. See Notice 97-34, Sec. VI, 1997-1 C.B. 422.
62. I.R.C. § 6677.
63. I.R.C. § 6677 (d).
64. 31 U.S.C. § 5321.
65. 31 U.S.C. §§ 5322(b), 5321(d).
66. I.R.C. § 6038D. This new section applies to ownership (not signatory authority over) specified foreign financial assets including: (1) ownership of any financial account maintained by a foreign financial institution, (2) any stock or security issued by a non US person, (3) any financial instrument or contract held for investment that has a non US issuer or counterparty, and (4) any interest in a foreign entity.
67. Form 90-22.1, Report of Foreign Bank and Financial Accounts (U.S. Treas. Dep’t).
68. I.R.S. Pub. No. 553, Highlights of 2008 Tax Changes (Jun. 2009). (l) The taxpayer’s average annual net income tax for the 5 years ending before the date of expiration or termination of residency is more than $139,000 (if expatriation or termination of residency occurs before Jan. 1, 2009); or (2) The taxpayer’s net worth is $2 million or more on the date of expatriation or termination of residency; or (3) The taxpayer fails to certify on Form 8854 that the taxpayer complied with all U.S. federal tax obligations for the 5 years preceding the date of expatriation or termination of residency.