STRANGERS IN A STRANGE LAND: NON-CITIZEN PLANNING

Transcription

1 STRANGERS IN A STRANGE LAND: NON-CITIZEN PLANNING Note: this AP Seminar outline is derived from Northwestern Mutual piece, Planning for Noncitizens, in depth ( ). Not like the brazen giant of Greek fame, With conquering limbs astride from land to land; Here at our sea-washed, sunset gates shall stand A mighty woman with a torch, whose flame Is the imprisoned lightning, and her name Mother of Exiles. From her beacon-hand Glows world-wide welcome; her mild eyes command The air-bridged harbor that twin cities frame. "Keep, ancient lands, your storied pomp!" cries she With silent lips. "Give me your tired, your poor, Your huddled masses yearning to breathe free, The wretched refuse of your teeming shore, Send these, the homeless, tempest-tost to me, I lift my lamp beside the golden door!" 1 1 The New Colossus, by Emma Lazarus, as inscribed on a bronze plaque originally mounted on the pedestal of the Statue of Liberty. 1

2 I. INTRODUCTION AND OVERVIEW The United States of America is the most radical, unique and successful experiment in human history. Along with the well-known reasons for this success, such as the idea that all men are created equal, is the historical acceptance and welcoming of people from across the globe who seek life, liberty and the pursuit of happiness. These ideals can be summed up in a phrase - The American Dream. The story of immigration to the United States is not one merely for the history books. Our country remains the destination for a multitude from around the globe. For many of those who immigrate, the principle of equality under the law all are treated the same regardless of religion, gender, nationality, race, ethnicity, citizenship, rank, office or birth can be a powerful concept. While this principle applies in most instances, it does not hold true for the transfer of wealth. The United States treats citizens and noncitizens differently when taxing the transfer of wealth, regardless of whether the transfer occurs during life or at death. This different treatment is aimed at preventing the transfer of assets to a noncitizen who can remove them from the U.S. tax system. 2 The foreign-born population in the U.S. was approximately 40 million in Of those, roughly 17.5 million are naturalized citizens while the balance are not. 3 For the sake of comparison, there were 7.6 million naturalized citizens among 16.8 million noncitizens residing in the U.S. in Only a small percentage of noncitizens have enough wealth to require a complex estate plan, especially with the increased gift and estate tax exemptions established in the American Taxpayer Relief Act of For those who do, many people assume that estate planning needs can be satisfied through familiar strategies including credit shelter trusts, irrevocable life insurance trusts, family business entities and charitable giving. This is not always the case since the status of a surviving spouse as a noncitizen complicates the planning process. This Study covers the Internal Revenue Code ( Code ) provisions concerning U.S. taxation of non-u.s. citizens and discusses options to help achieve the client s objectives while minimizing transfer taxes. Items taken into account include the definition of residency, deferred estate tax, the advantages and disadvantages of planning techniques such as the Qualified Domestic Trust ( QDOT ), the enhanced annual exclusion and the use of life insurance. To determine the extent of U.S. taxation on a noncitizen, the estate planner should consider the provisions of any applicable tax treaties. Although this Study does not delve into the details of the various tax treaties between the U.S. and other countries, Appendix B lists the tax treaties in effect as of June 11, H.R. Rep. No. 795, 100 th Cong., 2d Sess (1988), Ways and Means Committee Report on the Technical and Miscellaneous Revenue Act of U.S. Census Bureau: American Community Survey Reports The Foreign-Born Population in the United States: 2010, May U.S. Census Bureau 1995 population tables, (on May 16, 2003). 2

3 For purposes of this Study, key words and phrases hold specific meanings: Citizen A citizen of the United States, including those who hold citizenship in the United States and another country. 5 The term does not include those who hold U.S. citizenship solely by virtue of citizenship in a U.S. possession. Noncitizen A non-united States citizen including both residents and nonresident aliens. It does not include a taxpayer who renounces U.S. citizenship for tax purposes (i.e., expatriate) as special rules apply to these individuals. Resident A citizen of a foreign country residing in the United States for transfer tax purposes. Nonresident alien (or NRA ) A non-united States citizen residing outside the U.S. for transfer tax purposes. Deferred estate tax The tax imposed upon the estate of the first spouse to die when the surviving spouse is a noncitizen, the payment of which is delayed when the underlying assets are placed in a Qualified Domestic Trust. This Study focuses on the transfer tax system. The income tax standards for determining a noncitizen s residency are not factored in unless otherwise noted. II. RESIDENCY A citizen s residency is irrelevant for tax purposes. The United States government s long arm benefits its citizens and their property, wherever located throughout the world. The power to tax citizens is based on this relationship and not domicile, residency or the location of property. 6 The federal government retains the right to tax all of a citizen s income, wherever generated in the world. 7 At death, all of a citizen s assets are subject to U.S. estate tax, regardless of where those assets are located throughout the world. 8 For tax purposes, a noncitizen s residency is a vital concept. The United States uses a different tax framework for residents than for nonresident aliens. To further complicate matters, the rules for determining residency differ for income and transfer tax purposes. A. Income Tax The income tax test for residency is an objective test. A noncitizen is presumed to be a nonresident alien and bears the burden of proving residency. 9 Residency is determined annually. 10 To be a resident, the noncitizen must: Be lawfully admitted as a permanent resident; 5 The United States generally does not recognize dual citizenship. An individual with dual citizenship is considered a U.S. citizen for tax purposes. Estate of Vriniotis v. Commissioner, 79 T.C. 298 (1982). 6 Cook v. Tait, 265 U.S. 47, 56 (1924). 7 IRC 1; Treas. Reg (b), (a). 8 IRC 2001(a), 2031(a); Treas. Reg (b)(1), (a). 9 Treas. Reg (b). 10 IRC 7701(b)(1)(A). 3

4 Satisfy the substantial presence test; or Make an affirmative election to be considered a resident during the first year living in the United States. 11 Permanent residency is typically indicated by a green card giving the noncitizen the right to work in the United States. 12 A noncitizen is a resident under the substantial presence test if she is physically present in the U.S. for at least thirty-one days in the current calendar year and the sum of: 1. The number of days she is present in the U.S. during the current year; 2. One-third of her days of physical presence in the U.S. during the previous year; and 3. One-sixth of her days of physical presence in the second preceding year equals at least 183 days. 13 Certain days are excluded when determining days in the U.S. for the substantial presence test. Among those excluded are days in which the noncitizen is: Present in the U.S. as an exempt person (a foreign government-related individual, a teacher or trainee, a student or a professional athlete temporarily in the United States); 14 Prevented from leaving the U.S. due to a medical condition that arose while in the United States; 15 Commuting from Mexico or Canada to employment in the U.S.; 16 In transit between two points outside the United States; 17 and Temporarily present in the U.S. as a member of a foreign vessel s crew. 18 EAMPLE: Noncitizen Wife spends the first six months of 2013 in the United States. In addition, she was present in the U.S. for the last nine months of 2012 and December Assuming she is not an exempt person, she is treated as a resident for income tax purposes under the substantial presence test as follows: Year Days 2013 (181 days x 1) (275 days x 1/3) (31 days x 1/6) 5.2 Total A noncitizen satisfying the substantial presence test may nonetheless be treated as a nonresident if she (i) is not physically present in the U.S. for 183 days during the current tax year, (ii) maintains a home in a foreign country and (iii) has a closer connection to the country in which 11 IRC 7701(b)(1)(A); Treas. Reg (b) Treas. Reg (b)-1(b)(1). A green card rebuts the presumption that a noncitizen is a nonresident. 13 IRC 7701(b)(3)(A); Treas. Reg (b)-1(c). 14 IRC 7701(b)(3)(D)(i), 7701(b)(5); Treas. Reg (b)-3(a)(1), (b)-3(a)(2). 15 IRC 7701(b)(3)((D)(ii); Treas. Reg (b)-3(a)(2). 16 IRC 7701(b)(7)(B); Treas. Reg (b)-3(a)(4). 17 IRC 7701(b)(7)(C); Treas. Reg (b)-3(a)(3). 18 IRC 7701(b)(7)(D). 4

5 she has a tax home than to the United States. 19 The factors considered in determining whether a closer connection exists include, but are not limited to: Location of a permanent home; Location of family; Location of personal belongings; Location of social, political, cultural or religious organizations in which the individual maintains a current relationship; Location where banking is conducted; Location of driver s license; Location where the individual votes (a strange item to include since noncitizens are ineligible to vote in the United States); Country of residence designated on forms and documents; and Types of official forms and documents filed by the individual. 20 A noncitizen can also affirmatively elect to be considered a resident in the first year she is in the United States. 21 A noncitizen who satisfies the green card test, the substantial presence test or elects to be treated as a resident in the first year in the U.S. is a resident. A noncitizen who fails to satisfy either test and does not elect to be treated as a resident is a nonresident alien. B. Transfer Tax Congress never makes things easy. Residency for transfer (gift, estate, GST) tax purposes is determined differently than for income tax purposes. The test for determining transfer tax residency is more subjective than the income tax test. Residency requires not only a physical presence in the U.S., but the intent to remain in the U.S. indefinitely. 22 This parallels the common law concept of domicile. 23 Domicile in a given location is acquired 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 IRC 7701(b)(3)(B); Treas. Reg (b)-2(a). For purposes of establishing residency for a noncitizen, foreign country includes a U.S. possession. 20 Treas. Reg (b)-2(d). 21 IRC 7701(b)(1)(A)(iii), 7701(b)(4). The election is made on the noncitizen s U.S. income tax return by filing as a resident. IRC 7701(b)(4)(E). 22 Treas. Reg (b)(1), (b). An illegal immigrant can be a resident for transfer tax purposes presumably since the illegal immigrant intends to remain in the country. Rev. Rul See e.g., Farmers Loan & Trust Co. v. U.S., 60 F.2d 618, 619 (S.D.N.Y. 1932). 24 Treas. Reg (b)(1). 5

6 Once physical presence and intent coincide, domicile is established in that location until the factors coincide in another location. 25 The intention to stay can be evidenced by a variety of factors, including, but not limited to: Length of stay in the U.S. and other countries; Size, cost and nature of dwelling and whether the dwelling is owned or rented; Area in which dwelling is located; Location of cherished personal possessions; Location of family and friends; Church and social club memberships; Location of business interests; Declarations of residence or intent made in visa applications, wills, deeds of gift, trust instruments, letters and oral statements; and Visa status. 26 If domicile is not established, the noncitizen is treated as a nonresident alien. It is possible for the U.S. and another country to reach different results when determining residency. Theoretically, a noncitizen can reside in the U.S. according to U.S. standards while another country considers her to reside elsewhere. Barring a treaty provision to the contrary, this is the worst of all worlds the U.S. and the other country could theoretically tax all of the noncitizen s worldwide assets, with only the U.S. foreign tax credit rules to lessen the U.S. estate tax hit. 27 The planner should look not only to U.S. residency requirements but other countries residency requirements as well to ensure his client is not being double taxed. III. U.S. TAATION OF RESIDENTS The different transfer tax treatment is centered on the ability to collect taxes. A citizen always remains subject to U.S. taxation regardless of where in the world he lives. A married couple is considered one economic unit for tax purposes. As such, a married couple can file a joint income tax return. 28 Spouses can also transfer unlimited amounts of money to each other during life or at the first spouse s death as long as the recipient spouse is a citizen and thus subject to the long arm of the IRS. 29 A. Income Tax For a country founded on a cry of No taxation without representation, the U.S. taxation of residents is particularly appalling. Your author certainly understands if a resident who knows 25 Treas. Reg (b)(1), (b). 26 See e.g., Paquette Est. v. Comm r, T.C. Memo ; Fokker Est. v. Comm r, 10 T.C (1948), acq CB 2; Farmers Loan & Trust Co. v. U.S., 60 F.2d 618 (S.D.N.Y. 1932); Nienhuys Est. v. Comm r, 17 T.C (1952) acq., C.B The United States is unique in taxing a citizen s worldwide assets at death. Most countries tax only those assets physically situated in that country. 28 IRC 6013; Treas. Reg through IRC 2523, 2056; Treas. Reg ,

7 these rules feels compelled to dump tea into Boston Harbor. Of course, he also discourages such actions and disclaims all responsibility for them. 1. Basic Rules For income tax purposes, a resident is generally treated as a citizen despite the fact that a resident cannot vote in the United States. The U.S. taxes all income regardless of whether that income is generated in the U.S. or abroad. 30 Both a citizen and a resident living abroad can exclude up to $97,600 (2013 figure, adjusted annually for inflation) from U.S. income taxation. 31 Income from foreign investments is also subject to U.S. income taxation. Treaties with foreign countries can alter these general rules and usually will prevent double taxation of income. EAMPLE: Noncitizen Wife owns income-generating investments in India, Ireland, Denmark and Poland. Since she is a resident, income produced by those investments is subject to U.S. tax. Income tax treaties likely prevent (or at least minimize) taxation in multiple countries. Residents are entitled to an income tax deduction for contributions to qualified charities. 32 The deduction generally is limited to donations that either will be used in the U.S. or are made to a U.S. corporation, organization, or governmental entity. 33 Donations to Canadian, Mexican or Israeli charities may be deductible in the U.S. under the income tax treaties with those respective nations. 34 For sake of comparison, nonresident aliens are subject to U.S. income tax only on income from U.S. sources. 35 NRAs are not subject to U.S. tax on foreign-source income not connected with the conduct of a trade or business within the United States. A married couple cannot file a joint income tax return if one or both is a nonresident alien unless the NRA consents to U.S. taxation of all income earned worldwide Expatriation Congress has long been concerned with the perception that wealthy Americans are avoiding U.S. taxation by renouncing U.S. citizenship. The Heroes Earnings Assistance and Relief Tax Act of 2008 is Congress latest attempt to deal with this perceived abuse. The law affects not only citizens who renounce U.S. citizenship but long-term residents of the U.S. who cease to be permanent residents. 30 IRC 1; Treas. Reg (b), (a). 31 IRC 911; Treas. Reg ; Rev. Proc IRC 170; Treas. Reg A IRC 170(c). 34 IRS Publication IRC 871, 872; Treas. Reg , , , IRC 6013(g); Treas. Reg (b),

8 a. Covered Expatriates A Covered Expatriate is either a (i) U.S. citizen who relinquishes citizenship or (ii) noncitizen long-term resident who ceases to be a permanent resident; and: For the five preceding years ending before the date of loss of citizenship or residency, has an average annual net income tax liability exceeding $155,000 (2013 figure, adjusted annually for inflation); 37 Has a net worth of $2 million or more on that date; or Fails to certify that he has complied with all U.S. tax requirements and obligations for the five preceding years or fails to submit evidence of compliance. 38 The law does not apply to an individual who (i) is a dual citizen of both the U.S. and a foreign country since birth and has not been a resident of the U.S. for more than 10 of the past 15 years; or (ii) expatriates before age 18½ and has not been a resident of the U.S. for more than 10 years. 39 b. Mark to Market Deemed Sales A Covered Expatriate is subject to a mark to market tax on any net unrealized gain in his property. 40 Essentially, he is deemed to sell all property for fair market value on the day prior to expatriation. Gain or loss is recognized and subject to tax in the year of the deemed sale. 41 The first $668,000 of gain (2013 figure, adjusted annually for inflation) is excluded from taxation. 42 Wash sale rules do not apply. 43 The Covered Expatriate can make an irrevocable election to defer payment of the tax, but interest is charged using the Section 6601 interest payment deferral rules. 44 Adequate security (e.g. bond, letter of credit) to guarantee payment of the tax must be provided. Failure to provide security means the tax and interest are due. Deferral is not available unless the Covered Expatriate irrevocable waives all treaty rights which would otherwise preclude assessment or collection of the tax. The tax must be paid by the due date of the return for the tax year in which the underlying property is actually disposed, but may not be extended beyond the tax return due date for the year of the Covered Expatriate s death. c. Excluded Property Certain property owned by a Covered Expatriate is excluded from the mark to market deemed sale tax treatment. 37 Rev. Proc IRC 877A(g)(1). 39 IRC 877A(g)(1)(B). 40 IRC 877A(a). 41 IRC 877A(a)(2) 42 IRC 877A(a)(3); Rev. Proc IRC 877A(a)(2)(B). 44 IRC 877A(b). 8

9 1. Deferred Compensation (including 401(k) and pension plans) The deemed sale rules do not apply to eligible deferred compensation accounts including qualified retirement plans (e.g. 401(k) plans), qualified annuities under 403(a) and (b), SEP and SIMPLE plans. 45 Instead of a deemed sale, the payer is required to deduct and withhold 30% from any taxable payment made to a Covered Expatriate. 46 The taxable payment is the amount that would have been included in the Covered Expatriate s income if he remained a citizen or resident and does not include any amounts attributable to services performed outside the United States while the Covered Expatriate was not a citizen or resident Specified Tax Deferred Accounts Specified tax deferred accounts include Individual Retirement Accounts (other than SEP or SIMPLE accounts), 529 qualified tuition accounts, Coverdell Education Savings Accounts, Health Savings Accounts and Archer Medical Savings Accounts. 48 The Covered Expatriate is deemed to receive a distribution of the entire account balance on the day immediately preceding expatriation. 49 No early distribution penalties are assessed against a deemed distribution Nonqualified Deferred Compensation A nonqualified deferred compensation arrangement is not and eligible deferred compensation account and therefore is subject to different rules. Instead of withholding 30% at the time of payment, an amount equal to the present value of the benefit is treated as having been distributed to the Covered Expatriate on the day prior to expatriation. 51 Any item of deferred compensation not previously taken into account under Section 83 is treated as transferred and is no longer subject to a substantial risk of forfeiture on the day prior to expatriation and will be taxed. 52 No early distribution penalties are applied to a deemed distribution Non-Grantor Trusts Distributions from a non-grantor trust to a Covered Expatriate require the trustee to deduct and withhold 30% of the taxable portion of the distribution. 54 The trust recognizes gain on distributed property as if the distribution was a sale if the fair market value exceeds the trust s adjusted basis of that property. 55 The taxable portion of the distribution is the amount that would have been included in the Covered Expatriate s income if he was a citizen or a resident IRC 877A(c)(1). 46 IRC 877A(d)(1)(A). 47 IRC 877A(d)(1)(B). 48 IRC 877A(e)(2). 49 IRC 877A(e)(1). 50 IRC 877A(e)(1)(B). 51 IRC 877A(d)(2). 52 IRC 877A(d)(4)(D). 53 IRC 877A(d)(2)(B). 54 IRC 877A(f). 55 IRC 877A(f)(1)(B). 56 IRC 877A(f)(2). 9

10 d. Gifts and Bequests A gift or bequest from a Covered Expatriate to a citizen, resident or domestic trust is subject to a special transfer tax. 57 In a radical departure from traditional gift and estate tax rules, the recipient is responsible for payment of the tax. 58 The tax is determined by multiplying the value of the covered gift or bequest by the highest gift or estate tax rate in the year of the transfer. 59 The tax applies only to transfers in excess of the annual exclusion ($14,000 in 2013) 60 and can be reduced by the amount of any foreign gift or estate tax paid on the transfer. 61 A covered gift or bequest to a foreign trust is subject to tax at the time of distribution (principal or income) to a citizen or resident. 62 The recipient of a distribution from a foreign trust is allowed an income tax deduction for any tax paid under this section, but only to the extent the tax imposed on the distribution was included in the recipient s gross income. 63 There are some exceptions to this tax. A covered gift or bequest does not include property that is: Included on a timely filed gift tax return; Included in the gross estate of a Covered Expatriate and shown on the estate tax return; or Eligible for an estate or gift tax charitable deduction or marital deduction. 64 B. Transfer Tax The transfer (i.e., gift, estate and generation skipping) taxation of noncitizens is more complicated than the income taxation of noncitizens. The effect of the transfer tax system often turns on whether the noncitizen is a resident or a nonresident alien. Whether the noncitizen is the transferor or the recipient of the transferred asset is also a factor. 1. Gift Tax Gifts made by residents are generally subject to U.S. gift tax wherever the property is situated in the world. 65 a. Gifts to a Spouse Married couples can make unlimited gifts to each other during life as long as the recipient is a citizen. 66 The donor s citizenship and residency are irrelevant. 67 If the recipient is not a citizen, 57 IRC IRC 2801(b). 59 IRC 2801(a). 60 IRC 2801(c); Rev. Proc IRC 2801(d). 62 IRC 2801(e)(4)(B). 63 IRC 2801(e)(4)(B)(ii). 64 IRC 2801(e)(2); 2801(e)(3). 65 IRC 2501(a)(1); Treas. Reg (a)(1). 66 IRC 2523(a); Treas. Reg (a) Treas. Reg (i)-1(c)(2). 10

11 this unlimited gift tax marital deduction is not available. 68 Instead, the donor is allowed an enhanced annual exclusion. The donor can make tax-free gifts up to the enhanced annual exclusion limit ($143,000 in 2013, adjusted for inflation annually) each year without using any of his gift tax exemption. 69 An enhanced annual exclusion gift must satisfy the marital deduction requirements but for the fact the recipient spouse is not a citizen. 70 The following transfers qualify for the enhanced annual exclusion: An outright gift of a present interest; 71 A gift in trust which provides the spouse with life income and a general power of appointment; 72 A gift in trust which provides for distribution of the remainder interest to the surviving spouse s estate (estate trust); 73 or A trust which meets the requirements of a Qualified Terminable Interest Property Trust (QTIP). 74 The transfer of an interest in a joint and survivor annuity to a noncitizen spouse qualifies for the marital deduction. 75 Gifts from a noncitizen spouse to the citizen spouse qualify for the marital deduction. 76 Since the gift is to a citizen whose worldwide assets are subject to U.S. estate tax at death, there is no fear that the assets will escape U.S. taxation. EAMPLE: Citizen Husband can give Noncitizen Wife $143,000 in 2013 without making a taxable gift. She can give him an unlimited amount of money. b. Gifts to Third Parties A resident has the same $5.25 million (2013 figure, inflation adjusted annually) lifetime gift tax exemption as a citizen. 77 The tuition, 78 medical 79 and annual 80 exclusions are also available to shelter gifts from U.S. gift tax. 68 IRC 2523(i)(1); Treas. Reg (i)-1(a). 69 IRC 2523(i)(2); Rev. Proc IRC 2523(i)(2); Treas. Reg (i)-1(c). 71 Treas. Reg (i)-1(d) Example 1. In general, a present interest is an unrestricted right to the immediate use, possession or enjoyment of property. Treas. Reg (b). 72 Treas. Reg (i)-1(d) Example Treas. Reg (i)-1(d) Example IRC 2523(b); Treas. Reg (f) IRC 2523(i); Treas. Reg (i)-1(b) Example Treas. Reg (i)-1(a). The residency of the noncitizen donor is not a factor. Treas. Reg (i)- 1(c)(2). 77 IRC 2505; Rev. Proc IRC 2503(e)(2)(A); Treas. Reg (b)(1)(i). To qualify for the tuition exclusion, the gift must be qualified tuition paid directly to an educational institution for the education of an individual. Only the actual tuition payment qualifies payments for ancillary items such as room and board and books do not. Treas. Reg (b)(2). 11

12 A citizen or resident can minimize gift tax by splitting the gift to third parties with his spouse. 81 Each spouse must be a citizen or resident when a gift is split, meaning a gift cannot be split by or with a nonresident alien spouse. 82 c. Foreign Gift Tax Credit Generally, noncitizens cannot claim a credit for gift taxes paid to a foreign government. The credit is not expressly prohibited, rather there is no code provision authorizing such a credit. Compare this to the specific credits available to offset foreign income and estate taxes actually paid. 83 A treaty may allow a noncitizen to claim a credit on a U.S. return for gift taxes paid in a specified foreign country. For example, the treaty with Britain allows a credit in the U.S. for gift taxes paid in Britain in certain circumstances. 84 The United States has not ratified many gift tax treaties but gift tax provisions are sometimes included in an estate tax treaty. 2. Estate Tax In most instances, married U.S. citizens do not pay any federal estate tax until the second spouse dies. The U.S. tax system is designed to allow spouses to pass unlimited amounts to each other during life and at the first death without paying transfer taxes. 85 In order to qualify for this treatment, the spouse receiving the assets must be a U.S. citizen. There is less fear that the surviving citizen spouse can remove the money beyond U.S. enforcement since a citizen always remains subject to the U.S. tax system. Residents are generally subject to U.S. estate tax in the same manner as citizens. 86 A resident s gross estate includes all property located anywhere in the world. 87 A resident s estate applies the same tax tables, deductions and credits as a citizen s estate. However, these rules too can be changed by a tax treaty between the U.S. and the country in which the resident holds citizenship or where property (both real and tangible) is located. For example, a British citizen living in the U.S. will be taxed in the U.S. for property located in Britain except that her real property located in Britain will be taxed in Britain and not the United States IRC 2503(e)(2)(B); Treas. Reg (b)(1)(i), (b)(3). Payment must be made directly to the care provider or health insurer. 80 IRC 2503(b); Treas. Reg (a). The annual exclusion is $14,000 in Rev. Proc IRC 2513(a); Treas. Reg (a). 82 IRC 2513(a); Treas. Reg (b)(2). 83 IRC , U.S. U.K. Estate and Gift Tax Treaty, Art IRC 2523, 2056; Treas. Reg , IRC 2001(a) imposes estate taxes on all citizens and residents. 87 IRC 2031(a); Treas. Reg (b). 88 U.S. U.K. Estate and Gift Tax Treaty, Art. 5 & 6. 12

13 a. Property Ownership Since a resident s gross estate includes all of her property to the extent of her ownership interest, the titling of that property affects the gross estate. 89 Property ownership is treated differently in the United States than in most of the world since ownership is determined at the state and not the national level. State laws govern spousal rights for income, gift and estate tax purposes. Most U.S. states base property ownership on English common law, not civil law. Common law states do not operate under a community property theory. Most countries with civil law traditions (i.e., not based on English common law) use a community property framework. i. Community Property Because most countries use civil law as the basis of property ownership, chances are high that at least some portion of a married couple s assets are subject to a community property classification if one or both are noncitizens. In a community property jurisdiction, property owned by a husband and wife belongs to both in equal shares, except for property that can be proven to belong to one spouse separately. 90 Property acquired during the marriage is presumed to be community property. 91 Community property rules apply unless the couple opts out. 92 Nine American states (Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington and Wisconsin) have adopted community property laws, each with its own variations. Alaska has an elective community property system in which a married couple can opt-in to obtain community property treatment. At the death of the first spouse, the survivor is entitled to not only her separate property, but onehalf the community property. 93 The deceased s gross estate includes his separate property and one-half of the community property. 94 Mixing community property and separate property usually reclassifies the property so that it all is community property. 95 Reclassification results in a gift from the spouse who previously owned a majority interest in that property. The value of the gift is the net difference between the value 89 See pp. 4-6 of Estate Planning Basics, in depth by Barbara A. Bombaci, JD, CLU, CFP, AEP and Elizabeth B. Taylor, JD, CLU, CFP for more information on estate planning and property ownership. 90 See e.g., Wis. Stat (1), (9). 91 See e.g., Wis. Stat (4). Property acquired by one spouse via gift, inheritance or gain from the sale of individual property remains individual property. See e.g. Wis. Stat (7). 92 See e.g., Wis. Stat , See e.g., Wis. Stat (1); In re the Matter of Lloyd, 487 N.W.2d 647, 651 (Wis. Ct. App. 1992). 94 IRC 2033; Treas. Reg The gross estate includes all property to the extent of the interest as determined under state law. 95 See e.g., Wis. Stat (1). 13

14 of the spouse s separate property before the conversion to community property and that spouse s value in the community property after conversion. 96 Residency determines whether a particular state s community property law applies. Citizenship is ignored. EAMPLE: Citizen Husband and Noncitizen Wife reside in California. All assets in California are subject to California community property statutes unless they elect otherwise. Separately owned property retains its character unless mixed with community property. Property generally retains its community property character when a married couple moves from a community property jurisdiction to a common law jurisdiction even if the community property jurisdiction is a foreign country. 97 This can cause an unusual result in that a judge in an American state may be required to interpret foreign community property statutes. EAMPLE: American Citizen Husband and Norwegian Citizen Wife were married in Norway, a community property country. They resided there for five years before moving to Michigan, a common law state. Property classified as community property in Norway remains community property even though the couple now lives in a common law state. If community property funds are used to purchase their home, the home in Michigan is also community property. ii. Common Law Property Most American states use English common law as the basis for property ownership. Under common law, each spouse brings distinct assets to the marriage, and those assets remain separate property unless retitled. The survivor s separately owned property is not included in the deceased spouse s gross estate. iii. Jointly Owned Property Jointly owned property includes property titled as tenants in common, tenants by the entirety or as joint tenants with right of survivorship. The sale of a married couple s jointly owned property can cause unintended gifts when one or both are noncitizens. When the property is sold, each spouse is entitled only to a share of the proceeds proportionate to her individual contribution. If one spouse receives a larger share of the proceeds than her pro-rata contribution, the difference is a gift from the other spouse. If the 96 Rev. Rul Restatement (Second) of Conflict of Laws 259; Rev. Rul , CB 531 and General Counsel Memorandum (April 28, 1972) stating that when community property funds - as determined by Norwegian law - are used to purchase real property in a common law U.S. state, the real property is community property. 14

15 recipient is a citizen, the marital deduction prevents a taxable gift. If the recipient is not a citizen, the difference is subject to the gift tax rules. EAMPLE: Citizen Husband and Noncitizen Wife live in a common law state. In 1988 they purchase a house as joint tenants with right of survivorship for $100,000. Husband contributes $85,000 and Wife contributes $15,000. In 2013 they sell the house for $500,000 and split the proceeds equally. Since Wife contributed only 15% of the purchase price, she is entitled to only 15% of the proceeds ($75,000). She receives $250,000, of which $175,000 is a gift from Husband ($250,000 actually received - $75,000 share of proceeds to which she is entitled). The $175,000 gift from Husband exceeds 2013 s enhanced annual exclusion limit of $143,000, so a gift tax return must be filed and his lifetime gift tax exemption is reduced by $32,000 ($175,000 gift - $143,000 enhanced annual exclusion). If a married couple owns property as tenants by the entirety or as joint tenants with right of survivorship, generally only one half the value of the property is included in the deceased s estate. 98 However, the entire value of jointly owned property is included in the deceased s estate if the survivor is not a citizen. 99 The amount included in the estate can be reduced by subtracting the proportion of the property attributable to the consideration furnished by the survivor. 100 EAMPLE: Citizen Husband and Noncitizen Wife live in a common law state. Their house is titled in both names as joint tenants with right of survivorship. At Husband s death the entire value of the property is included in his gross estate unless the executor furnishes proof that Wife provided consideration for the purchase of the property. If the executor proves that Wife provided 1/3 of the purchase price, only 2/3 of the house s value is included in Husband s estate. If Wife dies first, the result is different. Since Husband is a citizen, half the value of jointly owned property is included in Wife s estate regardless of how much if anything she contributed to the purchase price. Only one-half the value of jointly owned property is included in the deceased s gross estate if the joint tenants acquired the property by gift, bequest, devise or inheritance. 101 b. Portability Portability is a relatively new estate planning technique by which the deceased spouse s executor can elect to transfer any unused portion of the deceased spouse s estate tax exemption to the surviving spouse. It was initially enacted in the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010, but was scheduled to automatically sunset after 98 IRC 2040(b); Treas. Reg IRC 2056(d)(1)(B); Treas. Reg A IRC 2040(a); Treas. Reg (a)(2), A-8(a)(2). 101 IRC 2040(a); Treas. Reg (a)(1). 15

16 2012. The American Taxpayer Relief Act of 2012 makes portability permanent. 102 While a resident can take advantage of portability, the executor of a nonresident alien s estate cannot make a portability election. 103 c. Foreign Death Tax Credit Citizens and residents who pay foreign estate taxes are entitled to a foreign death tax credit on the U.S. estate tax return. 104 The credit is limited to the tax paid on the property located in the country assessing the tax. 105 No credit is available for a foreign country s taxing of a resident s property in the U.S. or a third country. A resident can be denied a foreign death tax credit if she is a citizen of a country that does not allow a similar credit to the estates of U.S. citizens and the President publicly proclaims that the foreign death tax credit is disallowed Generation Skipping Transfer Tax Residents are subject to U.S. generation skipping transfer (GST) tax in the same manner as citizens. 107 Outright transfers by residents to skip persons (regardless of the recipient s citizenship or residence) are subject to GST taxes. Taxable terminations and taxable distributions from generation skipping trusts established by residents are subject to GST taxes, regardless of the citizenship or residence of the trust beneficiaries. All of a resident s property wherever situated in the world is subject to the GST tax system. The GST tax rate is the maximum federal estate tax rate in effect for a person dying at the time of the direct skip, taxable distribution or taxable termination. 108 The rate is 40% in 2013 is not scheduled to change. 109 A resident can use his GST exemption in the same manner as a citizen. 110 The GST exemption is $5.25 million in 2013 (adjusted annually for inflation) and tracks the federal estate tax exemption See The Aftermath of the American Taxpayer Relief Act (ATRA): Estate Planning in 2013 and Beyond, Advanced Planning Bulletin, February 2013 and American Taxpayer Relief Act of 2012 (ATRA): Summary and Commentary of Selected Provisions, Advanced Planning Bulletin, January 2013 for a more complete analysis of portability. 103 Treas. Reg T(a)(5). While this is a temporary regulation issued to deal with the two year temporary portability provisions created by the Tax Relief, Unemployment Insurance Reauthorization and Job Creation Act of 2010, the regulation does provide guidance now that portability is permanent. 104 IRC 2014(a); Treas. Reg Form 706-CE must be filed with the IRS and the foreign government to whom the foreign death taxes were paid before the IRS will allow the credit. 105 IRC 2014(a); Treas. Reg (a)(3). If the tax is imposed by a political subdivision of a foreign country, the foreign death tax credit is allowed even though it is not the foreign country s national government imposing the tax. 106 IRC 2014(h); Treas. Reg (c)(2). In his research, your author was unable to discover any such proclamation. 107 IRC 2601 imposes a tax on every generation-skipping transfer and does not distinguish between a citizen and a resident. Treas. Reg (a) imposes a tax on any generation-skipping transfer. 108 IRC 2602, American Taxpayer Relief Act of IRC 2631(a) and Treas. Reg allow the GST exemption for individuals and do not distinguish between citizens and residents. 16

17 IV. U.S. TAATION OF NONRESIDENT ALIENS A. Income Tax 1. Generally A nonresident alien is subject to U.S. income tax only on income from U.S. sources or income connected to the conduct of a U.S. trade or business. 112 An NRA s income from the conduct of a trade or business in the U.S. or the performance of personal services within the U.S. is taxed at ordinary graduated rates. 113 Income generated in the U.S. but not connected with a U.S. business (e.g., dividends, interest, royalties) is taxed at a flat 30%. 114 NRAs do not pay U.S. income tax on foreign-source income not connected with the conduct of a trade or business within the United States. A nonresident alien s surrender of a life insurance policy issued by a U.S. company is a taxable event. The gain is subject to income tax as income not connected to a U.S. trade or business and therefore subject to 30% taxation. Most insurance companies automatically withhold the 30%. An NRA can assert an income tax treaty right to have the gain taxed in a foreign county instead of the U.S. To avoid the payer withholding 30%, the NRS must file IRS Form W8-BEN with the withholding agent. The withholding agent will notify the IRS, which notifies its foreign counterpart. No gain or loss is recognized on the sale or other transfer of property to a spouse or a former spouse if the transfer is pursuant to a divorce. 115 However, gain or loss is recognized if the recipient spouse is an NRA Income Tax Deductions A nonresident alien cannot claim the standard income tax deduction 117 and must have a U.S. trade or business to claim income tax deductions. 118 If the NRA does have a U.S. trade or business, she can claim a deduction for any charitable donations Qualified Plan Distributions Qualified plan distributions are more complicated because the tax treatment is determined by whether an income treaty exists. If there is a treaty, qualified plans are typically taxed only in the country of residence American Taxpayer Relief Act of IRC 872(a); Treas. Reg IRC 871(b); Treas. Reg IRC 871(a); Treas. Reg IRC 1041(a); Treas. Reg T. 116 IRC 1041(d); Treas. Reg T Q IRC 63(c)(6)(B). 118 IRC 873(a); Treas. Reg (c)(1). 119 IRC 170; Treas. Reg A See e.g., U.S. United Kingdom Income Tax Treaty, Art. 17, 1(a). 17

18 If no treaty has been ratified, a qualified plan distribution is divided into three parts: 1. Contributions attributed to work in the United States are U.S. source income. It is not relevant whether the individual engages in work in the U.S. in the year of distribution. 121 Distributions are taxed using the tables applicable to citizens and residents. 122 Withholding is determined identically to withholding for citizens and residents. 2. Contributions attributable to foreign service are foreign source income and not taxed in the United States Earnings (income, dividends, appreciation) are U.S.-source income. 124 However, earnings are not considered connected to a U.S. trade or business and are therefore subject to withholding and tax at a flat 30%. 125 B. Estate Tax Other than the nonresident alien s gross estate being limited to assets located in the U.S., the gross estate is based on the same rules that apply to the estates of citizens and residents. 126 Property owned by an NRA at death gets the same adjustment in basis as a citizen or resident. 127 The citizenship or residency of the person receiving the property is irrelevant except in the case of marital bequests or expatriation. An NRA s estate can claim the estate tax marital deduction if the survivor is a citizen. If the survivor is not a citizen, no marital deduction is available. Instead, the property must pass to the noncitizen spouse through a QDOT in order to mimic the marital deduction and defer U.S. estate tax until the second death (or distribution). For estate tax purposes, a nonresident alien s property located in the U.S. includes: U.S. real property; 128 Tangible personal property located in the U.S.; 129 Stock of a domestic corporation, regardless of whether the stock certificates are physically located in the U.S.; 130 Property situated in the U.S. transferred subject to the ability to revoke the transfer or transferred within three years of death; 131 Debt obligations of a U.S. person (artificial or human), of the U.S. itself or a political subdivision of the U.S.; 132 and Annuities IRC 864(c). Pre-1987 contributions may be treated different. See PLR IRC 871(b); Treas. Reg IRC 871(f); Rev. Rul , CB IRC 861(a); Rev. Rul , CB 270; PLR IRC 871(a). 126 IRC 2103; Treas. Reg The estate of a nonresident must file Form 706-NA. 127 IRC 1014; Rev. Rul ; PLR Treas. Reg (a)(1). 129 Treas. Reg (a)(2). 130 IRC 2104(a); Treas. Reg (a)(5). 131 IRC 2104(b); Treas. Reg (b). 132 IRC 2104(c); Treas. Reg (a)(7). 18

19 Property excluded from the gross estate includes: Death benefit of a life insurance contract owned by the NRA insuring himself; 134 Shares of stock issued by a foreign corporation, regardless of the physical location of the stock certificates. 135 Bank deposits with foreign branches of domestic corporations or partnerships; 136 and Works of art on exhibition. 137 If the NRA owns a policy insuring someone else and the policy is issued by a U.S. insurer, the cash value should be included in his estate as either a debt instrument issued by a U.S. corporation 138 or under the basic principle that the cash value of such a policy is an asset included in the gross estate of a citizen or resident. 139 Whether property is deemed to be located in the U.S. can be changed by treaty Deductions Nonresident aliens can offset U.S. estate taxes on U.S. situs assets with certain deductions. The estate can deduct expenses, indebtedness, taxes and uncompensated losses. 141 These deductions are limited to a percentage of the total amount of such items. The percentage is the ratio of the value of the gross estate situated in the U.S. to the value of the gross estate situated in all countries. 142 For example, if only one-third of the gross estate is U.S. property, only one-third the amount of such expenses, indebtedness, taxes and losses are deductible. However, to claim this deduction, the estate must disclose the value of all property worldwide. 143 Many NRAs will forego the deduction rather than disclose the value of the entire estate. The estate can also deduct gifts to the U.S. government or to U.S. charities. 144 Deductions are limited in the same manner as citizens and residents Guaranty Trust Co. of New York v. Comm r, 16 B.T.A. 314 (1929), holding that annuities are not excluded from an NRA s gross estate as life insurance. 134 IRC 2105(a); Treas. Reg (g). 135 Treas. Reg (f). Note that foreign corporations often incorporate subsidiaries in the U.S. to do business in the U.S., and therefore the value of that stock is included in the gross estate. 136 IRC 2105(b); Treas. Reg (j). 137 IRC 2105(c); Treas. Reg (b). The artwork must be imported into the U.S. solely for exhibition and loaned to a public gallery or museum. The decedent or other individuals cannot financially benefit from such exhibition. 138 IRC 2104(c); Treas. Reg (a)(7). 139 IRC 2103; Treas. Reg Treas. Reg (c). 141 IRC 2106(a)(1); Treas. Reg , Treas. Reg (a)(2). 143 IRC 2106(b); Treas. Reg (b). 144 IRC 2106(a)(2)(A); Treas. Reg (a)(2). 145 IRC 2106(a)(2)(E), 2055(e). 19

20 2. Credits and Exemptions While citizens and residents have an estate tax exemption of $5.25 million in 2013, the nonresident alien s estate tax exemption is limited to $60, The exemption amount can be increased by treaty, in which case it is based on the proportion of the gross estate situated in the U.S. and the exemption available to citizens. 147 The estate can also claim a credit for: Federal gift taxes paid on property included in the gross estate; and Federal estate tax paid on prior transfers of property included in the gross estate. 148 The NRA s estate cannot claim a foreign death tax credit Bequests from an Expatriate A bequest received by a citizen, resident or domestic trust from a Covered Expatriate is subject to special reporting and tax. A bequest in excess of the annual exclusion ($14,000 in 2013) is taxable at the highest estate tax rate in effect on the date of the gift (40% in 2013). 150 The tax is reported and paid by the recipient, not the deceased s estate, and is reduced by any foreign estate tax paid on the transfer Portability The executor of a nonresident alien s estate cannot take advantage of portability. 152 C. Gift Tax 1. General Rules The NRA is subject to gift tax only on gifts of tangible personal property located in the United States. 153 Stock issued by a domestic corporation is property within the United States while stock issued by a foreign corporation is not. 154 Unfortunately, determining whether cash is tangible property is not always easy. If the NRA plans on giving cash to a resident, your author recommends that the transfer be completed outside the United States because the Service views cash located in the U.S. as tangible 146 IRC 2102(b)(1); Treas. Reg (c)(1). 147 IRC 2102(c)(3)(A); Treas. Reg (c)(2). 148 IRC 2102(a) allows an NRA s estate to use the credits found in Sections 2011, 2012 and The American Taxpayer Relief Act of 2012 permanently replaced the state death tax credit with a state death tax deduction, eliminating one credit. 149 Treas. Reg (a). 150 IRC IRC 2801(c); 2801(d). 152 Treas. Reg T(a)(5). 153 IRC 2501(a)(2), 2511(a); Treas. Reg (b), (a). Tangible property includes a U.S. corporation s stock and debt obligations issued by a U.S. corporation, business or governmental entity. 154 Treas. Reg (b)(3). 20