Ellen Harrison. Philadelphia Estate Planning Council ( PEPC ) October 21, 2014

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1 Ellen Harrison Philadelphia Estate Planning Council ( PEPC ) October 21, 2014

2 Topics to be covered Who and what is foreign under the Code and treaties US taxation of citizens regardless of residency Limited taxation of and deductions and credits for foreign persons Special rules for noncitizen spouses Foreign tax credits and role of treaties Application of anti avoidance rules Information reporting Impact of foreign law on estate planning Moving persons and property into or out of US taxing jurisdiction 1

3 Determining who is a foreign person and who is a U.S. person Different rules apply to individuals for transfer tax purposes and income tax purposes. A US citizen is always a US person regardless of residency or domicile. The definition of foreign trust is precise and broad (but different for tax and certain information reporting purposes) and there is no useful definition of when an estate is classified as foreign. Clients sometimes are not aware of their classification as foreign or US. Treaties may re classify an individual s domicile or residence. 2

4 Who is a foreign person for transfer tax purposes? Domicile no bright line test An individual who resides in US with intent to remain there permanently is domiciled in the US. Treas. Reg (b). Visa status is relevant but not controlling. Citizenship the accidental citizen Most children born abroad to one or more US citizen parents are US citizens if parents meet certain prior US residence thresholds. Children born abroad to non US parents can obtain derivative US nationality if one foreign parent naturalizes and certain other conditions are met before child reaches age 18. Treaties Tie breaker rules for determining domicile Saving clause preserves the US s right to tax citizens domiciled outside the US. 3

5 Who is a foreign person for income tax purposes? Lawful permanent resident (i.e., green card) test Physical presence test Exempt individuals Expatriates (i.e., former US citizens or former long term residents ) Part year residence Treaties Tie breaker rules for determining residency Elections for dual resident taxpayers Saving clause for US citizens 4

6 Income tax rules for foreign persons individuals, trusts and estates Foreign persons subject to tax on US source income and income connected with a US trade or business; if all tax due is collected by withholding at source, a tax return is not required. US source income is defined more broadly for certain expatriates. There is no income tax return form specifically for foreign trusts and foreign estates; foreign trusts/estates report using Form 1040NR. A foreign trust is treated as foreign individual and usually must file on a calendar year basis. DNI (which includes capital gains in the case of foreign trusts) and throwback rule measures tax owed by US beneficiaries on receipt of income of foreign nongrantor trust when distributed or deemed distributed. Character of income is not foreign based on status of trust itself. Foreign estates calculate DNI differently from foreign trusts (exclude gains and foreign source income) and throwback rule is inapplicable to estates. Qualified foreign revocable trusts may elect under section 645 to be taxed as foreign estates. 5

7 Anti avoidance rules transfers to foreign entities A US person recognizes gain (but not loss) on transfers of property to a foreign nongrantor trust. Section 684. Section 684 applies when US grantor of a foreign trust ceases to be treated as owner or dies, unless the assets receive a basis adjustment at the death of the grantor. Section 684 also applies if a US trust migrates and becomes foreign. Gain also generally is recognized on transfer of property by a US person to a foreign corporation. 6

8 Anti avoidance rules grantor trust rules A US person is treated as the owner of property such person transfers to a foreign trust under the grantor trust rules if the trust has or may have a US beneficiary. Section 679. A foreign person who funds a foreign trust and moves to the US within 5 years will be subject to section 679 as if the trust were funded on the residency start date. Section 672(f) limits circumstances in which a foreign person will be treated as the owner of a trust under the grantor trust rules. Certain revocable trusts and irrevocable trusts that, during the grantor s lifetime, benefit only the grantor and/or his/her spouse. Certain grandfathered grantor trusts under sections 676 and 677 existing at September 19,

9 Special anti avoidance rules for foreign nongrantor trusts A throwback tax and interest charge apply on distributions of accumulated income from foreign nongrantor trusts to US beneficiaries. Anti avoidance rules of section 643 apply to distributions from foreign nongrantor trusts to US beneficiaries via nominees and loans of cash or securities, or use of trust property. 8

10 Anti avoidance rules: CFCs and PFICs A US shareholder is taxed currently on her share of a CFC s Subpart F income, whether or not received. Also gain on disposition of CFC stock attributable to her share of E&P is treated as dividend. A holder of interests in a PFIC (e.g., a foreign mutual fund) is subject to tax and an interest charge on receipt of an excess distribution in a manner similar to trust throwback rule unless certain elections are made. Under broad and uncertain stock attribution rules, US beneficiaries of foreign nongrantor trusts may be treated as indirect owners of foreign corporations subject to US corporate anti deferral rules. CFC rules trump PFIC rules for US shareholders of post 1997 companies; pre 1998 companies qualifying as both CFCs and PFICs generally default to PFIC rules under once a PFIC... rule.

11 Anti avoidance rules for US persons in possession of assets belonging to or received from a foreign person Statutory executor Person in actual or constructive control of foreign decedent s US situs property may be obligated to file US estate tax return and pay tax from such property; statutory executor is not real executor and may not have personal liability but, in practice, should obtain tax transfer certificate before transferring property to anyone but decedent s estate. Transferee liability A person who has received property from another, including a foreign person, by way of gift or bequest may be liable for any unpaid income, gift or estate tax liability of transferor.

12 Anti avoidance rules for US persons in possession of assets belonging to or received from a foreign person Withholding liability FDAPI A person in control of certain types of US source income (not including income connected to a US trade or business) is obligated to withhold statutory 30% tax (rate may be reduced by treaty) when making payment to foreign owner. FIRPTA A person who purchases a US real property interest from a foreign owner is obligated to withhold 10% of purchase price unless IRS agrees to lesser amount. 11

13 Reporting/withholding rules for foreign financial institutions (FFIs) FATCA imposes withholding and reporting rules on FFIs (which includes most trusts) on assets owned or income payable to US persons and entities with US owners. To obtain a GIIN a FFI must agree to comply with these rules. Under certain intergovernmental agreements (IGAs) reporting is made to a foreign government rather than directly to the IRS and withholding is not required.

14 Significance of situs US only taxes a foreign person on the transfer by gift of US situs assets and the US situs assets owned by a foreign decedent s estate. The situs rules are different for gift and estate tax purposes. E.g., stock of a U.S. corporation is US situs for estate tax purposes but not for gift tax purposes. Gift tax applies to gifts of tangible real and personal property located in the US. Sections 2501(a)(2) and 2511(a). Estate tax applies to stock of a US corporation and debt obligations of US persons or governmental entities, subject to exceptions such as for life insurance on NRA, bank deposits and certain other debt obligations, art on loan to a museum and RICs (to the extent of foreign situs assets). See Section The situs rules are also different for some expatriates. See Sections 2501(a)(3) and (5) and 2511(b). Treaties may change the situs rules. Trusts don t change situs a look through rule applies. 13

15 Step Transaction Rules Goldschmidt Rothschild v. Com r, 168 F.2d 975 (2d Cir. 1948). NRA s gift of exempt property was a taxable gift where the gifted property was proceeds from the sale of nonexempt property made shortly before the gift and then the donee reinvested the property in nonexempt assets shortly after the gift was made because it was part of a pre arranged plan. Davies v. Com r, 40 T.C. 525 (1963) acq C.B. 2 an NRA gave 5,000 to his son and then sold U.S. real property to the son taking back a mortgage note. The 5,000 gift was subject to U.S. gift tax because made on the express condition that it be used to purchase the real estate, but subsequent cash gifts used by the son to pay off the mortgage were not taxable.

16 Problems and opportunities presented by use of foreign holding companies Foreign corporations are frequently used to change asset situs for estate and gift tax purposes; however, use of a foreign corporation may expose income to double tax and may expose US shareholders and beneficiaries to CFC and/or PFIC tax regimes and may be disregarded if viewed as a nominee. A liquidation or deemed liquidation (via a check the box election) may be used to re base assets owned by a holding company but: Might give rise to DNI/UNI at trust level if no basis step up in shares; If company is a CFC, gain might flow through to US shareholders currently; if holding company owns PFICs, gain might be subject to excess distribution treatment and be a deemed disposition by beneficiaries who are treated as indirect shareholders; Any US real property held by company will be taxed as if it were sold. Timing of liquidation CTB election can be retroactive which creates planning opportunities. Company won t be a CFC if not so classified for as much as 30 days. 15

17 Some troublesome situs rules Cash gift is treated as tangible personal property in some old rulings. Rev. Rul Checks are treated as gifts of cash made when donor parts with control. GCM /24/76 Partnerships and disregarded entities: aggregate of assets or entity theory? Rev. Rul situs is where entity does business. Retirement plans situs and source may depend upon nature of plan and whether or not US qualified plan. Is the arrangement a debt of a US person or is it a trust to which a look through rule applies? Inconsistent classification by different countries. E.g. a check the box election has no relevance outside the US. 16

18 Situs issues (continued) Assets of a trust subject to section strings provisions are subject to US estate tax at the death of the grantor if the assets are US situs either when the trust was funded or at the time of the grantor s death. Section 2104(b). ADRs and Foreign Depository Receipts Annuities with US insurance company

19 Gift and estate tax on foreign person s US situs assets Tax rates are the same as for US donors and US decedents but applicable credit amount is zero for gifts and only $60,000 for estates. Marital and charitable deductions are more limited. Treaties might change not only situs rules but also applicable credit amounts and marital and charitable deduction rules. Deductions are allowed only in the proportion US estate bears to worldwide estate except for nonrecourse debt. Applicable marital property regime determines what is owned by estate of a foreign decedent. Foreign tax credits are not allowed except under a treaty. 18

20 Section 1014 basis adjustments for foreign decedents A basis adjustment is allowed in US for assets inherited from a foreign decedent even if assets are not subject to US estate tax (e.g. foreign assets). Note, however, that assets may not acquire new basis in recipient s foreign residence country. Basis adjustment applies in limited circumstances to assets held in trust funded by foreign person section 1014(b)(2) and (3). 19

21 Special rules for transfers to a noncitizen spouse Estate tax marital deduction is not allowed unless assets pass to a QDOT. Some treaties allow a limited marital deduction; Consider marital property regime; Consideration furnished test (i.e., contribution tracing) applies for joint property; Post death funding of QDOT allows deduction; might have collateral tax consequences in the US or another country. Bank or bond requirement for large QDOTs; Termination of QDOT requirement if resident surviving spouse becomes citizen; Special rule for nontransferable retirement assets. Gift tax annual exclusion allowed for $145,000 in 2014 (indexed annually) A completed gift is not made when spouses, one of whom is not a citizen, create tenancies by the entirety in real property. 20

22 Foreign tax credits Credit for foreign tax on foreign source income and foreign situs assets avoids double tax. Treaties provide an ordering rule to determine which country has first right to tax (the other will allow a credit) and to match the type of foreign tax to US estate tax. Potential mismatch of US and foreign taxes due to differences in timing of imposition of tax or determinations of either situs, source or character. Foreign tax credits apply to US citizen domiciled in a treaty country who are exposed to tax on worldwide assets or income in both the us and a treaty country. 21

23 Saving clause and credits in treaties Treaties contain saving clause which preserves right of US to tax its citizens. Treaties generally allow estate of US citizen domiciled in treaty country to take foreign tax credit for all taxes imposed by country of domicile except for taxes imposed on assets, like US real estate, for which US has primary taxing rights under treaty. Absent treaty, there is double tax exposure due to limits on allowable foreign tax credits. 22

24 Choice of law and succession issues Choices for determining: Validity and construction of wills, trusts and testamentary arrangements Rights of a spouse Forced heirship Conflict of laws Place of domicile, place of citizenship, place of situs or choice of transferor? Role of res judicata and the race to the courthouse

25 Reporting obligations of US persons with foreign connections Form 3520 Annual Return to Report Transactions with Foreign Trusts and Receipt of Certain Foreign Gifts Form 3520 A Annual Information Return of Foreign Trust with a US Owner Form 926 Return by US Transferor of Property to a Foreign Corporation Form 5471 Information Return of US Persons with Respect to Foreign Corporations Form 5472 Information Return of 25% Foreign Owned US Corporation or Foreign Corporation Engaged in US Trade or Business 24

26 Information returns continued Form 8621 Return by Shareholder of a Passive Foreign Investment Company or a Qualified Electing Fund Form 8858 Information Return of US Persons with Respect to Foreign Disregarded Entities Form 8865 Return of US Persons with Respect to Certain Foreign Partnerships Form 8854 Initial and Annual Expatriation Information Statement Form 8938 Statement of Specified Foreign Financial Assets Form 114 (formerly TD F ) Report of Foreign Bank and Financial Assets ( FBAR ) 25

27 Information returns continued A few general comments: Substantial monetary and other serious penalties can apply if returns are not timely filed. Form 3520 A is due March 15, not April 15, and an extension of time to file is not deemed made when a person extends the time to file her annual income tax return; Form 7004 is required. Form 3520 A is supposed to be filed by foreign trustee, but rarely is. US law foreign trusts and US LLCs are US persons and have to file FBARs regardless of tax classification. There is no extension of time allowed to file FBARs. June 30 is a drop dead date. IRS voluntary disclosure initiatives substitute a fixed percentage accuracyrelated penalty for information return penalties, but late file and late pay penalties may still apply. Duplicate filing may be necessary (e.g., FBAR and Form 8938). Penalties generally may be abated for reasonable cause but FBAR penalty abatement turns on whether failure to file willful. 26

28 Steps to take before becoming a US tax resident Step up basis in assets; accelerate income (particularly to use losses, if any) and postpone deductions. Can use check the box election, but classification must be relevant for US tax purposes. Consider restructuring of trusts created by the immigrant or of which immigrant is beneficiary; note special grantor trust rules for preimmigration trusts and application of broader grantor trust rules for US persons. Consider disposing of CFC and PFIC holdings, if any. Consider making large gifts (including implementing freeze strategies) before establishing domicile in US. Think twice about applying for a green card. 27

29 Steps to take before emigrating from the US Check on exposure to exit tax under section 877A. Check on exposure to tax under section 684. Make gifts of US situs assets (e.g., real estate) using the remaining applicable gift exclusion amount, if any. Make gifts to spouse (or others) of appreciated assets if exit tax applies. Note, however, that significant balance sheet changes in 5 pre expatriation years must be disclosed on Form Consider making taxable disposition of appreciated assets to avoid basis mismatch in new country of residence. Consider potential tax under section 2801 if entire family doesn t expatriate. 28

30 Advice to give for foreign donor making gifts to US persons Create grantor trust to minimize US income and eventual estate tax. Incorporate provisions to allow grantor trust status to continue as long as possible, e.g., via resettlement by non US holder of general power of appointment. Avoid holding US situs assets in the trust if sections may apply. Avoid holding assets that will become CFCs or PFICs when grantor ceases to be owner of trust. Don t use foreign per se corporations as holding companies. Make gifts of stock of US corporations rather than holding them until death. 29

31 Advice to foreign donors (continued) Watch out for cash rule and circumstances that could give rise to IRS invoking step transaction or other judicial doctrines. Make any trust perpetual since GST tax will not apply if there is no transfer subject to US gift or estate tax. Endeavor to keep income tax basis in property high or qualify for a basis adjustment at death. Keep beneficial interests wholly discretionary. Avoid separate share rule. Allow for migration of foreign trust to US. Don t give US persons rights that expose them to gift or estate tax. 30

32 Advice to foreign donors (continued) Segregate UNI in separate trust, if possible. Consult foreign attorneys regarding applicable forced heirship and marital property regimes, and consider race to the courthouse rule. Consult foreign attorneys regarding use of trust structures or other actions that may give rise to additional foreign taxes or other problems. 31

33 Advice concerning foreign assets owned by US persons Typical probate avoidance techniques such as funded revocable trusts may have unintended tax consequences under foreign law. Consider a situs will to separately dispose of foreign assets. Consider forced heirship rules, spouses elective share rules and marital property regimes. Consider that trusts may not be recognized in civil law jurisdictions or that higher tax rates may apply under foreign law. Consider that entity ownership may cause higher wealth tax rates to apply. 32

34 Top take aways Residence is defined differently for income and transfer tax purposes; US taxes citizens regardless of residence and citizenship is more easily acquired than is generally known. Situs rules are different for gift and estate tax purposes; the situs of cash and partnership interests is uncertain; treaties may change situs rules; and the section 2104(b) rule and step transaction and other doctrines may expose non US situs assets to US transfer tax. Treaties may change tax rules but will not increase US tax above what is imposed by Code or reduce total tax burden of US citizens; it is not always possible to completely avoid double tax. 33

35 Take aways (continued) Foreign estates and foreign trusts are classified and taxed differently and section 645 election provides some options. A trust with mostly US features may be foreign ; foreign trusts are subject to rules that are not applicable to US trusts and may trigger information reporting obligations. Making a foreign person owner of a trust under grantor trust rules is best for US beneficiaries but not so easy to achieve; grantor exception to intermediary rule helps avoid US income tax on distributions where the trust is a nongrantor trust. 34

36 Take aways (continued) Foreign corporations provide transfer tax benefits but income tax risks; a check the box election provides some flexibility but only for corporations that are eligible for such an election. A basis adjustment is allowed for assets inherited from foreign person even if assets are not subject to US (or other) estate taxes. There are tax consequences and planning opportunities for change of person s citizenship or residency and transfer of assets out of US taxing jurisdiction. 35

37 Take aways (continued) Serious penalties can apply for a US person s failure to file information returns; duplicative returns may be required; returns are required even when no tax is due; Form 3520 A is due early ; the definition of US person for FBAR purposes is different from the tax definition; and participating in a voluntary disclosure initiative may reduce penalty exposure. A statutory executor and/or transferee may be liable for estate tax. 36

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