United States. A-Z of U.S. Estate Planning Concepts

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1 United States A-Z of U.S. Estate Planning Concepts This glossary is directed mainly at the solicitor whose clients are American, have assets in America, or U.S. family members who are beneficiaries of trusts. The U.S. Federal government imposes income and capital taxes on its citizens regardless of their residence or their domicile. However, the Federal government does not have its own probate or trusts law. The United States is composed of the District of Columbia and 50 states, each of which have their own probate, Wills, trusts and tax laws. Many states have adopted "uniform" laws that are promulgated by the Uniform Law Commissioners in an effort to create some uniformity among the laws of the various states. Uniform laws in the private client area generally include the Uniform Trust Code, the Uniform Probate Code, and the Uniform Principal and Income Act, which is the most widely adopted of the Uniform Laws in this area. See Many states have adopted tax codes that mirror the U.S. Federal tax code in varying degrees. All Section or references below are to the United States Federal Internal Revenue Code of 1986, as amended (the Code ) and to the Treasury Regulations promulgated thereunder (the Regulations ). A Administrator (or executor) The terms administrator and executor generally have the same meaning under U.S. law as they do under English law. The term "personal representative" is also used in the United States. However, for U.S. Federal estate tax purposes, the term executor means the executor or administrator of the decedent (i.e., the deceased), or, if there is no executor or administrator appointed, qualified, and acting within the United States, then any person in actual or constructive possession of any property of the decedent B Bare Trust The concept of a bare trust is generally unknown in the United States and is equivalent to the concept of a nomineeship. The U.S. rules are quite literal and in certain circumstances may be construed as creating a trust (however bare) where a nominee relationship is intended by the parties. It is preferable not to include the words (upon trust) in documents drafted for U.S. persons where it is not necessary to do so. Barrister and solicitor (lawyer or attorney) The U.S. legal system does not distinguish between solicitors and the Bar. Lawyers are admitted to practice on a state by state basis and may be permitted to practice before individual Federal district courts and courts of appeals and other specialist courts (such as the Federal Tax Court). C Charities Many States regulate charities as well as solicitations made on behalf of charities. Tax relief is available at the State and Federal levels. The primary tax exemption is provided by the U.S. Internal Revenue Service ( IRS ) which recognises charities as being tax exempt under Section 501(c)(3) of the Code. The income ( 170), gift ( 2522) and estate ( 2055) tax charitable deductions are all drafted slightly differently from one another. As a general matter

2 however gifts to an organization that is described in Section 501(c)(3) will qualify for the U.S. Federal gift and estate tax charitable deductions. Gifts to such an organization will qualify for a U.S. Federal income tax deduction if that organization is organized under the laws of the United States (regardless of where the organization is domiciled). Civil partnership Same-sex couples' rights and responsibilities are recognised in various states and the District of Columbia. In 2013 the U.S. Supreme Court invalidated the "Defense of Marriage Act" (see U.S. v. Windsor) which prohibited the U.S. Federal government from recognising same sex marriages. Same-sex couples who are married (as opposed to being civil partners or other same sex unions) must be recognised by the U.S. Federal government. Codicil Wills may be amended by codicils. A codicil must be executed in the same manner as a will. The term is the same in England and the United States. Court of Protection These issues are dealt with by different courts in different States (e.g., the Orphan's Court in Pennsylvania, the Surrogate's Court in New York). D Disclaimer of interest (deed of variation) When a deed of variation involving U.S. situs assets or U.S. Person beneficiaries is executed, it is important to ensure that none of the parties are inadvertently making a taxable gift. Deeds of variation are not tax neutral for U.S. Federal tax purposes. A timely disclaimer which complies with the requirements for a disclaimer under Federal ( 2518) and State (or other local law) will not trigger a gift tax liability. Distributable net income (or "DNI") For US Federal income tax purposes, the allocation of a non-grantor trust s income (and gains) is made each taxable year between the trust and the trust s beneficiaries by reference to the trust s DNI, which is an amount calculated under a formula set out in the Code ( 643). Broadly, for foreign non-grantor trusts, DNI equates to the trust s total net income (including net capital gains and tax exempt interest) before any distributions to beneficiaries. DNI of a domestic non-grantor trust generally does not include capital gains. Domestic trust A trust is either domestic or foreign for U.S. Federal income tax purposes. If a court within the United States is able to exercise primary supervision over the administration of the trust (court test) and one or more U.S. Persons have the authority to control all substantial decisions of the trust (control test), then the trust is a domestic trust for U.S. income tax purposes ( 7701(a)(30)). Domicile The concept of domicile, as understood under English law, exists in the United States and may be relevant when determining whether an individual is domiciled in one U.S. state versus another. However, the United States taxes its citizens on a worldwide basis and therefore the concept of domicile (where citizens are concerned) is largely irrelevant. Domicile is relevant for determining whether an individual who is not a U.S. citizen is subject to U.S. Federal transfer taxes, as an individual who is domiciled in the United States under the Code is subject to U.S. Federal transfer taxes on gratuitous transfers of his worldwide assets ( ).

3 F Foreign trust A trust is classified as a foreign trust for U.S. Federal income tax purposes if it does not meet the classification of a domestic trust ( 7701(a)(31)). Therefore, if a trust fails either the court test or the control test, it is classified as a foreign trust for U.S. Federal income tax purposes ( ). Foreign wills It is possible to dispose of U.S. property under a foreign Will. However, when dealing with U.S. citizens and individuals who are domiciled in the United States for U.S. Federal transfer tax purposes, it is important to ensure that any non-u.s. Will takes into account all relevant U.S. tax issues, including any State-level tax issues. G Gift inter vivos U.S. citizens and domiciliaries currently enjoy a U.S. Federal lifetime gift tax exemption amount of $5,430,000 (indexed annually for inflation). Unlike the U.K. nil rate band, once the exemption is exhausted, it does not renew except to the extent of increases in the exemption due to annual inflation adjustments. The U.S. Federal lifetime gift tax exemption amount and the U.S. Federal estate tax exemption amount are unified, meaning that use of the gift tax exemption during lifetime reduces the estate tax exemption amount available upon death, dollar for dollar. Non-citizens who are not domiciled in the United States for U.S. Federal transfer tax purposes do not have a lifetime gift tax exemption amount; however, such individuals are generally only subject to U.S. Federal gift tax on gratuitous transfers of certain U.S. situate property, such as U.S. real estate. Gifts Ordinarily Made Out of Income The U.S. corollary to "gifts ordinarily made out of income" are "annual exclusion" gifts. Every individual, whether a U.S. citizen, domiciliary, resident or non-resident, may make gifts of up to $14,000 per calendar year to an individual or organization without making a taxable gift. The annual exclusion amount applies per donee, per calendar year. The gift must be a gift of a "present interest" (as opposed to a future interest). The amount of the annual exclusion gift that can be made to a non-u.s. citizen spouse is $147,000 (indexed for inflation). This increased annual exclusion amount is permitted in lieu of the unlimited gift tax marital deduction available with respect to gifts to a U.S. citizen spouse. Grantor trust An ordinary trust (as opposed to a business trust) is classified as either a grantor trust or a non-grantor trust for U.S. Federal income tax purposes. A trust that is classified as a grantor trust is not considered a taxpayer for U.S. Federal income tax purposes. Rather, for the person deemed to be the owner of the trust (the grantor ) for U.S. Federal income tax purposes is treated as the tax owner of the trust s underlying assets and the income and gains generated on such assets. If a trust is classified as a grantor trust, its grantor includes all items of trust income, gain, deduction, etc. in computing his taxable income as if he had received such items directly. Generally, this applies regardless of whether the trust is a domestic trust or a foreign trust and regardless of whether the grantor is a U.S. Person or a non-u.s. person. Most trusts settled by U.S. Persons are classified as grantor trust. If a U.S. Person makes a gratuitous transfer to a trust and retains any one of a number of grantor trust powers (or interest), the trust will be classified as a grantor trust, and he will be considered the owner of the trust s assets for U.S. Federal income tax purposes. In addition, a U.S. Person who directly or indirectly transfers property to a foreign trust will be treated as the owner of the portion of the trust attributable to such property if there is a U.S. Person

4 beneficiary of trust, irrespective of whether the U.S. Person settlor retains any power over or interest in the trust. Also, a person other than the grantor can be treated as the owner of any portion of a trust with respect to which he has the power exercisable solely by himself to appoint the capital or income of the trust to himself. It is more difficult for a non-u.s. person to create a grantor trust. Under the general rule, if a non-us person makes a gratuitous transfer to a trust, he will not be considered the owner of the trust and its underlying assets for U.S. Federal income tax purposes. Rather, the trust is generally classified as a non-grantor trust and taxed as a separate entity. However, there are generally two exceptions to this rule. If a non-u.s. person makes a gratuitous transfer of his property to a trust, the trust (or a portion thereof) will qualify as a grantor trust for U.S. Federal income tax purposes if either (i) the power to revest absolutely in the grantor title to such property is exercisable solely by the grantor without the approval or consent of any other person or with the approval or consent of a related or subordinate party who is subservient to the grantor, or (ii) the only amounts distributable from the trust during the lifetime of the grantor, whether from income or capital, are amounts distributable to the grantor or the grantor s spouse (i.e., the grantor and/or the grantor s spouse are the only permissible beneficiaries of the trust during the grantor s lifetime). I Income in respect of a decedent ( IRD ) Income in respect of a decedent includes all types of taxable income earned, but not received by the decedent by the time of death. For example, IRD includes the taxable portions of annuities and retirement plans, Series EE U.S. Savings Bonds, instalment agreements, wages paid after death, as interest and dividends earned, but not received, before death. Inheritance tax (aka U.S. Federal estate tax) The U.S. Federal estate tax is the U.S. equivalent of UK inheritance tax. A U.S. citizen is subject to U.S. Federal estate tax on the gratuitous transfer of his worldwide assets, irrespective of where he resides or where the asset is located. An individual who is domiciled in the United States for U.S. Federal estate tax purposes is also subject to worldwide estate tax. A person acquires a domicile in a place by living there, for even a brief period of time, with no definite present intention of moving elsewhere ( ). The U.S. Federal estate tax exemption is currently $5,430,000, less any portion of the U.S. lifetime gift tax exemption utilised during the decedent's lifetime. Several States in the United States have their own inheritance or estate taxes that are imposed in addition to U.S. Federal estate tax (e.g., New York). Intestacy rules Each State (and the District of Columbia) has its own intestacy rules. Inventory The concept of an inventory exists under State law. L Land Registry All titles relating to property in the United States are held on a state by state basis. Lasting powers of attorney Powers of attorney are executed under state law. Law Society The U.S. equivalent is the bar of each state (or the District of Columbia). Each state has its own admission requirements, its own CPD requirements and its own ethics rules. The State bar associations deal with all complaints regarding lawyers.

5 M Matrimonial regime The majority of the States (and the District of Columbia) do not have a community property regime. Nine states including Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington, and Wisconsin have adopted community property laws. Alaska allows for an optional community property election. The U.S. Territory of Puerto Rico is also a community property jurisdiction. N Non-grantor trust If a trust (or any portion thereof) does not qualify as a grantor trust for U.S. Federal income tax purposes, it is classified as a non-grantor trust and consequently, treated as a separate taxpayer. A non-grantor trust generally calculates its taxable income in the same manner as an individual, subject to several modifications under the Code, which allocate the trust s income, gains, deductions and credits between the trust and its beneficiaries. Distributions of accumulated income and gains to a U.S. Person beneficiary from a foreign non-grantor trust are subject tax under the throwback rules. A U.S. Person will recognise capital gains if he transfers appreciated property to a foreign non-grantor trust. The value of a U.S. Person beneficiary s beneficial use of trust property owned by a foreign non-grantor trust is treated as a distribution to such beneficiary, taxable by reference to the trust s DNI and UNI. Non-resident alien ( NRA, or non-u.s. person ) An individual is a non-resident alien if such individual is neither a citizen of the United States nor a resident of the United States under Section 7701(b)(1)(A). See definition of U.S. Person below. Generally, an NRA is subject to U.S. Federal income tax only on certain U.S. source income. P Potentially Exempt Transfers ("PET") The U.S. does not recognise PETs. A PET is treated as a gift and utilises all or a portion of an individual s annual gift tax exclusion amount and/or his lifetime gift tax exemption amount. Gifts to a non-u.s. citizen spouse are not eligible for the unlimited gift tax marital deduction and are subject to annual exclusion limits ($147,000 in 2015) and otherwise use the donor's lifetime gift tax exemption. Q Qualified Domestic Trust (or "QDOT") Bequests to non-us citizen spouses are not eligible for the unlimited estate tax marital deduction. A bequest to a non-citizen spouse that passes to a QDOT will qualify for the estate tax marital deduction, such that estate tax will be deferred until the death of the surviving spouse. QDOTs must be drafted and administered under U.S. law. The rules are extremely detailed however and it should be noted that a trust will not qualify as a QDOT if it includes overriding powers of appointment that can be exercised in favour of anyone other than the surviving spouse. T Throwback rules Under the throwback rules, a beneficiary receiving a distribution of UNI is taxed as if the trust had distributed that UNI in the year it accumulated the UNI. In other words, the UNI is thrown back to a previous year or years and taxed as if it was received by the U.S. Person

6 beneficiary in such previous year. Further, the UNI is recharacterised as ordinary income (even if it were capital gain or qualified dividend income when earned) and taxed at the beneficiary s highest marginal income tax rate and subject to a penalty interest charge. Transfer taxes U.S. Federal transfer tax means any one of the United States federal transfer taxes imposed under Subtitle B of the Code, namely the Federal gift tax, Federal estate tax and the Federal generation-skipping transfer tax. U Undistributed net income ("UNI") UNI is equal to the undistributed (accumulated) portion of a trust's DNI for a year less the taxes imposed on the trust for that year. UNI is deemed to be distributed before a trustee makes any distributions of capital. The ordering rules are first DNI, then UNI and then capital. If the amount of the aggregate distributions made during the calendar year (or within sixty-five days of the close of the calendar year, provided an election is made) exceeds DNI, then the trust is deemed to have distributed UNI (if any), which is then subject to tax under the throwback rules. United States person ( U.S. Person ) The term United States person, or U.S. Person means (i) a citizen of the United States, (ii) a resident of the United States as defined under Section 7701(b)(1)(A) of the Code, (iii) a domestic partnership, (iv) a domestic corporation, (v) any estate other than a foreign estate as defined in Section 7701(a)(31) of the Code, and (vi) any domestic trust. Section 7701(b)(1)(A) of the Code provides that the term resident of the United States for US Federal income tax purposes means any individual who (i) is a lawful permanent resident of the United States (i.e., a green card holder) at any time during the calendar year, (ii) meets the substantial presence test set out in Section 7701(b)(3) for any calendar year, or (iii) makes a special election to be treated as an income tax resident of the United States. Subject to certain exceptions under the Code and Regulations and/or an applicable income tax treaty, a U.S. Person is subject to U.S. Federal income tax and reporting obligations on his worldwide income and gains. Butler Snow v2

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