Estate Planning Concepts for Nonresident Aliens: What Mexican Nationals and Their Advisors Need to Know

Estate Planning Concepts for Nonresident Aliens: What Mexican Nationals and Their Advisors Need to Know San Antonio CPA Society CE Symposium September 22, 2011

Foreign Investment in the United States Foreign Direct Investment in the United States Year Amount 2006 $243.2 Billion 2007 $275.8 Billion 2008 $319.7 Billion 2009 $152.1 Billion 2010 $194.5 Billion Source: Organization for International Investment, September 2011 2

Foreign Investment in the United States Residential Real Estate in Texas Year Purchased By Nonresidents of the U.S. 2007 8% 2008 7% 2009 11% 2010 8% (projected) Source: National Association of Realtors, June 2010 3

SOI Tax Stats On Nonresident Estate Tax Returns Form 706-NA Year 2007: IRS Statistics Number of Form 706-NAs filed: 120 Taxable Returns Over $1 million: 21 Total Amount of Taxable U.S. Property Reported: $71.4 million Total Reported Worldwide Assets Reported: $171.3 million Total Taxable U.S. Real Estate Reported: $20.7 million Total Taxable U.S. Publically Traded Stock Reported: $30.9 million Total Taxable U.S. Cash Assets Reported: $11.8 million Lesson: There is vast under reporting of foreign wealth based in the U.S. on estate tax returns. The Obama Administration is highly aware of noncompliance with nonresident tax provisions and is moving to correct it. Source: IRS, Statistics of Income Division, September, 2009 4

GAO Report On Nonresident Tax Compliance In May of 2010, the GAO issued a report on NRA tax compliance revealing broad non-compliance with many reporting and payment requirements. The report states that few NRAs are fully compliant with U.S. tax reporting requirements. The GAO opines that the situation is potentially leading to broader noncompliance if individuals assume the lack of enforcement extends to other tax rules. The Service s Large and Mid-sized Business division of International Compliance Strategy and Policy Group plans to hire 202 new examiners in 2010. LMSB International is actively cross-checking international filings across tax regimes to try to close the NRA noncompliance loop. LMSB International has an internal marketing campaign within the Service to increase NRA enforcement across divisions, including income tax and transfer tax areas. The Obama Administration has been concentrating on offshore/nonresident issues through FBAR, FATCA, and other initiatives that aim to derive more revenue from these types of taxpayers. The Internal Revenue Service is targeting NRA noncompliance. Source: GAO-10-429: Report to the Chairman, Subcommittee on Select Revenue Measures, Committee on Ways and Means, House of Representatives: Tax Compliance IRS May Be Able to Improve Compliance for Nonresident Aliens and Updating Requirements Could Reduce Their Compliance Burden, May 14, 2010. 5

Treaties The United States has treaties with the following countries regarding estate, gift, or generation-skipping transfer tax matters: Australia Austria Canada Denmark Finland France Germany Greece Ireland Italy Japan Netherlands Norway Republic of South Africa Sweden Switzerland United Kingdom 6

Taxes The Four Taxes There are four U.S. taxes which must be considered for business and personal estate planning: Income Tax: A tax on personal earnings, wages, capital gains, and business income. See generally, IRS Publication 519 for information on income taxation of NRAs. Gift Tax: A tax on gratuitous transfers: any transfer to an individual, either directly or indirectly, where full consideration (measured in money or money's worth) is not received in return. The gift tax provisions applicable to NRAs are found in Code Sections 2501(a)(2) and (3), (b) and (c), and 2511. Estate Tax: A tax arising on the death of an individual levied against the property included in the decedent s estate. The estate tax provisions applicable to NRAs are found in Internal Revenue Code Sections 2101 through 2108 and in Code Sections 2208 and 2209. Generation Skipping Transfer Tax: A tax on a gift to a grandchild, or to an unrelated person 37.5 years younger than the transferor. generation-skipping transfer ( GST ) made by a NRA is subject to the U.S. GST tax only if the transfer is also subject either to the U.S. estate tax or the U.S. gift tax or, if the transfer is from a trust, if the NRA's transfer to the trust was subject to the U.S. estate or gift tax. 7

Forms These are some of the tax forms associated with international taxation. Form W-7 (Application for Individual Taxpayer Identification Number) W-8 Certificate of Foreign Status W-8EXP Certificate of Foreign Government or Other Foreign Organization for United States Tax W-8BEN Certificate of Foreign Status of Beneficial Owner for United States Tax Withholding W-8ECI Certificate of Foreign Person s Claim for Exemption From Withholding on Income Effectively Connected With the Conduct of a Trade or Business in the United States W-8IMY Certificate of Foreign Intermediary, Foreign Partnership, or Certain U.S. Branches for United States Tax Withholding Form 706 United States Estate (and Generation-Skipping Transfer) Tax Return Form 706-A United States Additional Estate Tax Return Form 706-GS(D) Generation-Skipping Transfer Tax Return for Distributions Form 706-GS(D-1):Notification of Distribution from a Generation-Skipping Trust Form 706-CE Certificate of Payment of Foreign Death Tax Form 706-GS(T) Generation-Skipping Transfer Tax Return for Terminations Form 706-NA United States Estate (and Generation Skipping Transfer) Tax Return Form 706-QDT U.S. Estate Tax Return for Qualified Domestic Trusts Form 720 Quarterly Federal Excise Tax Return 8

Forms Here are some more. This list is from California Attorney Phil Hodgen: Hogden.com Form 1001 Ownership, Exemption, or Reduced Rate Certificate Form 1040NR U.S. Non-Resident Alien Income Tax Return Form 1040NR-EZ U.S. Income Tax Return for Certain Nonresident Aliens with No Dependents Form 1042 Annual Withholding Tax Return for U.S. Source Income of Foreign Persons Form 1042-S Foreign Person s U.S. Source Income Subject to Withholding Form 1078 Certificate of Alien Claiming Residence in the United States Form 1120-F U.S. Income Return of a Foreign Corporation Form 5472 Information Return of a 25% Foreign-Owned U.S. Corporation or a Foreign Corporation Engaged in a U.S. Trade or Business Form 8288 U.S. Withholding Tax Return for Dispositions by Foreign Persons of U.S. Real Property Interests Form 8288-B Application for Withholding Certificate for Dispositions by Foreign Persons of U.S. Real Property Interests Form 8300 Report of Cash Payments Over $10,000 Received in a Trade or Business Form 8709 Exemption from Withholding on Investment Income of Foreign Governments and International Organizations TD F 90-22.1 Report of Foreign Bank and Financial Accounts TD F 90-22.47 Suspicious Activity Report TD F 90-22.53 Designation of Exempt Person 9

Status for Income Tax Any individual who is not a resident of the U.S. is subject to U.S. income tax only on U.S. income. Resident means: The individual is a lawful permanent resident of the U.S. (green card holder), or The individual is deemed substantially present in the U.S. 10

Status for Income Tax Substantial Presence Test A mathematical calculation comprised of two parts: The 31-day test and the 183 day test. To be considered substantially present in the U.S. under the test, an alien must be physically present in the U.S. for at least 31 days during the current calendar year, and 183 days during the 3-year period that includes the current year and the 2 years immediately before that, counting: All the days present in the current year, and 1/3 of the days present in the first preceding year, and 1/6 of the days present in the second preceding year Summary: if an alien is in the U.S. for an average of 122 days each year over three years, then the test is met. There are certain exceptions available even if the substantial presence test is met. The Service will look to closer connections to determine income tax residency. Certain exceptions and alterations of the basic test are articulated in Mexico-US income tax treaty. 11

Status for Income Tax Substantial Presence Test Decision Tree from IRS 12

Status for Income Tax Why Residency Matters Resident Alien Status: U.S. income tax imposed on worldwide income. Nonresident Alien Status for Income Tax Purposes: U.S. income tax imposed only on income from the U.S. See Publication 519 for more details. 13

Status for Income Tax Why Residency Matters A NRA is subject to U.S. income tax on income effectively connected with a U.S. trade or business at the same rates as apply to U.S. income tax residents. Income from fixed or determinable annual or periodical gains, and profits, are generally taxed at a flat 30%. Interest on bank deposits, and portfolio interest such as income from bonds, is exempt from U.S. income taxation. Gains from the sale of a stock of a U.S. corporation are generally exempt from income taxation, unless the NRA is present in the U.S. for 183 days in the year of sale. Rental income from a U.S. source will generally be taxed at the 30% level unless the NRA makes an affirmative election to treat it as business income. The sale of U.S. real property results in capital gains tax if gains are realized. Under the Foreign Investment in Real Property Tax Tax (FIRPTA) there is a withholding of 10% of the amount realized. FIRPTA withholding applies if the sale is for a loss or for a gain. 14

Status for Income Tax US-Mexico Tax Treaty Article 4 of the U.S.-Mexico Income Tax Treaty, augments the basic substantial presence test. Under the terms of the Treaty, having a permanent home available in the U.S. is a factor in determining income tax residency. If a Mexican national has permanent homes in both the U.S. and Mexico, then the Treaty requires the application of a legal test that looks to the taxpayer s center of vital interests, or habitual abode. Mexican nationals should be aware that owning a home in the U.S. is a tiebreaking factor in determining income tax residency under the Treaty. The U.S.-Mexico Income Tax Treaty modifies the tax rates on dividends from U.S. corporations, and interest on debts and mortgages. Additionally, there are credits available to mitigate double taxation. Income that tax residents of Mexico receive for personal services performed in the U.S. as independent contractors or self-employed individuals are exempt from income tax in the U.S. if the Mexican national is not in the U.S. for more than 183 in a 12-month period, and has no fixed base that they regularly use to perform services. The Treaty also makes special provisions for Mexican students in the U.S. so that their worldwide income is not taxed even if they stay for extended periods of time. 15

Status for Income Tax Reporting Obligations. In additional to paying tax on worldwide income to the U.S., income tax residents are also required to report information to the Service: If a domestic corporation has foreign shareholders owning 25% or more then it must file Form 5472 to report transactions with foreign or domestic related parties. U.S. persons who receive aggregate foreign gifts or bequests of more than $100,000 from an individual, or $10,000 from a partnership or corporation, during a tax year are required to file Form 3520. U.S. person who controls a foreign corporation or partnership (greater than 50% vote or value), or who is a 10% shareholder of a controlled foreign corporation, must file Form 5471 (for corporations) or Form 8865 (for partnerships) to report certain information concerning the foreign corporation or partnership 16

Status for Income Tax Reporting Obligations. A U.S. grantor of a foreign trust must file Form 3520, and if there is a US beneficiary, he or she must file Form 3520-A to report trust information. Report of Foreign Bank and Financial Accounts, or FBAR, Form is TD F 90-22.1. Requires a US tax resident to report foreign accounts with a value over $10,000. Offshore Voluntary Disclosure Initiative ended September 9, 2011. US tax resident can still disclose, but amnesty is not guaranteed and civil penalties will have to be negotiated. U.S. owner of passive foreign investment companies (often interpreted by the Service to include foreign mutual funds) must file Form 8621(there are also some ugly tax consequences to owning PFICs for U.S. tax residents). 17

Status for Transfer Tax Tests Not The Same The tests for income tax treatment and transfer tax treatment of foreign persons are not the same under U.S. law. Meeting a domicile test subjects a person to transfer tax, not the residency test used for income tax. 18

Status for Transfer Tax Domicile Means: The individual is physically present in the U.S., and The individual has the current intention to remain indefinitely in the U.S. Intent is the operative factor Shown by surrounding facts and circumstances 19

Status for Transfer Tax What Domicile Really Means: Alien was in the U.S. because he could not return home to Holland during World War II. For his living space, the alien bought only light, inexpensive furniture. The alien did not join a church while in the U.S. At death the alien s remains were taken to Holland. Held: no U.S. domicile. See Estate of Nienhuys v. Commissioner, 17 T.C. 1149 (1952). Canadian alien had a home in Florida where he lived from October to April. He had no home in Canada. But he voted and filed income tax in Canada, and kept his Canadian driver s license plus car registration. The widow testified that the alien decedent intended to keep Canadian domicile. Held: No U.S. domicile. See Estate of Paquette v. Commissioner, T.C. Memo 1983-571 (1983) Alien left the U.S. in 1986, returning to home country Pakistan. He died in 1991. Though the decedent held a green card, he allowed his re-entry permit to expire, and had filed Form 1040NR purportedly abandoning the U.S. as an income tax resident. Decedent never spoke English. Held: domiciled in the U.S. for estate tax purposes. The court emphasized that the tests for income tax residency and estate tax domicile are distinct. See Estate of Khan v. Commissioner, T.C. Memo 1998-22 (1998). 20

Status for Transfer Tax Why Domicile Matters: Domiciled alien: U.S. estate tax imposed on worldwide estate. Non-Domiciliary status for Estate Tax Purposes: U.S. estate tax imposed on estate of U.S. situs property only. For the balance of this presentation, a NRA is defined as an individual who is not domiciled in the U.S. for estate tax purposes. Some practitioners refer to these individuals as Non-Doms. 21

What s The Difference? For 2011, 2012 and beyond? US Domiciliary: Taxed on property worldwide $13,000 Annual 2503(b) Gift Exclusion Under unified credit can gift up to $5 Million in life. $5 Million Estate Tax Exemption under unified credit. $5 Million GSTT Unlimited Marital Deduction Non-Domiciliary: Taxed on U.S. situs property $13,000 Annual 2503(b) Gift Exclusion No unified credit. Taxed on gifts over annual exclusion $60,000 Estate Tax Exemption $5 Million GSTT Exemption $136,000 Annual Gift Exemption to Non-citizen Spouse (Indexed) Unlimited Marital Deduction for gift to noncitizen spouse allowed at death only through a special trust (QDOT). 22

What s The Difference? Special Rules for 2010 US Domiciliary: No Estate Tax Carryover Basis Can Step Up $1.3 Million in Basis Additional $3.0 Million Spousal Basis Step Up No GSTT applied Non-Domiciliary: No Estate Tax Carryover Basis Can Step Up $60,000 in Basis Additional $3.0 Million Spousal Basis Step Up No GSTT applied 23

Estate Taxation of Non-Domiciliaries Special Estate Tax Rules for 2010 for Non-Domiciliaries No Estate Tax on U.S. situs property Can get a basis step up on $60,000 of U.S. property Can get spousal basis step up on $3.0 million of U.S. property Cannot elect QDOT treatment for trusts benefiting a surviving NRA spouse. QDOTs explained below. Transfer from a U.S. estate to a NRA is treated as a sale. Gains must be recognized by the estate if the fair market value exceeds decedent s basis. 24

Estate Taxation of NRAs Estate Tax Rules for 2011 No unified credit available to Non-Domiciliaries. Non-Domiciliaries receive instead an estate tax credit of $13,000. Treaties alter this rule. In essence, a Non-Domiciliary can pass $60,000 of U.S. situs property free of estate taxes. The estate tax rate imposed on transferred property over $60,000 is progressive, with a maximum rate of 35%. 25

Estate Taxation of NRAs Estate Tax Imposed on NRA s Gross Estate in the U.S. Code Sections 2031 through 2046 are used to determine what property is included in the Gross Estate. Same tests as those used for a U.S. citizen or domiciliary. If property falls under these Code Sections, then a further analysis is required to ascertain the situs of the property for NRA transfer tax purposes. Property that has a U.S. situs is included in the Gross Estate of the NRA for U.S. transfer tax purposes. 26

Estate Tax Situs Rules Upon the death of a NRA, the NRA s estate shall be assessed estate taxes on any property deemed to be situated within the U.S. on the date of death. See Code Sections 2101 and 2103. Application of the situs rules differ depending on the nature of the property. The situs rules for Estate Tax and Gift Tax are not the same for purposes of determining a NRA s tax liability. This disjunction provides for both confusion and planning leverage. 27

Estate Tax Situs Rules Property Deemed to Have U.S. Situs for Estate Tax U.S. Real Estate. See Treas. Reg. 20.2104-1(a)(1). U.S. real estate is in the gross estate of the NRA if owned directly, or owned as a joint tenant (to the extent the NRA contributed to the acquisition of the property). Common use of foreign corporate forms to hold U.S. real estate. If a foreign corporation owns U.S. real estate, the death of the stock holder results in no inclusion of either the real property or the foreign corporation stock in the U.S. estate. Other tax implications must be carefully considered before implementing any ownership structure using an offshore corporation. See discussion of structuring of NRA home purchases in the U.S., following. 28

Estate Tax Situs Rules Property Deemed to Have U.S. Situs for Estate Tax Tangible Personal Property If the property is located in the U.S., it is includible in the gross estate. See Treas. Reg. 20.2104-1(a)(2). Cash in a safe deposit box is tangible personal property. See Rev. Rul. 55-143. Property in transit is not included in the gross estate. Jewelry and personal effects of NRA who died in Florida during stop-over en route from Canada to Nassau, was not U.S. situs property for federal estate tax purposes. See Murchie v. Delaney, 82 F.Supp. 176 (D. Mass), aff d 177 F.2d 444 (1 st Cir. 1949). Artwork on loan to a gallery is also excluded. See PLR9141014 29

Estate Tax Situs Rules Property Deemed to Have U.S. Situs for Estate Tax Stock in a U.S. corporation. See Code Section 2104(a). Both publicly-traded and closely-held stock have U.S. situs. Note: the rule is the opposite for gift tax. Shares of mutual funds incorporated in the U.S. See Code Section 2104(a). Includes money market funds. U.S. Partnership Interest? See Code Section 2103. The treatment of interests in U.S. partnerships and limited liability corporations are by no means clear. See discussion later in this presentation. 30

Estate Tax Situs Rules Trust Interests Property Deemed to Have U.S. Situs for Estate Tax Property owned by a NRA through a revocable trust is treated as owned by the grantor. See GCM 38916 Whether or not a trust will be includible in a NRA s U.S. estate should be analyzed in a manner similar to those used for U.S. citizens, that is, through application of Code Sections. 2033-2046. Case law holds that a NRA s interest in an irrevocable trust should be considered as an interest in each asset of the trust. See CIR v. Nevius, 76 F.2d 109 (2 nd Cir. 1935). Just because a trust is a foreign trust and is not subject to U.S. income taxes does not preclude its assets from inclusion in the NRA s gross estate for U.S. estate tax purposes. 31

Estate Tax Situs Rules Property Deemed to Have U.S. Situs for Estate Tax Transfers Under Code Sections 2035-2038 The transfer sections of the Code apply to U.S. situs interests held by NRAs (e.g. U.S. real estate transferred to a revocable trust) Debt Obligations that do not meet the portfolio interest exception of Code Section 871(h). Nonbank Deposits (e.g. cash in a brokerage money market account). Intangible Property (if enforceable against a U.S. resident) Patents, copyrights, goodwill, trademarks, etc. Right to receive payment from a U.S.-issued annuity. 32

Estate Tax Situs Rules Property Deemed to Have Non-U.S. Situs for Estate Tax Foreign Real Estate. See Treas. Reg. 20.2105-1(a)(1). Foreign Tangible Personal Property: physically located outside U.S. See Treas. Reg. 20.2105-1(a)(2). Life Insurance: proceeds from a policy owned by the NRA on the life of the NRA, issued by a U.S. carrier. See Code Sections 2104(c) (1) and 2105(a) Extremely powerful planning opportunity for NRAs. Note: cash value of a policy on the life of another individual is includible. Stock issued by foreign corporations. Shares of foreign mutual funds. 33

Estate Tax Situs Rules Property Deemed to Have Non-U.S. Situs for Estate Tax Deposits in Foreign Branches of Domestic Banks. See Code Section 2105(b)(2). Domestic Bank Accounts: Deposits and CDs at a U.S. bank, savings institution, or credit union. See Rev. Rul. 83-175, 1983-2 C.B. 109. Unless the interest earned is effectively connected with the conduct of a trade or business in the U.S. See Code Section 2105(b). Or, if the NRA is deemed a U.S. resident for income tax purposes. Caution: while accounts holding money in depository institutions (aka banks ) are non-u.s. situs for estate tax, cash in a brokerage money market account is deemed to have U.S. situs for estate tax purposes. 34

Estate Tax Situs Rules Property Deemed to Have Non-U.S. Situs for Estate Tax Foreign Partnership Interests if not engaged in U.S. business See general discussion of includibility of partnership interests below. Code Section 871(h) Obligations: debt instrument issued by a U.S. person if the interest generated constitutes portfolio interest under 871(h)). Most U.S. corporate bonds and government bonds meet the portfolio interest exception. Review investments carefully under Code Section 871(h) to determine if the debt holdings do indeed fall under the portfolio interest exception. 35

Estate Tax Situs Rules Analyzing Partnership Interests The U.S. estate tax treatment of a partnership, or LLC, interest held by a NRA is not clear. There is no bright line rule as to whether a NRA partner would be deemed to own a prorata share of the underlying assets of the partnership or whether a partnership ownership would be treated as an intangible interest. The IRS has specifically declined to rule on the gift tax status of a partnership interest owned a NRA. See Rev. Proc. 99-7. The refusal to rule likely also extends to estate tax treatment. Without further guidance from the Service, ascertaining whether or not a partnership or LLC interest owned by a NRA is taxable in the U.S. estate becomes a matter of relying on other authority, such as case law. If a one-person LLC is classified as a corporation for U.S. income tax purposes, it is arguable that the interest should be treated like corporate stock for estate and gift tax purposes in the NRA context. Partnership interests owned by a NRA must be carefully considered for transfer tax purposes. 36

Estate Tax Situs Rules Analyzing Partnership Interests If the Service will not provide guidance, then how about other sources of guidance? The judicial, regulatory and legislative history is inconsistent, with both the aggregate approach and the entity approach used by authorities to analyze NRA ownership of partnership interests. Aggregate: looks a variety of factors to determine situs. Entity: looks to the legal status of the entity to determine situs. Case law is sparse, and the lack of guidance on this issue leads to uncertainty. This, in turn, leads to conservative planning. 37

Estate Tax Situs Rules Analyzing Partnership Interests The seminal case in support of an aggregate approach is Sanchez v. Bowers, 70 F.2d 215 (2 nd Cir. 1934). In Sanchez, Judge Learned Hand held that the death of a resident and citizen of Cuba caused the termination of a Cuban entity in which the decedent had an interest (sociedad de gananciales). This termination, in turn caused the estate to own a proportionate share of the entity s assets. It is arguable that had the entity not terminated, nothing would have been included in the estate. In dicta, however, the court suggested that the level of the entity s activities in the U. S. could also be a foundation for inclusion of the assets in the estate. 38

Estate Tax Situs Rules Analyzing Partnership Interests In support of the entity theory, that a partnership or LLC interest is akin to an interest in a corporation and therefore inclusion in the gross estate is determined by reference to the status of the partnership (domestic or foreign), is Blodgett v. Silverman, 277 U. S. 1 (1928). In Blodgett the Supreme Court affirmed a lower Connecticut court decision that held that a partnership interest was intangible property even though the partnership owned real estate. Since the decedent was domiciled in Connecticut at his death, a Connecticut law taxing the succession of all personal property of a domiciliary applied. 39

Estate Taxation of NRAs Deductions on NRA Estate Taxation Much like the estate of a U.S. citizen, a NRA s estate is permitted to take deductions for expenses, losses, indebtedness, transfers for public, charitable and religious uses, and state death taxes. A NRA s estate may also take a marital deduction (limited when there is a non-u.s. citizen surviving spouse). Permitted Deductions for a NRA s estate Include: Deductions for expenses, losses, indebtedness and taxes. See Code Sections 2053 and 2054. Charitable Deduction. See Code Section 2106(a)(2) Marital Deduction. See Code Section 2056A 40

Estate Taxation of NRAs Deductions on NRA Estate Taxation Deductions for U.S. estate tax under Code Sections 2053 and 2054 are calculated pursuant to the ratio of the U.S. estate to the worldwide estate. Example: If an NRA has a world-wide estate of $1,000,000, with $250,000 of U.S. situs property subject to U.S. estate, and qualified expenses totaling $100,000, then the U.S. estate tax deduction would be limited to $100,000 x ($250,000 / $1,000,000) = $25,000. The same analysis is used for personal indebtedness in the US. Filing for a deduction under Code Sections 2053 or 2054 for U.S. estate tax requires disclosure of worldwide property on Form 706-NA. Privacy issues must be balanced against the value of the deduction. Higher risk of audit when deduction is taken. 41

Estate Taxation of NRAs Deductions on NRA Estate Taxation Charitable deductions for U.S. estate tax under Code Sections 2106(a) are limited to transfers for the exclusive use of the U.S. government or political subdivision, or a U.S. domestic charity. See Treas. Reg. 20.2106-1(a)(2). Executor had the power to make gifts to both U.S. and foreign charities. The executor chose to make gifts solely for the benefit of U.S. charities and claimed a deduction on Form 706- NA. The Service denied the charitable deduction as not complying with Code Section 2106(a)(2). See PLR9135003. Some estate tax treaties modify this rule. 42

Estate Taxation of NRAs Deductions on NRA Estate Taxation Unlimited marital deduction is available for the estate of NRAs. If the surviving spouse is a U.S. citizen, the unlimited marital deduction applies. If the surviving spouse is not a U.S. citizen, the marital deduction can be claimed only for property passing to a Qualified Domestic Trust (Code Section 2056A). QDOT trusts are generally extremely unfavorable to the surviving NRA spouse, but are the exclusive avenue to pass U.S. situs property to a non-citizen spouse tax-free. Note that surviving spouses who are legal permanent residents (green card holders) are still subject to the QDOT rules for the marital deduction. Only U.S. citizens obtain the benefits of the unlimited marital deduction without using a QDOT. 43

Estate Taxation of NRAs Basic QDOT Rules Trustee must be U.S. citizen or corporation. If the QDOT is over $2 million, the trustee must be a U.S. bank, or the individual trustee must post a bond equal to 60% of the value of the trust. Income can be distributed tax-free to the surviving spouse, but principal distributions are taxed at estate tax rates in effect at death of the decedent spouse. For example, if the decedent spouse died in 2007, the estate tax rates from that year, as applicable to the decedent s estate, will be applied to QDOT distributions from principal in 2012. There is a hardship exception for some principal distributions that will avoid taxation, such as qualified medical care, or necessary support. 44

Estate Taxation of NRAs Basic QDOT Rules Surviving NRA spouse can convert out of QDOT if he or she later becomes a U.S. citizen. QDOTs can be formed post-mortem by surviving spouse, up to 15 months after the death of the decedents. Election is made on the estate tax return. At the death of NRA spousal beneficiary, estate tax is imposed on the property at the rate applicable for the estate of the first spouse to die. Comment on QDOTs: they are not a favorable planning tool. The restrictions on the surviving spouse are onerous. However, QDOTs are the only way to defer estate tax through a marital deduction where a NRA surviving spouse is involved. QDOTs should be used as a backstop for U.S. property that can not otherwise be planned around. 45

Estate Taxation of NRAs QDOT Rules for 2010 No QDOT election available in 2010. Analogous to how no marital deduction is available in 2010. Proper planning will allow the QDOT to spring in 2011 when QDOT elections will again be permissible. Non-hardship principal distributions in 2010 are still taxed at the estate tax rate of the date of death of the U.S. citizen spouse. QDOT beneficiaries do not get a break from estate tax in 2010. 46