This is Part 1 in a three-part series about Estate Planning for Non-Citizens. In Part 2, I discuss what is a QDOT. In Part 3, I discuss the various ways foreigners can own U.S. real property.
This article is focused on the issues that occur with regards to estate planning when a non-U.S. citizen is involved. It is vital to understand that the tax consequences can be extremely expensive and caution should be taken to speak to a legal professional in order to plan for a whole host of potential tax consequences that may not be discussed in this article. Thus, please speak to a professional about your particular case.
Specific Estate Planning Issues Related to Non-Citizens
It must be stated at the outset that regardless of age, amount of wealth, or citizenship status, everyone must create an estate plan in order to protect against a probate at death, incapacity, or simply to name guardians for their minor children.
But for non-US persons, there are specific income taxes and transfer taxes that affect their estate planning. For example, the federal estate tax is a tax imposed at death for the transfer of any wealth from the decedent to any person inheriting. Specifically, this estate tax is very expensive – to the tune of 40%. If an individual attempts to avoid the estate tax by transferring assets while they are alive, then there is a gift tax to plan around – also to the tune of 40% if it gets triggered. The rules for non-US persons differ substantially when it comes to gift and estate tax planning.
Before we can address these various tax issues, we must first define who qualifies as a US person. As you will see, the definition differs substantially depending on whether we are discussing income taxes or transfer taxes, and this definition becomes absolutely critical when we discuss married non-citizen couples as well.
US Person for Income Tax Purposes
Federal income taxes, and their rates, differ depending on whether you are a “US person” or not.
The definition of a “US person” is like opening a nesting box; one definition generally leads to another, which leads to yet another. For US income taxes, a “US person” is defined as either (a) a US citizen; or (b) a US resident. A “US resident” in turn is defined as someone who either has a green card or meets the “substantial presence test”. The substantial presence test essentially is defined as someone who spends at least 31 days in the U.S. in the current calendar year and has collectively spent 183 days or more in the U.S. when adding up the following: (a) the number of days in the U.S. in the current calendar year; plus (b) 1/3 of the days spent in the U.S. the year prior; plus (c) 1/6 of the days spent in the U.S. 2 years prior. If a non-citizen, non-green card holder spends less than 183 days in the US according to this formula, she is not considered a “US resident”. (Fun fact: According to the formula, the math makes 121 days the magic number that an individual can spend in the U.S. three years in a row, and not trigger the substantial presence test. Anything more than 121 days on average will trigger the formula’s 183-day test, and make the individual a “US person” for income tax purposes).
Therefore, it is possible and common that a non-citizen is still regarded as a “US person” when it comes to income tax purposes. This individual is then taxed in the US on their worldwide income. But there are known exceptions to the 183-day rule. For example, if a person can claim a “closer connection” to their home country, they may be exempt from being regarded as a “US person.” Additionally, those on student visas, diplomatic visas, or those with treaty “tie-breakers” can argue that they are not subject to US income taxes as a “US person”.
For those who are not US persons, there are several different tax treatments that will pertain to them from an income tax standpoint. I have listed just a few of them here:
- FDAP: Fixed, Determinable, Annual or Periodical Taxes (e.g., dividends from US corporations (but not proceeds from the sale of US securities), interest (but not on bank deposits), salary for service performed in the US, rents, and royalties (but not gains from sale of real property)), which generally is subject to a 30% gross withholding;
- ECI: Income that is “effectively connected” with the conduct of a US trade or business, which can be taxed at graduated rates of up to 37% (but which allow for deductions);
- Capital gains: generally none except with sale of US real estate, which is taxed at ECI (unless long-term capital gains rate applies) and there will also be FIRPTA withholding/taxes, regardless of whether owned for personal use or business reasons;
- FIRPTA: a tax withholding (10%-15% generally) that applies to the sale by a non-US person, of both direct and indirect interests in real property (but does not apply to sale/disposition of stock in a foreign corporation that holds US real estate);
- Rental income: taxed as FDAP at 30%, plus state taxes with deductions, unless the individual elects to tax the rent at ECI, by making a “net rent election” under IRC 871(d). Although higher tax rates apply for ECI and it requires filing a federal tax return, the owner can deduct expenses (like depreciation), leading to a lower effective tax rate.
- No 3.8% NIIT: No 3.8% Net Investment Income tax applies to non-US persons
US Domiciliary for Transfer Tax Purposes
When it comes to transfer taxes (gift taxes, estate taxes, generation-skipping taxes), the definition of a US person is not as objectively defined. In fact, the term “US resident” does not even apply. Instead, a new term is introduced, called a “US domiciliary.” The definition matters because US domiciliaries receive more favorable tax treatment compared to non-US domiciliaries.
Even though US domiciliaries are taxed worldwide on gift taxes and estate taxes and generation-skipping transfer taxes, if you are a “US domiciliary,” you are afforded a much higher exemption than a non-US domiciliary. In 2022, a US domiciliary is granted a $12.06 million exemption, which represents the amount that can be left at death tax-free without triggering the estate tax. By contrast, a non-US domiciliary is subjected to transfer taxes only on their US-situs assets, but are granted only a $60,000 exemption! Anything beyond that is taxed at 40%. (Situs is a technical term meaning the location of the assets for legal purposes.)
Unfortunately, a “US resident” for income tax purposes is not necessarily a “US domiciliary” for transfer tax purposes.
Who then is a US domicile?
An individual is a US domiciliary “if he lives in the US and has no definite present intent to leave, as show by surrounding facts and circumstances.” Thus, it is a subjective test that measures “intent” based on a variety of factors, including:
- Duration of stay in the U.S. and other countries, and frequency of travel between countries;
- Size, cost, and nature of homes (vacation homes, homes owned, homes rented, etc.);
- Location of business and social contacts;
- Family ties;
- Membership in religious and other organizations;
- Location of expensive/cherished personal possessions;
- Registration to vote;
- Place of driver’s license and vehicle registration;
- Location of bank and investment accounts;
- Reasons for residency (temporary employment, etc.);
- Declaration of residency or intent made in visa applications, estate planning documents, letters, and oral statements
For those who are not US domiciliaries, the following rules will apply when it comes to gift and estate taxes.
Gift Taxes for Non-US Domiciliaries
If a non-US domiciliary makes lifetime gifts of over $60,000 (and annual gifts to an individual over $16,000 in 2022) of real property and tangible personal property sitused in the U.S., this will trigger a 40% gift tax. However, the following assets (even though sitused in the US) will NOT trigger US gift taxes:
- Gifts made of US LLC interests or shares of US stock (since these are regarded as intangible assets);
- Gifts of cash made by a non-US person to a US-person, as long as the transaction is done outside the United States are not subject to gift taxes (whereas gifts of cash and possibly checks that take place within the United States may be subject to gift taxes)
Therefore, for gift tax reasons, non-US domiciliaries should own US rental properties through an LLC, because gifts of LLC membership interests should not trigger a gift tax, whereas if the LLC did not exist, then any transfer of real property owned directly by a non-US domicilary would trigger a gift tax. This is a huge planning opportunity for those individuals looking to plan their estates in the most tax efficient way possible.
Estate Taxes for Non-US Domiciliaries
With one limited exception, when a non-US domiciliary dies, all of their US-situs assets will be subject to estate taxes. (This is similar to when a US domiciliary dies, but there, all of their worldwide assets are subject to estate taxes). The estate tax will apply even to intangible assets like US stock and LLC membership interests. The only assets that would not be subject to US estate taxes at death for a non-US domiciliary would be:
- US life insurance, unless the life insurance is on the life of another person and decedent owned the policy, in which case it is subject to estate taxes. (Still, practitioners will still use an ILIT here, see below);
- Bank accounts maintained with US banks (including checking and savings accounts);
- Publicly traded bonds issued after July 18, 1984
Threading the Needle: Planning Opportunities Prior to Becoming a US Person
Given the disparity of treatment between the gift tax and estate tax when it comes to intangible assets like corporate stocks or LLC membership interests, this creates a major planning opportunity for non-US domiciliaries or for those looking to become US domiciliaries at some point.
- If a non-US domiciliary is attempting to become a US-domicile, then the tax-free gifting of US intangible assets is important to take advantage of, because if the individual dies as a non-domiciliary, the intangible asset will then be subject to estate taxes. It is generally advisable to take advantage of this limited window.
- If an individual is seeking to settle in the US, then the tax-free gifting of non-US situs assets is critical before they emigrate to the US, because upon becoming a US Resident and/or a US domiciliary, they are subject to US income and transfer taxes on their worldwide assets. Again, it is generally advisable to take advantage of this limited window.
Married Non-Citizen Couples: Pitfalls for the Unweary
When it comes to gift taxes and estate taxes, there is something very important that affects married individuals: transfers between spouses.
Many times, we do not consider that when we transfer assets to our spouse that might be triggering a gift tax. Similarly, when you die, and your assets go to your spouse, we do not consider this to be a transfer for estate tax.
The reason why many times we think that these are tax-free transfers is because, often times, they are. One exception to the gift tax and estate tax is something known as the “unlimited marital deduction” (UMD), which posits that spouses can pass to one another – both in life and in death – an unlimited amount of money without triggering any kind of transfer tax. In other words, a spouse can gift to another spouse an unlimited amount of money in their lifetime, and when that same spouse passes away, the surviving spouse can inherit an unlimited amount of money that will not be taxed.
But there’s a catch! The UMD only applies to U.S. citizens. Non-citizens do not enjoy the UMD. For them, strict limits are imposed as to how much money they can transfer to a spouse during life and at death; anything transferred beyond those set limits is taxed at 40%.
Thus, if 2 citizens are married to one another, the UMD applies and there are no taxes between them at life or death. But what happens if a citizen is married to a non-citizen? Does it even matter if the non-citizen is a US domiciliary or not?
I have outlined a simple two-part test that analyzes transfers where one or more of the spouses is not a US citizen.
RULE 1: Is the recipient spouse a US citizen?
- If the spouse receiving the gift or inheritance from their spouse is a U.S. citizen, then there is no gift or estate tax on the transfer to the citizen spouse. In other words, the UMD still applies, and you do not need to refer to Rule 2. In other words, the status of the donor spouse makes no difference.
- But if the recipient spouse is not a U.S. citizen, then there is no UMD. To calculate whether there is a tax on the transfer, you need to refer to Rule 2.
RULE 2: Is the donor spouse a US citizen or US Domiciliary?
- If the donor spouse (the one making the gift or leaving the inheritance) was a US citizen/domiciliary, then the amount that can be transferred tax-free to the non-citizen spouse is $12.06 million in 2022 (this assumes the donor spouse did not use any of their lifetime exemption).
- If the donor spouse was not a US domiciliary, then the annual gift to the non-citizen spouse is limited to $164,000 in 2022. This is the amount they can also leave at death to their spouse. Anything beyond that will trigger a 40% gift tax. This means if you are a non-US domicile and either add your non-citizen spouse to the property as a joint tenant, or leave the entire property to them at your death, only the first $164,000 is gift-tax exempt, and there will be a 40% tax on anything beyond that.
- If the donor spouse was not a US domiciliary, then the amount that can be left at death tax-free to a non-spouse is $60,000. Anything beyond that will trigger a 40% estate tax.
Threading the Needle: Planning Opportunities for Non-Citizen Married Couples
With these special tax rules in mind for married non-citizen couples, what can you do to minimize your estate and gift tax liability?
- Plan to Gift Over a Period of Years
One option is to start transferring your assets to your spouse during your lifetime. If your spouse is a citizen, then of course the UMD comes into play during life or death. But if your spouse is not a citizen, the annual exemption amounts can be used to transfer money to your spouse who can then use those annual gifts to purchase a life insurance policy in the amount of the estimated estate tax that would be owed.
Additionally, as mentioned earlier, a non-US domiciliary who is contemplating becoming a U.S. resident or obtaining citizenship should first consider gifting US intangible assets and any non-US assets to family members. This is because the gift tax does not apply, but once the individual becomes a resident and domiciled, for income and transfer tax purposes respectively, he is then taxed on all of his worldwide assets.
- Use a Qualified Domestic Trust (QDOT)
Another option for those married to non-citizens is to transfer any assets at the first death above the lifetime exemption to a qualified domestic trust (QDOT). A QDOT is an irrevocable trust that is designed to offer the unlimited marital deduction where the surviving spouse is not a US citizen. The surviving spouse uses the QDOT to hold assets during their lifetime without an estate tax (if the spouse withdraws principal from the trust, that portion may be taxed though). There are special rules required for the QDOT to maintain and comply with, but the main item to understand is that a QDOT only defers federal estate taxation until their own death, at which there may still be an estate tax owed unless the surviving spouse becomes a citizen.
- Apply for US citizenship or Green Card Status
While many of the estate and gift tax considerations may become non-issues with citizenship or green card status, all U.S. citizens and domiciliaries are then taxed on all of their worldwide assets for income, gift, estate, and GST tax purposes. The trade-off thus must be seriously considered.
- Use Irrevocable Trusts or Foreign Blockers to Hold Real Estate Assets
According to Treasury Regulation Sections 20.2104 and 20.2105, non-US domiciliaries can gift and receive an unlimited amount of intangible personal property. With the exception of US-sitused real estate, cash, artwork and jewelry, there are no gift taxes on interests in LLCs and corporate stock. Thus, it would appear, that with regards to intangible personal property, one can nearly avoid the entire transfer tax regime by owning real estate in LLCs and corporations and gifting them to an irrevocable trust or a foreign corporation/partnership in order to avoid the adverse income, gift, and estate taxes that apply to non-residents, non-domiciliaries outlined above. While the rules here can be involved, many of our non-citizen clients use these structures to hold real estate. I have addressed various strategies that foreigners can use to own U.S. real property.
- Avoid joint tenancies
Under joint tenancy rules, when one joint tenant dies, the surviving joint tenant becomes the sole owner of the entire property. As such, under IRC Section 2056(d)(1), when one joint tenant dies and a noncitizen becomes the sole owner, the entire property is included in the decedent’s estate and becomes immediately subject to estate taxes.
6. Use an ILIT
Life insurance at death can be used to pay estate taxes due. However, one must be careful to note that while life insurance might be income-tax free, it is not estate tax free unless owned by an ILIT or similar instrument. For example, if John has an estate worth $1 million and only has a $60,000 exemption, he may purchase a $500,000 life insurance policy for his heirs to pay the tax at his death. However, upon obtaining the life insurance, John may have included another $500,000 in his estate (now making his estate worth $1.5 million, in which case, the estate tax has also increased, thereby eclipsing the death payout). An ILIT solves this problem by owning the life insurance policy in such a way that the death payout is not included in John’s estate at death.
6. Tax-free Transfers
There is an unlimited amount that can be transferred gift-tax free to educational and medical providers, just as there is for US domiciliaries. So, if parents send cash to their student children, or worse yet, transfer from an account in their name in the US to the student, these are regarded as taxable gifts and anything above the annual exemption is subject to gift tax. Instead, if they transfer directly to the educational or medical provider on behalf of their child, then there is an unlimited tax-free amount that can be gifted.
Caveats & Concluding Remarks
A few significant caveats to mention:
- There are some nations that have treaties with the United States and those treaties may have significant modifications when it comes to the above rules.
- A “long-term” green card holder is one who has had their green card for more than 7 of the last 15 tax years and there is a rebuttable presumption that they are a US domiciliary. If so, this individual is, like a US citizen, subject to an “exit tax” for expatriation purposes.
Clearly, there are many things to consider when it comes to planning for the non-citizen. Be sure to select an attorney who has experience with these sorts of issues and who will work well with your accountant. At Bridge Law, we specialize in income tax planning, transfer tax planning, and international tax planning issues as well.
This is Part 1 in a three-part series about Estate Planning for Non-Citizens. In Part 2, I discuss what is a QDOT. In Part 3, I discuss the various ways foreigners can own U.S. real property.