According to the 2011 American Community survey (by the U.S. Census Bureau), 37.9% of Angelinos were born outside of the United States. Additionally, many international investments are being made in California to take advantage of the EB-5 and other visa programs. As such, more and more clients, spouses and family members are not U.S. citizens. Unfortunately, planning for non-citizens is much more complicated than planning for U.S. citizens. International clients must be very careful to implement the right planning techniques, some of which must be done prior to obtaining a visa.
Non-resident aliens are considered U.S. residents for estate and gift tax purposes even if they are non-residents for income tax purposes
In regards to estate and gift taxes, an alien is considered a U.S. resident if he or she is domiciled in the U.S. at the time of his or her death or at the time of a gift. If an alien enters the U.S. for even a brief period of time, with no specific plans of later leaving the U.S., he or she is deemed to be domiciled in the U.S. and, therefore, is considered a U.S. resident for estate and gift tax purposes. An alien may be considered a nonresident for estate tax purposes and a U.S. resident for income tax purposes, or vice versa, since the estate tax residency test is the more subjective domicile test just described, while the income tax residency test is met if the alien satisfies an objective day count test known as the “substantial presence test” or holds a green card.
Those domiciled outside of the U.S. (who are not U.S. citizens or green card holders) only have a $60,000 estate tax exemption
Resident aliens (green card holders) are taxed on their world-wide assets for estate purposes, just like U.S. citizens. Non-resident aliens are only taxed on their U.S. sitused assets. It is important to note that life insurance is not considered a U.S. sitused asset and as such an irrevocable life insurance trust is unnecessary when the owner of a policy is a non-resident alien (see IRC Section 2105(A)). Additionally, U.S. bank accounts, CDs, annuities, stocks in foreign corporations, artwork and municipal bonds are not considered U.S. sitused assets. The Unified Tax Credit for transfers from resident aliens to anyone is the same as the Unified Tax Credit for American Citizens except that the unlimited gift tax marital deduction does not apply (see below). This is currently $13,610,000 per person and $27,220,000 per married couple (2024). This is adjusted annually for inflation under the American Taxpayer Relief Act of 2012. The estate tax rate on assets in excess of $13,610,000 is forty percent. A credit is allowed for foreign taxes paid on foreign assets under IRC Section 2014. Under the Technical and Miscellaneous Revenue Act of 1988, transfers from non-resident aliens (not domiciled in the U.S. at the time of death or the time of the gift) to anyone have an exclusion of only $60,000, unless you are a domiciliary of an estate and gift tax treaty nation. Estate and gift tax treaties are different from the income tax treaties that many people are familiar with. If you are a domiciliary of an estate and gift tax treaty nation, then you may be entitled to an exclusion of an amount up to the current unified credit amount of $13,660,000. Some treaties reference older limits. The estate tax rate on assets in excess of the exemption amount, whether your exemption is $60,000 or $13,610,000, is forty percent. Generally speaking, there is often a formula that is to be used to calculate the percentage of the unified credit available to the non-resident alien from an estate and gift tax treaty nation. The estate and gift tax treaty nations are Australia, Austria, Canada, Denmark, Finland, France, Germany, Ireland, Italy, Japan, Netherlands, Norway, South Africa, Sweden, Switzerland and the United Kingdom. Each treaty is unique. If a non-resident alien is from a non-estate and gift tax treaty nation, they will most likely need to purchase life insurance to pay the forty percent estate tax on all U.S. sitused assets where the collective value is over $60,000.
Non-citizens have no marital deduction
If a surviving spouse is a U.S. citizen and inherits assets from the deceased spouse’s estate, he or she is entitled to the full marital deduction and may defer all tax owed on the decedent spouse’s estate until the surviving spouse’s death (i.e., the second death). A non-citizen spouse that inherits assets from the decedent spouse does not have a martial deduction. However, resident alien spouses are treated the same as citizens for lifetime gift tax exemption purposes, so resident aliens still have their own $13,610,000 estate tax exemption that should not be wasted.
If you leave assets to a non-citizen spouse, regardless of whether or not you are a U.S. citizen, you can only get the full benefit of the marital deduction if you establish a Qualified Domestic Trust (“QDOT”) for the benefit of your surviving non-citizen spouse. If you meet all of the QDOT requirements, this will allow your family to defer payment of the estate tax on the decedent spouse’s estate until the death of the surviving non-citizen spouse (i.e., until the second death). If the non-citizen surviving spouse becomes a citizen before the estate tax return (IRS Form 706) is filed and so long as the surviving spouse was a U.S. resident at the time of decedent’s death and remained so at all times thereafter until citizenship (IRC Section 2056(d)(9)), the decedent’s estate will be entitled to the marital deduction and estate tax deferral just the same as a U.S. citizen. Having a QDOT in your trust is the only way a non-citizen spouse can inherit assets from the deceased spouse and use the marital deduction. The QDOT must comply with the following requirements:
1.The trust must be an “ordinary” trust.
2.The trust must have at least one U.S. (individual or corporate) trustee.
3.The trust must prevent distributions unless a U.S. trustee has the right to withhold tax imposed on the distribution.
4.The trust must be maintained under the laws of a U.S. state or the District of Columbia.
5.The estate representative for the decedent must make an election to apply the QDOT rules.
6.The trust must also otherwise qualify for the marital deduction under provisions of IRC Section 205619.
There are also complicated reporting requirements and a bond may need to be posted if the trust assets are over $2,000,000. While U.S. citizen spouses can receive unlimited annual gifts from their spouses, non-citizen spouses can only receive $182,000 (2024) in annual gifts from their spouses. As such, an alternative to the QDOT is to gift each year the non-citizen spouse the $182,000 annual gift exclusion amount which is then used to buy life insurance owned by a spousal lifetime access trust. The death benefit can used to provide for the living expenses of the non-resident spouse. Additionally, the deceased spouse could leave his or her assets in a trust and the non-resident spouse could be the beneficiary of up to the $182,000 non-citizen spouse annual gift exclusion amount. The problem with these two techniques is that if the estate is larger than $13,610,000 and the non-citizen spouse is a citizen from an estate tax treaty nation, that non-citizen spouse’s unused estate tax exemption amount is wasted.
Another problem with QDOTs is that if principal distributions are made from a QDOT to a non-citizen spouse, estate tax is imposed at the decedent’s estate tax rate and the Trustee must have the right to withhold this tax per IRC Section 2056A(b). Even if a QDOT is used, distributions should only be made after the $182,000 annual exclusion is already gifted from a non QDOT trust and the non-citizen spouse actually needs more money. When a distribution from a QDOT is made, the estate tax is immediately due and payable unless if an urgent hardship is allowed under Treasury Reg. 2056A-5(c) for health, education, support and maintenance. You can also make a distribution from a QDOT and not have to pay immediate estate taxes if the distribution is for a qualified charitable donation (see IRC Section 2056(A)(b)(10)). Once the additional distribution is made to pay the immediate estate tax owed, then another distribution is required to pay the estate tax on the distribution taken to pay the estate tax and so on…
Unfortunately, in the ideal world, QDOT assets will never be withdrawn for use by the non-citizen spouse and are only left there to take advantage of the martial deduction for the ultimate benefit of the remainder beneficiaries.
Non U.S. citizens should never own property as joint tenants
Under joint tenancy, 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 non-citizen becomes the sole owner, the entire property is included in the decedent’s estate and becomes immediately subject to estate tax.
When a non-citizen is married to a U.S. citizen, all property should be owned as community property
The unified tax credits of both spouses automatically apply to community property, irrespective of whether or not the U.S. citizen spouse dies first. This is not the outcome with QDOT property because the non-citizen’s unified tax credit cannot be used due to IRC Section 2056A(b)(6): “Each trustee shall be personally liable for the amount of the tax imposed by paragraph (1).” In other words, the non-citizen surviving spouse’s uniform tax credit is more likely to be fully used at death if the trust property is community property. Additionally, community property allows a legal resident spouse to participate in gift-splitting (i.e., spouses can combine their $18,000 (2024) annual gift tax exclusion for a total of $36,000 per donee, annually). Adding spouses and grandchildren, the amount of assets you can get out of an estate using annual gifting can really add up. Non-citizen spouses who do not live in a community property state should strongly consider applying for U.S. citizenship.
Non-resident aliens can transfer and receive an unlimited amount of intangible personal property
The $18,000 annual gift tax exclusion applies to everyone. However, non-resident aliens can gift and receive an unlimited amount of intangible personal property (Treasury Regulation Sections 20.2104 and 20.2105). What this means is that a non-resident alien can inherit/receive and can then bequeath/transfer any amount of almost every asset type with the exception of real estate, cash, artwork and jewelry. There are no gift taxes and no estate taxes owed on transfers of securities (equities, bonds and business interests), intellectual property and life insurance. There is no estate tax on bank accounts, gift tax still applies. Additionally, cash drawn on a foreign bank account in the non-resident alien’s sole name but payable by a domestic bank is not subject to gift tax as it is considered a non U.S. sitused asset (if for more than $100,000, Form 3520 must be filed). As such, it would appear, that in regards to intangible personal property, one can nearly avoid the entire transfer tax regime by marrying a non-resident alien and insuring that the non-resident alien spouse has an irrevocable trust (that is enforceable in the non-resident spouse’s home jurisdiction) set up to benefit one’s own beneficiaries. As to the tangible property like real estate, a QDOT is necessary but entity valuation discounts still apply.
Foreigners who come to the U.S. must gift U.S. intangible assets and foreign assets prior to coming to the U.S. If they are not planning on becoming a permanent resident, U.S. based real estate should be owned by domestic LLCs that are in turn owned by foreign corporations or trusts
Under IRC Section 2523(f), the life time gift tax exclusion is not available to non-resident aliens (i.e. non-U.S. domiciled persons). We are currently seeing large numbers of foreign investor’s enter the domestic market making large real property and business investments under the EB-5 visa programs. The majority of these investors are from China. The good news is that the EB-5 program gets you a green card so they automatically become permanent residents. However, for those people coming to the U.S. for temporary work or to start a business under the H1, L1 and E1 visa programs, a green card is not automatically granted. As such, many retain non-resident alien status indefinitely and eventually return to their home country. Often times these skilled workers or their employers retain the services of immigration attorneys to assist them in this process. Unfortunately, many immigration attorneys do not understand that once their clients obtain the visas, the clients are instantly becoming U.S. taxpayers and sometimes this requires them to disclose their worldwide assets under the FBAR (reporting signatory authority over or interests in foreign accounts), Form 8938 (reporting foreign assets, including all real estate owned by an entity or a trust) and Form 3520 (reporting foreign trusts and gifts) even if they are a non-resident alien and certainly if they are a resident. Most likely the non-resident alien is going to elect to be treated as a resident for tax purposes to avoid the thirty percent mandatory withholding on U.S. derived income. Once they obtain their visa, many of these clients are likely going to become non-resident aliens (as they may intend to return or in fact do return to their home country), some have no plans to become permanent residents and they are going to have to pay hefty taxes once they transfer their U.S. investment asset upon their death or otherwise.
Example: A Taiwanese businessman wants to obtain an E1 visa to start a business and live part time in the U.S. due to the relative stability and transparency of the U.S. economic and political systems. This businessman’s oldest daughter is also attending the University of Southern California and he would like to purchase an apartment building to provide an income stream and to provide a place for his daughter to live while studying. He purchases the apartment building in his name individually per the instructions from his immigration attorney. He plans to one day gift the apartment building to his daughter. He then obtains the E1 visa and his daughter then obtains her F-120 visa. This was a mistake. When he transfers the apartment building to his daughter, either later in life or at death, he must pay a forty percent tax on practically the entire value of the apartment building, on top of capital gains taxes. His transfer tax exemption is only $60,000. Since his daughter later becomes a U.S. resident, her entire share of the inherited U.S. and international assets are going to eventually become subject to U.S. estate taxes.
Setting the apartment building aside, this businessman should have set up a foreign trust and gifted his daughter her share of her other inheritance prior to either of them obtaining a U.S. visa. Since these assets would have been owned by an offshore irrevocable trust, these assets would not necessarily be subject to U.S. transfer taxes. Regarding the apartment building, he should have purchased it in the name of a single purpose entity, like a California limited liability company, that was solely owned by an offshore business entity or trust. Non-resident aliens are taxed only on assets that are “sitused” in the U.S. at death under IRC Section 2103. Under IRC Section 2104, property deemed in the U.S. includes personally owned real estate, equities and debt obligations of U.S. citizens or legal residents. However, a non-resident alien can avoid estate taxation by having their U.S. equities and real estate owned by a foreign corporation or trust. This is an effective technique for estate tax purposes, but it may have adverse income tax consequences and one must take this into account when planning the ownership of these particular assets. Ownership of a personal residence by a foreign corporation does not exclude the home from estate taxation. During the 2017 tax year there is a new requirement to file Form 5472 under IRS Section 6038A. Form 5472 is required of all U.S. single member LLCs and other domestic disregarded entities that have foreign owners in order identify those foreign owners and report certain related party transactions. This form does not cause a U.S. tax liability but is used for record keeping and other compliance requirements imposed on the U.S. government so that it can meet its obligations under information exchange agreements with foreign governments.
If you have a foreign client that is seeking to purchase real estate in the United States, please call Caldwell Law for effective estate planning advice (if possible) prior to your client gaining his or her visa.
The information in this article is intended to be a general description of tax laws and is not advice as to any transactions, nor is this article advice to any person or to any client and should not be relied upon as such. If you or your client desire to receive specific legal or tax advice on a specific transaction, then please call Caldwell Law at (818) 651-6246.