This article focuses on both the exposure of non-U.S. persons to the U.S. transfer and income tax systems, as well as the U.S. tax treatment of the bequests and trusts that non-U.S. persons leave for their beneficiaries. This article also demonstrates some of the ways in which the rules can work to the benefit or detriment of U.S. and non-U.S. persons for estate planning purposes. This article explains certain threshold tax concepts that are key to understanding how the U.S. taxes individuals. This article discusses how the U.S. classifies trusts as foreign or domestic, the U.S. tax implications of grantor and non-grantor trusts, and how the U.S. gift and estate taxes can affect individuals who are neither citizens nor residents of the U.S. This article also explains why a foreign settlor may wish to include a U.S. trust as a part of their tax and estate plan. Finally, this article includes case studies illustrating the application of the rules discussed.
Globalization and the adoption of a market economy model by all major trading countries has led to significant reductions in global poverty over the past three decades. During the same period, there has been, in part due to globalization, an increase in private wealth in both industrialized and developing economies. A less noticed consequence of the latter of these two trends is the increase in cross-border private wealth flows and the mobility of individuals of means.
From the perspective of U.S. estate planners--responsible for establishing estate and succession plans that not only address the donative intent of the settlor but also minimize tax exposure, whether from estate, inheritance, or income taxes--globalization and the increase in global private wealth has increased the likelihood that they will have clients with all or partial foreign dimensions concerning their planning. Today there are a variety of reasons--economic, political, and personal safety considerations, among others--why a non-U.S. resident may want to consider utilizing U.S. laws as part of their estate plan.
The purpose of this article is to focus on both the exposure of non-U.S. persons to the U.S. transfer and income tax systems and the U.S. tax treatment of the bequests and trusts that non-U.S. persons leave for their beneficiaries. Additionally, this article will demonstrate some of the ways in which the rules can work to the benefit or detriment of U.S. and non-U.S. persons for estate planning purposes. This article will first explain certain threshold tax concepts (citizenship, residence, and domicile) that are key to understanding how the U.S. taxes individuals. It will then discuss how the U.S. classifies trusts as foreign or domestic, the U.S. tax implications of grantor and non-grantor trusts, and how the U.S. gift and estate taxes can affect individuals who are neither citizens nor residents of the U.S. It will also explain why a foreign settlor may wish to include a U.S. trust as a part of their tax and estate plan. Finally, this article will include three brief case studies which illustrate the application of the rules discussed.
The U.S. tax code does not provide a definition of a citizen or a resident of the U.S., but there are statutes which provide guidance on who is qualified for U.S. citizenship. (1) Under the terms of the Immigration and Nationality Act, an individual acquires citizenship by: (i) birth within the U.S.; (ii) birth outside of the U.S. to parents who are U.S. citizens; (iii) birth outside of the U.S. to one parent who is a U.S. citizen if that parent satisfies certain residency requirements; and (iv) naturalization. (2) Although this definition may seem simple, it becomes quite problematic in determining who is not a citizen or how one loses citizenship because the Act did not provide a mechanism to renounce one's citizenship. (3) As a consequence, a U.S. citizen departing the U.S. intending never to return could remain a citizen for life. To further complicate matters, that person's children would become citizens under the Act and may not even realize that they are U.S. citizens subject to the U.S. tax regime.
It was not until 1996 when Congress passed the Health Insurance Portability and Accountability Act that a remedy to the problem was provided by requiring any individual who wanted to relinquish U.S. citizenship to report to the Department of State and to provide information to the Treasury. (4) Subsequent legislation in 2008 finally required the Department of State to issue a certificate of loss of nationality with the date for the loss of citizenship being the date that a certain qualifying event occurred. (5)
RESIDENCY AND DOMICILE
The second element of taxation relates to residency. The term "resident" for transfer tax purposes and for guidance under the gift tax regulations is provided in the United States Treasury Regulations as follows:
A "resident" decedent is a decedent who, at the time of his death, had his domicile in the United States.... A person acquires a domicile in a place by living there, for even a brief period of time, with no definite present intention of later removing therefrom. Residence without the requisite intention to remain indefinitely will not suffice to constitute domicile, nor will intention to change domicile effect such a change unless accompanied by actual removal. (6) Because the test is one of subjective intent as to "domicile," it is at times very difficult to determine, especially in those instances where the determination is made after the death of the individual. The difficulty in making the determination has often led to court intervention. The courts look to various factors when faced with the issue. (7) This is further complicated by the fact that each country is able to establish its own definition of domicile. Having no concrete definition that applies universally leads to situations where an individual may be deemed to be domiciled in more than one country, or even more complicating, domiciled in no country. To confuse matters even further, the definition of residency for gift and transfer tax purposes is not the same definition when determining income tax. (8) Residency for income tax purposes is determined under section 770 l(b) of the Internal Revenue Code and provides that an individual is a U.S. income tax resident if he or she is a lawful permanent resident of the U.S. at any time during a calendar year or if the individual meets the "substantial presence test." (9) The "substantial presence test" is satisfied for a particular year if the individual was present in the U.S. for at least thirty-one days during a given year, and the number of days the individual was in the U.S. during that year as well as the two preceding years equals or exceeds 183 days. (10) For purposes of this calculation, each day in the first preceding year counts as only one-third of a day and each day in the second preceding year counts as only one-sixth of a day. (11) There are also several exceptions to the rule that can be applied to refute residency for income tax purposes. (12)
TAX RESIDENCE OF TRUST
Another consideration estate planners must address with clients is the tax residence of their client's trusts. A trust must meet both the "court test" and the "control test" to be considered a domestic trust. (13) If a trust is not a domestic trust, it is considered a foreign trust. First, a trust must...