International Estate Planning: Traps and Tips for the Domestic Estate Planner

• Publication year: 2019
• Author: By Rebecca L. Van Loon, Esq.*

INTERNATIONAL ESTATE PLANNING: TRAPS AND TIPS FOR THE DOMESTIC ESTATE PLANNER

By Rebecca L. Van Loon, Esq.*

The world is becoming smaller and families are naturally becoming more diverse and global. It is not uncommon for estate planners to encounter U.S. clients with international connections, such as ownership interests in foreign assets, beneficial interests in foreign trusts, non-citizen spouses, or children living in foreign countries. In addition, foreign clients may seek advice regarding their exposure to U.S. gift and estate taxes when making gifts or investments in the U.S. This article is intended to provide domestic estate planners with an understanding of the general framework of estate and gift taxes in an international context and to help identify potential cross-border issues and planning opportunities.

I. CITIZENSHIP AND RESIDENCY CONSIDERATIONS AND TAXATION

In addressing potential cross-border issues, the first step is to identify your client's citizenship and residency. An individual's citizenship and residency will determine the applicable tax regimes. This initial step may seem simple, but individuals may be dual citizens, treaties can override domestic rules, and residency is not always apparent or straightforward. In addition, clients may inaccurately characterize their own citizenship and residency. There may be instances in which an individual is considered a United States resident for income tax purposes, but a nonresident alien for estate and gift tax purposes, or vice versa. Residency determinations may also change over time depending on a client's travel habits, business relationships, and family dynamics. It is therefore imperative that the domestic estate planner carefully analyze a client's situation before that client enters into transactions, such as gifts, sales and purchases of assets, formation of trusts or entities, changes of citizenship, residency or immigration status, or receipt of gifts or inheritances. In addition to determining an individual's residency, the client may establish, or have an interest in, a trust or estate, and the residency of such trust or estate must also be determined. As discussed below, because there is no distinction between U.S. residents and citizens for income tax purposes or for gift and estate tax purposes, this article refers to both as "U.S. persons." An individual who is neither a citizen nor a resident will be referred to in this article by the official Internal Revenue Service ("IRS") designation, "nonresident alien."

A. Income Taxation

A detailed analysis of the income taxation of United States citizens, residents, nonresident aliens, domestic grantor trusts, foreign grantor trusts, domestic non-grantor trusts, and foreign non-grantor trusts is beyond the scope of this article. However, the domestic estate planner should understand the income tax consequences that could arise from these different scenarios. This section provides a brief and general background to related income tax issues and other issues that arise in the estate planning, gift tax, and estate tax contexts.

1. United States Citizens and Residents

In general, United States citizens and residents are subject to income tax on their worldwide income.¹ A United States resident for income tax purposes is an individual who is lawfully admitted for permanent residence in the United States (generally referred to as a green card holder),² meets the substantial presence test,³ or makes a first year election.⁴ An individual meets the substantial presence test for any year if that individual is present in the United States for at least 31 days in that year⁵ and has been cumulatively present in the United States for at least 183 days over the current year and previous two years.⁶ For purposes of this calculation, each day in the current year counts as one day, each day in the first preceding year counts as a third of a day, and each day in the second preceding year counts as a sixth of a day.⁷ Any fraction of a day under this formula counts as a whole day when preparing this calculation. This formula will cause any individual who consistently spends over 120 days in the United States each year (for three years or more) to trigger the substantial presence test and be deemed an income tax resident.⁸ There is an exception to the substantial presence test for an individual who is present in the United States for less than half of the current year (i.e., 182 days or fewer), has a tax home in a foreign country, and has a closer connection to that foreign country than to the United States.⁹ There is also an exception to the substantial presence test for exempt individuals¹⁰ or individuals unable to leave the United States because of a medical condition which arose while the person was present in the United States.¹¹Exempt individuals include a foreign government-associated individual, a teacher or trainee, a student, or a professional athlete who is temporarily in the United States to compete in a charitable sports event.¹² As described above, residency determination for income tax purposes is objective, technical, and intended to establish a jurisdictional basis for taxation based on an adequate and appropriate connection between

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the United States and the taxpayer.¹³ A number of countries have income tax treaties with the United States that address taxpayer residency and provide tie-breaker provisions when both treaty countries count an individual as a resident under their respective domestic laws.

In addition to taxation on worldwide income, U.S. persons are also subject to reporting requirements with respect to investments in foreign assets, including foreign bank and investment accounts, foreign corporations, other foreign entities, and specified foreign financial assets. Failure to comply with these reporting requirements may subject the individual to steep penalties, both civil and criminal. Domestic estate planners should generally be aware of such requirements in order to advise their clients to properly report such assets or to work with a tax return preparer who is knowledgeable in reporting requirements for foreign assets held by U.S. persons.

2. Nonresident Aliens

A nonresident alien for income tax purposes is any individual who is not a United States citizen and who does not meet one of the residency tests described above.¹⁴ In very broad terms, a nonresident alien is only subject to income tax on United States source income. U.S. source income includes (i) income effectively connected to a United States trade or business, which is taxed at graduated rates, and (ii) fixed, determinable, annual, or periodic ("FDAP") income, which is subject to a withholding tax on the gross amount paid.¹⁵ Nonresident aliens may also have various reporting requirements based on investments or holdings in the United States.

3. Trusts and Estates

Just as individuals are deemed to be U.S. persons or nonresident aliens for income tax purposes, trusts and estates are also subject to residency determinations for purposes of imposing U.S. income tax.

a. Estates: Domestic Versus Foreign

Due to the lack of guidance, the estate planner may have difficulty differentiating a foreign estate from a domestic estate. While many estate planners reasonably assume that the estate of a nonresident alien is a foreign estate and that the estate of a U.S. person is a domestic estate, the Internal Revenue Code ("IRC") defines such estates differently. Instead, a foreign estate is defined as an estate with income from sources without the United States and which are not effectively connected with the conduct of a trade or business within the United States.¹⁶ A domestic estate is any other estate.¹⁷

b. Trusts: Domestic Versus Foreign

A domestic trust is a trust that is subject to the primary supervision of a court within the United States (the "Court Test") and of which all substantial decisions of the trust are controlled by one or more U.S. persons (the "Control Test").¹⁸ The Court Test is generally met if the trust instrument does not direct that the trust be administered outside the jurisdiction of the United States, the trust is actually administered within the United States, and the trust is not subject to a migration clause.¹⁹ The Control Test is generally met as long as a U.S. person controls all substantial decisions of the trust,²⁰ including the authority to make or determine the amount of distributions, select beneficiaries, allocate receipts to income or principal, remove, replace, or appoint trustees, or make investment decisions.²¹ As a result, it is imperative to determine the citizenship and residency of any person designated as a trustee, successor trustee, or other officeholder who is authorized to make any kind of substantial decision to avoid inadvertently converting a domestic trust to a foreign trust (known as an inadvertent migration). For example, a domestic trust can accidently become a foreign trust if a foreign person is named and subsequently acts as a successor trustee.

Any trust that does not meet either the Court Test or the Control Test is a foreign trust.²²

c. Grantor Trusts: U.S. and Foreign Grantors

Grantor trusts are trusts that are disregarded for U.S. income tax purposes; any income from such trusts is attributable and taxable to the grantor.²³ The grantor is treated as the owner of the trust assets and income taxation is based on the citizenship or residency of the grantor.²⁴ The most common type of grantor trust is a revocable trust.²⁵ An irrevocable trust may also be treated as grantor trust as to a U.S. income tax resident if the grantor retains certain dispositive and administrative rights and powers over the trust (such as the powers to control distributions of income,²⁶ distribute trust income to or for the benefit of the grantor or grantor's spouse without the consent of an adverse party,²⁷ permit income to be used to pay premiums on life insurance policies insuring the...