U.S. estate tax exposure for foreign nationals.

• Author: Schaefer, Michael K.

Foreign nationals who live and/or work in the U.S. should be aware of the particular rules that may apply to their estates. Certain tax-saving provisions applicable to U.S. estates, such as the marital deduction and inclusion of only half the value of jointly owned property, may not be available to the estates of foreign nationals or may be severely limited. This article examines these issues and offers planning strategies.

The U.S. generally taxes its citizens on their worldwide income under Regs. Sec. 1.1-1(b), regardless of their country of residence or source of income. Additionally, U.S. citizens pay Federal estate tax on their worldwide assets, without regard to the location of such assets.

A foreign national (i.e., a non-U.S. citizen) who qualifies as a U.S. resident for income tax purposes and is classified as a resident alien under U.S. tax law, is taxed virtually the same as a U.S. citizen. Once so classified, the foreign national becomes subject to income tax on his worldwide income. Many foreign nationals planning an extended stay in the U.S. often address the income tax issues through tax treaties with their home country or tax equalization or compensatory bonuses. However, the estate tax rules, which operate in a similar fashion, are often overlooked and can provide a trap for the unwary.

Background

The estate of a foreign national who dies while a U.S. resident may be subject to substantial U.S. estate tax on worldwide assets, including assets not accumulated during his stay in the U.S. or which otherwise had no connection with his presence in the U.S.

For 2000, the Sec. 2010(c) unified credit is $675,000 (and is scheduled to increase to $1 million by 2006). This constitutes a $675,000 exemption on both lifetime and post mortem transfers. Net assets in excess of $675,000 are subject to transfer taxes at rates varying from 37%-55%.

Most married U.S. citizens can avoid the imposition of the estate tax by leaving assets to their spouse. Assuming the assets qualify for the Sec. 2056 marital deduction, they will pass to the surviving spouse untaxed and will be subject to tax only on the surviving spouse's death. Thus, the effect of a premature or unexpected death can be mitigated by leaving $675,000 (i.e., the lifetime exemption) to children or other relatives, and the balance to the spouse.

Unfortunately, the same strategy is not available to a decedent whose spouse is not a U.S. citizen. Under Sec. 2056(d)(1)(A), the marital deduction is not allowed for bequests to noncitizen spouses; thus, the estate may be subject to substantial transfer taxes, despite the fact that the assets pass to the surviving spouse. Further, the treatment of jointly held property is also disadvantageous in the case of noncitizen spouses. For two U.S. citizen spouses, under Sec. 2040(b),jointly owned property is deemed to be owned 50% by each, regardless of who provided the funds for the property's acquisition. Thus, only 50% of...