My Spanish in-laws are not wealthy, unfortunately. But if they were and they wished to leave assets to my husband or our daughter, they would be part of a burgeoning group: rich foreign nationals planning for the futures of their children and grandchildren in the United States.
Call it another stream in the flood of foreign money hitting the U.S, along with the cash and real estate investments of wealthy foreigners that are flowing here because of an ironic twist: The U.S. has become one of the world’s favored tax havens. Moreover, foreign family money is pouring in at a time when changes to U.S. tax law have all but eliminated estate transfer taxes, making the income tax aspect of estate planning the primary issue for the vast majority of wealthy families.
Strategies for the growing number of multinational family trusts and income tax strategies for estate planning in general, for example, were two of the most talked about themes at the recent Heckerling Institute on Estate Planning conference in Orlando, Fla.
“There was a whole international track at Heckerling this year. Five years ago that would have been unheard of,” says Suzanne Shier, chief wealth planning and tax strategist at Northern Trust, who spoke at the conference, along with the other tax attorneys and financial advisors interviewed for this story. The change reflects increasing relevance within the industry. “Ten years ago we pretty much assumed our trusts were domestic,” Shier says. “We can’t make that assumption now.”
Not Born In The U.S.A.
A dramatic rise in the number of rich immigrants entering the U.S. is driving the demand for multinational estate planning, including a decade-long surge of professionals and entrepreneurs coming to the U.S. to live and work. But more interesting is the increasing number of wealthy families in other parts of the world who covet an American education for their children—who go to school here and often end up staying.
“There are a lot of people, particularly from Asia, who have made their wealth in the last couple of decades and are sending their children here for college or even high school. And, not surprisingly, those children end up falling in love with an American and marrying them,” says Rachel Harris, chair of international trust and estate planning at Loeb & Loeb in Los Angeles. “There’s a lot of this happening. … People engage in all kinds of good tax planning and then somebody in their family goes and marries an American and suddenly they have U.S. citizen grandchildren and all their structures have to be looked at again because they no longer make sense.”
Indeed, the number of international students attending U.S. colleges and universities for the 2014-15 academic year increased by 10% to a record high of nearly 975,000, the highest growth rate in 35 years, according to a November report by the Institute of International Education. China remained the top country of origin, climbing by 11% to more than 300,000 students. India’s growth outpaced China’s, jumping by nearly 30% to a record high of more than 130,000 students. There were also large increases in the number of students from Brazil, Kuwait and Saudi Arabia.
While there is an onerous income-tax system for the U.S. beneficiaries of most foreign trusts, the exception to that is trusts created by non-resident aliens for the benefit of U.S. beneficiaries. The foreign grantor trust is one where the grantor retains certain powers, such as the right to revoke or amend the trust or the power to direct income and/or principal distributions. Grantor trusts are treated as flow-through entities for tax purposes, with all income and deductions attributed to the grantor, regardless of whether he or she receives distributions. This enables the trust to grow tax-free, with any distributions to beneficiaries tax-free as well.
“If Chinese parents, for example, create a trust purely for the benefit of their U.S. children, but they are allowed to terminate the trust and take the money back anytime they wish to, then even though there’s tons and tons of income, and even though normally when you make a distribution it’s counted as income, it’s just an exception—you get it tax free,” says Joshua Rubenstein, national head of the trusts and estates practice at Katten Muchin Rosenman in New York. “It’s basically a purposeful loophole to encourage foreign people to send money into the states. Then, once the kids get it, they put it in their bank accounts and start paying income taxes on the income.”
The New Switzerland
Minimizing income taxes has become an international obsession due to increased tax enforcement and reporting. In 2014, the Organization for Economic Co-operation and Development (OECD) adopted common reporting standards, basically its own version of the U.S. Foreign Account Tax Compliance Act. Better known as FATCA, the act has required non-U.S. financial institutions to report U.S. assets kept overseas since 2010.
“What’s interesting is that the [OECD] disclosure obligations are even more detailed than the requirements under FATCA,” says Northern Trust’s Shier. “The big picture is that there is much more transparency.”
Ironically enough—and infuriating to foreign bankers—this transparency has led to the U.S. playing the role of Switzerland. The U.S. has resisted the new global disclosure standards and the land of the free is fast becoming the go-to place to stash foreign wealth. A recent story by Bloomberg News notes that shifting money from offshore secrecy havens to the U.S. has become a brisk business, with the world’s rich moving accounts from places such as the Bahamas and the British Virgin Islands to Nevada, Wyoming and South Dakota.
“A lot of the rest of the world is accusing the U.S., after having beaten everybody up with FATCA, of now being the world’s biggest tax haven,” Rubenstein says.
Apparently, it’s not simply an accusation. The U.S. now ranks third in the financial secrecy index, produced every two years by the Tax Justice Network, overtaking Singapore, Luxembourg and the Cayman Islands as an attractive destination for the super-rich to hide their cash.
Tax Planning For The 99.8%
Meanwhile, FATCA has persuaded many wealthy Americans to bring their money back home, where U.S. taxpayers are today navigating a system where the estate tax affects very few, making income tax management the key to most estate planning.
Since 2013, when the American Taxpayer Relief Act (ATRA) and its $5.25 million federal estate tax exemption (increased to $5.45 million for 2016) went into effect, very few families have been subject to the tax—99.8% of estates owe no estate tax at all, according to the U.S. Congress Joint Committee on Taxation, which means that basically only two out of every 1,000 estates have to pay. For the overwhelming majority of wealthy families, a couple can exclude $10.9 million from estate or gift taxes and with smart planning—putting assets into an irrevocable trust, for example—pass on many times that amount tax-free to the next generation. Additionally, the estate tax for those few who do have to pay was reduced to 40% from 55%, and most states have gotten rid of their death taxes. At the same time, income tax rates for those in the highest tax bracket increased, including the bump to 20% from 15% on long-term capital gains and the introduction of the Net Investment Income Tax (NIIT), which added another 3.8% on top of all other income.
“So the conversation has changed to focus on income tax planning and the significant income tax savings you can get when you pass away and get a step-up in basis,” says Paul Lee, senior regional wealth advisor with Northern Trust’s New York office.
“Basis” is what a person paid for the asset and a capital gain or loss is the difference between the basis and the amount the person gets when he sells an asset. In other words, if you sell an asset that is worth more than you paid for it, you will have to pay taxes on the gain. But while capital gains taxes can be significant, this tax can be avoided if the person’s heirs inherit the asset. When someone inherits an asset, the cost basis of the asset is “stepped up to value” on the date of death.
For example, say an elderly parent leaves a home to his children, which is valued at $750,000 on the date he passes away. Because the property was purchased 20 years ago for, say, $250,000, the cost basis is only that: $250,000. So the beneficiaries will not be responsible for capital gains tax on $500,000 worth of gains.
“In a simplistic sense, what you should try to do, if at all possible, is die with only highly appreciated assets,” Lee says. “So you can get a free step-up and your beneficiaries can sell without having to pay a lot of capital gains tax.”
The only strategy for changing the basis of assets, maximizing the step-up and deferring and shifting tax items is the use of partnerships, says Lee. General partnerships, limited partnerships and limited liability companies are all considered pass-through entities and taxed as partnerships. “Partnerships are the only vehicle out there that allow you to manipulate basis or disproportionately allocate tax items in one direction or another, and that allows different people to have different economic interest in the underlying assets,” Lee says.
For example, the estate planning world knows what to do with a client who has two assets, where one has zero basis and the other has high basis. You arrange for the client to keep the lower basis investment until she passes away and try to get the high-basis investment out of the estate because it provides no benefit from the step-up. The problem is that this strategy only works with very high and very low-basis assets. What do you do if a client has two assets and both of them are 50% over basis? According to Lee, you can use a partnership to take the basis off of one asset and move it to the other asset, so you end up with one at 100% and one at zero. The only way you can do that is by comingling the assets in a partnership, letting them sit there for seven years or more and then making the right distributions and elections at the right time to shift the basis from one asset to the other.
Estate Planning In Three-Part Harmony
Mark Parthemer, managing director and senior fiduciary counsel at Bessemer Trust in Palm Beach, Fla., adds that financial advisors should look at estate planning as three parts working together, like a three-part harmony.
First, the trust needs to be properly structured; second, there needs to be a thoughtful use of entities complementing the trust structure, such as limited partnerships and limited liability companies; and third, there needs to be proper asset allocation.
“Without eliminating or reducing a client’s overall diversification … you can create different allocations within different trusts and individual accounts,” Parthemer says. “You still have global diversification, but you have more focused, more appropriate allocations in particular pockets.”
Some of the income taxes can be managed through portfolios that have lower turnover or less income, he says. Private placement life insurance and private placement annuities that are deferred annuities can also be used, he says.
“Those strategies can further the goals of the trust and minimize income tax inefficiency,” Parthemer says.
Private placement life insurance, for example, has received a lot more attention since ATRA. That’s because there’s a deferral on income tax and private placement life insurance provides the flexibility to use an investment advisor of choice. A client may also choose to use a lower-turnover portfolio to minimize capital gains. If the average turnover is 40% a year, maybe the advisor can find an allocation that’s more like 20% a year. By reducing selling and buying, you’re not triggering current gain, so you’re avoiding paying more tax early.
Looking into the future, one of the most important things to keep in mind is flexibility, estate planning professionals say. Flexibility in the distribution of a client’s assets can help beneficiaries. While specific distribution schemes that limit a trustee’s or executor’s ability to maneuver assets certainly serve a role, it is important to remember that circumstances change, assets change value and what once was a perfectly reasonable distribution may not make sense given a change in circumstances. This is especially true in a mobile world where the rules and families are constantly changing.
“Governments helping each other enforce each other’s tax laws? That never used to be the case,” Rubenstein says. “When almost anybody who’s a lawyer today went to law school, we were told countries help each other enforce each others criminal laws because you wouldn’t want someone to commit a crime and then escape to your country. But they never helped each other enforce tax laws. That was a domestic issue. Now that’s turned upside down.”