Avoid costly assumptions based on U.S. income tax principles.


Most non-U.S. citizens with U.S. connections and interests (for convenience, a "noncitizen") are generally aware of critical U.S. income tax principles. They are aware that U.S. income tax applies to the worldwide income of U.S. persons, and that a U.S. person for this purpose not only includes all U.S. citizens, regardless of their place of residence, but also "resident" aliens.

They are aware that residence, for this purpose, depends on factors such as the type of visa held by the noncitizen and the number of days spent in the U.S. by the noncitizen. And they are aware that regardless of a noncitizen's place of residence, the U.S. will tax some income deriving from certain property within the U.S. held by the noncitizen.

Unfortunately, these noncitizens are often far less aware of two significant disconnects between this income tax analysis and the somewhat parallel U.S. estate tax, gift tax and generation-skipping transfer tax considerations. This lack of awareness can result in substantial, surprising and often very avoidable net tax costs to the noncitizen and his or her family (this article focuses only on U.S. estate tax, although in many cases the same issues apply to U.S. gift and generation-skipping transfer taxes).

U.S. Estate Tax Background

U.S. estate tax applies to the net assets held by certain people at the time of their death, and can be quite onerous, with a maximum federal rate of 45%. Coupled with the possibilities of state death taxes and U.S. generation-skipping transfer taxes, U.S. taxes at death can exceed 70% in certain cases. The scope of a person's assets for estate tax purposes is very broad, including many types of assets controlled indirectly by the person.

The application of U.S. estate tax to noncitizens varies, as a noncitizen will fall into one of two categories for U.S. estate tax purposes: domiciliary and non-domiciliary. The U.S. imposes its estate tax on domiciliaries' worldwide net estate similarly to the way it does a U.S. citizen. In contrast, the U.S. only imposes its estate tax on non-domiciliaries to the extent of their property within the U.S.

U.S. Domiciliaries

One important disconnect between U.S. income and estate taxes occurs because U.S. estate tax is imposed based on the highly subjective concept of a person's "domicile" within the United States, unlike the very objective set of standards used to determine "residence" for U.S. income tax purposes. Domicile in the U.S., very generally, can be described as living in the U.S. with no present intent of later leaving (in other words, with the intent to remain indefinitely). In determining a person's intent for this purpose, the relevant authority will scrutinize all the facts and circumstances. But because the analysis is subjective, a nonresident for income tax purposes with a temporary visa could be judged as having the requisite intent to be a U.S. domiciliary for estate tax purposes. Meanwhile, a resident with a green card could have lived here for a number of years and might be viewed as lacking the required intent to be a U.S. domiciliary.

Complicating things is that the weights of the individual factors used to determine a person's intent to stay vary from case to case, depending on the circumstances. (Other complexities arise when people relinquish their long-term residency, but these are generally outside the scope of this article.)

Non-U.S. Domiciliaries

The second important disconnect between U.S. income tax and U.S. estate tax occurs in the case of non-domiciliaries, and involves the type of property that generates a U.S. tax liability. A foreign citizen might never set foot in the U.S. but still be subject to U.S. estate tax to a limited extent, just like he would be to the income tax. With the estate tax, however, U.S. taxation is derived from property within this country instead of U.S. source income. These differences distinguish the U.S. income tax from the U.S. estate tax on three levels.

First, the fact that the U.S. estate tax is generally a net-asset tax causes it to deem even non-income producing assets as property within the U.S.  For example, neither a U.S. vacation house that is never rented nor the valuable paintings and antiques in that house generate a U.S. income tax liability or a U.S. income tax filing requirement, yet both are included in a non-domiciliary's gross estate as property within the U.S. if owned outright by the non-domiciliary.

Second, some property might produce foreign-source income for U.S. income tax purposes, yet be considered property within the U.S. for U.S. estate tax purposes. Other property might produce U.S.-source income for U.S. income tax purposes, yet not be considered as property within the U.S. for U.S. estate tax purposes, including, for example, a U.S. branch or subsidiary of a foreign corporation owned by the non-domiciliary. Some of the most commonly held types of property subject to the estate tax include U.S. real property, stock in U.S. corporations (regardless of where the brokerage account is held), tangible personal property located in the U.S., debt obligations of a U.S. person, and some intangible personal property (which may include contract rights enforceable against a U.S. person).

Third, the U.S. will even deem certain assets having no current connection to the U.S. as property here. For example, under certain provisions, if a stock in a U.S. corporation is transferred by a non-domiciliary to an offshore revocable trust, and the trust later purchases foreign corporation stock with the proceeds, the U.S. would not only deem the U.S. corporation stock as property within the U.S., but also the sale proceeds and, eventually, the foreign corporation stock! Because of such provisions, great care must be taken in any transfer of property that is within the U.S.

A non-domiciliary should also understand that U.S. estate tax, when applicable, can be different than it is for a U.S. domiciliary. The most important example is that, although the IRS allows domiciliaries to make bequests of $2 million free of estate tax to persons other than their spouses and to charities, non-domiciliaries may only pass $60,000 to these parties, and specific steps must be taken for amounts passing to the non-domiciliary's spouse to not be counted against this limit.

Planning Opportunities

The advice to a particular noncitizen will obviously depend on that person's circumstances. Once the estate planning attorney develops this understanding, the groundwork is set for some interesting planning alternatives, often including some of the following:

For U.S. residents who are not U.S. domiciliaries and who do not intend to become U.S. domiciliaries: These noncitizens should avoid unwittingly becoming subject to U.S. estate taxation on their worldwide holdings by learning and keeping in mind the conditions under which they would be considered U.S. domiciliaries. These noncitizens should also mind the situs of their assets, as indicated below for non-domiciliaries who hold property within the U.S.

For non-domiciliaries who will move to the U.S. for a period of years and who do not intend to become U.S. domiciliaries: As in the previous case, these noncitizens should learn and keep in mind the factors that would cause them to become considered U.S. domiciliaries. Also, before moving to the U.S. or otherwise becoming a U.S. income tax resident, these noncitizens should consider offshore annuity options to remove a substantial amount of assets from U.S. income taxation during their U.S. residence. Last, these noncitizens should mind the situs of their assets, as indicated below for non-domiciliaries who hold property within the U.S.

For noncitizens who are not U.S. domiciliaries, but who may soon become one: These noncitizens should consider eliminating possible U.S. estate and generation-skipping transfer taxation with respect to some portion of their assets. These strategies typically involve a properly timed transfer to a specifically tailored irrevocable trust (substantial, albeit slightly more limited, opportunities exist where one spouse is a U.S. domiciliary, but not the other spouse). Depending on the type of trust, its jurisdiction and holdings, this technique can also eliminate U.S. income taxation on the property held by the trust and better protect the trust assets from certain U.S. litigation threats. A perpetual trust can make particular sense where the noncitizen has U.S. domiciliary descendants, eliminating U.S. estate and generation-skipping taxes for future generations (as addressed below for non-domiciliaries with U.S. domiciliary children).

For non-domiciliaries who hold property within the U.S.: These noncitizens should consider eliminating possible U.S. estate and generation-skipping transfer taxation through shifting the situs of any owned property within the U.S. These strategies typically involve offshore holding companies and not only achieve tax goals, but, when combined with offshore trust structures, often help to streamline global investment management and access to worldwide investments; help reduce filing obligations that might otherwise accompany international holdings; help eliminate or greatly reduce costs, delays, expenses and uncertainty associated with multijurisdictional, international estate administration; help protect worldwide holdings; and help avoid forced share rules of foreign domicile countries.

For non-domiciliaries with U.S. domiciliary children: These noncitizens should consider permanently removing assets-whether within the U.S. or not-from eventual U.S. estate, gift and generation-skipping transfer taxes that would be imposed at the death of their descendants. These strategies typically involve giving or bequeathing assets to perpetual trusts for such descendants, rather than outright to such descendants. This structure can also provide significant creditor protection for the descendants. These noncitizens should also mind the situs of their assets, as indicated above for non-domiciliaries who hold property within the U.S.

Each of these strategies involves complex assessments of a noncitizen's specific facts, as well as carefully planned timing and thoroughly considered and specifically tailored documentation, in addition to ongoing client commitment, participation and reporting obligations. Noncitizens with U.S. interests often have substantial estate planning opportunities unavailable to U.S. citizens, but a variety of pitfalls-including assumptions based on U.S. income tax considerations-could prevent the realization of these opportunities, and consultation with an estate planning attorney is strongly recommended in all cases.

Michael D. Erickson is an associate in the northern Virginia office of Hogan & Hartson LLP, where he specializes in domestic estate planning and administration, and international tax and trust planning for resident and nonresident aliens and U.S. citizens living abroad.