Paula M Jones, Esq, Tax, Benefits & Wealth Planning, Reed Smith LLP, Philadelphia, PA, USA
Paula M Jones, Esq, on the benefits of planning ahead for a move to the US.
Unlike many other Western countries, the United States (US) reaches well beyond its borders to tax individuals under its federal estate and gift tax (transfer tax) system. The US claims taxation authority on the basis of US citizenship, expatriation and renunciation of legal resident status, and US residency. (Thanks to new legislation passed in June of 2008, those who have expatriated or renounced their legal residency are subject to one of two possible tax structures.)
Wealthy non-resident aliens (NRAs) – those individuals who are not US citizens, US residents or in either category of expatriates or former legal residents of the US – who are thinking about coming to the US have an amazing window of opportunity to transfer wealth. That window of opportunity closes once these wealthy individuals become resident in the US.
Individuals should first verify that they are considered NRAs for US transfer tax purposes. Figuring out if one is a citizen is an easy test, since an individual must apply for and receive approval of US citizenship. Since there is a clear date on which an individual becomes a citizen any pre-immigration planning will be completed far in advance of this date. Under the laws of 2009, the transfer tax laws for US citizens included a USD3.5 million estate tax exemption amount for all property wherever situated in the world.i
There was also an unlimited marital deduction against any federal estate tax otherwise due for any assets passing to a US citizen spouse that was not afforded to a spouse who is not a US ciitizen.iii An ‘expatriate’ is one who has given up US citizenship and a ‘former legal resident’ is a US resident (not a US citizen) who has renounced US residency. Those who have expatriated or renounced legal residency prior to 17 June 2008 are still subject to transfer taxing authority for 10 years after their departure. Those who renounced on or after 17 June 2008, however, do not fall under the ‘10-year rule’but instead, are subject to an exit tax for federal income tax purposes.ii In addition, should these individuals die with US beneficiaries or give gifts to US persons, the US recipients are subject to a transfer tax upon receipt.iii
There is not necessarily a clear date on which an individual becomes a US resident (and therefore, subject to the US transfer tax). For pre-immigration planning purposes, it is vital to determine whether one has not yet been considered a resident, prior to making any transfers. If this is the case, and the individual is also not a citizen, expatriate or former legal resident, the individual is a non-resident alien and pre-immigration planning options are available.
The test for determining residency for federal transfer tax purposes is different from the residency tests for federal income tax or immigration purposes. A ‘resident’, for federal transfer tax purposes, is an individual who is domiciled in the US. An ‘individual’ is deemed to be domiciled in the US if one is ‘living in a particular location, for even a brief period of time, with no definite present intention of later removing therefrom’.iv There is no bright line test to determine an individual’s intention but various factors are considered in evidencing that intention, or lack thereof. These factors include, but are not limited to:
Immigration status is not determinative of one’s residency for estate tax purposes. For instance, an employee of an international organisation, in the US on a temporary visa, was found to have formed the intent to remain indefinitely in the US. Upon his passing away, this intention deemed him a resident decedent and subject to federal estate tax on his worldwide property.v
If an individual does not fit into the other categories above, they are a non-resident alien for federal transfer tax purposes. The only transfer taxation an NRA needs to worry about is if the NRA owns US situs property. In regard to lifetime transfers, an NRA is only taxed on real or tangible property situated in the US.vi US situs property would include real estate physically located within US borders, for instance.
An NRA is also afforded the annual gift tax exclusion of USD13,000 per gift recipient, per year for the transfer of that US situs property.vii This means that an NRA who transfers an interest in tangible personal property physically located in the US and/or real estate physically located in the US is subject to the gift tax (after the annual gift tax exclusion is applied). Upon the death of an NRA owning US situs property, however, the federal estate tax applies to all US situs property – tangible or intangible. For instance, if an NRA dies owning stock in US corporations, those stocks will be included in the NRAs US estate, in addition to any US real estate. An NRA is afforded a federal estate tax exemption of USD60,000 for transfers upon death.viii
While an individual is still considered an NRA for transfer tax purposes, unlimited transfers of assets (not physically located in the US) can be made. There is almost complete flexibility in the ability of the individual to make whatever transfers are necessary to plan his or her estate, without being limited by the federal estate tax exemption, the lifetime gift tax exemption, the annual gift tax exclusion and possible limitations on a marital deduction. Once the individual has established residency in the US, limitations on transfers are imposed as described above and the wealthy client will most likely need many years’ worth of exemptions and exclusion amounts to transfer what could be transferred in one year with NRA status.
Once resident in the US, an individual can make unlimited transfers to a US citizen spouse only. If the spouse is a US resident only, there is an annual limit of USD139,000, indexed for inflation, that can be transferred to that spouse.ix Prior to settling in the US, a married couple in which only one spouse holds the majority of the assets should consider an equalisation of assets between the two spouses. This equalisation of assets can make future estate planning techniques within the confines of the US transfer tax system much easier to implement.
Consider a married couple made up of two NRAs, with a net worth of USD15 million. There is a ‘rich spouse’ holding almost all of the assets and a ‘poor spouse’. Once resident in the US, the ‘rich spouse’ is only able to transfer the USD139,000 annual limit to the US resident ‘poor spouse’.x This limitation will drastically slow down any asset transfer that should take place in the estate planning context. If the couple executes estate plans, each providing a credit shelter trust to benefit the other, it will take years for the ‘poor spouse’ to shift enough assets to fund the credit shelter trust to benefit the ‘rich spouse’. Instead, if a rich NRA spouse transfers half of the assets to the poor NRA spouse, once they establish residency in the US each of them are free to continue with estate planning, without first having to equalise their estates.
Consider the same wealthy couple who, as a part of their estate planning, wish to benefit their children and grandchildren either now or in the near future. The couple can irrevocably transfer a portion of the estate to the children and grandchildren now. NRAs can open up and transfer unlimited non-US situs funds to an irrevocable US trust. There is no gift tax on the creation and funding of the trust and there will be no estate tax upon the death of the transferors. If NRAs add dynasty provisions to the US trust, the trust will continue indefinitely, for as many generations as descendants exist. An irrevocable US dynasty trust would be created in a jurisdiction that has repealed the rule against perpetuities, such as Delaware, Pennsylvania, Nevada or Alaska.
A ‘plain vanilla’ version of a dynasty trust might provide for income and principal to be paid out under certain standards for the children of the NRAs and possibly grandchildren. For future generations, whom the NRAs may never know, income and principal could be paid out at the sole discretion of the trustee. The NRAs can decide what terms best fit for their own estate planning goals.
Dynasty trusts are free of transfer taxes at the death of the NRA and at the death of each member of subsequent generations. This enables the trust principal to grow, which can make a staggering difference over time. For example, if USD1 million is put into an irrevocable US dynasty trust, 100 years later, at an average growth of 7 per cent, there will be over USD800 million in the trust. If federal transfer taxes were not avoided in the same trust, the principal would grow to only USD68 million. For a more short-term view, if USD1 million is put into an irrevocable US dynasty trust for 50 years with an average annual growth of 4 per cent, there will be over USD7 million in the trust. If federal taxes were not avoided in such a trust, the principal would grow to less than USD2 million.
Pre-immigration planning is an amazing opportunity to complete vital portions of one’s estate planning without the confines of the transfer tax system. The window of opportunity for this planning can be narrow, however, and any professional advisors should alert clients as soon as the thought of moving to the US arises. For those who are still non-resident aliens in the US, they should take extra care to ensure all factors point toward an NRA status, prior to making any large transfers. Once they are confident the NRA status is correct, the bulk of transfers for estate planning purposes can be completed prior to establishing residency in the US
Author’s Note: As of the date of this article, the US federal estate tax is repealed for 2010. However, this article is written with the full expectation that the federal estate tax will return, retroactively for 2010. The author assumes, based on the proposed laws being considered in Congress, that the estate tax exemption amount in the range of USD3.5 million will return, along with a tax rate of about 45 per cent.
i 26 USC.A. §2031
ii 26 USC.A. §877A
iii 26 USC.A. §2801
iv Treas. Reg § 20.0-1(b)(1)
v Rev. Rule 80-363, 1980-52
vi 26 USC.A. §2501(a)(1) and (2), 2511 (a) and (b)
vii 26 USC.A. §2503(b)
viii 26 USC.A. §2107(c) (1)
ix 26 USC.A. §2523(i)(2)
Paula M Jones, Esq, Tax, Benefits & Wealth Planning, Reed Smith LLP, Philadelphia, PA, USA