Five Tax Traps for Resident Noncitizens (and Their Attorneys!)
As the world becomes increasingly “global,” so too do many of our practices. Estate planners in particular find themselves increasingly faced with international issues and clientele. In Florida, these clients often include “multi-national” families, many of whom have ties to Latin America and who seek to take advantage of investment opportunities, higher education, and a higher quality of life. While the United States provides many opportunities in these areas, non-U.S. citizens who establish residency in the U.S. (resident noncitizens, or RNCs) also face a host of complex legal issues. To RNCs, these legal issues may be foreign in every sense of the word, as our tax and property regimes have notable distinctions from other legal systems. Many RNCs find these distinctions surprising. Moreover, the tax issues that RNCs face can be far more complex than those posed in the standard domestic context. These complexities arise because RNCs are caught in a precarious position — they are taxed as U.S. persons, but maintain interests abroad that U.S. tax law is designed to discourage. Thus, RNCs and their attorneys must tread lightly to avoid the prominent tax traps that await the unwary. This article provides estate planners an introduction to a few of these traps.
Trap #1: Worldwide Taxation
The most significant trap facing RNCs is the imposition of U.S. tax on their worldwide income and assets. For the unsuspecting, this can present serious unanticipated tax results. For example, an RNC’s sale of a non-U.S. residence may unexpectedly result in U.S. income taxation, or a gift of stock in a non-U.S. corporation to a non-U.S. relative may result in U.S. gift tax. Many RNCs are surprised to learn of these consequences. Indeed, their countries of citizenship may very well decline to tax such transactions. Fortunately, some RNCs are aware of these issues prior to retaining U.S. advisors, and most U.S. advisors are familiar with the tax consequences of establishing U.S. residency. What is often less known are the precise rules governing the establishment of such residency.
• Income Taxation — Section 7701(b)1 provides the tests for determining whether an individual is a U.S. resident for income tax purposes. An individual is classified as a resident for U.S. income tax purposes in any year in which the individual satisfies the permanent residency test (PRT) or the substantial presence test (SPT). Under general principles of U.S. income tax law, RNCs are subject to tax on their worldwide income. In an RNC’s first or last year of U.S. residency, the RNC can be treated as a “part-year” resident.2 As such, the RNC would be subject to worldwide taxation only for the portion of the year in which the RNC is a U.S. resident.
Under the PRT, an individual is a U.S. resident if the individual is a “lawful permanent resident” of the U.S.3 This means the individual holds a U.S. green card.4 An RNC under this test is considered to be a resident until such time as the RNC surrenders the green card or it is revoked. Under the SPT, an individual is a U.S. resident if physically present in the U.S. (U.S. days) for at least 31 U.S. days during a particular year and the sum of all U.S. days for that year, one-third of the U.S. days from the first preceding calendar year, and one-sixth of the U.S. days from the second preceding calendar year is at least 183 days.5 In general, any day that the individual is physically present in the U.S. counts as a U.S. day, regardless of how much time during that day the individual is present in the U.S.6
• Transfer Taxation — Similar to the income tax, the transfer tax regime applies to the worldwide assets of an RNC. However, the test for determining residency for transfer tax purposes is not nearly as clear-cut as in the case of income tax. For transfer tax purposes, the test is based on “domicile” in the U.S. rather than on an individual’s U.S. days or status as a green card holder. An individual “acquires domicile in a place by living there, for even a brief period of time, with no definite present intention of later removing therefrom.”7 There is no hard and fast rule for evaluating whether an individual has formed such intent. Prominent considerations include where the individual maintains residences, the amount of time spent at such residences, the value of such residences, the domicile of the individual’s friends and family, where the individual maintains social, professional, and religious affiliations, and the location of investments and business interests.
Trap #2: The “Anti-deferral Regime”
The “anti-deferral regime” is a complex set of rules designed to prevent the deferral of U.S. income tax liability through the use of non-U.S. corporations. Estate planners working with RNCs need to be able to identify two classifications of corporations and to understand the tax consequences of ownership in such corporations. Although such ownership is innocuous prior to moving to the U.S., RNCs can find themselves trapped with adverse U.S. tax consequences after establishing U.S. residency.
• Controlled Foreign Corporations — An RNC can be trapped by ownership of stock in a controlled foreign corporation (CFC). A CFC is any non-U.S. corporation in which U.S. shareholders own more than 50 percent of the total combined voting power of all classes of voting stock or of the total value of all classes of stock.8 A U.S. shareholder is any U.S. person9 who owns 10 percent or more of the total combined voting power of all classes of voting stock.10 Special rules apply for determining the ownership of stock to treat a shareholder as owning stock directly, indirectly, and constructively. Stock owned by or for a foreign corporation, partnership, trust, or estate is considered to be owned proportionately by its shareholders, partners, or beneficiaries.11 Stock is treated as owned constructively through the stock attribution rules of §318, subject to certain modifications particular to the CFC regime.12
If an RNC owns stock in a CFC on the last day of any taxable year, the RNC will be required to include in gross income the pro rata share of the CFC’s “subpart F income.” Although the definition of subpart F income is complex, it notably includes passive income such as interest, dividends, rents, royalties, and net gains on the sale or exchange of property producing such income.13 Inclusion of subpart F income results regardless of an actual distribution from the CFC to the shareholder. This “phantom” income may leave the shareholder with a large tax liability, but no cash with which to satisfy the liability. The income is essentially taxed as a nonqualified dividend at the shareholder’s effective tax rate.
• Passive Foreign Investment Companies — An RNC can also be trapped by ownership of stock in a passive foreign investment company (PFIC). A PFIC is any non-U.S. corporation if 75 percent or more of the gross income of such corporation in the taxable year is passive income, or if 50 percent or more of the assets held by such corporation during the taxable year produce or are held for the production of passive income.14 In computing these amounts, a look-through rule applies to attribute ownership of an underlying corporation’s assets and income if the non-U.S. corporation owns 25 percent or more of the value of stock in such a corporation.15 Once a non-U.S. corporation is classified as a PFIC during the shareholder’s holding period, it will remain a PFIC in such shareholder’s hands for all subsequent taxable years.16 Notably, the CFC rules trump the PFIC rules, meaning that the PFIC rules only apply to shareholders who are not U.S. shareholders in a CFC.17 As with the CFC regime, direct and indirect ownership rules apply to determine ownership of PFIC stock;18 unlike the CFC regime, however, constructive ownership rules do not apply.
Under default rules, a shareholder in a PFIC is subject to a special tax on the PFIC’s “excess distributions.”19 An excess distribution occurs to the extent that the shareholder receives a distribution from a PFIC that exceeds 125 percent of the average distributions within the three preceding taxable years (or within the shareholder’s holding period, if shorter).20 Notably, any gain recognized on the disposition of stock in a PFIC is treated as an excess distribution. The excess distribution is allocated ratably over the shareholder’s holding period, and the shareholder must include in the current year as ordinary income the portion of the excess distribution allocated to the current year and to previous years, plus a special PFIC interest charge. The interest charge is computed on the amounts of the excess distribution allocated to years other than the current year (or years prior to becoming a PFIC) by computing an “aggregate increase in taxes.” The aggregate increase in taxes is the sum of the tax liabilities that would have been incurred for each year the corporation was a PFIC had the amount of the allocable excess distribution been included in gross income in that year and taxed at the highest tax rate in effect for that year. This aggregate increase in taxes is then subject to interest at the §6621 rate, which is the short-term applicable federal rate, plus three percentage points.21
Often, the PFIC trap can be avoided from the outset by electing one of two alternative methods to tax shareholders who own PFIC stock. The first method is the qualified electing fund (QEF).22 The result of a QEF election is to treat the shareholder as receiving a pro rata portion of the PFIC’s ordinary income and net capital gain. Similar to the CFC regime, this income flows through to the shareholder and is includable in income, irrespective of cash distributions from the corporation. To be able to compute the pro rata portions of income, the shareholder must ensure appropriate access to the PFIC’s books and records. The second method is the mark-to-market election. This election requires the shareholder to include any appreciation in the PFIC stock during the tax year in gross income; the shareholder may also deduct any decrease in value. These items are treated as ordinary income and loss. The shareholder’s basis is adjusted by the amount of any such income or loss. Of course, to make the mark-to-market election, the stock must be “marketable.”23 This is generally the case when the PFIC stock is publicly traded, for example, in the case of a non-U.S. mutual fund.
Trap #3: The “Throwback Rules”
The so-called “throwback rules” apply to certain distributions from foreign nongrantor trusts (FNTs) to U.S. persons, including RNCs. Like the PFIC and CFC regimes, the throwback rules are designed to prevent the deferral of U.S. income tax via a non-U.S. entity. Their application often comes as a surprise to RNCs and practitioners alike.
To constitute an FNT, the trust, of course, must be foreign. The code defines a foreign trust in the negative as any trust that is not a U.S. trust.24 A trust is a U.S. trust if a U.S. court is able to exercise primary jurisdiction over its administration (the court test) and one or more U.S. persons have the authority to control all substantial decisions of the trust (the control test).25 Thus, a trust’s failure to meet either the court or control test will render it a foreign trust. This determination has nothing to do with whether the grantor of the trust is a U.S. person.
The court test is satisfied if the trust falls within a safe harbor provided in the regulations. This requires that the trust instrument does not direct that the trust be administered outside of the U.S.; the trust, in fact, is administered exclusively in the U.S., and the trust is not subject to an automatic migration provision that would cause the trust to migrate from the U.S. in the event that a court in the U.S. attempted to exercise jurisdiction over the trust.26 The control test is also clarified by the regulations. Notably, substantial decisions are defined by way of example to include the timing and amount of distributions, the selection of a beneficiary, allocations between income and principal, termination of the trust, actions with respect to claims against and on behalf of the trust, removal and replacement of trustees, and investment decisions.27 U. S. persons must control all of these decisions; if a non-U.S. person holds express or de facto veto power over any decision, the trust will be foreign.
In addition to being a foreign trust, the trust must be a nongrantor trust. It is essential to note that the ordinary grantor trust rules do not apply in the case of a non-U.S. grantor of the trust. Instead, §672(f) prevents the attribution of items of trust income, deduction, and credit to a non-U.S. grantor unless the grantor has retained the power to revoke the trust without the approval or consent of any other person (unless such person is a related or subordinate party who is subservient to the grantor), or, the only permissible beneficiaries are the grantor or the grantor’s spouse. Accordingly, a foreign trust will be an FNT unless it is revocable or the grantor or the grantor’s spouse are the only permissible beneficiaries.28
Once an FNT is at issue, it is critical to determine whether distributions from that trust to an RNC will be subject to the throwback rules. The throwback rules apply to accumulation distributions made to U.S. beneficiaries. An accumulation distribution occurs when the discretionary distributions from an FNT under §661(a)(2) exceed the FNT’s DNI for the year. Importantly, an accumulation distribution does not occur if the distribution is of a specific gift or bequest under §663(a) or if the distribution is not in excess of the trust’s fiduciary accounting income.29 If the RNC is unable to obtain the information necessary to determine the amount of an accumulation distribution, the RNC may use a default method of computation, which determines the current year accumulation distribution by subtracting from the total current year distribution the average of 125 percent of the total distributions in the three prior years.30
In the event that an RNC receives an accumulation distribution, the tax consequences of such distribution are determined under a complex set of rules based on the concept of undistributed net income (UNI). To determine UNI for a particular year, one must begin with the more familiar concept of distributable net income (DNI), which is the trust’s taxable income excluding the trust’s distribution deductions and personal exemption, and including any tax-exempt interest.31 In the case of a foreign trust, capital gains and losses are included in the computation of DNI.32 Generally, a trust’s UNI for a particular year is the amount by which the trust’s DNI exceeds the sum of amounts distributed to beneficiaries under §661 and any taxes paid by the trust (or its grantor).33
The throwback rules work to allocate an accumulation distribution back to the years in which the trust had UNI, starting with the earliest years first.34 allocating the accumulation distribution among these years, the application of the throwback rules results in an addition to tax in the year of the accumulation distribution that approximates the taxes that the beneficiary would have paid had the allocable UNI actually been distributed in the tax year in which it was earned as DNI. In addition to the throwback tax itself, the throwback rules impose a punitive interest charge on the throwback tax. Interest is charged at the §6621 rate and compounds daily over a weighed average time period.35
Trap #4: The Marital Deduction
In estate planning for RNCs, the most common tax trap arises in planning for the marital deduction. Most practitioners who are accustomed to planning for married U.S. citizens rely heavily on the unlimited marital deduction available to such couples. The unlimited marital deduction plays a key role in the ability to equalize wealth between spouses in order to fully utilize the “poor” spouse’s unified credit (notwithstanding the temporary repeal of the estate and generation-skipping transfer taxes in 2010) and provides a notable benefit of tax deferral until the death of the second spouse. These benefits become much more difficult to obtain in the context of planning for married RNCs.
• The Gift Tax “Marital Deduction” — Technically speaking, the gift tax “marital deduction” really isn’t a marital deduction at all. Section 2523(i) expressly provides that no deduction shall be allowed if the spouse of the donor is not a U.S. citizen. Instead, the donor is permitted a larger annual exclusion under §2503(b) with respect to gifts made to the non-U.S. citizen spouse. In 2010, this amount was $134,000. This nuance is of particular importance when drafting trust provisions that include a withdrawal right equal to the annual exclusion amount for a spouse who is not a U.S. citizen — applied literally, the spouse would be entitled to $134,000, not a mere $13,000.
• The Estate Tax Marital Deduction — As with the gift tax, the marital deduction is expressly disallowed for the estate tax when a decedent’s property passes to a surviving spouse who is not a U.S. citizen. This general rule is subject to a significant exception — the qualified domestic trust (QDOT). If the transfer to trust would otherwise qualify for the marital deduction as qualified terminable interest property under §2056(b)(7), and the trust satisfies the additional QDOT requirements, then an unlimited marital deduction is permitted even when the surviving spouse is not a U.S. citizen. Generally speaking, a trust is a QDOT if it satisfies three conditions.36 If the trust fails to satisfy these conditions, it can possibly be reformed; a surviving spouse is also permitted to create a self-settled QDOT after the decedent’s death that can qualify for the marital deduction.37 First, at least one trustee must be an individual who is a U.S. citizen or a domestic corporation, and the trust must provide that no distribution of principal be permitted unless such trustee may withhold from the distribution a special QDOT tax. The QDOT tax is imposed on distributions of principal to the surviving spouse during life and upon the value of the trust at the surviving spouse’s death. The tax is determined by recomputing the deceased spouse’s estate tax liability with an increase in the taxable estate for the amounts distributed.38
Second, the trust must satisfy some additional requirements imposed under the regulations. Notable among these are the requirement that the trust be administered under U.S. law and the special security requirements for QDOTs having gross assets in excess of $2 million.39 The QDOT can satisfy the security requirement by having a U.S. bank serve as trustee, posting a bond equal to at least 65 percent of the QDOT’s gross assets, or receiving an irrevocable letter of credit equal to at least 65 percent of the QDOT’s gross assets.
Third, the decedent’s executor must elect treatment as a QDOT. Assuming all the other requirements are satisfied, this election can be made on the decedent’s federal estate tax return. The election can also be made protectively, but it is irrevocable once made, should it prove to be relevant.
Trap #5: The Expatriation Regime
Perhaps the most surprising of the tax traps is the application of the U.S. expatriation regime to RNCs. To most, the term “expatriation” connotes the giving up of one’s citizenship. Thus, its application to RNCs is unexpected. Nonetheless, certain RNCs can come within the U.S. expatriation regime and face substantial adverse U.S. income and transfer tax consequences.
• Definition of “Covered Expatriate” — The application of the current U.S. expatriation regime is dependent upon the RNC being classified as a covered expatriate.40 Three requirements must be satisfied for an RNC to be a covered expatriate.41 The first requirement is that the RNC must be an “expatriate.” As most would suspect, the term “expatriate” includes U.S. citizens who relinquish their citizenship. Surprisingly, the term also includes certain RNCs who are classified as long-term residents who surrender their green cards, thereby ceasing to be RNCs under the permanent residence test. A long-term resident is any RNC who has been a lawful permanent resident for at least eight of the previous 15 years.42 The second requirement is that the RNC’s expatriation date must be on or after June 17, 2008. In the case of an RNC who is a long-term resident, the expatriation date is the date on which the RNC surrenders the RNC’s green card. The third requirement is that the expatriate must meet any one of the following three requirements: 1) the expatriate’s average annual net income tax liability for the five years preceding the expatriation date is greater than $145,000 (in 2010);43 2 ) the expatriate’s net worth as of the expatriation date is $2,000,000 or more; or 3) the expatriate fails to certify under penalty of perjury that the expatriate has complied with U.S. tax obligations for the five years preceding the expatriation date.44
• Income Tax Consequences — RNCs who are covered expatriates become subject to the expatriate exit tax upon surrendering their green cards. Generally speaking, all of the covered expatriate’s property is treated as sold for fair market value on the day before the expatriation date. Any gain or loss realized is required to be recognized. However, the covered expatriate is permitted to exclude up to $627,00045 of gross income resulting from the deemed sales. The covered expatriate can elect to defer the recognized gain until such time as the property is actually sold, if the covered expatriate provides adequate security to cover the deferred tax liability. The expatriation rules also aggressively tax deferred compensation, including items of deferred compensation that have not yet vested and are subject to a substantial risk of forfeiture, and they require trustees to withhold 30 percent on distributions from nongrantor trusts that would be includible in the expatriate’s gross income if the expatriate were taxed as a U.S. person.
• Transfer Tax Consequences — The transfer tax consequences of expatriation are technically imposed upon the beneficiaries of the transfer, rather than on the covered expatriate. Section 2801 imposes a special inheritance tax on any U.S. citizen or resident who receives any “covered gift or bequest.” A covered gift is any property received from a donor who is a covered expatriate. A covered bequest is any property received from a decedent who was a covered expatriate at the time of death. The recipient is subject to tax on the value of the covered gift or bequest at the highest transfer tax rate in effect when the property is received. These rules also apply to covered gifts or bequests made to U.S. trusts. In the case of a foreign trust, the covered gift or bequest is not treated as occurring until a distribution from the trust is made to a U.S. person; however, the foreign trust may elect to be treated as a U.S. trust solely for purposes of treating transfers to it as covered gifts or bequests.
These rules can be particularly harsh when applied to former RNCs who have returned to their countries of citizenship. A former RNC who has held a green card long enough to be considered a covered expatriate upon surrender of the green card will subject to the inheritance tax any beneficiaries and heirs who are U.S. persons. Consider for example, a former RNC who holds a green card for nine years and then returns to his home country. While in the U.S., the former RNC has a child, who by reason of birth in the U.S. is a U.S. citizen. The former RNC and child never return to the U.S. again. When the former RNC dies, he leaves to his child a piece of non-U.S. real property that has been in the family for generations. Under the special inheritance tax rules, this bequest will be a covered bequest, and the U.S. will endeavor to tax this transfer of property. This is clearly a trap for the unwary.
RNCs who come to the U.S. find an abundance of opportunity. However, establishing U.S. residency carries a host of complex tax issues that must be properly addressed to avoid adverse tax results. These tax traps can often be avoided through proper planning — planning that should take place even in advance of the establishment of U.S. residency. Unfortunately, many clients fail to seek proper counsel, or the counsel they do seek may fail to identify some of the issues the RNC will face. In these cases, additional complexities can be created in redressing the tax issues, often adding time and expense to the RNC’s estate planning. Accordingly, RNCs and their attorneys must be on the look out for these traps. Proceed with caution.
1 Unless otherwise noted, all citations are to the I.R.C. of 1986 and to the Treasury Regulations promulgated thereunder.
2 I. R.C. §7701(b)(2).
3 I. R.C. §7701(b)(1)(A). Status as a lawful permanent resident is also relevant for determining whether an RNC is eligible for Florida homestead. See Fla. Admin. Code §12D-7.007(3) (disallowing homestead for RNCs on temporary visas).
4 I. R.C. §7701(b)(6).
5 I. R.C. §7701(b)(3)(A).
6 I. R.C. §7701(b)(7). Certain days are excluded. For example, any day that an individual spends in the U.S. on behalf of the government of another country, as a teacher or trainee, as a student, as a professional athlete engaged in a charitable sporting event, under certain medical conditions, or in transit between two points outside of the U.S. is not counted as a U.S. day. I.R.C. §§7701(b)(1)(3)(D), (b)(5), and (b)(7). An individual can also exclude up to 10 U.S. days in the first or last year of residency if the individual can establish a closer connection to a country other than the U.S. I.R.C. §7701(b)(2)(C). If an individual has fewer than 183 U.S. days during a calendar year and can establish a closer connection outside of the U.S., then the individual will not be treated as a resident for any part of the taxable year, notwithstanding the fact that the individual would otherwise satisfy the SPT when including the previous years’ U.S. days. I.R.C. §7701(b)(3)(B).
7 Treas. Reg. §§20.0-1(b)(2) and 25.2501-1(b).
8 I. R.C. §957(a).
9 The definition of “U.S. person” is modified for CFC purposes. See I.R.C. §957(c).
10 I. R.C. §951(b).
11 I. R.C. §958(a)(2).
12 I. R.C. §958(b).
13 See I.R.C. §954(c).
14 I. R.C. §1297(a).
15 I. R.C. §1297(c).
16 I. R.C. §1298(b)(1).
17 I. R.C. §951(c).
18 See I.R.C. §1298(a).
19 I. R.C. §1291(a). Distributions that are not “excess distributions” are subject to tax under general corporate tax principals.
20 I. R.C. §1291(b).
21 I. R.C. §1291(c).
22 See I.R.C. §1295.
23 I. R.C. §1296(e);
Treas. Reg. §1.1296-2.
24 I. R.C. §7701(a)(31)(B).
25 I. R.C. §7701(a)(30)(E).
26 Treas. Reg. §301.7701-7(c)(1).
27 Treas. Reg. §301.7701-7(d)(1).
28 A grandfathering rule also applies to certain trusts in existence on September 19, 1995, if otherwise treated as grantor trusts under §676 or §677 (other than §677(a)(3)), as long as they would continue to be treated as such. See Treas. Reg. §§1.672(f)-3(a)(3) and 1.672(f)-3(a)(4).
29 I. R.C. §665(b).
30 See Notice 97-34, 1997-1 C.B. 422.
31 I. R.C. §643(a).
32 I. R.C. §643(a)(6)(C).
33 I. R.C. §665(a).
34 See I.R.C. §666.
35 See I.R.C. §668.
36 I. R.C. §2056A(a).
37 See I.R.C. §§2056(d)(5) and 2056(d)(2)(B).
38 See I.R.C. §2056A(b).
39 See Treas. Reg. §§20.2056A-2(a) and 20.2056A-2(d).
40 The expatriation regime was amended substantially under the Heroes Earnings Assistance and Relief Tax Act of 2008. The current regime became effective for individuals expatriating on or after June 17, 2008.
41 See I.R.C. §877A(g).
42 See I.R.C. §§877A(g)(5) and 877(e)(2).
43 This amount is adjusted from $124,000 for inflation beginning in 2005.
44 I. R.C. §877(a)(2).
45 This amount adjusted from $600,000 for inflation beginning in 2007.
Scott Andrew Bowman is an associate at Proskauer in Boca Raton. He practices in the areas of domestic and international estate planning and received his J.D. and LL.M. (taxation) from the University of Florida Levin College of Law. He is currently a fellow in the ABA Real Property, Trust and Estate Law Section.
This column is submitted on behalf of the Tax Section, Guy E. Whitesman, chair, and Michael D. Miller and Benjamin Jablow, editors.