The U.S. has one of the most complex tax systems in the world. Potential immigrants with significant assets who want to preserve and secure those assets cannot afford to forgo careful tax planning before they arrive in America. Consulting qualified U.S. tax, financial and legal professionals should begin long before starting the immigration process. This paper is intended to give you an overview of some of the areas of concern.
Income Tax Residency Status
It is important to understand (and often overlooked by many) that a non-resident alien (“NRA”) can become a U.S. tax resident (that is, liable for U.S. income tax) without ever being physically present in the United States. Once a person has received a “green card” and is therefore lawfully authorized for permanent residence in the U.S., he or she automatically becomes a U.S. tax resident.
U.S. tax residents are taxed identically to U.S. citizens – on their entire worldwide income, regardless of source.
The other method of becoming a U.S. tax resident is to meet the “substantial presence test.” This test is satisfied if a) the sum of the following equals at least 183: (1) the number of days spent in the U.S. during the current year, (2) one-third of the days in the first preceding year, and (3) one-sixth of the days in the second preceding year; and b) the individual is present in the U.S. for 31 days in the current year. Thus, an individual who is not present in the United States for more than 121 days in any year will never be a resident alien under the substantial presence test.
(The U.S. tax system for individuals is based on a calendar year, which requires tax returns to be due by April 15th, provided that extensions are available until October 15th.)
Note that there are a few very limited exceptions to this substantial presence rule for certain individuals, including Canadian or Mexican commuters, students, teachers, diplomats, trainees, and certain professional athletes. Also, tax treaties between the U.S. and other countries often affect tax residency status.
If a person is not considered a resident alien under the above test, he or she may nonetheless be required to file a form 1040NR, an individual income tax return on U.S.-source income of non-residents. One must also be concerned with dual residency status during the year that an individual becomes a U.S. resident alien.
Dual Status Taxpayer
In the year of change of tax residence, a special rule governs the taxability of non-U.S.-source income. If such income is not effectively connected with a U.S. trade or business and is received during the dual status year before the immigrant becomes a U.S. tax resident, it is not taxable, even though the immigrant became a U.S. citizen or resident after its receipt. On the other hand, all such income received while the immigrant is a U.S. tax resident is taxable, even though it was earned before he or he becomes a U.S. tax resident. Thus, an NRA who anticipates generating a substantial amount of foreign-source income after becoming a resident should attempt to receive as much of that income as possible before moving to the U.S. or acquiring his or her green card.
The timely creation of a non-U.S. trust (formerly known as the “Bermuda stop” trust) may provide an immigrant with the opportunity to divest himself/herself of assets and/or income flow prior to becoming a U.S. taxpayer. This will result in income tax and death tax savings. But this trust must be set up five years in advance of acquiring U.S. tax residency in order to avoid onerous reporting and income inclusion rules. In addition, immigrants with relatives outside the U.S. whom they wish to provide for should also consider establishing non-U.S. trusts. Consideration must also be given to the fact that the U.S. is a much more litigious society than most other countries. High-visibility persons – such as athletes and entertainers, persons in high-risk occupations such as physicians, and persons with substantial net worth – need to consider establishing trusts outside the U.S. for protection of their assets.
The WealthFortress Trust™ is a powerful vehicle for elimination of income tax, capital gains tax and death tax. (Please consult our office in this regard.)
A person who dies a citizen of, or domiciled in, the U.S. is subject to estate tax on his or her assets, regardless of the location of the assets or residence of the beneficiaries or the trustees and beneficiaries of a testamentary trust. Note that “domiciled” is not the same as “tax resident”– it is possible for a non-citizen to be a U.S. tax resident but not be domiciled in the U.S., and, vice-versa, it is possible for someone domiciled in the U.S. not to be a U.S. tax resident. Tax treaties also affect whether someone is characterized as domiciled in the U.S. Very careful consideration must be given to a host of factors in determining when, or whether, an immigrant will be subject to U.S. estate tax.
There are numerous estate expenses which may be deductible from the decedent’s assets: claims against the estate, funeral and administration expenses, state death and inheritance taxes, charitable transfers, mortgages on and indebtedness relating to the property included in the gross estate, and casualty losses. A bequest to a spouse who is a U.S. citizen is commonly eligible for the marital deduction, which renders the bequest free from tax. Transfers to a non-U.S. citizen spouse generally must be made to a special type of trust, called a qualified domestic trust (“QDOT”), or the surviving spouse must become a U.S. citizen before the federal estate tax return is filed, in order for the marital deduction to be available. Otherwise, the marital deduction is not allowed.
There are also credits available against the estate tax:
- Unified credit, currently exempting estates of up to $5,250,000 per person. A single, progressive unified rate schedule applies for determining estate and gift taxes. The top rate for estates of decedents dying and gifts is 40%.
- Credit for gift taxes paid on assets included in the gross estate.
- Credit for estate taxes paid on property received from a prior decedent who died within 10 years of the current decedent (the credit for tax on prior transfers).
- Credit for foreign death taxes on assets located outside the U.S. and included in the gross estate.
Non-Resident Aliens (NRA)
A NRA is subject to estate tax only on U.S. situs assets. U.S. situs assets include:
- U.S. situs real property;
- U.S. situs tangible personal property like: currency, jewelry, furniture, coin and stamp collections, gold bars, and artwork (unless the work is imported into the U.S. solely for exhibition purposes);
- Cash accounts, other than bank accounts, maintained by U.S. companies, such as cash balances in brokerage accounts;
- Shares of stock of U.S. corporations, including mutual funds and shares of U.S. cooperative apartments;
- Interests in limited or general partnerships that do business or invest in the U.S.;
- Debt obligations (including convertible bonds or debentures), other than publicly traded portfolio debt;
- Cash surrender value of life insurance issued by a U.S. insurer (this does not include life insurance proceeds paid on the death of an NRA); and
- Assets transferred by the decedent within three years of death.
The difference in tax obligations between a decedent having a U.S. domicile and one not domiciled in the U.S. can be substantial – among other reasons, there are virtually no credits available against the estate tax for a non-U.S. domiciliary. This can be especially true for high net worth individuals who have substantial assets located outside the United States. Furthermore, unless an estate tax treaty applies (see below), a recent immigrant may find his former home country also looking to impose its own death taxes. This frequently generates a risk of double tax at combined rates exceeding 100%.
The United States has entered into various tax treaties with most countries in the world that have developed tax systems and with which it is a major trading partner. The purpose of such treaties is to prevent double taxation on the individual. There are a number of special provisions that provide varying results to persons who reside in different countries.
In addition to income tax treaties, the U.S. has estate tax treaties with: Australia (including a separate Gift Tax Treaty), Austria, Canada, Denmark, Finland, France, Germany, Greece, Ireland, Italy, Japan (including a separate Gift Tax Treaty), The Netherlands, Norway, Switzerland, South Africa and the United Kingdom.
It is important to examine any particular provisions that may apply when planning an estate for a client where a treaty is relevant. This search for applicable treaties is especially true for any estate plan that involves persons or property located in more than one country.
More significant to such estate planning is being aware of what assets are subject to tax. None of the estate tax treaties exempt:
- U.S. real property from U.S. estate tax. NRAs will be subject to estate tax on direct ownership of U.S. real estate regardless of where they live; hence the need to consider transferring such assets into corporations or trusts.
- Because the maximum U.S. estate tax rate stands at 40%, an unexpected death soon after migrating to the U.S. can effectively wipe out a substantial portion of a family’s assets, regardless of the fact that most of it was earned outside the United States prior to gaining U.S. residency. The best way to avoid this possibility is to seek the proper tax planning advice before moving to the U.S.
U.S. citizens and residents are subject to gift taxes on all lifetime transfers, whether in trust or outright, and regardless of the recipient’s citizenship or residency or the nature and location of the property. Gifts of up to (currently) $14,000 per donee per year are exempt. Also, educational and medical expenses of a donee paid directly to the institution which provides services to the donee are completely excluded from gift tax.
An outright gift to a spouse who is a U.S. citizen (not just, as for income tax purposes, a U.S. resident) qualifies for an unlimited marital deduction; that is, is free from gift tax. A gift in trust for a spouse needs to satisfy particular rules to qualify for the marital deduction.
Gifts to spouses who are not U.S. citizens are subject to tax, however. The exemption is $100,000, adjusted for inflation. Thus, in 2013, up to $143,000 of gifts to a non-citizen spouse per year may be excluded from tax.
A couple consisting of one or both non-citizen spouses must be cautious when buying property jointly. Often one-half of any amounts contributed by the paying spouse over any amounts contributed by the other spouse to the joint tenancy (in excess of the annual exclusion) is treated as a gift to the non-paying spouse. Therefore, if a husband purchased a condominium (using only his own funds) for $750,000 in joint name with his non-citizen wife, he has effectively made a taxable gift of $232,000 to his wife. [Half of the value ($375,000) minus marital deduction ($143,000) = $232,000].
Non-Resident Aliens: Gift Taxes
NRAs are generally subject to gift tax only on property transfers situated in the U.S. (real estate and tangible personal property located in the U.S. at the time of the gift). A gift of foreign real estate or a gift of intangible personal property is not subject to gift tax. Real estate may include buildings, fixtures, improvements, growing crops, rights to timber, and mineral rights. This does not include leaseholds or security interests. Problems may arise when U.S. law and foreign law treat a particular property interest differently, that is, whether it is deemed real estate or not.
Tangible personal property is deemed to be situated in the U.S. when it has a “residence” in the U.S. Therefore currency, including checks, held in the U.S. is treated as U.S. property.
There are methods to avoid a gift tax on U.S. real estate. An NRA can transfer real estate to a U.S. or foreign corporation and make a tax-free gift of the shares of stock of that corporation. However, the IRS may treat the corporation as a non-entity for gift tax purposes if this is the sole purpose of using that corporation.
An NRA will be subject to the same gift tax rate as a U.S. citizen (currently 40%) and is entitled to the $14,000 gift tax annual exemption. Charitable gifts are deductible if made to (1) U.S. charities; (2) charitable trusts that will use the gift(s) in the U.S.; (3) organizations that use the gifts within the U.S. for charitable, religious, literary, scientific, or educational purposes; and (4) veteran organizations organized in the U.S.
The following are not available to an NRA:
- No gift tax unified credit is available.
- Gift splitting is not permitted because both spouses must be U.S. citizens or residents to split gifts.
- There is no unlimited marital deduction for transfers to a non-citizen spouse, but there is a $100,000 annual exclusion for such gifts, indexed for inflation ($143,000 in 2013).
CAVEAT: U.S. estate and gift taxes are in a state of flux at the present time. Some political forces want to make the repeal the taxes altogether. Obviously, this issue will be monitored closely by our staff so that we will be in a position to advise you of the course of action to take regardless of the outcome.
AVOIDING LIABILITY ISSUES: ASSET PROTECTION
The United States is a “litigious society” where many individuals would not hesitate to take an issue to court. Legal claims can affect a person or his/her business, such as malpractice, sexual harassment, product liability, environmental or other claims, leaving a professional or businessperson liable for part or all of the entire claim. Depending on the type of suit, an award of damages can be millions of dollars. Therefore, to avoid exposure to such potential lawsuits and claims, it may be wise to leave assets offshore in an appropriate vehicle.
IMPORTANT: This is a general explanation only. It is not intended to constitute a professional opinion or tax advice. Please consult a competent professional for specific counsel.
IRS CIRCULAR 230 DISCLOSURE: To ensure compliance with requirements by the IRS, be advised that any U.S. tax advice provided by us is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter.
The Gerber & Co International Tax Planning and Compliance Department provides a broad range of consulting and advisory services to US clients investing or doing business abroad and to international clients in the areas of tax treaty analysis; USA disclosures needed for foreign corporations and trusts; asset protection and offshore trusts; offshore variable universal life insurance; U.S. tax compliance and pre-immigration tax planning.