This article is focused on the issues that occur with regards to estate planning when a non-U.S. citizen is involved. It is vital to understand that the tax consequences can be extremely expensive and caution should be taken to speak to a legal professional in order to plan for a whole host of potential tax consequences.
Let’s start from the beginning. When a person passes away, a probate is a very likely possibility if there is no estate planning in place. Putting that aside, in addition to a probate, a transfer tax is also assessed by the IRS for the transfer of any wealth that occurs from the person who died to the person inheriting. Specifically, this estate tax is very expensive – to the tune of 40%.
Transfer Taxes Among Spouses
One exception to this rule is something known as the “unlimited marital deduction” (UMD), which says that spouses can pass to one another – both in life and in death – an unlimited amount of money without triggering a transfer tax. In other words, a spouse can gift to another spouse an unlimited amount of money in their lifetime. Also, when one spouse passes away, the other spouse can inherit an unlimited amount of money that will not be taxed.
But there’s a catch. The UMD only applies to U.S. citizens. Resident aliens (RAs) and non-resident aliens (NRAs) do not enjoy the unlimited marital deduction. For them, strict limits are imposed as to how much money they can transfer to a spouse; anything transferred beyond those set limits is taxed at 40%.
This leads to a common question. What if a citizen is married to a RA or NRA? Then what happens?
The answer is that it depends on the citizenship status of the surviving spouse. If the surviving spouse is not a U.S. citizen, there is no unlimited marital deduction.
Additionally, each citizen and RA has a lifetime exemption amount of $5.45 million (in 2016). This means that a citizen or RA can die and leave up to $5.45 million to their non-citizen spouse free of the estate tax. But the maximum exemption amount a NRA can leave to a non-citizen spouse is only $60,000, after which point a 40% tax is imposed on everything above that amount.
One common thought to avoid the estate tax is to give to your spouse all of your assets in your lifetime. However, this strategy would trigger another kind of transfer tax called the “gift tax,” and any gifts to a non-citizen spouse are limited to only $148,000 annually (in 2016). Any amount gifted above that is taxed at 40%. Compare this to the taxes paid when one gifts to a citizen-spouse: zero. The amount gifted can be unlimited.
Transfer Taxes Among Non-Spouses
What happens if property transfers to a non-spouse and someone is a non-citizen? A common example is what happens when a non-citizen passes his or her assets to their children?
A NRA upon death can only pass $60,000 free of the estate tax to a non-spouse. Anything above that is taxed at 40%. A citizen or RA can pass the first $5.45 million to a non-spouse upon death without having to pay the estate tax.
Interestingly, when it comes to gifting to a non-spouse, the annual cap (free of gift tax) is $14,000 per donee regardless of citizenship status of the donor or donee. However, if the donor goes beyond that amount annually, and if they are a citizen or RA, they can avoid the gift tax by deducting the overage from their lifetime exemption of $5.45 million. A NRA has no such lifetime exemption for purposes of the gift tax and thus a NRA cannot transfer more than $14,000 in a calendar year to a donee without having to pay a gift tax.
With these special tax rules in mind, if you are married to a non-US citizen, what can you do to minimize your estate and gift tax liability?
- Plan to Gift Over a Period of Years
One option is to start transferring your assets to your spouse during your lifetime. If your spouse is a citizen, the unlimited marital deduction comes into play. If your spouse is not a citizen, the annual $148,000 exemption amounts can be used to transfer money to your spouse who can then use those annual gifts to purchase a life insurance policy in the amount of the estimated estate tax that would be owed.
Additionally, a NRA who is contemplating becoming a U.S. resident or obtaining citizenship should first consider gifting assets located in foreign countries to family members. This is because once the NRA becomes domiciled, for income tax purposes, he is taxed on all of his worldwide assets.
- Use a Qualified Domestic Trust (QDOT)
Another option is to transfer assets through a qualified domestic trust (QDOT). A QDOT is an irrevocable trust that is designed to offer the unlimited marital deduction where one or both spouses are non-US citizens. With a QDOT, you transfer your assets to the trust during your lifetime, and then your spouse (who is named as the beneficiary in the trust’s documentation) becomes entitled to the assets automatically upon your death. However, a QDOT has several limitations and requirements associated with it. The main item to understand is that it only defers federal estate taxation entirely.
- Find Out if Your Spouse is Eligible for US Citizenship
While many of the estate and gift tax considerations may become non-issues with citizenship status, all U.S. citizens (and even residents like green card holders) are taxed on all of their overseas assets for income tax purposes. The trade-off must be seriously considered.
- Use Foreign Trusts to Hold Assets
According to Treasury Regulation Sections 20.2104 and 20.2105, NRAs can gift and receive an unlimited amount of intangible personal property. What this means is that a NRA can inherit/receive and can then bequeath/transfer any amount of almost every asset type with the exception of real estate, cash, artwork and jewelry. There are no gift taxes and no estate taxes owed on transfers of securities (equities, bonds and business interests), intellectual property and life insurance. There is no estate tax on bank accounts, gift tax still applies. Additionally, cash drawn on a foreign bank account in the nonresident alien’s sole name but payable by a domestic bank is not subject to gift tax as it is considered a non U.S.-sitused asset (if for more than $100,00, Form 3520 must be filed). As such, it would appear, that in regards to intangible personal property, one can nearly avoid the entire transfer tax regime by marrying a NRA and insuring that the NRA spouse has an irrevocable trust (that is enforceable in the NRA’s home jurisdiction) set up to benefit one’s own beneficiaries. As to the tangible property like real estate, a QDOT is necessary but entity valuation discounts still apply.
- Non-citizens should never be joint tenants
Under joint tenancy, when one joint tenant dies, the surviving joint tenant becomes the sole owner of the entire property. As such, under IRC Section 2056(d)(1), when one joint tenant dies and a noncitizen becomes the sole owner, the entire property is included in the decedent’s estate and becomes immediately subject to estate tax.
There are many things to consider when it comes to planning for the non-citizen. Be sure to select an attorney who has experience with these sorts of issues and who will work well with your accountant. Both will be able to offer valuable suggestions to your planning.