chapter 11 hidden traps when crossing bordersestateplanningsmarts.com/images/ch11revised2010.pdf ·...

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Hidden Traps When Crossing

BordersRead this chapter if you or a family member

is a citizen of another country, lives abroad or has foreign investments.

Chapter 11

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EstatE Planning smarts

ith families increasingly spread among different countries and shifting assets across borders, it is important to be aware of how various links to foreign countries can affect

your estate plan. this is true whether or not you are a U.s. citizen.the United states is one of the few countries that impose taxes during

life and at death on property anywhere in the world. these far-reaching tax rules apply to U.s. citizens, resident aliens and domiciliaries – a

legal term for people who expect to live in a place indefinitely. they may be subject to income tax on money earned anywhere in the world, estate tax on worldwide assets totaling more than $3.5 million and generation-skipping trans-fer tax on worldwide assets worth more than $3.5 mil-

lion going to grandchildren and more remote generations. in some cases a tax credit may be available for taxes paid to foreign countries.

although U.s. residents who are not domiciliaries must pay income tax on worldwide income, they are subject to gift and estate tax only on transfers of U.s. assets (such as stocks or real estate). a resident for income tax purpos-es is someone who has a green card or is in the U.s. more than 183 days in any one year or more than 120 days a year in three consecutive years.

Foreigners who do not live in the U.s. (non-resident aliens) may be surprised to find that without some precautionary steps, U.s. assets that they acquire may be subject to tax when those assets are trans-ferred during life or at death.

WIn This Chapter...n Foreign Assets Owned by U.S.

Citizens and Domiciliaries

n Gifts and Inheritances From Foreigners

n Gifts and Bequests to Non-Citizen Spouses

n The Long Arm That Reaches Foreign Trusts

n Expatriate Tax Rules

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ChaPtEr 11 n hiddEn traPs WhEn Crossing bordErs

pForeign Assets Owned by

U.S. Citizens and Domiciliaries

suppose you have kept a foreign bank account that you set up during an overseas posting, or you are thinking of buying a ski chalet in the alps.

since U.s. estate tax applies to your worldwide assets, both could be taxed if you leave behind total assets worth more than $3.5 million. if you transfer those foreign assets during life to anyone other than a spouse who is a U.s. citizen, you will have to pay gift tax if the total value of your gifts exceeds the $1 million lifetime gift tax exemption.

there’s also the possibility of double tax on your overseas assets – inheri-tance tax in the country where they are situated, as well as U.s. estate tax. only 16 countries have estate or gift-tax treaties with the U.s. that may prevent or minimize double taxation: australia, austria, Canada, denmark, Finland, France, germany, greece, ireland, italy, Japan, the netherlands, norway, south africa, switzerland and the United Kingdom.

Forced heirship rules in some countries are another issue that may arise. these rules, which are designed to avoid disinheritance of a spouse or child, give that person a preset share of what you leave behind. Where forced heir-ship rules exist, they can frustrate estate-planning strategies that are popular in the U.s. For example, if you have children, you may not be able to leave foreign real estate entirely to your spouse – something you would typically do in order to take advantage of the unlimited marital deduction that U.s. law af-fords (as discussed in Chapter 3).

if instead you must leave part of the property to your children and their portion is worth more than the $3.5 million federal exemption (or the state exemption if you live in a state with a separate estate tax), the foreign property could be subject to estate tax in the U.s. Were it not for the forced heirship law, you would be able to avoid that tax when the first of you dies by leaving the entire property to the surviving U.s. citizen spouse.

likewise, an estate planning tool used to avoid inheritance tax in certain foreign countries – retaining the right to live in a house while you are alive and giving your children a remainder interest in the property after that – would be ineffective for U.s. estate tax purposes. in fact, this arrangement would cause the entire value of the property to be included in your estate and potentially be subject to tax.

owning real estate abroad therefore requires coordination between your

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estate planning lawyer in the U.s. and a knowledgeable adviser in the country where the property is situated. it may be possible to avoid both foreign tax and inheritance laws by putting the foreign property into a foreign corpora-tion. that way the assets are owned by the corporate entity you create, rather than by you directly. however, local taxes may be imposed on such transfers.

another question that arises is whether you need a separate will just to cover valuable property in a foreign country, prepared in that country in accordance with its laws. this greatly complicates and adds to the cost of your estate planning and should be avoided if possible. some countries have entered into multinational treaties requiring certain formalities in

preparing and signing a will and recognizing the validity of wills done in participat-ing countries. (the U.s. is a signatory to one such trea-ty, known as the Washington Convention.) You might need a separate will if your assets are in a country that has not signed the treaty or in other special situations, such as when a country’s succession rules are incon-sistent with your estate planning goals. trusts, for

example, are rarely or never used in many countries. another reason to write a separate will is if you are expecting an inheritance battle; the will can include provisions, based on local law, that can minimize or avoid the kinds of problems that you anticipate.

Foreign bank accounts or brokerage accounts, as well as other foreign investments, raise additional issues. Whether you inherited such an account or opened it with your own funds, you must disclose it on your annual tax return. if the total of all these accounts is more than $10,000 at any point dur-ing the year, you must also submit a Foreign bank account report, known as the Fbar (pronounced eff-bar) to the treasury department by June 30 of the following year. starting with the 2011 tax year, you will also have to disclose many other foreign investments, whether or not held at a financial institu-tion, if they total more than 50,000. not making all the required disclosures,

Did You Knowif you plan to spend time overseas and buy or sell real estate, transact business or open a bank account, you need a durable power of attor-ney that’s valid in that country. this document appoints an agent to act on your behalf in case of physical or mental disability.

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or supplying false or fraudulent information, can result in substantial penal-ties and, in certain cases, criminal charges. if you have questions about the Fbar, you can submit them to [email protected] or call 800-800-2877.

pGifts and Inheritances From Foreigners

Certain assets, including U.s. equities, real estate and tangible personal property in the U.s., will be subject to U.s. gift tax, federal estate tax (and

possibly state estate tax) and generation-skipping transfer tax when they are transferred, even if both the owner and the gift recipients are non-resident aliens. many people are not aware of this. For example, if an indian citizen who is a resident of mumbai dies owning a condominium in new York, his children cannot inherit that property, regardless of their nationality, until they have paid both federal and state estate tax.

Unlike U.s. citizens and domiciliaries, foreigners are not eligible for the $1 million lifetime gift tax exemption or the $3.5 million estate tax exemption. When they transfer interests in U.s. property during life, they must pay gift tax if the value of a gift is more than the $13,000 annual exclusion. gifts in excess of that amount are taxed, based on their aggregate value during the foreigner’s lifetime, at a rate of up to 45 percent. an exception applies when the gifts are made to a spouse who is a U.s. citizen; in that case, the unlimited gift-tax mari-tal deduction applies (as noted in Chapter 3).

transfers through an estate plan get a credit of $13,000 (in effect an exemption of $60,000 because of the graduated estate tax rates that apply in this context). For amounts above that, an estate tax of 18 to 45 percent applies. here, too, there’s an unlimited marital deduction for assets inherited by a spouse who is a U.s. citizen.

but these taxes can be easily avoided if a foreigner acquires and holds the assets through a corporation situated in a jurisdiction that does not have estate or income tax (such as bermuda or the Cayman islands), rather than owning them directly. that converts what would otherwise be considered U.s. assets into offshore assets, which aren’t subject to U.s. estate tax. another advantage is privacy, because the shareholder of record is the corporation, not an individual.

often shares in the corporation are owned, in turn, not by individuals, but by an offshore trust that is also situated in a tax-friendly jurisdiction. the trust

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can shield the assets from creditors (see Chapter 18) and provide for distribu-tions under its terms, both during life and afterward. this can avoid tax on the assets by either the U.s. or the foreigner’s home country. it also can avoid forced heirship in countries that have such rules.

different rules apply when the transfers do not involve U.s. property. these assets are generally not subject to gift or estate tax. so, for example, a U.s. per-son could receive a gift or inheritance of any amount from her Canadian father and not have to pay any U.s. tax (though there may be foreign tax implications).

however, money coming into the U.s. is tightly regulated, and it may be nec-essary to report the gift or inheritance even if there is no tax on it. Consider the U.s. person with a Canadian father: if the amount she receives in a given year from him and any other nonresident aliens and foreign estates totals more than $100,000, she must report each gift of more than $5,000 to the internal revenue service on Form 3520. Why? the irs is on the lookout for income masquerading as gifts and wants to decide for itself, based on the information you supply, whether what you received is taxable income rather than a non-taxable gift. assuming the transfer is indeed a gift, no tax will be due, but you must still file the form – there is a penalty of up to 25 percent of the amount of the gift if you are required to file the return and don’t. the reporting require-ment does not include direct payments of tuition or medical expenses, which are discussed in Chapters 9 and 13.

a much smaller threshold – $14,139 in 2009, indexed for inflation – applies to gifts received from foreign partnerships, foreign trusts or foreign corpora-tions. the rule covers funds you receive directly, as well as money doled out on your behalf, such as the payment of credit card bills.

pGifts and Bequests to Non-Citizen Spouses

if your spouse is not a U.s. citizen, you will not be able to rely on the unlim-ited gift tax and estate tax marital deduction. annual gifts to your spouse

of more than $133,000 (indexed for inflation) count against the $1 million lifetime exemption.

assume lucy, an american, marries ricky, a Cuban who has a green card, and they live in miami. if lucy dies first and leaves ricky more than $3.5 mil-lion, anything above that limit is immediately subject to a 45 percent tax unless

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it goes into a special kind of trust, called a qualified domestic trust, or Qdot. if this trust distributes principal, it must withhold estate tax – at the rate that was in effect when lucy died. (When ricky receives distributions of income, they are subject to income tax but not estate tax.) the Qdot was discussed extensively in Chapter 3.

in contrast, if ricky gives or leaves property to lucy, these transfers are entitled to the unlimited marital gift-tax or estate-tax deduction. therefore, a Qdot to benefit lucy is not necessary.

Complications arise when you own property jointly with rights of survivor-ship or in tenancy by the entirety, two forms of title discussed in Chapters 3, 4 and 18. although typically when spouses own property this way only half its value is included in the estate of the first to die, a different rule ap-plies when one of them is not a U.s. citizen.

For real estate, the tax treatment in this situation depends on when the couple acquired the property. if it was after July 14, 1988, the whole property is included in the estate of the first to die unless the survivor can show how much he contributed to the purchase price. in that case, what is counted as part of the estate would be reduced to reflect the portion that he paid. For real estate bought before 1988, state law determines how each spouse’s interest is calculated.

likewise, if the property is sold or the couple ends the joint ownership ar-rangement by putting title in just one of their names, any proceeds or share in excess of what the recipient contributed is considered a gift. the non-citizen spouse can make this transfer to the citizen spouse without paying gift tax (just like ricky’s gifts to lucy). but if annual gifts from the citizen spouse to the non-citizen spouse exceed $133,000 (indexed for inflation), it counts against the $1 million lifetime gift tax exemption.

similar issues arise with joint bank accounts or brokerage accounts that give each spouse the right to make withdrawals freely. if either spouse takes

Did You KnowCertain assets, including U.s. equi-ties, real estate and tangible person-al property in the U.s., are subject to U.s. gift tax, estate tax and gen-eration-skipping transfer tax when they are transferred, even if both the owner and the gift recipients are non-resident aliens.

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ties to a foreign country can affect the tax on transfers during life and through your estate plan. the tax that applies in a given situation may depend on who owns the assets, where they are situated and who is receiving them.

U.s citizens/domiciliaries

Foreigners (non-resident aliens or resident aliens who are not domiciliaries)

Expatriates who gave up U.s. citizenship after June 17, 2008

Worldwide

U.s. equities, real estate and tangible personal property

Worldwide

Whom doesthe tax cover?

What assets does the tax cover?

Connecting the Dots

*Unlimited marital gift tax deduction or estate tax deduction applies to transfers to a spouse who is U.S. citizen.

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ties to a foreign country can affect the tax on transfers during life and through your estate plan. the tax that applies in a given situation may depend on who owns the assets, where they are situated and who is receiving them.

• Lifetime gifts

• Bequests

• Lifetime gifts

• Bequests

• Lifetime gifts to U.s. persons

• Bequests to U.s. persons

• $13,000 annual exclusion• $133,000 annual

exclusion gift to non-citizen spouse

• $1 million lifetime exemption*

• $3.5 million*

• $13,000 annual exclusion*

• $13,000 credit*

• $13,000 annual exclusion*

• $13,000

Up to 45%

45%

Up to 45%

Up to 45%

highest rate in effect

highest rate in effect

When doesthe tax apply?

How much is exempt?

Tax rate (once exemptions exceeded)

Connecting the Dots

*Unlimited marital gift tax deduction or estate tax deduction applies to transfers to a spouse who is U.S. citizen.

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out more than the portion he or she put in, it’s considered a gift. and when one spouse dies, his contribution and share of the appreciation is considered part of his estate. these rules make it very difficult for spouses to hold valuable property as joint owners when one is a citizen and the other is not.

pThe Long Arm That Reaches Foreign Trusts

From a tax perspective, U.s. persons – U.s. citizens and resident aliens who hold a green card – are better off being beneficiaries of domestic trusts

than foreign ones, but under federal rules a trust could easily be character-ized as a foreign one instead. to make matters worse, U.s. beneficiaries can get nailed with taxes on foreign trust earnings, and the law on who falls in this category is very broad.

Unless the trust is a grantor trust – one in which the person creating the trust retains certain rights or powers – it typically pays the income tax on its earnings but takes a deduction for net income (income minus expenses) distributed to beneficiaries. With non-grantor foreign trusts, however, the trust pays tax only on income that comes from a U.s. source, such as dividends from corporations, rents from real estate or capital gains from the sale of real estate or stocks. in contrast, U.s. beneficiaries of these trusts are taxed on all distri-butions of income, including income from capital gains, whether it comes from a U.s. source or a foreign one. and any time a U.s person transfers property to a foreign trust, there’s a presumption under federal law (very hard to over-come) that it has a U.s. beneficiary.

likewise, the scale tips toward foreign trusts more often than some people realize. Under treasury department regulations, a trust is treated as a domestic trust only if it meets both these criteria: a U.s. court can exercise primary su-pervision over the administration of the trust (the “court test”) and one or more U.s. persons have the power to control all substantial decisions of the trust (the “control test”). Under the regulations, “substantial decisions” include whether and when to distribute income or principal; the amount of any distribution; whether to remove, add or replace a trustee, and the power to make investment decisions. a trust can have a foreign investment adviser without being consid-ered a foreign trust if the adviser can be dismissed by the U.s. trustee.

if a trust flunks either test, it is considered a foreign trust. the fact that the

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trust says the laws of a particular state apply to it or that it was created under a will that was probated in a U.s. state doesn’t change the result.

how might you inadvertently turn a domestic trust into a foreign one? hav-ing a foreigner serve as a trustee with the power to make substantial decisions is one way, for example, when non-resident aliens set up trusts to provide for U.s. beneficiaries (as discussed in Chapter 5). their inclination might be to name a family member from the home country as trustee. that could make the trust a foreign trust.

the irs is on the lookout for foreign trusts. on the annual federal income tax return, you must indicate whether you have received distributions from foreign trusts during the past year or whether you set up or transferred any funds into one of these trusts. if so, you must report that on Form 3520, filed with the return. the penalty for not filing is 35 percent of the distri-bution. other penalties apply if the trust distributes accumulated income from previous years.

pExpatriate Tax Rules

tax law discourages people from expatriating just to avoid taxes. two provisions of the tax code, added in 2008 through the heroes Earnings

assistance and relief tax act of 2008 (the so-called hEart legislation), could have a significant impact on expatriates or U.s. persons who receive gifts or inheritances from them.

Who’s covered? these provisions apply to someone who expatriates on or after June 17, 2008, by giving up his citizenship, or in the case of long-term residents (those who have spent at least 8 of the 15 years before expatriating living in the U.s.) by giving up his green card, if in either case they fit at least one of these descriptions:

n their average annual income tax for the previous five years was more than $139,000 (indexed for inflation)

n their net worth is $2 million or more (including interests in trusts)n they fail to certify, under penalty of perjury, that they have complied with

the tax law during the previous five years.

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there are exceptions for certain minors and for those who have been dual citizens since birth who remain a citizen of another country at the time of expatriation and have not been U.s. residents for more than 10 of the last 15 years before expatriating.

What’s the tax pain? When you expatriate, the law imposes an exit tax on your worldwide property (not just your U.s. assets), including property in a trust if you are the grantor – the person who created it. Whether or not you sell that property when you expatriate, it is treated as if you had on the day before you expatriated, and there is capital gains tax due on any appreciation of more than $600,000 (adjusted for inflation). if you want to defer that tax until the asset is actually sold or you die, you must make a deal with the irs – for example, by posting a bond.

Certain interests in deferred compensation plans and trusts that you did not set up are not subject to the exit tax. instead, there is a 30 percent withholding tax on payments from these plans or trusts as you receive them.

Perhaps more importantly, once you expatriate there’s a steep tax when you benefit U.s. citizens or residents through lifetime gifts, distributions from trusts that you have set up or bequests under your estate plan. (note that, in this context, the income and net-worth thresholds are applied as of the date of a gift or immediately before death, not at the time of expatriation.) anything they receive that exceeds the $13,000 annual exclusion amount (indexed for inflation) is subject to gift tax or estate tax at the highest rate in effect at the time. recipients, whether they are individuals or U.s. trusts, are liable for the tax unless you have filed a gift tax return or your estate has filed an estate tax return. Payments that would qualify for the unlimited marital deduction are not subject to this requirement (again, special rules apply if your spouse is not a U.s. citizen).

there is no $1 million gift tax exemption or $3.5 million estate tax exemp-tion in this context. if you are planning to expatriate you should consider using your $1 million gift tax exclusion to make gifts to friends or family before you do. otherwise, that exemption will be lost when you expatriate.

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Get the Right Advisers on Your Teaminternational estate planning is a highly specialized field. although most competent trust and estate lawyers could handle the basic issues involving a U.s. citizen who is married to someone who isn’t, for anything more complex, it pays to consult a sub-specialist (for general advice on finding a lawyer, see Chapter 19). You may also need whomever you choose to coordinate with advisers in the country where you live, own assets or have family. You should seek an international estate-planning expert if you are:

n a U.s. citizen or green card holder and expect a significant gift or inheri-tance from someone who is a resident of a foreign country

n a U.s. citizen or green card holder and the beneficiary of a foreign trust

n a U.s. citizen or green card holder and the grantor of a trust that names a foreigner as trustee

n a U.s. citizen or green card holder and own or are about to buy property, such as real estate or business interests, in a foreign country

n Planning to live abroad – for example, to work or retire – but still consider the U.s. your home country

n thinking of giving up your U.s. citizenship or green card

n an expatriate and plan to make a significant gift or bequest to a U.s. person

n a citizen and resident of another country and own or are about to buy U.s. equities, real estate or tangible personal property

n a citizen and resident of another country and want to benefit a family member who is coming to the U.s. to work or study or who is a U.s. citizen or green card holder.

To-Do List

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