U.S. Tax Planning For Non-U.S. Persons And Trusts: An Introductory Outline - Income Tax - United States (2024)

Estate planning for non-U.S. persons differs from domesticplanning not only in the specific rules that apply, but in themental outlook that the planner must bring to the process. To putit simply, in planning for a U.S. person we begin with theassumption that all income and assets are subject to U.S. income,estate and gift tax, and we then hunt for exceptions (a.k.a."loopholes") that will shelter some income and assetsfrom these taxes, i.e., municipal bond interest, charitabledeductions, the estate tax marital deduction. Non-U.S. persons, onthe other hand, start out in an environment in which no U.S. incomeor estate taxes are payable, and the planner's job is to keepan eye out for pitfalls (U.S. residence, U.S. source income andU.S. situs assets) that may produce such taxes.

The following is an outline of the rules that apply in estateand tax planning for non-U.S. persons and trusts. It is notintended to be the exhaustive word on the subject—volumesare required for that task—but is meant to serve as ageneral guide to the subject.

I. BASIC RULES

II. WHO IS A U.S. PERSON?

A. Individuals, Corporations and Trusts. Theterm "U.S. person" includes U.S. individuals as well asdomestic corporations and U.S. trusts. (I.R.C. §7701(a)(30))

B. When is an Individual a U.S. Person? Anindividual is a U.S. person if he or she is either:

• A U.S. citizen, regardless of residence, and including a dualcitizen of the U.S. and one or more other countries; or
• A U.S. resident, regardless of citizenship.

C. Who is a U.S. Resident?

1. Income Tax Resident: A resident forincome tax purposes is:

1. A green card holder (or other lawful permanent resident) who ispresent in the United States for at least one day of a calendaryear. (I.R.C. § 7701 (b)(1)(A)) There are special rules forthe first and last year of lawful residence. For the first year, ifthe individual was not a resident in the prior calendar year, theindividual is treated as a resident only for the portion of theyear starting when the residence began. (I.R.C. §7701(B)(2)(A)) For the final year, if an individual turns in hisgreen card and leaves the U.S., is not a U.S. resident in thefollowing year and has a closer connection to another taxjurisdiction, he or she will only be a U.S. income tax resident forthe portion of the year that he or she was a card holder. (I.R.C.§ 7701(B)(2)(B)) (As to departing residents, however, thereare special rules for Long-Term Residents, discussed infra)
2. Under the "substantial presence" test, a person is aU.S. resident for a given calendar year if he or she either (a) ispresent in the United States for 183 days in that year, or (b) ispresent in the U.S. for at least 31 days of that year and has beenpresent in the U.S. for an average of more than 121 days per yearover that year and the two prior years. (I.R.C. § 7701(b)(3)(A))

Exceptions:

1. A person holding a diplomatic visa or a full-time student,teacher or trainee visa, or an employee of an internationalorganization, is not a U.S. resident, regardless of the number ofdays spent in the U.S. (I.R.C. § 7701 (b)(5)(A) and (B))
2. A person who is present in the U.S. for less than 183 days inthe calendar year, but whose 3-year average is greater than 121days, can avoid U.S. resident status by demonstrating that he orshe has a tax home in and a "closer connection" to aforeign country. (I.R.C. § 7701(b)(3)(B))
3. Treaties with some countries contain "tie-breaker"provisions to resolve the issue of residence for a person who wouldotherwise be treated as a resident of both of the treatycountries.

D. What Constitutes a Domestic Corporation? Acorporation that is organized or created in the United States.I.R.C. § 7701(a)(3)

E. What Constitutes a Domestic Trust? Under thelaw in effect as of 1996 (I.R.C. §§ 7701(a)(30)(E) and(31)(B)), every trust is a foreign trust unlessboth of the following are true:

1. A United States court can exercise primarysupervision over the administration of the trust; and
2. One or more U.S. persons have the power to controlall substantial decisions of the trust.

Under Reg. § 301.7701-7, the "United States"refers only to the fifty states and the District of Columbia. Asafe harbor is created whereby a trust is a domestic trust if it isadministered exclusively in the U.S., has no provision directingadministration outside the U.S., and has no automatic change ofsitus clause (except in case of foreign invasion or widespreadconfiscation of assets in the U.S.) If a person other than atrustee (such as a Protector) has the power to control substantialdecisions, that person will be treated as a fiduciary for purposesof the control test. Powers exercisable by a grantor or abeneficiary, such as a power to revoke or a power of appointment,will also be considered in determining "substantialcontrol."

Under the Regulation, "substantial decisions"include:

1. Whether and when to distribute income or corpus.
2. The amount of any distribution.
3. The selection of a beneficiary.
4. The power to make investment decisions. (However, if a trusthas a foreign investment advisor who can be removed by the U.S.trustee at any time, this will not make the trust foreign.)
5. Whether a receipt is allocable to income or principal.
6. Whether to terminate the trust.
7. Whether to compromise, arbitrate or abandon claims of thetrust.
8. Whether to sue on behalf of the trust or to defend suitsagainst the trust.
9. Whether to remove, add or name a successor to a trustee.

If a vacancy occurs through the death or sudden resignation of atrustee which would shift control of a substantial decision out ofthe hands of U.S. trustees, the trust has twelve months to reassertU.S. control by either a change of fiduciaries or a change ofresidence of a fiduciary. If such a change is made within twelvemonths, the trust will be treated as having remained a U.S. trust;if no such change is made, the trust will have become a foreigntrust on the date the vacancy occurred.

This new definition makes it easier to determine whether a trustis U.S. or foreign. It also is heavily tilted towards a conclusionthat a trust is foreign. For instance, if a New York residentcreates a testamentary trust for his New York resident children byhis will probated in New York, with a New York bank and an Irishcousin as trustees, and if principal distributions to the childrencan only be made by majority vote of the trustees, the trust is aforeign trust under the new law since a substantial decision is notcontrolled by a U.S. fiduciary.

III. TAXATION OF NON-U.S. PERSONS

Persons who are neither U.S. citizens nor U.S. residents("Non-Resident Aliens" or "NRAs") are subjectto U.S. taxes as follows:

A. Income Tax: NRAs are subject to U.S. incometax only on U.S. source income, generally at a 30% withholdingrate. (I.R.C. § 871(a)(1))

U.S. Source Income for Income Tax Purposes (I.R.C.§ 871(a)):

• Dividends from U.S. corporations, but not the proceeds of saleof U.S. securities.
• Rent from U.S. real property, and capital gains on the sale ofU.S. real property or real property holding companies.
• Interest on debts of U.S. obligors. However, interest on mostpublicly traded bonds issued after July 18, 1984 constitutes"portfolio interest" and therefore qualifies for theportfolio exemption and is not taxed as U.S. source income (I.R.C.§ 871(h)).
• Salaries paid by U.S. and non-U.S. entities for servicesperformed by the recipient in the United States.
• U.S. royalties.

NRAs are also subject to income tax at the same graduated ratesas U.S. persons on their income in connection with the conduct of atrade or business in the U. S. (I.R.C. § 871(b))

Interest on U.S. bank accounts, including time deposits andcertificates of deposit, is not U.S. source income.

Income tax treaties between the U.S. and other countries canalter these rules, particularly the withholding rate.

B. Estate Tax: Estates of NRA individuals aresubject to U.S. estate tax only on U.S. situs assets. The tax isassessed at the same rates as for U.S. citizens, up to 35% for 2011and 2012, but with only a $60,000 exemption (as opposed to thecurrent exemption of $5,000,000 for a U.S. person). (I.R.C. §2106 (b)) Worldwide debts and administration expenses may bededucted, but only in the proportion that the U.S. assets bears tothe decedent's worldwide assets. The unlimited maritaldeduction is available; however, if the surviving spouse is not aU.S. citizen, only property left to a Qualified Domestic Trust(QDT) will qualify (see Section VIII (B) below). The charitablededuction is available only for bequests to U.S. charities.

U.S. Situs Assets for Estate Tax Purposes: Thefollowing is a partial list:

• U.S. situs real property, including houses and condominiums.(Treasury Reg. §§ 20.2104-1 (a)(2); 20.21051 (a)(2))
• U.S. situs tangible personal property, such as jewelry,antiques, artworks and cars, unless the items are in transit or onloan for an exhibition. (Treasury Reg. §§ 20.2104-1(a)(2); 20.21051 (a)(2))
• Shares of stock of U.S. corporations, including shares of aU.S. co-operative corporation representing a co-op apartment.(I.R.C. § 2104(a)) Shares of non-U.S. corporations are notU.S. situs property. The location of the certificate is immaterial.Mutual funds (including money market funds) organized in corporateform are U.S. situs property if incorporated in the United States.(I.R.C. § 2104(a)) If the fund is structured as a partnershipor grantor trust, the situs of the fund depends on the situs of theunderlying assets of the fund.
• Cash deposits with U.S. brokers, money market accounts withU.S. mutual funds and cash in U.S. safe deposit boxes are U.S.situs property. (I.R.C. § 2104 (c))
• Debts of U.S. obligors. Once again, however, publicly tradedbonds issued after July 18, 1984 qualify as "portfoliodebt" and therefore are not subject to U.S. estate taxation.(I.R.C. § 2105 (b)(3)) Previously, only bonds with a maturityof more than 6 months qualified for the estate tax portfolio debtexemption, so that short-term Treasury bills, for example, wereU.S. situs assets. However, this distinction was eliminated by theTaxpayer Relief Act of 1997, and bonds now qualify for theportfolio debt exemption regardless of maturity.
• Interests in limited or general partnerships that either dobusiness in the U.S. or own assets in the U.S. will probably beconsidered U.S. situs assets.
• Life insurance proceeds paid by a U.S. insurer on the life of anon-U.S. person is not U.S. situs property. However, the cashsurrender value of life insurance owned by a non-U.S. person on thelife of another person is U.S. situs property if issued by a U.S.insurer. (Treasury Reg. § 20.2105-1 (g))

Bank accounts maintained with U.S. banks are not U.S. situsproperty: this includes checking and savings accounts, timedeposits and certificates of deposit. (I.R.C. § 2104 (c))

Again, treaties with various countries can alter these rules,particularly as to whether U.S. stocks owned by a citizen andresident of another country will be taxed by the U.S.

C. Gift Tax: NRAs are subject to gift tax onlyon gifts of U.S. situs real property and tangible personalproperty. The annual exclusion of $13,000 for gifts of a presentinterest may be applied; however, the $60,000 credit that NRAs havefor estate tax purposes may not be applied to gifts. Gifts ofshares of stock of U.S. corporations are not subject to U.S. gifttax. However, gifts of cash (possibly including checks) that takeplace within the United States may be subject to gift tax;therefore, any gifts of cash by a non-U.S. person to a U.S. personshould be made outside the United States. (I.R.C. §§ 2501(a)(3); 2511 (b))

D. Reporting of Gifts by NRAs to U.S. Persons:Any U.S. person who receives "large gifts" (over$100,000) from a foreign person during any calendar year must filea report describing these gifts. (I.R.C. § 6039F; Form 3520)(The recipient must be a U.S. person for income tax purposes, andthe foreign person may be either a foreign individual for incometax purposes, or a foreign entity—corporation,partnership, trust or estate). The stated purpose of this reportingrequirement is to insure that the purported gift is not really adisguised distribution of income from a foreign trust.

The term "gifts" includes bequests from estates ofnon-U.S. persons. (I.R.C. § 6039F(b)) Qualified medical oreducational payments under I.R.C. § 2503(e) are not consideredto be gifts and are not subject to reporting.

In determining whether a U.S. person has received gifts duringthe taxable year from a particular foreign donor in excess of$100,000, the U.S. donee must aggregate gifts from foreign personsthat he knows or has reason to know are related, within the meaningof § 643(i)(2)(B). For instance, if an NRA mother and fathereach give their U.S. son $60,000, the gifts are aggregated, the$100,000 reporting threshold is exceeded and the son must reportboth gifts. Once the $100,000 threshold has been met, the doneemust separately identify each gift in excess of $5,000.

A U.S. person is required to report the receipt of purportedgifts from foreign corporations and foreign partnerships if theaggregate amount of purported gifts from all such entities exceeds$10,000 in any year. (This threshold is indexed for inflation andis presently $12,760.) The use of the word "purported" inthe Notice gives an indication of the jaundiced eye with which theI.R.S. will view such "gifts." The I.R.S. mayrecharacterize those "gifts" as taxable dividends fromthe corporation.

The form used to report gifts from foreign persons (Form 3520)asks for a brief description of the property received as a gift,whether the foreign donor is an individual, corporation,partnership, or estate, and whether the foreign donor was acting asa nominee or intermediary for another person. The form does not askfor the identity of a foreign individual donor, although the IRScould ask for this information.

While there is no tax on gifts from foreign persons, the penaltyfor failure to report the gifts is severe. If a gift is notreported on Form 3520, the tax consequences of the receipt of thegift shall be determined by the Secretary. (I.R.C. §6039F(c)(1)(A)) In addition, the recipient is subject to a penaltyequal to 5 percent of the value of the gift for each month in whichthe gift is not reported, not to exceed 25 percent. (I.R.C. §6039F(c)(1)(B)) The penalties can be waived if the failure to filewas due to reasonable cause and not willful neglect. Ignorance ofthe law is not reasonable cause.

E. Estate Tax and Generation-Skipping TransferTaxes: Transfers by a NRA to a U.S. person are not subjectto U.S. income, estate or gift tax except as to assets that haveU.S. situs for estate or gift tax purposes.

A transfer by a NRA will be subject to GST tax only if it isalso subject to U.S. estate or gift tax, which will be the caseonly if it consists of U.S. situs property. (Treas. Reg. §26.2663-2)

F. Treaties: Treaties with individual countriesmay alter some of these rules, particularly as to determination ofresidence, source of income, situs of assets and income withholdingrates. The U.S. generally enters into treaties with countries thathave significant taxes of their own, to help avoid double taxation.Therefore, if a treaty allows a NRA to reduce his U.S. taxliability, there will usually be an offsetting tax in the NRA'scountry of residence.

The United States never enters into a treaty which exemptsU.S. citizens from worldwide income, estate, gift, orgeneration-skipping taxation.

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