It's not uncommon for professionals and entrepreneurs to move to the U.S. from abroad to make their fortunes. In many instances, these successful, first-generation Americans have wealthy relatives who remain in their native countries and do not intend to move to the U.S. While this can present a number of wealth-planning challenges, there are ways to protect family wealth from taxation under U.S. gift and estate tax laws.
In order to evaluate, select and implement an effective wealth-transfer strategy for a multinational family, it's critical to understand how IRS rules and other regulations treat various types of wealth transfers by non-resident aliens.
The classification of assets as "U.S. situs" or "non-U.S. situs" is crucial to whether the asset will incur gift or estate tax, and is determined by the IRS. A "U.S. situs" asset is one that is located within the jurisdiction of the United States, either physically (for tangible assets, such as real estate or jewelry) or legally (for brokerage accounts, or shares of stock in U.S. companies). An applicable gift or estate tax treaty may modify which assets are classified as “U.S. situs" (see Figure 1).For example, the estate tax exemption for transfers of U.S. situs assets is only $60,000 for non-resident aliens, and there is no exemption from gift tax. Furthermore, there's a common misconception that a gift tax will be imposed on wealth transferred to someone in the U.S. by a relative living abroad. In fact, in many cases, such a transfer may be able to be made tax free (although there may be some reporting requirements, depending on the size of the transaction).The various IRS rules and regulations around such transfers can be difficult to navigate — particularly now that the U.S. government has become more diligent about tracking the flow of foreign sources of wealth. Too often, families take action, or fail to act, based on bad advice or incorrect information. The consequences can be significant. That's why advisors such as attorneys, accountants and wealth managers play a crucial role in the implementation of these strategies.
Transferring Assets Using Irrevocable U.S. Trusts
Establishing a U.S.-based trust is perhaps the most effective means of making gifts to family members who reside in the U.S.
For example, if a non-U.S. person were to simply transfer their non-U.S. situs assets to the child living in the U.S., the child would be taxed on all future income from those assets. Further, at the child's death, those assets would be part of his or her taxable estate. If, however, an irrevocable trust were established in a state like Delaware or Florida (which do not impose an income tax on trusts and no longer have the traditional “rule against perpetuities"), any assets transferred into the trust could grow without ever being subject to U.S. gift, estate or generation-skipping transfer taxes.
When seeking to establish a U.S.-based trust, multinational families may benefit from the informed advice of a U.S. advisor, who is likely to be familiar with the various protections and tax-law benefits in various U.S. jurisdictions. A U.S.-based trust can provide better access to the assets, more direct contact with the trustee and, in many instances, a greater feeling of security.
In order to avoid the estate tax on U.S. situs assets, a trust must be irrevocable. This means that the ability to change aspects of the trust in the future is very limited. Otherwise, the transfer will be considered incomplete until the grantor of the trust dies — at which point the IRS will assess the estate tax at the same rate they would have if there had been no trust at all. Non-U.S. situs assets can be transferred to the trust with no gift-tax implications.
Case Study 1: The Patel Family
Mr. Patel, an Indian citizen, has a son, John, who works in New York and has a green card. Mr. Patel wishes to leave $10 million to John's young children, who were born and live in New York. If Mr. Patel were to wait until his death to pass this money to his heirs, some or all of it may be subject to U.S. estate and generation-skipping tax, depending on the type of assets and what the situs of those assets is.
If Mr. Patel made an outright gift to his son during his lifetime, he may be able to avoid gift tax on some or all of the assets, although John's children would receive significantly less, as the full amount would be subject to the U.S. estate tax upon John's death. Furthermore, he may not be able or willing to gift the full amount in one lump sum, as India's exchange controls may limit the amount of money he can transfer out of the country in a given year.
In this situation, Mr. Patel could create an irrevocable life insurance trust (ILIT) in Delaware or Florida. The only asset of this trust would be a U.S.-compliant life insurance policy on John's life, acquired by the trustee.
Each year, Mr. Patel would transfer non-U.S. situs assets into the trust to cover the insurance premiums. Because the insurance policy is the only asset in the trust, there would be no income taxes due during Mr. Patel's life and no transfer taxes due upon his death. If Mr. Patel were to transfer more than $100,000 into the trust in a given year, the ILIT would need to file Form 3520 with the IRS.
When John does pass away, the death benefit on the life insurance policy would be payable to the trust, which could then make distributions to John's children or retain the funds for future generations.
Lifetime vs. Posthumous Funding
Depending on the type of assets being transferred, it may be more advantageous for Mr. Patel to fund this trust or make gifts to John and his children during his own lifetime, rather than waiting to leave them the assets after his death.
As a non-U.S. person, Mr. Patel would only be assessed a gift tax on lifetime transfers if he were to give his son tangible property (such as U.S. real estate, or the cash in a U.S. bank account). However, he could fund the trust or make outright gifts with U.S. situs intangible assets (such as stock in U.S. companies) without any gift tax.
Were Mr. Patel to die owning more than $60,000 of U.S. situs intangible personal property, John's inheritance would be reduced by U.S. estate tax as the rules for transfers upon death are different than those made during life.
There is another way for Mr. Patel to transfer U.S. real estate without incurring the gift tax. If he wanted to transfer a U.S. vacation home to John, he could establish a non-U.S. corporation to purchase the home, thus converting the real estate to an intangible asset. Instead of giving John the home itself, Mr. Patel could give him shares in the corporation. Such an arrangement would also help Mr. Patel if he preferred to wait until his death to transfer those assets. However, there are some income tax drawbacks to that strategy and Mr. Patel would be wise to first consult with an expert.
Figure 1. Property Transferred by Non-Resident Alien
Case Study 2: The Peng Family
Mrs. Peng and her two children are U.S. citizens. Her aunt has established an offshore, revocable trust for their benefit.
The Pengs have two major concerns: whether transfers from the trust will be subject to gift taxes, and whether the trust could be revoked at any time.
After meeting with their advisors, the Pengs discover that their concern about the gift tax is unfounded. They also learn that if the funds of the revocable trust are paid over to Mrs. Peng at some point, she would be limited in her ability to ultimately transfer the funds to her children without having to pay U.S. gift or estate taxes.
With the input of their advisors, the Peng family determined that their best course of action was to have Mrs. Peng's aunt establish an irrevocable dynasty trust based in Delaware, and to fund it with the assets of the offshore trust. This will provide for greater flexibility in the trust agreement and greater security for the inheritance — as well as significant transfer tax savings, which would not have been possible if the funds were directly transferred to Mrs. Peng.
Transferring Assets Using Non-U.S. Grantor Trusts
Non-U.S. grantor trusts allow family members living outside the U.S. to retain control and use the funds in the trust during their lives, and then transfer their wealth to U.S. family members upon their death.
If structured properly, these trusts are tax efficient for the U.S. family members who receive distributions. Remember, however, that transfers to a non-U.S. grantor trust do not shelter U.S. situs assets from the U.S. estate tax.
In order for a non-U.S. trust to be considered a grantor trust for U.S. income tax purposes, the IRS requires that the grantor must have the power to revoke the trust or to restrict distributions to either the grantor or his or her spouse. All of the income and deductions attributable to a grantor trust are treated as those of the grantor, regardless of whether the grantor receives any income from the trust. This allows for tax-free growth within the trust and tax-free distributions to beneficiaries.
Case Study 3: The Patel Family
Mr. Patel has had a change of heart regarding his gift to his son, John. He now wishes to retain control over the $10 million during his lifetime, with the intent of passing it on to John when he passes away. In this situation, a non-U.S. grantor trust could serve Mr. Patel's needs.
Depending on the type of assets he wishes to hold in the trust, Mr. Patel may need to establish an offshore private investment company (PIC) to hold the assets of the trust fund. For example, U.S. equities and real estate are subject to U.S. estate tax when held by a non-U.S. person like Mr. Patel. U.S. Treasuries, other U.S. bonds, and non-U.S. equities are not.
The trust would own shares of this offshore PIC. Any distributions to John (or to a U.S. trust for his benefit) during Mr. Patel's life would not be subject to U.S. gift tax, and upon his death, would avoid any U.S. gift, estate or inheritance taxes.
Mr. Patel's family should immediately consult with a tax advisor upon his death. The advisor may recommend that the PIC be liquidated within 30 days of Mr. Patel's death in order to avoid application of the onerous U.S. Controlled Foreign Corporation and Passive Foreign Investment Company rules to John. If that is not possible because the 30 days have elapsed, steps can still be taken to ensure the PIC is treated as a disregarded entity.
Transferring Assets Using Non-U.S. Non-Grantor Trusts
In contrast to a grantor trust, a non-grantor trust is treated as a separate taxpayer for tax purposes. The income of the trust is taxed either to the trust, the beneficiaries, or partly to each. The allocation of taxable income is achieved by permitting the trust a deduction for distributions of current income to beneficiaries of the trust. Trusts established in tax-free jurisdictions will obviously have no tax liability.
However, distributions to U.S. beneficiaries will be subject to tax and reporting. Any distribution will carry out trust income (interest, dividends and capital gains) and will be taxable to the beneficiary receiving it. Beneficiaries will have the duty to report distributions received on their individual income tax returns in accordance with U.S. tax laws. The trustee chosen should understand these reporting requirements and provide the relevant reportable information.
Distributions of income accumulated in prior years from non-grantor non-U.S. trusts are subject to the so-called “throwback rules," the aim of which is to negate any tax-deferral benefit to a U.S. person from the accumulation of income in such a trust. Experienced advisors and trustees can avoid these onerous rules by carefully structuring and administering the trust.
Choice of Trustee
Regardless of the specific type of trust a non-resident selects, it's important to pay special attention to the choice of trustee, in order to maximize the value. While family involvement may be appropriate, there are many advantages to having a corporate trustee or co-trustee of long-term trusts. Besides avoiding the problems of mortality, a corporate trustee can provide the objectivity, experience and empathy that are keys to a successful partnership with the family over future generations.
Where a non-U.S. trust is determined to be the best vehicle, it will add great value down the road if the corporate trustee is a “global" trustee, has experience with U.S. and non-U.S. trusts, and capabilities in both foreign and domestic jurisdictions. This can greatly assist in a seamless transition should there be a need to domesticate trusts into the U.S. for U.S. beneficiaries. Such trustees will also have a firm understanding of the rules applicable to U.S. beneficiaries of non-U.S. trusts.
Other Issues to Consider
Treaties. Treaties between U.S. and other countries can affect treatment of gifts and inheritances. These may be more favorable or less favorable than the default standards discussed in this paper.
Exchange Controls. Many countries have currency control laws and limitations on how much money can be transferred to other jurisdictions. This may favor a multiyear transfer process, such as transferring maximum allowable amounts annually.
Forced Heirship. Forced heirship and clawback provisions, while virtually unknown in the context of American and English estate and gift law, play a major role in planning for wealth transfers in most European and Latin American countries. Forced heirship laws mandate that a significant portion — often as high as 50% — of a deceased person's estate be divided equally among his surviving children. Parents who think they can circumvent these requirements by giving away assets prior to their deaths may be stymied by the “clawback" rules for gifts made during their lives. The length of the lookback period varies significantly between countries. It may be as little as a couple of years or as long as 10 or more years.
Forced heirship and clawback laws, long entrenched in countries following the Napoleonic code, are intended to promote “family solidarity." However, they are little understood in the United States and even in England, and may have unexpected and unpleasant consequences for multinational families. Forced heirship laws are not recognized by many offshore jurisdictions, such as the Cayman Islands, and attacks brought by heirs in the courts of these jurisdictions will likely fail.
Next: Reporting Requirements
As part of sweeping anti-money laundering, anti-terrorism and tax collection efforts, oversight and scrutiny of foreign assets is growing exponentially on both a national and global basis. This is leading to increasingly strict reporting requirements, particularly for U.S. citizens and residents who have bank accounts, trusts or other funds outside of the United States. In the next part of our series on wealth planning for multinational families, we'll investigate the reporting requirements for U.S. grantors or beneficiaries of foreign trusts.