As international tax attorneys, one of the main areas of practice our firm handles involves foreign inheritances that are left by individuals who are Legal Permanent Residents. Millions of Legal Permanent Residents pass away each year and unfortunately due to all the misinformation online, oftentimes the heirs and beneficiaries of Legal Permanent Residents are confused as to how both foreign and domestic assets of the legal permanent resident will be taxed.Golding & Golding – International Business Tax Lawyers
The following is a primer on foreign and international estate planning/inheritances for property within the United States and outside of the United States.
- 1 Gift & Estate Tax
- 2 International Property
- 3 Legal Permanent Resident/United States Resident
- 4 Foreign/Overseas Property
- 5 U.S. Property
- 6 Non-Resident & U.S. Estate Tax
- 7 Avoiding U.S. Estate Tax
- 8 Include a Child, Parent or Relative on Title
- 9 Analyze the Estate Tax Treaties
- 10 Foreign Corporation Ownership
- 11 Purchase Life Insurance
- 12 Form a Trust
- 13 Golding & Golding, A PLC
Gift & Estate Tax
Gift and estate tax can be a complex area of law, but due to recent changes in the law over the last 3 to 7 years, gift and estate tax has become somewhat less of the interceding issue for individuals inheriting property.
Generally, the amount of gift and estate tax will first be determined by the status of the individual who passed. It is important to remember that it is estate tax and not inheritance tax; in other words, it is the actual estate (if at all) that is being taxed.
A US citizen and Legal Permanent Residents have many of the same rights and responsibilities when it comes to gift and estate tax (except for the unlimited marital deduction which can only be enjoyed when the recipient is a US citizen).
- Gift and Estate Tax Exemption: when a person is either a US citizen or legal permanent resident they are entitled to a $5.43 million gift and estate tax exemption. That means that if a legal permanent resident was to die – irrespective of where the legal permanent resident resided – the first $5.43 million of the estate is left tax-free to the beneficiaries/heirs. The $5.43 million will be reduced by any gifts that were made during the season’s lifetime that exceeded the annual gift exclusion for the year at issue (this is not normally a big factor, but here’s an example):
- David is a legal permanent resident who passed away in 2015. During his lifetime David had gifted a total of $1 million (above the annual exclusion amount per each year he made a gift) to various friends. As such, David’s estate worth $4 million would still be distributed tax-free. That is because $1 million plus $4 million (it can get more complicated with claw-back provisions but in this scenario, David should still be fine) is $5 million which is below the $5.43 million exemption.
- Unlimited Marital Deduction: A spouse can leave an unlimited amount of money and assets to their spouse as long as the recipient spouse is a US citizen. Thus, if the person who passes away is a US citizen or non-US citizen, as long as the surviving spouse is a citizen when he or she would receive the full estate with no tax liability. This is not apply to estates left children.
When it comes to international property the loss can get a little more confusing.
Legal Permanent Resident/United States Resident
A legal permanent residents or US resident is entitled to the $5.43 million exemption for their estate. Therefore, if David has $3 million worth of US assets and $2 million with the foreign assets as far as the United States is concerned David will not be taxed in his estate, because the estate is below $5.43 million exemption.
What is very important to keep in mind is that this only involves US law. For example, let’s say David has $1 million worth of assets in a foreign country that taxes estates. Therefore, David is taxed 20% in the particular country in which the assets are located. Unfortunately for David, the United States (unless there is an estate tax treaty with the particular country issue) can do nothing to save David from the foreign estate tax.
While there is usually a foreign tax credit in foreign countries in which a US taxpayer has to pay income tax or investment taxes on passive income or long-term/short-term capital gain, it generally doesn’t apply to estate tax. That is because the United States is not tax estates less than $5.43 million.
As such, David may end up paying $200,000 on his $1 million with assets in a foreign country due to the fact that a particular foreign country issue has its own estate tax. This will not impact David in the United States but it is important that his beneficiaries are where of the tax responsibilities in these particular country where David has assets.
*This is also why it is very important to be sure that you contact an experienced international tax attorney before distributing any assets from an inheritance, especially when their asses located in several different countries.
As indicated above, when a person is a Legal Permanent Resident they are entitled to the full $5.43 million on the full value of the state. Thus, in David situation he will not be taxed in the US for estate tax but the same time the United States will not provide any credit for state taxes paid in a foreign country.
**United States has estate tax treaties with less than 20 different countries, but for the country that issue there could be tax credits and exclusions for the state with respect to the foreign estate taxes paid.
Therefore, it is important to:
- Conduct research as to the specific countries at issue where the decedent held property;
- Determine the amount of property in that particular jurisdiction;
- Research whether there is an estate tax treaty that jurisdiction,
- Evaluate the estate tax treaty limits or excludes estate tax for permanent residents of the United States (even if they reside in a different country)
Non-Resident & U.S. Estate Tax
The inheritance and estate tax laws are wildly different from non-permanent residents. For a nonpermanent resident, the estate tax exemption is only $60,000. That’s right, while a permanent resident and/or resident of the United States is entitled to a $5.43 million exemption, a nonresident is only entitled to $60,000 exemption.
Here is an example:
- David owns a piece of property in the United States worth $1 million. Under most circumstances, if David is a Legal Permanent Resident of the United States, then it does not matter which country David resides in, he still gets the $5.43 million exemption so that the tax liability on the US property zero, as long as his overall estate value is less than $5.43 million.
- David’s brother, Scott is a Japanese citizen who is not a legal permanent resident of the United States. He owns a piece of property that sits next to David’s property, which is also worth $1 million. Since Scott is a non-US citizen/nonpermanent resident, Scott’s exemption amount is only $60,000. It is important to keep in mind that since Scott is a non-US citizen and non-US legal permanent resident he is not subject to US estate tax except for his US situs (which generally involves property).
- As a result, Scott’s U.S. estate will be subject to gift and estate tax on any amount over $60,000. Therefore, unless Scott properly planned, his US property would be taxed at the gift and estate tax rate of 40% to the value that exceeds $60,000. In other words, Scott the estate would pay 40% of $940,000 which comes out to $376,000.
As you can see, the difference in the estate tax is staggering and nothing else should at least nudge you, your parents, relatives or friends with US property to ensure that they are properly plan their estate to avoid this completely unfair and irrational outcome.
Avoiding U.S. Estate Tax
There are various planning strategies that should be taken into consideration in determining what a foreign investor can do in order to try and avoid this unjust result.
The following are a few examples of planning techniques:
Include a Child, Parent or Relative on Title
It is common for wealthy foreign persons who have children to send their children to the United States for education. In many foreign countries the competition is so tough and the opportunities are so limited for success that if a foreign investor has children and wants to provide their child with the best opportunity to obtain an education, they may send them to the United States.
Once the child is in the United States and qualifies as a US resident in the child’s will also qualify for the increased gift and estate tax exemption. Thus, when that child passes away in the future, then he or she is entitled to $5.43 million gift and estate tax exemption (the gift and estate tax exemption can be modified at any time).
Therefore, if the foreign investor has significant real estate assets or accounts in the United States, the investor should consider placing the child or children on the title. By doing so, when the children pass, each child will have the $5.43 million gift and estate tax exemption which will effectively help to significantly reduce gift and estate taxes.
Analyze the Estate Tax Treaties
The United States has entered into certain estate tax treaties with various other countries. While there are significantly more income tax treaties between the United States and foreign countries (to avoid double taxation of earned income and FDAP), there are also certain estate tax treaties with different countries as well.
You should review the different estate tax treaties which can be found on the IRS website to determine whether the United States has entered into an estate tax treaty with your country. If so, then the harsh realities of estate tax for foreign investors in the United States might be minimized. That is because in accordance with these estate tax treaties certain foreign persons will have the opportunity to enjoy the full gift and estate tax exemption as if they were a US citizen or legal permanent resident.
Foreign Corporation Ownership
Another method used by foreign investors for ownership of real estate (when an investor does not wish to place their U.S. children on title or do not have that as an option) is to form a foreign corporation and then have the foreign corporation own the real estate. Instead of the foreign investor owning the real estate directly, the foreign corporation will own the real estate and the foreign investor will own shares in the foreign corporation.
Under this scenario, the foreign corporation would generally not get hit with any estate tax sine the foreign corporation is not an individual. Of course, with anything there are some downsides to using the strategy. The main downside is that income earned by the sale of the property will be hit with the corporate tax rate of 35% but can be higher depending on net investment tax and other related passive activities. This is in contradiction to an individual who is taxed at short-term and long-term capital gains rates — which tend to be significantly less than corporate tax rates.
One issue to consider is that if a foreign corporation owns the property directly then it may be subject to branch tax. In order to avoid the branch tax, the foreign corporation might decide not to hold the property directly but instead had a US corporation, which is then own by foreign corporation and have the US Corporation own the property. While this may result in higher income tax, the US Corporation would generally be able to take many of the same deductions that a direct order probably would have such as mortgage, depreciation, interest, repairs and management fees.
Therefore, the foreign investor has to take some time to determine whether they want to try and focus on current ownership issues with the idea of selling the property before they reach old age (with additional planning for unpleasant consequences of an early death) or focus on current ownership and reduce income/capital gains tax if the goal of the foreign investor to sell the property before it would become a part of their estate for estate tax purposes.
Purchase Life Insurance
Depending on the age and health of the foreign investor, one common method of the foreign investor to avoid heavy estate tax for his or her beneficiaries is to purchase a life insurance policy. There are various different types of life insurance policies, with the goal being the use of the life insurance funds in order to pay the gift and estate tax that is due.
For example, if a $5M life insurance policy costs the foreign investor (or his ILIT) $20,000 a year, and the foreign investor has $10 million worth of US property, then if the foreign investor lived for 10 more years, the cost of the policy would be $200,000. But, the payout of $5 million would cover the $3.9 Million – $4 Million worth of estate tax that would be due on the value of the property. Therefore, the beneficiaries of the estate would essentially received the state with no state tax due beyond the $4 million – which would be covered entirely from the path of the life insurance policy – with some additional money to spare.
Form a Trust
Depending on the value of the property and the intent of the foreign investor, another method the foreign investor can use is to form a trust. There are many different types of trust, but usually an irrevocable trust will ensure that the properties removed from for investors estate and therefore not subject to estate tax.
Of course, this will cause other issues such as ownership and the ability to modify the trust in the future (although structured properly normally trustor/grantor can exchange the property and not cause penalties as would if an irrevocable trust’s terms are violated.
Before a foreign investor purchases US real estate, the investor should speak with an experienced international tax attorney to evaluate and analyze the different options and assess whether the key planning considerations should be while the person is alive or after the person the passed. It should be further noted that these two concepts are not mutually exclusive one another and should be considered together to achieve the most cost-effective strategy for the Foreign Investor to enjoy the property during life – but plan for death and unforeseen consequences.
Golding & Golding, A PLC
We have successfully represented clients in more than 1000 streamlined and voluntary disclosure submissions nationwide, and in over 70-different countries.
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