Estate planning is not an easy process. When considering the issues that need to be addressed and the questions that need to be answered, it is easy to become overwhelmed. Perhaps not surprisingly, this process becomes even more difficult when viewed from an international perspective.
An essential part of estate planning is understanding the taxation of wealth transfers. In the United States, wealth transfer taxes include:
- Gift tax
- Estate tax
- Generation skipping transfer tax
The Internal Revenue Code (“IRC”) treats US citizens and noncitizens differently when taxing the transfer of wealth, regardless of whether the transfer occurs during life or due to death. These differences are often predicated on the residency of the individual(s) involved.
Basic Rules of Transfer Taxes for US Citizens
- Every individual can make annual transfers to any other person tax free as long as the transfer is $14,000 or less (2014 limit, indexed for inflation).
- Every married individual can make unlimited transfers to their spouse (during life or at death).
- Spouses may elect to treat gifts to third parties as being split between them, thus increasing their ability to make annual transfers.
- Every individual is allowed a one time estate/gift tax exemption of $5,340,000 (2014 limit, indexed for inflation).
All of these general rules have twists that apply when you are dealing with resident and non-resident noncitizens. The following is an overview of these differences.
Residency – Citizen versus Noncitizen
When it comes to residency, the important thing to remember is:
- A citizen’s residency is irrelevant, and
- A noncitizen’s residency is vital for transfer tax purposes.
To be considered a noncitizen resident, one must not only be physically present in the US, but must also intend to remain in the US indefinitely. This is referred to as establishing domicile. The IRC typically determines domicile based on a series of facts and circumstances (i.e., owning or renting a home, location of cherished personal possessions, location of family and friends, etc.). If domicile is not established, the noncitizen is treated as a nonresident alien (“NRA”).
Lifetime gifting is a useful estate planning strategy, however, caution should be exercised by NRAs and individuals with noncitizen spouses.
The good news for NRAs is they are only subject to gift tax on gifts of tangible personal property located in the United States. The bad news is, they are not eligible to claim the $5,340,000 lifetime estate/gift tax exemption or apply gift splitting techniques often utilized by US citizens and resident noncitizens.
Additionally, one of the more generous provisions regarding gifting is the unlimited exclusion for gifts to a spouse during one’s lifetime. This exclusion is not available if the recipient is a noncitizen (regardless of residency). Due to this limitation, the purchase or sale of a married couple’s jointly owned property can often come with unintended gift tax consequences when one or both spouses are noncitizens. In place of the unlimited marital exclusion, gifts to noncitizen spouses qualify for a $143,000 enhanced annual exclusion (as opposed to the standard $14,000 annual exclusion mentioned above).
As a result of the enactment of the American Taxpayer Relief Act of 2012, the concept known as “portability” became permanent. For many individuals, this drastically simplified estate planning. Coupled with the unlimited marital deduction, the ability to transfer any unused portion of a deceased spouse’s $5,340,000 lifetime estate/gift tax exemption to a surviving spouse allows for increased flexibility regarding how assets are allocated in an estate plan.
Not only are NRAs unable to take advantage of portability or the unlimited marital deduction, but their lifetime estate tax exemption is limited to $60,000. In fact, an estate can only utilize the unlimited marital deduction if the surviving spouse is a citizen (regardless of residency).
An estate planning technique often put to use with noncitizen spouses is a Qualified Domestic Trust (“QDOT”). If property left to a surviving spouse would qualify for the unlimited marital deduction but for the surviving spouse’s lack of citizenship, it can be placed into a special
trust designed to provide a modified version of the marital deduction. While a QDOT will not eliminate the estate tax, it does provide a way to defer the estate tax due at the death of the first spouse until a later date.
When it comes to transfer taxes, the easiest way for noncitizens to reduce future tax liabilities is to become a citizen. If citizenship is not desired or attainable, ensuring US residency can help mitigate the tax bite due to the higher exemption level. This, of course, must be weighted against the consequences of subjecting all worldwide assets to US taxation.
In addition, equalizing the estates of each spouse can be a way to ensure estate tax exemptions are available without the necessity of the portability provisions. This can be done through retitling of property, however caution must be exercised with noncitizen spouses due to the gifting rules.
Finally, life insurance can also be an estate planning tool, especially for noncitizens. At the very least, life insurance provides liquidity for a surviving spouse or relative to deal with the various expenses incurred when someone passes away, including taxes.
As noted above, the intricacies of estate planning become increasingly complex as the limitations associated with noncitizens and nonresidents are introduced. Effective planning can go a long way in ensuring one’s heirs are provided for in the best possible way.