International Estate Planning Pt. 3
It is becoming more common for Americans who are not otherwise considered wealthy to own assets outside of the US, and conversely, for foreigners to own assets in the US. Will the US get to tax these assets, and if so, how?
This is the third in a series of blogs about the tax aspects of international estate tax planning.
How does income taxation fit in?
Although these writings are about estate taxes, you can’t discuss that without at least mention of income taxes, so I’m going to slip in a quick refresher right now.
For US taxpayers, the tax base and income tax concepts are simple. You are taxed on worldwide income – everything, no matter what country, source, category, or type the income comes from.
The tax base for non-US taxpayers is more complex. You are generally taxed on three types of income categories. First, there is a concept called effectively connected income, abbreviated as ECI. That is income effectively connected with a US trade or business. If you come from a treaty country, the buzz word that is used in treaties is whether you have a US permanent establishment.
What exactly is a trade of business is a factual question. There are all kinds of litigation on the issue and it depends on facts and circumstances. There’s really no bright line test as to what is a “trade or business”. Obviously if you’re selling and servicing thousands and thousands of widgets, it’s a business, but when it comes to something less involved and more passive, it can be dicey in terms of whether, or not, it’s considered a trade or business. ECI is taxed on a net income basis at graduated tax rates.
Category two are special rules for real estate. These rules are under a law called FIRPTA – foreign investment in real property tax act of 1980. Under FIRPTA, gain or loss from the disposition of a US real property interest [which by the way is specifically defined] by a non-US person is taxed as if it were a US trade or business. In other words, that gain or loss would be ECI. To enforce this, those buying from non-US sellers generally must set aside 15% of the purchase price and pay it as a withholding tax to the IRS. Perhaps you have all signed forms in real estate transactions certifying that you are a US person, to avoid this withholding requirement.
Category three would be, if the non-US person isn’t subject to the ECI regime or the FIRPTA regime, they might be subject to the FDAP regime. FDAP stands for fixed, determinable, annual, or periodic. This would include income from interest, dividends, rents, royalties, and other types of fixed income that aren’t necessarily tied to a trade or business activity. Foreign persons are generally subject to 30% tax on US source income received. Payers are charged with the job of enforcing this, and withholding the 30%, or lesser amount if a tax treaty says so, from payments they would otherwise pay the owner, and turning it over instead to the IRS.
What are some planning ideas to either reduce or defer the US estate tax?
One way for you, as a non-US domiciliary, to reduce your exposure to US estate taxes would be for you to encumber your US property with debt, which can reduce the value includible in your estate. However, you should be aware, that US debt other than non-recourse debt, does not work well to reduce your US taxable estate. That is because, debt other than non-recourse debt, is prorated among all the worldwide assets of a non-domiciliary decedent.
US bank accounts and CDs may be held by non-US domicillaries or non-residents and these investments will not be subject to US estate taxes or US income taxes unless they are effectively connected with a US trade or business. Form W-8BEN must be filed with the institutions holding these investments in order to declare the owner’s non-taxable status. If Form W-8BEN is not filed, the interest on these accounts will be subject to withholding tax.
Life insurance is widely recommended to fund estate tax payment requirements where there will be exposure to the US estate tax. In some situations, it works well to have life insurance policies on husband and wife with payment to be made at the death of the second to die. This can minimize premium costs and provide liquidity at the appropriate time, particularly when a “qualified domestic trust” is used to defer estate taxes until second death.
A “qualified domestic trust” is a planning tool for situations involving a non-US citizen spouse. It allows for a marital deduction which is otherwise not allowed, but there would be taxation if and when the trust principal is distributed, or on the second death as to the remaining corpus. A QDOT can be created at any time before the estate tax return [Form 706-NA] is filed.
Structuring Real Estate Holdings to Avoid Estate/Gift Taxes
Before you think about strategies for holding or titling real estate, it is important to understand that all gains on sale or dispositions of US real property interests are subject to income tax. The income tax consequences are unavoidable, regardless of the asset holding structure. However, proper planning and structuring can avoid the imposition of US estate and gift taxes on these assets.
In this regard, structuring the ownership of US real estate by a US subsidiary of a foreign corporation has advantages:
- It protects the beneficial owner against US estate & gift taxes
- It protects against the branch profits tax;
- It eliminates US withholding tax on a subsequent sale of the property;
So again, if the focus is on saving US estate and gift taxes, you should buy US real property using a US corporation, and the US corporation should in turn be owned by your foreign corporation. Shares of a foreign corporation are intangible property for gift tax, and are not US situs property for estate tax, so holding US real property by a US subsidiary of a foreign corporation protects against both US gift and estate taxes.
A foreign individual would not be protected if the US real property interests were held individually, as there would be both gift & estate tax exposure. Nor would there be protection if the property is held by a US corporation, which is owned directly by the foreign person, as there would be estate tax exposure. You need to have the intervening foreign corporation, which is classified as intangible and non-US situs property in the hands of the non-US domiciliary beneficial owner.
Ownership of US real estate by a US subsidiary of a foreign corporation also protects the ultimate beneficial owner against something called the branch profits tax. The branch profits tax would apply if ownership of the actual US real estate is in the name of the foreign corporation. This is because the US real estate is considered to be a branch operation of the foreign corporation, so this branch operation would be subject to tax, i.e., the branch profits tax.
Of course, if there wasn’t a branch, but instead, there was a US subsidiary corporation holding the real estate, the US corporation would be taxed, so the BPT is fair. It’s just that the branch profits tax is complex and difficult to plan with.
From a structuring point of view, generally, a separate US corporation should hold each separate US real property interest, to allow for maximum flexibility if the property gets sold.
Another advantage of holding US property by a US subsidiary of a foreign corporation is that this structure is exempt from withholding taxes on sales of real estate. Non-resident owners of US real estate are subject to a 15% withholding tax, but if the real estate is owned by a US corporation, it is not a non-resident, so withholding taxes are N.A.
For questions, please connect with Daniel Won at [email protected]