In Part 1 of our article, which appeared in the November 2019 issue of Trusts & Estates, we began our discussion of the U.S. inheritance tax under Internal Revenue Code Section 2801, which can follow U.S. expatriates for many years after they leave the United States. Our article included some tips on how to plan for this dreaded tax. We’ll now offer some other strategies for helping clients, who have or are contemplating expatriation, avoid the tax.
Transfers Subject to Tax
Before advisors can follow our suggestions, they must have a thorough understanding of which transfers are subject to the inheritance tax and which aren’t.
Transfers subject to tax. The most important term in IRC Section 2801 is “covered gift or bequest.” This term includes: (1) any property acquired by gift directly or indirectly from an individual who, at the time of such acquisition, is a covered expatriate; (2) any property acquired directly or indirectly by reason of the death of an individual who, immediately before such death, was a covered expatriate;1 and (3) distributions from a foreign trust that isn’t an electing foreign trust.2
It isn’t relevant where the transferred property is located (that is, the situs of the property isn’t relevant for purposes of Section 2801, subject to an exception discussed below). Remarkably, it’s not even relevant whether the property was acquired by the covered expatriate long after expatriation from the United States.3 Finally, it isn’t relevant that the recipient may not have been born when the covered expatriate officially expatriated from the United States or lived in a foreign country at the time of such expatriation.
A “covered bequest” includes property transferred by bequest, devise, trust provision, beneficiary designation or similar arrangement. The proposed regulations (proposed regs) issued under Section 2801 provide that a “covered bequest” also includes any property that would have been includible in the gross estate of the covered expatriate under the U.S. estate tax if the covered expatriate had been a U.S. citizen or domiciliary at the time of death.4 This means that transfers made, for example, to a foreign trust over which the covered expatriate as settlor retains certain proscribed powers under IRC Sections 2036-2038 or 2041, could be considered a “covered bequest” subject to Section 2801.5
The proposed regs also confirm that the exercise, release or lapse of a covered expatriate’s general power of appointment for the benefit of a U.S. citizen or resident is a covered gift or covered bequest.6
Transfers not subject to tax. Although not explicitly stated in the statute, a “covered gift or bequest” can’t include fair market value (FMV) transactions because such transactions are neither gifts or transfers by reason of death. Although in connection with a contemplated sale to an intentionally defective grantor trust in exchange for note transaction, the seed gift made by a covered expatriate to an irrevocable trust that’s a foreign grantor trust (because the only permissible beneficiaries of trust income and principal during the life of the settlor are the settlor and her spouse) in preparation for a subsequent sale for promissory note transaction is a “covered gift,” the subsequent sale for FMV in exchange for a promissory note shouldn’t be a transfer subject to the inheritance tax. If the asset to be sold is an illiquid non-traded asset, it’s necessary to obtain a valuation by a qualified U.S. appraiser. Use of an independent trustee is recommended, and the terms of the sale transaction and note should be commercially reasonable.
The inheritance tax doesn’t apply to annual exclusion gifts. Interestingly, Section 2801(c) doesn’t require the gift to meet the requirements of an annual exclusion gift. The language in the statute merely says the inheritance tax is imposed only to the extent the value of a covered gift or bequest exceeds the gift tax annual exclusion amount specified in IRC Section 2503(b). If a covered expatriate made a gift of $30,000 (two times the current gift tax annual exclusion amount) to an irrevocable domestic trust that doesn’t contain a Crummey withdrawal power, there will be an inheritance tax on $15,000. In contrast, if the same covered expatriate gave $30,000 to a foreign trust, there’s no inheritance tax on such gift because a foreign trust isn’t a U.S. recipient. If the trustee of such foreign trust subsequently distributes $15,000 to each of two different U.S. citizen trust beneficiaries, there’s no inheritance tax due because each of the U.S. recipients would be entitled to a Section 2801(c) annual exclusion.7
Among the most important exceptions under Section 2801 is for transfers otherwise subject to U.S. gift or estate tax.8 This means that if a covered expatriate who’s permanently left the United States for a foreign country makes a transfer of U.S. situs property (for example, U.S. real estate), either for gift or estate tax purposes, such transfer is outside the scope of Section 2801 provided it’s properly reported to the Internal Revenue Service.9
Also, if a lifetime or testamentary transfer by a U.S. domiciliary donor or decedent would qualify for a charitable or marital deduction under the relevant U.S. transfer tax statute, the transfer isn’t a “covered gift or bequest.”10 The proposed regs confirm that a bequest to a qualified domestic trust (QDOT) for which a QDOT election is made will qualify for this exception.11 There’s no such thing as an inter vivos QDOT, so this exception is unavailable to mitigate either the gift tax or inheritance tax for gifts to a non-U.S. citizen spouse.
Finally, transfers made before the expatriation date wouldn’t be covered gifts or bequests because the Green Card holder isn’t yet a covered expatriate. Long-term Green Card status terminates when an individual loses it through revocation by the U.S. Citizen and Immigration Services (CIS) (or by administrative or judicial determination), as well as when an individual is treated as a resident of a foreign country having a treaty with the United States, doesn’t waive treaty benefits and notifies the IRS of such treatment.12 Once an individual who holds U.S. permanent resident status (that is, a Green Card holder) establishes a domicile abroad and no longer has any intention of returning to live in the United States, the U.S. CIS takes the position that such individual has abandoned his permanent resident status, even though the Green Card is unexpired, and it would be unlawful for such individual to use his Green Card to re-enter the United States.13 The U.S. CIS expects such an individual to complete a formal abandonment process (that is, file Form I-407) and relinquish the Green Card either to a U.S. embassy in the foreign country or to the U.S. CIS. Abandonment of the Green Card would then require the individual to obtain a U.S. visa to enter the United States for business trips or for personal travel.14 To terminate lawful permanent status, one of three actions must occur: (1) the U.S. government formally revokes the Green Card; (2) the Green Card holder formally abandons the Green Card (that is, files Form i-407); or (3) the Green Card holder converts to nonresident status for income tax purposes in the United States by virtue of an income tax treaty under IRC Section 7701(b)(6).
Funding a Pre-Expatriation Trust
For a host of reasons, the expatriating individual may not want to make outright gifts of assets to reduce his net worth below $2 million (an expatriating long-term Green Card holder isn’t a covered expatriate if he has a net worth below $2 million as of the date of expatriation). As an alternative, a long-term Green Card holder could create and fund an irrevocable self-settled non-grantor U.S. domestic discretionary trust for his own benefit and that of his spouse and descendants.
Still living in the United States. There are a number of technical requirements and considerations in structuring the terms of a pre-expatriation trust for an individual who’s still living in the United States and is a U.S. domiciliary for transfer tax purposes.
First, the trust must be settled under the state laws of any number of U.S. jurisdictions that have adopted an asset protection statute that permits self-settled discretionary trusts. The asset protection jurisdictions, such as Alaska, Delaware, New Hampshire, Nevada, South Dakota and Wyoming, provide an advantage because the trust assets wouldn’t be included in the estate of the settlor for U.S. estate tax purposes. The U.S. tax advisor wants confirmation that by making a gift to an asset protection trust settled in an asset protection jurisdiction, the Green Card holder contemplating expatriation makes a completed gift, and the trust assets won’t be included in the expatriate’s gross estate.15
Even if the trust is settled in an asset protection jurisdiction, the IRS will likely attempt to value and include the settlor’s retained “beneficial interest” in the trust. In valuing a beneficial interest, the IRS uses a facts-and-circumstances test, looking at not only the terms of the trust agreement but also letters of wishes, historical patterns of trust distributions and the powers of a trust protector. Notice 97-19 provided guidance on the application of IRC Section 877 to determine expatriation status under the prior exit tax regime; however, the current exit tax regime retains the same net worth, income tax and prior compliance tests as was found in prior Section 877(a)(2). The drafter of the expatriation trust should include the settlor as only one member of a class of permissible trust beneficiaries, along with the spouse and descendants. Despite such terms, the U.S. tax advisor and trustee should advise the settlor-expatriate well before the trust is established and funded that the optimal situation is for there to be no history of trust distributions to the settlor and spouse. Perhaps the best approach is for the trust to provide that approval by adverse parties (for example, the adult children of the settlor) is required before a distribution can be made to the settlor and spouse, as this strengthens the non-inclusion argument.
If a beneficial interest can’t be allocated to the settlor under the facts-and-circumstances test, the IRS will allocate the interest based on the intestate succession rules in the Uniform Probate Code (UPC), with the settlor as the party assumed to have died. If the settlor intends to expatriate, the rules of intestate succession would allocate zero to the settlor of the expatriation trust. The spouse would have a beneficial interest, and the draftsperson should consult with UPC Sections 2-102 and 102A.
Second, the trust must be classified as a non-grantor trust for federal income tax purposes under IRC Sections 671-679. The IRS takes the position on Form 8854 and its instructions that the entire value of a grantor trust is includible for purposes of the net worth test. To prevent grantor trust status, the terms of the expatriation trust must provide that no income or principal can be distributable to the settlor without the consent of an adverse party.16 Approval must come from the adult children who are adverse parties to the settlor (and not from the spouse, who isn’t adverse).17
Moreover, the pre-expatriation trust must not be a grantor trust under Section 679. Accordingly, the trust shouldn’t be a foreign trust for federal income tax purposes. (A foreign trust is considered a grantor trust under Section 679(a)(1) if such foreign trust is established by a “U.S. person” and a “U.S. person” is one or more of the beneficiaries. A “U.S. person” in this context is a domestic corporation or a citizen or resident of the United States. This would be the case if the settlor is a permissible or discretionary beneficiary.) To further inoculate the trust from being considered a foreign trust for federal tax purposes, the U.S. tax advisor must make sure that the trustees, as well as the persons with power to remove a trustee (for example, a trust protector) and the adverse parties who’ll control distributions from the trust, are at all times “U.S. persons.” Thus, “U.S. persons” must hold all relevant powers under the expatriation trust. (“Residency” for these purposes is the definition for income tax purposes, so a child living abroad with a Green Card could be a permissible adverse party.)
Third, if the individual Green Card holder is living in the United States with no current plan to move abroad or to his country of origin, the trust settlor will be considered a U.S. resident (domiciliary) when funding the expatriation trust. The settlor in this situation would only owe U.S. gift tax on the value of the transfer to the trust in excess of $11.58 million (2020). Given the large exemption amount, it’s possible for the executive-settlor to make a completed gift to the trust of significant asset value so that following funding of the trust, such individual falls below the $2 million net worth threshold.
There’s a complicated multi-year strategy available in which the amount needed to fall below the $2 million net worth threshold exceeds the settlor-expatriate’s remaining gift tax exemption amount. To accomplish the twin goals of gift tax avoidance on gifts over the available exemption amount and excluding assets from the net worth test, such a gift to the expatriation trust must be incomplete.18
Living abroad. An unusual feature of the expatriation rules is that the exit tax and inheritance tax are triggered for a long-term resident Green Card holder only if the individual voluntarily or involuntarily terminates Green Card status or elects treaty benefits and discloses such position on his U.S. income tax return. These taxes aren’t triggered for an individual who retains his Green Card and becomes a non-resident of the United States for transfer tax purposes. This could occur when a long-term Green Card holder changes his domicile from the United States to a foreign country and is prepared to continue to pay U.S. income tax on his worldwide income while simultaneously paying income tax in such foreign country.
Most advisors recognize that when a long-term Green Card holder files a Form I-407 with the U.S. CIS, this is an act of voluntarily abandoning his Green Card, and if the individual is a covered expatriate at the time of such filing, this triggers the exit tax and potentially subjects the U.S. heirs of such individual to inheritance tax until his assets are fully distributed.
In addition, loss of lawful permanent resident status in the United States can occur when three conditions are met: (1) the individual begins to be treated as a resident of a foreign country under the provisions of an income tax treaty between the United States and the foreign country; (2) the individual doesn’t waive the benefits of such treaty applicable to residents of the foreign country (that is, the individual benefits in some monetary way from claiming tax treaty relief); and (3) the individual notifies the IRS of the commencement of such treatment as a non-resident of the United States for income tax purposes.19
Most U.S. tax treaties generally provide that if the regular domestic tax law of the foreign country would treat this Green Card holder as a resident, then he’ll be a resident for purposes of the tax treaty. Moreover, the Green Card holder must disclose to the IRS a desire to waive the treaty benefits. Finally, the IRC and Treasury regulations now both require a taxpayer to give notice to the IRS by filing Form 8833.20 If a Green Card holder residing in a foreign country doesn’t give notice claiming treaty relief by filing Form 8833, there’s a penalty, but the taxpayer presumably doesn’t lose the right to claim the treaty benefits, and therefore, the Tax Code has only limited application to such taxpayer.
Death as an Exit Strategy?
A Green Card holder theoretically could leave the United States and live abroad indefinitely without notifying the U.S. CIS or the IRS. While a Green Card is generally valid for 10 years, the Green Card would continue to be valid so long as the U.S. CIS doesn’t revoke it, the Green Card holder doesn’t abandon it and the Green Card holder doesn’t proactively file anything with the IRS claiming nonresident status for income tax purposes pursuant to a bilateral U.S. income tax treaty.21 The IRS considers such an individual a “resident alien,” which means he’s still a U.S. taxpayer for income tax purposes.
Arguably, a Green Card holder living abroad can expatriate and never notify the U.S. government. Perhaps behaving for U.S. tax purposes in a way that’s consistent with the tax treaty may be sufficient to overcome never filing Form 8833. Presumably, such individual will claim that he expatriated years ago, before the current expatriation rules were enacted pursuant to the Heroes Earnings Assistance and Relief Tax Act of 2008 (2008 Tax Act), enacting IRC Section 877A. Such individual is relying on the premise that the U.S. government will treat him as a lawful permanent resident until he actually files paperwork claiming non-resident status in the United States.
The risks of detection by the U.S. government are extraordinarily high for a Green Card holder living abroad who intends to adopt a do nothing strategy (that is, never contacting the U.S. government) for the balance of his life about his Green Card status. Such individual would need to be very careful not to trigger the attention of the U.S. government, which includes the U.S. CIS and IRS. The Foreign Account Tax Compliance Act (FATCA), travel to the United States or investment in U.S. assets are all problematic for an individual adopting a do nothing strategy. What if the individual has U.S. heirs? Under the inheritance tax, the burden is on the U.S. heirs to prove that their relative wasn’t a covered expatriate when he gave up Green Card status. Moreover, every year such Green Card holder adopts a do nothing approach to expatriation from the United States and fails to file U.S. income tax returns (which are required of a Green Card holder with legal permanent resident status until terminated) will create perhaps decades of non-filing of U.S. tax returns and non-payment of U.S. income tax, with potentially enormous penalties. In addition, such individual will run afoul of FATCA and the electronic Report of Foreign Banks and Financial Accounts (FBAR) filing requirements, which may present practical problems with respect to his foreign bank accounts.
At some point, the U.S. government will upgrade its overall internal data capabilities, and the IRS and U.S. CIS will eventually share databases and begin cross-checking Green Card holders against income tax returns filed to locate Green Card holders not living in the United States. Once it discovers those individuals, the U.S. CIS will revoke their Green Cards, and covered expatriate status will be thrust on such individuals adopting a do nothing, lay low strategy.
Avoiding Covered Expatriate
A do nothing, lay low strategy while living abroad presumably isn’t viable. However, a compliant Green Card holder can legally move from the United States to a foreign country, change his domicile (assuming the facts and circumstances support such position) and yet remain a U.S. permanent legal resident (Green Card holder) subject to U.S. income tax on worldwide income. This may be viable for an individual moving to a high tax jurisdiction with little U.S. source income. There’s nothing in the Tax Code that provides that a Green Card holder who successfully argues a change of domicile from the United States to a foreign country will be classified as a covered expatriate for both exit tax and inheritance tax purposes. Not only can an individual change his domicile from the United States to a foreign country without any U.S. tax consequences, but also there’s no duty imposed on such individual to notify the IRS of his change of domicile.22
A potentially significant U.S. transfer tax advantage in becoming a non-domiciliary of the United States is that gifts of foreign situs property (for example, real estate, intangible or tangible property located outside the United States) as well as gifts of intangible property located anywhere (including stock in U.S. corporations) aren’t subject to U.S. gift tax regardless of their size. It’s highly desirable that the recipient of the gift not be a U.S. tax resident or U.S. citizen; otherwise, the carryover basis in the hands of the recipient following a gift simply shifts the U.S. capital gains tax burden from the donor to the recipient if the recipient won’t hold such asset until his death. One possible strategy to backstop the reporting position of non-domiciliary status for U.S. transfer tax purposes is to create a U.S. bank account with a balance of $15,100. The non-domiciliary would then make a gift to a child or parent of the balance of this U.S. bank account and subsequently file a Form 709 reporting such gift and paying $40 of gift tax. While the statute of limitations is only relevant to the gift and not for inheritance tax purposes, such gift reporting memorializes the taxpayer’s transfer tax status as a non-domiciliary of the United States.
Moreover, foreign counsel should be consulted to determine if the foreign country has a gift tax treaty with the United States that includes a tie-breaker provision. If so and it’s clear such individual is a domiciliary of the foreign country and not the United States, he might consider filing Form 8833 with the IRS concerning any gifts that might be subject to U.S. gift tax under the IRC but that are exempt under the relevant gift tax treaty.
Before a Green Card holder uses the tie-breaker provision of a U.S. income tax treaty claiming he wishes to be treated as a resident of a foreign country for income tax purposes, he must consider the collateral consequences of such action. Will he risk losing the Green Card by acknowledging that he’s a non-resident alien—not a permanent legal resident—of the United States? As a result of the 2008 Tax Act, long-term residency in the United States is now also terminated if an individual elects to be treated as a resident of a foreign country having an income tax treaty with the United States, doesn’t waive treaty benefits and files Form 8833. However, reliance on a U.S. tax treaty tie-breaker provision merely makes such individual a non-resident for income tax purposes but doesn’t avoid FBAR and certain other U.S. tax information return reporting obligations.
For the well-advised Green Card holder approaching his seventh year as a permanent legal U.S. resident with a net worth in excess of $2 million, the best option may be to plan to abandon Green Card status by moving to a foreign country and claiming possible treaty relief in or before the seventh year. Claiming treaty benefits will limit U.S. income tax to U.S. source income and somewhat limit U.S. tax reporting obligations, but perhaps most importantly, it will prevent such individual from becoming a long-term covered expatriate subject to the exit and inheritance taxes. Most Green Card holders moving to South America don’t have this option available because the United States has no income tax treaties with any of these countries.
On the other hand, moderately affluent Green Card holders with a net worth currently above $2 million living in a foreign country may choose to satisfy the 8-of-15-year test (that is, they’ve been permanent legal residents of the United States during eight of the previous 15 years) by retaining their Green Cards indefinitely beyond the seventh year but avoiding the exit and inheritance taxes as of their expatriation date by planning ahead to reduce their net worth below $2 million. The implementation of a gift strategy to avoid covered expatriate status on the expatriation date may be easier to achieve once the Green Card holder has moved to a foreign country and changed his domicile.
Trust Gift Options
Suppose that an executive holding a Green Card resettles decisively in a new country (or returns to his country of origin) with no current intent to move elsewhere. The executive will become a domiciliary of the new country and will cease to be resident of the United States for transfer tax purposes. What gift options in trust are available?
Establishing a pre-expatriation trust while living abroad. Many of the same considerations described above will apply to the would-be settlor living abroad. The settlor should: (1) settle the trust under the laws of a U.S. state that’s adopted a self-settled asset protection statute; (2) establish and fund the trust at least three years before expatriating (to prevent the 3-year reach back under IRC Sections 2035 and 2038); (3) require adverse parties to approve any distribution to the settlor or spouse; (4) ensure the trust won’t be classified as a foreign trust under U.S. federal tax law; and (5) avoid distributions to the settlor and spouse before the expatriation date.
In this situation, the individual’s definitive move to a new country should confirm that he’s no longer a U.S. domiciliary for gift tax purposes. If so, the executive can make completed gifts of intangible assets, including stock in U.S. companies, to the pre-expatriation trust because they’re not U.S. situs assets for gift tax purposes. The longer the period of time between creation/funding of the expatriation trust and the actual date of expatriation, the more difficult it will be for the IRS to claim the individual was still a domiciliary for transfer tax purposes on the date of expatriation.
Before undertaking any gifts, the individual living abroad must consult with local tax counsel in the new country of residency. A key issue before making any gift while resident in a new country is whether such country imposes an inheritance or gift tax on such transfer. If the gift is to be made to a pre-expatriation trust, local counsel in a civil law country must also advise on the viability of using a common law expatriation trust in such civil law country. Many civil law countries no longer recognize a common law trust. In countries such as Germany, a transfer to a trust is assigned to the least favorable transfer tax category, which results in a higher German gift/inheritance tax rate. Further, under Common Reporting Standard requirements, some countries now impose significant disclosure rules on settlors, trustees and beneficiaries who are resident in their countries.
One possible disadvantage of the pre-expatriation trust strategy is that by creating a U.S. domestic trust, to the extent the trust income is accumulated and not distributed currently to non-U.S. beneficiaries, the trust will incur U.S. income tax at compressed tax rates. If an individual has already moved to a low tax jurisdiction and plans to give up his Green Card, there may be some hesitation to incur higher U.S. income taxes without offsetting treaty benefits because the United States generally has no treaties with no or low tax jurisdictions.
Lifelong (or longer) reach of Section 2801. Most pernicious is that the inheritance tax consequences for families of a covered expatriate don’t end until the decedent’s worldwide assets are exhausted, which would typically be on the death of such individual but could be longer if property passes at death to a foreign trust for subsequent distribution to U.S. beneficiaries. Therefore, the burden is on the U.S. recipient of a gift or bequest to determine whether the expatriate was a covered expatriate, and if so, whether the gift or bequest was a “covered gift or bequest.”
Other Planning Possibilities
What are the other possibilities for a long-term Green Card holder who’s living abroad as a covered expatriate? Joseph P. Toce, Jr. of Andersen and his co-author Joseph R. Kluemper share some potential planning opportunities in their still highly relevant article, “Estate Planning for Expatriates Under Chapter 15.”23
They suggest that a covered expatriate should be able to make loans to a U.S. citizen or resident organized as borrower, as well as to a domestic trust or entities owned by U.S. citizens or residents, without triggering the inheritance tax, as long as the loans bear an adequate interest rate (and presumably are represented by an enforceable written promissory note).
Suppose the covered expatriate originally funded a foreign trust during his lifetime and subsequently dies survived by children and grandchildren now living in the United States. Can the foreign trust make loans to the U.S. beneficiaries without triggering the inheritance tax? Under IRC Section 643(i), if a non-U.S. settlor creates a non-grantor offshore trust that then loans cash or marketable securities to a U.S. beneficiary or settlor or to a U.S. relative of the trust settlor, the loan will be treated as a distribution to the person receiving it and will be taxed accordingly, even if the loan is later repaid.
In Notice 97-34, however, the Treasury carved out an exception to this deemed distribution rule. This exception permits a foreign trust to lend money to a U.S. beneficiary without having it treated as a distribution if it’s a “qualified obligation.”24
There’s no legal authority on whether a “qualified obligation” under Section 643(i) will prevent imposition of the inheritance tax on a loan from a foreign trust established by a covered expatriate to a U.S. beneficiary. No one knows whether the principles of Notice 97-34 will extend safe harbor loan treatment under the inheritance tax.
Toce and Kluemper also raise the possibility of using a foreign trust established by a covered expatriate to defer the inheritance tax, as well as provide for income tax savings on non-U.S. source investment or business income of the trust. They warn that careful planning is required to minimize the confiscatory accumulation distribution rules of IRC Sections 665-668.
Because it’s difficult for a foreign trust to qualify as a grantor trust and distributions of undistributed net income (UNI) from a foreign non-grantor trust to a U.S. beneficiary have such negative tax consequences (for example, they’re subject to the accumulation distribution rules), trustees will often look for ways to cleanse accumulated income in a trust. One idea is to distribute the accumulated income to a foreign intermediary (an individual, corporation or another trust), which can then later pay it to the U.S. beneficiary in the guise of current income, principal distribution or a gift.25
If the intermediary can be viewed as an agent of the foreign trust, a distribution will be deemed to take place from the foreign trust to the U.S. beneficiary at the time the intermediary makes the distribution to the U.S. beneficiary. If the intermediary can be viewed as an agent of the U.S. beneficiary, a distribution will be deemed to have been made to the U.S. beneficiary when the foreign trust makes the distribution to the intermediary.
Trustees of foreign trusts often want to make distributions to U.S. beneficiaries out of trusts with substantial UNI. If a foreign trust with UNI makes a distribution to a non-U.S. person or a distinguishable foreign trust distributes all of the trust’s UNI, the original trust becomes “cleansed” and can make a large principal distribution to a U.S. beneficiary in the next calendar year without carrying out accumulated income. The question remains of what to do with the tainted funds if they’re added to a new trust; they can remain with the offshore beneficiaries or trusts or go to charities, but it will be difficult for those funds to find their way to the U.S. beneficiaries without running afoul of the intermediary rules.
Presumably, relying on the same principal agency theory already made applicable to the accumulation distribution rules, the IRS might also eventually extend the same concept to the inheritance tax to prevent its circumvention through the use of related party entities in foreign jurisdictions so as to capture indirect transfers. The proposed regs take an expansive view of a covered gift or covered bequest made through or to a corporation or foreign trust.26
Toce and Kluemper also raise an interesting intergenerational planning idea when a terminally ill but very wealthy grandparent who’s a non-citizen, non-domiciliary (NCND) of the United States has a U.S. child but non-U.S. grandchild. Suppose the U.S. child is already very wealthy. Instead of making transfers to a covered expatriate child, which will create either U.S. estate tax or possible future inheritance tax issues for such child, the grandparent could bypass his U.S. child and make a transfer of non-U.S. situs assets directly to his grandchild (or to an irrevocable foreign trust for the grandchild). Transfers by NCNDs are subject to generation-skipping transfer (GST) tax on direct skips but only to the extent that the transfer is subject to U.S. gift or estate tax. As a result, so long as the grandparent doesn’t own U.S. real estate or tangible property located in the United States at the time of transfer, there can be no GST tax imposed on such a transfer by an NCND grandparent to an NCND grandchild.
Similarly, taking advantage of residency changes by children and grandchildren may be relevant in managing and minimizing the inheritance tax. Suppose a grandchild of a very wealthy Chinese national grandparent who’s a covered expatriate of the United States qualified for a student visa while he attends undergraduate college in the United States. Assume the grandparent, now deceased, was a former long-term Green Card holder who was a covered expatriate on the date of departure from the United States years before the grandchild was born. After college, the grandchild moves back to China for a few years to learn the family business following education in the United States and before moving back to the United States to attend graduate school and to expand the business. While the grandchild is living definitively in China, the trustee of the foreign trust could make very significant distributions from the foreign trust established by the grandfather to such grandchild, which wouldn’t be subject to the inheritance tax due to the residency of the grandchild outside of the United States at the time of his receipt of such distributions. Perhaps the trustee might take advantage of this window of opportunity while the grandchild is residing in China to make a complete distribution of the original trust to the grandchild, knowing that following a move back to the United States by the grandchild, any transfer from the foreign trust to the grandchild would be subject to inheritance tax.
Suppose that while the grandchild is back in China before graduate school in the United States, the foreign trust makes a complete distribution of its assets to the grandchild. A few months after receipt of all the trust assets, the grandchild contributes these assets to a foreign corporation organized in a no-tax jurisdiction. Immediately thereafter, the grandchild contributes the stock of such foreign corporation to a new drop-off trust established by the grandchild in a no-tax common law jurisdiction. While the drop-off trust might be considered a grantor trust as to the grandchild because he’ll become a U.S. resident within five years of funding such trust, arguably principal distributions wouldn’t attract an inheritance tax.
Burden of Proof
The proposed regs27 impose on the recipient of a gift or bequest the burden to determine whether he received a covered gift or bequest. The burden is on the recipient to determine whether the donor or decedent is or was a covered expatriate. As the preamble to the proposed regs acknowledges, this is easier said than done. The proposed regs provide that a recipient of a gift or bequest may submit a request to the IRS, with the consent of the expatriate, to disclose certain return information of the expatriate that may assist the recipient in determining whether the donor or decedent is or was a covered expatriate.
Although the IRS, if authorized, may disclose returns and return information on request, the IRS won’t make determinations of covered expatriate status. This is an extremely intrusive proposal, and it doesn’t solve the threshold issue of the recipient not knowing whether the donor is an expatriate. The proposed regs further provide that if the expatriate donor doesn’t authorize the IRS to release the relevant return information to the recipient, there’s a rebuttable presumption that the expatriate donor is a covered expatriate and that each gift from that expatriate to a U.S. citizen or resident is a covered gift. There’s no guidance in the proposed regs regarding how one rebuts the presumption.
Moreover, what happens if the covered expatriate has died before any distributions from a foreign trust are made to U.S. recipients? Can the executor of the deceased covered expatriate authorize the IRS to disclose confidential tax information about the covered expatriate to his U.S. relatives, some of whom he may have never met?
Reporting
The IRS intends to release Form 708 once the proposed regs are finalized, and those final regulations will provide the due date for filing Form 708 and for the payment of the inheritance tax. Form 3520 only applies to gifts or bequests of $100,000 or more received directly by U.S. citizens or residents from covered expatriates. Most importantly, a U.S. recipient of a distribution of any amount from a foreign trust must also report his receipt of such distribution on Form 3520 and complete Part IV of such form.
Consequences of the Inheritance Tax
Long-term Green Card holders too often think that only the wealthy among them should be concerned about becoming covered expatriates, and this is a mistake. Moderately affluent long-term Green Card holders at the time of expatriation shouldn’t lose sight of the U.S. tax costs to the future beneficiaries of their estates and any long-term trusts they fund. For instance, if the spouses of the children of a covered expatriate are U.S. citizens (or even unborn grandchildren) and the children are U.S. domiciliaries, there might be an unforeseen tax to pay many years in the future.
The current inheritance tax rate is 40% of the gross value of the covered gift or the covered bequest or foreign trust distribution. The U.S. recipient pays this tax. Can the U.S. recipient apply his own lifetime gift tax exemption to the inheritance tax? If so, now would be a good time to accelerate covered gifts from a departed covered expatriate to U.S. heirs because the children could use a significant portion of their current lifetime exemptions of $11.58 million to blunt the inheritance tax. The current inheritance tax rate of 40% of the gross value is much higher than the current 23.8% “mark-to-market” exit tax imposed on only the income or gain inherent in the property and not its full value.
To demonstrate an extreme but real example, suppose an executive and his spouse move to the United States in 2011, and immediately, they each obtain a Green Card. The executive and his spouse abandon U.S. permanent legal residence in 2019 by filing Form I-407 when they have $4 million of cash as their only worldwide assets. Cash has no realized gain, so this couple has no exit tax to pay. However, having resettled in a foreign country, suppose this couple then grows a successful business over the 30 years following departure from the United States. Despite creating significant value in the foreign business only after departing the United States, any future gifts or bequests made to U.S. persons would be subject to a 40% tax.
If the same couple grows the business so that the total assets of the couple are $20 million in foreign assets at their deaths, and their wills bequeath these assets to their two dual national (including U.S. citizen) children, the children will have to pay $8 million of U.S. inheritance tax under the current inheritance tax regime. This is true even if none of the children live in the United States at the time of their parents’ deaths. Instead of this very bad tax outcome, had the parents equally divided their respective estates so each owned $10 million and had both become naturalized U.S. citizens when their Green Cards expired, there would be no U.S. estate tax to them under the current U.S. estate tax law. Their children would have received the $20 million from both parents free from all U.S. tax. One trade-off of achieving this far more desirable transfer tax result is that prior to their deaths, the parents would likely have to continue to waive treaty benefits and file and pay U.S. income tax on worldwide income and report all foreign bank accounts and foreign mutual funds as U.S. residents.
Endnotes
1. Internal Revenue Code Section 2801(e)(1).
2. See IRC Section 2801(e)(4)(B)(i), which provides that in the case of a covered gift or bequest made to a foreign trust, Section 2801(e)(1) shall apply to any distribution attributable to such gift or bequest from such trust (whether from income or corpus) to a U.S. citizen or resident in the same manner as if such distribution were a covered gift or bequest.
3. Proposed Treasury Regulations Section 28.2801-2(f) and (g).
4. Prop. Treas. Regs. Section 28.2801-3(b).
5. Ibid.
6. Prop. Treas. Regs. Section 28.2801-3(e).
7. For a comprehensive analysis of Section 2801 and the implications of the proposed regulations, see Stephen Liss and Ellen Harrison, “Expatriation and the New Section 2801 Proposed Regulations,” prepared on behalf of the Tax Planning Committee Income and Transfer Tax Planning Group of the Real Property, Trust & Estate Law Section of the American Bar Association.
8. Section 2801(e)(2).
9. Ibid.
10. Section 2801(e)(3).
11. Prop. Treas. Regs. Section 28.2801-3(c)(4).
12. IRC Section 7701(b)(6).
13. See the website of the U.S. Citizen and Immigration Services (CIS), Green Card, After A Green Card is Granted, Maintaining Permanent Residence, Abandoning Permanent Resident Status, in which the U.S. CIS states that an individual may lose permanent resident status by intentionally abandoning it. An individual may be found to have abandoned permanent resident status if such individual moves to another country, intending to live there permanently.
14. See the website of the U.S. CIS, Green Card, After a Green Card is Granted, International Travel as a Permanent Resident, Does Travel Outside the U.S. Affect My Permanent Resident Status and What if My Trip Abroad Will Last Longer Than 1 Year. The U.S. CIS states that permanent residents (that is, Green Card holders) are free to travel outside the United States, and temporary or brief travel usually doesn’t affect permanent resident status. If the U.S. CIS determines that an individual didn’t intend to make the United States his permanent home, however, such individual will be found to have abandoned his permanent resident status. A general guide used by the U.S. CIS is whether the individual Green Card holder has been absent from the United States for more than a year. The U.S. CIS further states that if an individual plans on being absent from the United States for longer than a year, prior to leaving the United States, it’s advisable to first apply for a reentry permit on Form I-131. Otherwise, it will be necessary to obtain a returning resident visa from a U.S. Embassy or Consulate abroad. If an individual remains outside the United States for more than two years, any reentry permit granted before departure will have expired, and the U.S. CIS advises such individual to consider applying for a returning resident visa (SB-1) at the nearest U.S. Embassy or Consulate.
15. Revenue Ruling 77-378.
16. IRC Sections 674 and 677.
17. See IRC Section 672(e).
18. For an excellent analysis of this strategy developed back in 2009 when the gift tax exemption amount was only $1 million, see John L. Campbell and Michael J. Stegman, “Confronting the New Expatriation Tax: Advice for the U.S. Green Card Holder,” 35 ACTEC Journal 266 (2009), at pp. 35-36. The authors explain how a Green Card holder can carefully make an incomplete gift in trust while living in the United States and then complete the gift once the settlor is decisively resettled in the new country by having the settlor renounce his testamentary limited power of appointment. Moreover, the U.S. advisor will want to allow three years to elapse between renunciation of this power and the affirmative act of expatriation (that is, filing of Form I-407). Foreign counsel would be a necessity to ensure that there are no adverse inheritance or gift tax laws applicable in the new country.
19. Section 7701(b)(6).
20. IRC Section 6114 and Treas. Regs. Section 301.7701(b)-7.
21. See supra note 11. Under Section 7701(b)(6), immigration status continues after tax status ends, reversing prior law under Section 7701(n), which allowed continued tax status after immigration status terminated. IRC Section 6114 and Treas. Regs. Section 301.7701(b)-7 both require a taxpayer to give notice to the Internal Revenue Service when taking a position for tax purposes that invokes rights under a treaty. Use Form 8833 to do this. Query whether a Green Card holder living abroad can expatriate by doing nothing, arguing that not giving notice under a treaty (that is, not filing Form 8833) and not filing other paperwork with the IRS (that is, not filing a Form 1040) is sufficient to remove the individual from the U.S. tax system. The safer assumption is the U.S. government will treat a Green Card holder as a lawful permanent resident until such individual actually files paperwork claiming nonresident status in the United States.
22. See Thomas S. Bissell, “Green Card Aliens Living Abroad Who Claim They Are No Longer U.S. Domiciled,” Tax Management International Journal (Bloomberg Tax 2019), at p. 2.
23. Joseph P. Toce, Jr. and Joseph R. Kluemper, “Estate Planning for Expatriates Under Chapter 15,” Estate Planning Journal (January 2013).
24. A qualified obligation must meet the following requirements: (1) the obligation is set forth in a written agreement; (2) the term of the obligation doesn’t exceed five years; (3) all payments on the obligation are denominated in U.S. dollars; (4) the yield to maturity of the obligation is not less than 100% and not greater than 130% of the applicable federal rate (for the day on which the obligation is issued); (5) the U.S. borrower extends the period for assessment by the IRS of any income tax attributable to the loan and any consequential income tax changes for each year that the obligation is outstanding, to a date not earlier than three years after the maturity date of the obligation; and (6) the U.S. obligor reports the status of the obligation, including principal and interest payments, on Form 3520 for each year that the obligation is outstanding. A loan can’t be rolled over at the end of five years, and a new loan from the trust to the same U.S. beneficiary raises the issue of whether it constitutes a rollover.
25. To address this, Treas. Regs. Section 1.643(h)-1 sets out the circumstances in which such intermediaries will be disregarded and the treatment of structures that employ intermediaries. Essentially, when property is transferred to a U.S. citizen or resident by another individual or entity (the intermediary) who’s received property from a foreign trust, the U.S. citizen or resident will be treated as having received the property directly from the foreign trust if the intermediary received the property from the foreign trust pursuant to a plan in which one of the principal purposes was the avoidance of U.S. tax. Such a principal plan of avoidance will be deemed to exist if:
a. The intermediary is “related” to the grantor of the foreign trust or has a relationship to the grantor that establishes a reasonable basis for concluding that the grantor of the foreign trust would make a gratuitous transfer to the U.S. person;
b. The U.S. citizen or resident receives from the intermediary, within the period beginning 24 months before and ending 24 months after the intermediary’s receipt of property from the foreign trust, the property the intermediary received from the foreign trust, proceeds from such property or property in substitution for such property; or
c. The U.S. citizen or resident can’t establish that the intermediary acted independently, had a reason for making gratuitous transfers to the U.S. citizen or resident and wasn’t the agent of the U.S. citizen or resident, and the U.S. citizen or resident reported the gift.
26. Prop. Treas. Regs. Section 28.2801-2(i)(1) and (2).
27. Prop. Treas. Regs. Sections 28.2801-1 through 28.2801-7.