Increasingly, marriages and families span international borders with different mixes of citizenships and national origins. High profile cases such as Prince Harry’s marriage to American Meghan Markle make headlines; however, even non-royal families commonly face complex international tax issues. Encountering a cross-border planning issue is no longer a rare event for many U.S. professional advisors.
Estate and income tax planning may be challenging under normal circumstances, but mixed nationality families face added challenges (and opportunities). When one spouse is a U.S. citizen and the other isn’t, typical U.S. estate planning and investment strategies may be counterproductive and ignore certain advantages. Let’s review several tax disparities between spouses who may be nonresident aliens (NRAs) and U.S. residents/citizens, where planning is helpful to optimize a family’s global balance sheet.
Residency vs. Domicile
U.S. citizens are subject to income and estate and gift taxation by virtue of their U.S. citizenship. For non-U.S. citizens, it’s critical to understand how the concept of residency (income taxation) is different from domicile (estate and gift taxation) to determine taxability.
When is a non-U.S. citizen subject to U.S. income tax? There are two main ways for a non-U.S. citizen to become a U.S. income tax resident. The first is by becoming a legal permanent resident, which means obtaining a Green Card. The second is called the “substantial presence test” (a day count test codified by the Internal Revenue Service). After meeting these requirements, U.S. income taxation applies to worldwide income and assets in the same way as to a U.S. citizen.
For example, a British executive moved from London to New York on an employment visa on Oct. 1, 2019 and intends to stay until Dec. 31, 2020. During 2019, he wouldn’t be considered a tax resident, and only his U.S. employment income is subject to U.S. taxation. However, during 2020, he would satisfy the substantial presence test becoming a U.S. tax resident, which exposes his worldwide income and assets to U.S. taxation.
What makes a person a U.S. domicile subject to U.S. estate and gift tax? U.S. citizens, domiciles and U.S. situs assets are subject to U.S. estate and gift taxation. A foreign national is a U.S. domicile if he intends to make the United States his permanent home with no present intention of leaving. There are no set rules for determining domicile, but obtaining a Green Card is an objective fact that points towards domicile. Courts also review family ties, employment, location of property and other subjective factors.
The same British executive who moved from London to New York on a short-term assignment (15 months) is likely not domiciled in the United States. The expectation is that he would return to London after the assignment. If, however, the executive extends his U.S. stay or acquires a Green Card, factors may point in favor of attaining U.S. domicile subjecting his worldwide assets to U.S. estate and gift taxation.
What taxes are imposed on NRAs? An NRA is the tax classification given to individuals who aren’t U.S. citizens, U.S. tax residents or U.S. domiciles. For income tax purposes, NRAs are generally taxed only on U.S. source income. For estate and gift tax purposes, NRAs may have estate tax exposure on their U.S. situs assets. U.S. situs assets generally include real and tangible personal property located in the United States. Unless modified by a bilateral estate and gift tax, NRAs only have a $60,000 estate tax exemption on U.S. situs assets.
An NRA living in the United Kingdom and owning IBM stock (U.S. based company, U.S. situs asset) won’t face any extra U.S. taxation due to specific provisions in the U.S./U.K. estate tax treaty. However, if this individual moved to Dubai permanently, where there’s no estate tax treaty, the value of IBM is taxed at 40% on any amount over $60,000.
Pre-Immigration Financial Planning
Pre-immigration financial planning is often overlooked, but essential for individuals immigrating to the United States in mixed nationality marriages. A non-U.S. citizen spouse with non-U.S. assets, foreign trusts or ownership in non-U.S. companies should contemplate certain tax elections and other considerations prior to U.S. immigration to avoid adverse taxation on becoming a U.S. tax resident and/or U.S. domicile. These strategies may be as easy as selling certain assets to as complex as setting up a trust or corporate structure.
One simple technique may be to accelerate the recognition of income and reset cost basis before immigration. There’s no step-up basis in assets on becoming a U.S. tax resident. This might make sense when immigrating from a low or no tax jurisdiction. On the other hand, there could be advantages to hold off on realizing losses until an individual is a U.S. taxpayer. Losses may be more beneficial to offset other U.S. taxes. This will depend on whether the tax rates in the home country are lower than those in the United States.
Another common strategy may involve using a drop-off trust to increase the cost basis in assets. A transaction between an individual and trust occurs to step up cost basis in assets before becoming U.S. taxable. This is an effective tool for individuals who need to sell non-U.S. funds, closely held businesses or other low basis assets during their U.S. residency.
The creation of trusts may also be appropriate prior to establishing U.S. domicile for estate tax reasons. For example, gifts of non-U.S. situs assets or the creation of a trust with non-U.S. situs assets, prior to establishing U.S. domicile, may effectively “quarantine” these assets from U.S. estate and gift tax if structured properly. This strategy becomes more complicated if a U.S. citizen spouse or other U.S. citizens are beneficiaries of the trust.
Timely implementation of a pre-immigration financial plan is of vital importance. Many of these opportunities no longer exist once an individual becomes a U.S. tax resident. Families should act sooner rather than later if immigration to the United States is a possibility.
Planning Strategies and Structures
A married couple who both are U.S. citizens have a combined estate exemption of $23.16 million (2020). In addition, U.S. citizen spouses may also use the unlimited marital deduction to transfer wealth, estate and gift tax free between each other. Families whose wealth is under the lifetime exemption limits often don’t need extensive U.S. estate tax planning.
However, in a marriage in which one spouse isn’t a U.S. citizen (not merely a U.S. permanent resident/domiciliary), there’s no unlimited marital deduction. The U.S. spouse only has his lifetime exemption of $11.58 million (2020). Assets above this amount, even if passed to the non-U.S. spouse, are subject to estate and gift tax. Some strategies to use include the creation of a qualified domestic trust (QDOT), strategic lifetime gifting and asset titling.
QDOTs. U.S. citizens married to Green Card holders and non-U.S. citizens often use a QDOT. QDOTs were more common when the U.S. estate tax exemption limits were lower. Today, QDOTs are still an important planning tool for a U.S. citizen spouse with wealth approaching the $11.58 million lifetime allowance.
A QDOT is a special kind of trust that allows non-U.S. citizens who survive a deceased U.S. citizen spouse to take the marital deduction, even if the surviving spouse isn’t a U.S. citizen. A QDOT may be elected after death by the executor of an estate to preserve these tax benefits. After assets are placed in a QDOT, the surviving non-U.S. spouse receives income from the trust but doesn’t own trust assets. Trust distributions of income to the non-U.S. citizen surviving spouse are exempt from the estate tax.
It’s important to keep in mind that a QDOT only defers estate taxation; U.S. estate taxes will still be due at the surviving spouse’s death. To avoid this, a non-U.S. spouse may acquire U.S. citizenship. This strategy is only possible if either the surviving spouse was a U.S. resident at decedent’s death, or no taxable distributions were made from the QDOT prior to the surviving spouse becoming a citizen.
A QDOT may not always be the best solution for a mixed nationality couple. If the non-U.S. citizen spouse lives or intends to live in a jurisdiction that doesn’t recognize or punitively taxes trusts, a QDOT may be counterproductive. An alternative strategy may be purchasing life insurance within an irrevocable life insurance trust that can provide for the estate tax on the death of the U.S. citizen spouse.
Inter-spousal gifting. As discussed above, there’s no unlimited marital exemption between a transfer from a U.S. spouse to a non-U.S. spouse. There is, however, a special annual exclusion amount of $157,000 (2020) for these gifts above the normal $15,000 annual gift allowance (2020). Before gifting, local country estate and inheritance taxes must be closely reviewed. It might be punitive for a family to transfer assets into a jurisdiction with higher taxes.
One lifetime gifting strategy may involve gifting appreciated assets to a non-U.S. spouse. If the non-U.S. spouse lives in a country with no income tax, the appreciated asset may be sold with no U.S. capital gains. A recent U.S. Tax Court decision, Hughes v. Commissioner,1 strengthens this strategy. In Hughes, the IRS argued, and the court confirmed, that a gift of appreciated stock to an NRA spouse was a non-recognition of income event.
A more aggressive strategy to remove larger amounts from a U.S. spouse’s estate may be structuring loans between spouses. The debt may eventually be forgiven by the U.S. spouse. In a country that doesn’t impose income taxation on this type of debt forgiveness, this may be another very tax advantageous strategy, but one with less U.S. legal precedent.
Lastly, the United States doesn’t impose tax on a U.S. spouse receiving assets from a non-U.S. spouse. A U.S. taxpayer must report gifts of over $100,000 received from a non-U.S. person on IRS Form 3520. Careful attention should be paid to the gifting of U.S. situs property owned by an NRA, as this may inadvertently trigger U.S. gift taxation.
Joint accounts and asset titling. Married couples commingle assets in joint accounts for practical and estate-planning considerations. However, common U.S. account ownership structures may create income and estate-planning issues when one spouse isn’t a U.S. citizen. The decision on how to title accounts will be very circumstance specific, but a few common issues are described below.
Generally, one-half of the value of a joint property is included in the decedent spouse’s estate if both are U.S. citizens. If a surviving spouse isn’t a U.S. citizen, the entire value of the joint property will be included in the estate of the first-to-die U.S. citizen spouse’s estate. This assumption is rebuttable to the extent that the personal contributions of the non-U.S. spouse may be substantiated in acquiring the property.
Income tax considerations must also be considered. On a joint U.S.-based account, an investment custodian will generally report all income on IRS Form 1099 issued to the U.S. citizen spouse. The income may shift to the non-U.S. citizen spouse through a special tax filing, but this may not always be advantageous. On non-U.S. financial accounts, the IRS may look to local property laws and contributions to determine who the beneficial owner is for tax purposes. The U.S. citizen spouse may face complex U.S. taxation specific to foreign financial assets.
There may be some advantages to joint ownership, including possibly ease of transfer at death. However, often, there may be considerable tax savings if spouses with different tax statuses keep assets in separate accounts.
A more permanent method of avoiding U.S. taxes is expatriation. See “Relinquishing U.S. Citizenship,” p. 32.
Other Planning Considerations
Implementing holistic wealth management is more than tax and legal structures. Given the different income and estate tax statuses, there may be some very strategic options when positioning investment strategies and other financial planning considerations.
Asset allocation. When a couple resides outside of the United States and maintains different tax statuses, there may be some very strategic planning on which spouse owns certain assets. This is particularly true in low or no tax jurisdictions. For example, the non-U.S. spouse should focus on holding non-U.S. situs assets and U.S. tax-inefficient assets such as investments that would be considered passive foreign investment companies (PFICs) under IRS rules. On the other hand, the U.S. citizen spouse may want to focus on owning U.S. assets that may have income tax withholding and would be considered U.S. situs for estate tax if held by the non-U.S. spouse.
The NRA may also wish to focus on holding higher growth assets. This would avoid future capital gains on growth. In a country with no capital gains tax, the NRA’s higher growth assets may be treated like a Roth individual retirement account, as the growth will be tax free!
Retirement accounts. Care should be taken if an NRA owns an Internal Revenue Code Section 401k or IRA. These U.S. retirement assets will be considered U.S. situs assets for estate tax purposes. If an individual is resident in a country where this is the case, it may be an effective strategy to liquidate U.S. retirement accounts to decrease the size of a U.S. taxable estate (country-specific income tax withholding must also be considered).
U.S. Social Security. A non-U.S. citizen spouse may be entitled to receive U.S. Social Security spousal benefits. For any spouse who isn’t a U.S. citizen or Green Card holder, the general rule is that Social Security payments must stop if the spouse lives outside of the United States for six consecutive months. However, there are many exceptions based on either the receiver’s country of citizenship or residence that allow payments outside of the United States to continue. Many international families don’t realize that most non-U.S. spouses may receive U.S. Social Security when living abroad under many circumstances.
Life insurance. Properly structuring life insurance policies between a U.S. and non-U.S. spouse is critical. Proceeds from a life insurance policy on the life of a non-U.S. spouse generally aren’t U.S. situs assets and aren’t subject to U.S. estate tax. Additionally, life insurance may be a great tool to protect a family if an individual becomes inadvertently U.S. domiciled. The life insurance proceeds may be used to pay estate tax exposure.
Holistic Planning
An integrated financial plan will not only consider legal rules but also the subjective needs of the individual family. Families may feel uncomfortable gifting assets to their spouse/children, setting up irrevocable trusts or engaging in other more permanent planning strategies. A strategy that works for one family might not be suitable for another family with different goals and values.
Advisors should work hard to understand a client’s intentions while also managing multijurisdictional legal requirements. One thing is certain: Families must plan for laws to change, and it’s important to keep strategies flexible. Families will move to different jurisdictions, laws will change and planning strategies should evolve. It’s important for mixed nationality couples to develop a plan that not only is tax efficient and compliant but also suits the goals and circumstances of their relationship to protect and build the family’s international wealth for current and future generations.
Endnote
1. Hughes v. Commissioner, T.C. Memo. 2015-89 (May 11, 2015).