Step up in basis for nonresident’s assets in irrevocable trust
What “basis” is
One of the continuing mysteries of life involves the concept of “basis”. Think of basis as your acquisition cost. This is essential in calculating your capital gain tax after selling an asset. Capital gain is the difference between the sale price and your acquisition cost. The higher your basis — or acquisition cost — for an asset, the lower your capital gain (and therefore capital gain tax) will be.
Here is an example:
A person bought a piece of land 20 years ago for $100,000, and now it is worth $1,000,000. If that person sells the real estate today, the capital gain would be $900,000 ($1,000,000 received from sale minus $100,000 acquisition cost). Multiply the $900,000 capital gain by the correct tax rate and you have the tax that must be paid in the year of sale.
Basis when you inherit an asset
It is easy to understand “acquisition cost” when you buy something: how much money did it cost? But what about when you inherit something?
In that case, your acquisition cost (or “basis”) is the fair market value of the asset when the previous owner died. (In some instances you can use the value on the date 6 months after the person died). Think of this as if you “bought” the asset at fair market value on the date of death of the person who left you the inheritance.
Again, an example:
A person bought a piece of land 20 years ago for $100,000, and it is worth $1,000,000 when he dies. The person leaves the land to you in his will. You are treated as if you acquired the land at a cost equal to the value of the land on the day of death.
These basis rules are found in Internal Revenue Code Section 1014.
Step up in basis
Wait. There’s a disconnect: $900,000 of taxable capital gain evaporated. You got a fresh start, so if you sell the land for $1,000,000 you will pay zero capital gains tax — because you have zero capital gain. The land is worth $1,000,000 and your acquisition cost (“basis”) is $1,000,000. Yet, if the person who left you the land had sold it a month before he died, there would have been $900,000 of capital gain, and capital gain tax would be imposed. What happened?
The “what happened” is a concept called “step up”. Simply put, if someone owns an asset when he dies, all of the built-in capital gain is eliminated. The deceased person’s basis (acquisition cost) in the asset adjusted upward to the fair market value when he died. This upward adjustment is called “step up” in tax jargon.
The reverse can happen, of course. The adjustment goes to market value on the date of death. Market value can be lower than acquisition cost. It’s been known to happen once or twice.
Inheriting from a nonresident
The same concepts apply when a U.S. taxpayer inherits an asset from a nonresident.
A resident of Saudi Arabia bought a piece of land in Jeddah 20 years ago for $100,000, and it is worth $1,000,000 when he dies. You inherit the land. You are treated as if you acquired the land at a cost equal to the value of the land on the day of death.
The first time I wrestled with this idea, I was boggled. Here was a tax break (the step up in basis) extended by the U.S. government to an asset outside the United States — an asset that had never been subjected to U.S. estate tax. It made sense, I thought, that the step up in basis idea would apply to an asset that passed through the U.S. estate tax gauntlet. If you inherit something and Uncle Sam had the chance to tax it (by imposing a tax on the estate of the deceased person), fairness says you get the new “acquisition cost” or basis in the asset you inherit.
Yet we have the interesting situation that a piece of land outside the United States is now owned by a U.S. person with an acquisition cost equal to the value of the property on the date of death.
Inheriting through a trust from a nonresident
Now we get to the point of this blog post. For a variety of reasons, people use trusts to hold their assets and pass the assets to their heirs. It’s usually simpler than the local Probate Court proceedings, and it gives far greater privacy. Probate is usually a publicly visible process. Trusts can be opaque to the outside world. Trusts are also a useful tool if you want to have outside managers for your assets.
But assets put into a trust are no longer passed to the heirs at death as an inheritance. The “heirs” are beneficiaries of the trust. What they receive (and when they receive it) is governed by what the trust document says.
This means that you cannot rely on the classic “step up in basis” rules I have described above. If an asset is distributed to a beneficiary from a trust, it will have the same acquisition cost (“basis”) as the trust had in the asset. The tax law jargon for this is “carryover basis”.
But that’s not universally true. It is possible for a nonresident to put assets into a trust (thereby avoiding the local probate procedures) and at the same time get step up in basis for the trust beneficiary (the heir) who receives the assets when the nonresident dies. All of this can happen while there is no U.S. estate tax imposed on the assets.
A resident of Hong Kong creates the right kind of trust (I will describe what “right kind of trust” means in a minute). He bought land in Hong Kong 40 years ago for US$100,000, and now it is worth US$1,000,000. He transfers the land in to the trust. A U.S. individual is the beneficiary of the trust. When the Hong Kong resident dies, the terms of the trust instruct the trustee to distribute the land to the beneficiary.
The beneficiary will receive the land from the trust with a stepped up basis of $1,000,000. If the beneficiary immediately sells the land at its fair market value of $1,000,000, he will have zero capital gain because his acquisition cost (basis) is US$1,000,000 and the money received from the sale is US$1,000,000.
Best of both worlds, etc. There is no U.S. estate tax (and no Hong Kong estate tax, for that matter). And there is no U.S. capital gain tax.
What kind of trust will work? A “grantor” trust
So what kind of trust should a nonresident of the United States establish in order to leave assets to a U.S. person at the time of the nonresident’s death? Simple: a “grantor” trust. This is a trust that — according to U.S. tax law — is treated as if the settlor (the person who contributed the assets to the trust) is the owner of all of the trust assets.
The grantor trust rules are in Internal Revenue Code Sections 671 through 679.
There are two kinds of grantor trusts that will work for nonresidents of the United States:
- Revocable. The idea here is that if the settlor can unilaterally take the assets out of the trust at any time, the situation is functionally identical to direct ownership of the assets by the settlor. The assets remain in the trust solely at the settlor’s whim.
- Irrevocable. With an irrevocable trust, the settlor does not have the unilateral power to extract assets from the trust anytime he wants to. But an irrevocable trust can be a grantor trust if the settlor (or settlor plus spouse) is the sole beneficiary during the lifetime of the settlor (or spouse).
A grantor trust can be a “foreign” grantor trust or a domestic grantor trust. We usually refer to domestic grantor trusts as simply being a grantor trust. A “foreign” trust of any type, whether grantor or nongrantor, is a trust that is either governed by a court outside the United States or is controlled (even just a little bit) by someone who is not a U.S. resident or citizen. I will leave the discussion of whether to make your grantor trust “foreign” or domestic for another blog post.
Private Letter Ruling 201245006 – An Irrevocable Trust is Approved
Don’t take my word for it. Read Private Letter Ruling 201245006. Specifically, look at Issue 1, where the use of an irrevocable trust (properly configured to be a grantor trust) was approved. Private Letter Rulings are only applicable to the taxpayer receiving the ruling, yadda yadda.
Internal Revenue Service
Department of the Treasury
Washington, DC 20224
Release Date: 11/9/2012
Index Number: 671.00-00, 1014.00-00
Person To Contact:
Refer Reply To: CC:PSI:B04 _PLR-105239-12
Date: JULY 19, 2012
Company 1 =
Company 2 =
Dear [redacted data]:
This letter responds to your authorized representative’s letter, dated February 2, 2012, requesting a ruling on the application of § 671 and § 1014 of the Internal Revenue Code.
The facts submitted and representations made are as follows:
Taxpayer, a citizen and resident of Country, proposes to transfer assets to Trust, an irrevocable trust subject to the laws of Country. The assets of Trust include cash and stock in Company 1 and Company 2 that are publicly traded in Country and on the New York Stock Exchange. Taxpayer and X, an unrelated party, are Trustees.
Under the terms of Trust, Trustees are to pay all of the income of Trust to Taxpayer during his lifetime and may, in Trustees’ absolute discretion, pay principal of Trust to Taxpayer. Article IV. Upon the death of Taxpayer, any income of Trust and any corpus remaining in Trust are to be paid or transferred to or in trust for one or more of Taxpayer’s issue in such proportions as Taxpayer may appoint by deed or will. In default of appointment, corpus and accumulated income will be held in further trust for the benefit of Taxpayer’s issue. Article V. Trust further provides that during Taxpayer’s lifetime no adverse party within the meaning of § 672(a) is eligible to serve as Trustee. Article XI.
You have requested the following rulings:
1. Following the death of Taxpayer, the basis of the property held in Trust at Taxpayer’s death will be the fair market value of the property at the date of Taxpayer’s death under § 1014(a).
2. Taxpayer will be treated as the owner of Trust for purposes of § 671, such that the items of income, deductions and credits against tax of Trust will be included in computing Grantor’s taxable income and credits against tax.
Section 1014(a)(1) provides that the basis of property in the hands of a person acquiring the property from a decedent or to whom the property passed from a decedent shall, if not sold, exchanged, or otherwise disposed of before the decedent’s death by such person, be the fair market value of the property at the date of the decedent’s death.
Section 1014(b)(1) provides that property acquired by bequest, devise, or inheritance, or by the decedent’s estate from the decedent shall be considered to have been acquired from or to have passed from the decedent for purposes of § 1014(a).
Section 1014(b)(9) provides that, in the case of a decedent dying after December 31, 1953, property acquired from the decedent by reason of death, form of ownership, or other conditions (including property acquired through the exercise or non-exercise of a power of appointment), if by reason thereof the property is required to be included in determining the value of the decedent’s gross estate, shall be considered to have been acquired from or to have passed from the decedent for purposes of § 1014(a).
Section 1014(b)(9)(C) provides that § 1014(b)(9) shall not apply to property described in any other paragraph of § 1014(b).
Section 1.1014-2(b)(2) of the Income Tax Regulations provides, in part, that § 1014(b)(9) property does not include property that is not includible in the decedent’s gross estate, such as property not situated in the United States acquired from a nonresident who is not a citizen of the United States.
In this case, Taxpayer’s issue will acquire, by bequest, devise, or inheritance, assets from Trust at Taxpayer’s death. The assets acquired from Trust are within the description of property acquired from a decedent under § 1014(b)(1). Therefore, Trust will receive a step-up in basis in Trust assets under § 1014(a) determined by the fair market value of the property on the date of Taxpayer’s death. See Rev. Rul. 84-139, 1984-2 C.B. 168 (holding that foreign real property that is inherited by a U.S. citizen from a nonresident alien will receive a step-up in basis under § 1014(a)(1) and 1014(b)(1)). This rule applies to property located outside the United States, as well as to property located inside the United States.
Accordingly, based solely upon the information submitted and the representations made, we conclude that following the death of Taxpayer, the basis of the property held in Trust will be the fair market value of the property at the date of Taxpayer’s death under § 1014(a).
Section 671 provides, in part, that where it is specified in subpart E of subchapter J that the grantor or another person shall be treated as the owner of any portion of a trust, there shall then be included in computing the taxable income and credits of the grantor or the other person those items of income, deductions, and credits against tax of the trust which are attributable to that portion of the trust to the extent that such items would be taken into account under this chapter in computing taxable income or credits against the tax of an individual.
Section 672(f)(1) and § 1.672(f)-1 provide that, as a general rule, the grantor trust rules (§ § 671 through 679) apply only to the extent such application results in an amount (if any) being taken into account (directly or through one or more entities) in computing the income of a citizen or resident of the United States or a domestic corporation. Section 672(f)(2)(A)(ii) and § 1.672(f)-3(b)(1) provide that the general rule does not apply to any portion of a trust if the only amounts distributable from such portion (whether income or corpus) during the lifetime of the grantor are amounts distributable to the grantor or the spouse of the grantor.
Section 677(a)(1) provides that the grantor shall be treated as the owner of any portion of a trust, whether or not he is treated as such owner under § 674, whose income without the approval or consent of any adverse party is, or in the discretion of the grantor or a nonadverse party, or both, may be distributed to the grantor or the grantor’s spouse.
Under the terms of Trust, the trustees are required to pay all Trust income to Taxpayer during his lifetime and the trustees are authorized to pay, in their absolute discretion, any amounts out of the capital of Trust to Taxpayer. In addition, the only distributions that Trust may make during the Taxpayer’s lifetime are to Taxpayer. Thus, § 672(f) will not prevent Taxpayer from being treated as the owner of Trust. Therefore, Taxpayer will be treated as the owner of Trust under § 677(a).
The rulings contained in this letter are based upon information and representations submitted by the taxpayer and accompanied by a penalty of perjury statement executed by an appropriate party. While this office has not verified any of the material submitted in support of the request for rulings, it is subject to verification on examination.
Except as specifically ruled herein, we express no opinion on the federal tax consequences of the proposed transaction under the cited provisions or under any other provisions of the Code.
This ruling is directed only to the taxpayer who requested it. Section 6110(k)(3) provides that it may not be used or cited as precedent.
Leslie H. Finlow
Senior Technician Reviewer, Branch 4
Office of Associate Chief Counsel
(Passthroughs and Special Industries)
Copy for section 6110 purposes
Cairo Airport Lounge, 1:00 am
This is what the business class lounge looks like if you are in the Cairo airport at 1 am.
Deliberately Choosing Covered Expatriate Status
I received a question from a reader that is worth discussing. Lightly edited to protect the innocent here is the question:
Describing an anonymous third-party friend here of course. [Of course. ] Dual US-Canadian citizen from birth, born in the US, lived a few years in the US in the 90s, filed tax returns those years only, then moved back to Canada. Recently discovered the whole tax and FBAR thing, far too stubborn to comply at this point.
To the question. If the net gain on all your assets was less than $650k (or whatever the limit is), could or should you renounce US citizenship, indicate that you were not tax compliant on form 8854, and enter the exit tax regime as a covered expatriate? Then you’d just have to do the exit declaration, at which you show net gains under the limit for taxation, rather than fuss about with five years of 1040s and FBARs and all that.
Or would this just piss off the powers-that-be? Fines aren’t collectible in Canada, so the risk is more travel inconvenience than financial penalty.
The Question is Really . . .
What the reader is asking is whether pursuing a strategy of deliberately declaring status as a covered expatriate will work.
Sheep and Goats
When you give up your U.S. citizenship the IRS categorizes you as a sheep or a goat.
You are a goat and condemned to hell if you are are rich (the definition is irrelevant for this question) or if you have not been faithful with your U.S. tax obligations (paperwork and payment of tax). The IRS is too polite to call you a goat, so they call you a “covered expatriate.”
If you are poor (again, we don’t care about what this means for the purpose of this blog post) and you have been faithfully filing tax returns and paying your U.S. taxes, then you are, to the IRS, a sheep. You are a mere “expatriate”.
“I Want to be a Goat”
In the scenario described above, the dual citizen is presumably does not meet the financial tests to become a covered expatriate. This means when he gives up his U.S. citizenship his status as “sheep or goat” (meaning “expatriate” or “covered expatriate”) turns on whether his U.S. tax paperwork and tax payments are up to date. Or not.
And here we are exploring a deliberate choice of NOT bringing all of the paperwork up to date, and NOT paying any U.S. income tax that is due.
If you want to see where this happens, look at page 1 of Form 8854, near the bottom, where the person signing the statement says under penalty of perjury that all of the tax obligations for the last five years (Title 26 is the part of the United States Code having to do with taxes) are up to date and paid.
This person will deliberately not file tax returns for the prior five years, and of course will not pay the taxes due. Or the penalties for late filing various forms — whatever they are. He will, however, presumably file excruciatingly correct U.S. tax returns for the year of expatriation.
Consequences of Covered Expatriate Status
The consequences of being a
goat covered expatriate are:
- Gift. If you make a gift to a U.S. person, the recipient has a potential tax to pay. See 26 USC Section 2801. Presumably our hypothetical dual U.S./Canadian individual will never give a penny to a U.S. person.
- Bequest. If you die and leave an inheritance to a U.S. person, the recipient has a potential tax to pay. Again, see 26 USC Section 2801. Again, I assume this is not going to happen, so our hypothetical dual citizen won’t care about this.
- Lorena Bobbit. The IRS could go on a binge of jilted-lover vengeance and attempt to tag our hypothetical dual citizen with U.S. tax liabilities and penalties for past sins. This is a risk if the Canadian tax authorities are playing footsie under the table with our IRS Overlords. If the Canadians have half a spine and tell the U.S. government to go bite tires, then there is no risk — unless our would-be goat decides to travel to the United States. I suspect there is no extraordinary rendition of Canadians to the United States for taxes owed to the USA. Yet.
- “Hello, Lion. May I inspect your teeth?”. If our deliberate goat decides to travel to the United States, the consequences are unknown to me. If there is a criminal indictment, there would be the possibility of arrest. If it is a mere civil tax debt to the U.S. government, well, I thought we abolished debtor’s prisons a while ago. But don’t quote me on this–it’s a Brave New World we’re living in. So the better answer is to stay out of the United States for the rest of your life.
In short, I think you could be a covered expatriate, and you keep yourself and your money out of the United States for the rest of your life, then you can be a happy goat.
This is not my advice to my expatriation clients. I keep telling them over and over again — your primary purpose is to exit the United States cleanly and permanently. It is worth doing some extra paperwork and possibly paying some tax to be absolutely bulletproof. Don’t let grumpiness cloud your judgment.
2012 Tax Filing Deadline Tips for Friends of Bander
Two important deadlines for 2012 income tax returns are approaching fast. If you are a U.S. citizen (or green card holder) living outside the United States, do the following things now:
File Form 4868 to get an extension of time to file your tax return until 15 October 2013.
Prepare and file Form TD F 90-22.1. I recommend getting this form in a courier envelope for delivery to the IRS no later than Monday, 24 June 2013.
I’m in Riyadh, and flying out tonight. (Lufthansa. Riyadh to Frankfurt to Los Angeles). Bander Alnogaithan was kind enough to give my Saudi mobile to a few of his friends. I met him on Twitter a few years ago. He is @saudilawyer on Twitter. Follow him!
Two of his friends called. They both had the same questions. I will bet there are a few other people out there on the internet who have the same problem. So this blog post is for all of you.
Who Needs This Information
This information matters to you if you are:
- A U.S. citizen or green card holder; and
- You live outside the United States; and
- You have not done anything about your income tax returns for 2012.
Yes, you almost certainly do have a requirement to file a U.S. income tax return. I’m not going through the analysis for you. If you are breathing, there is SOME reason why the United States government thinks you should file income tax returns.
By 17 June 2013: Get an Extension of Time to File Income Tax Returns
For U.S. citizens or green card holders living abroad, the filing deadline for tax returns for the 2012 calendar year is 15 June 2013. Because that falls on a Saturday this year, the filing deadline is the next business day–17 June 2013. Today is 10 June 2013.
You need to file Form 4868 (PDF). Now.
You can mail the form. You can send it by FedEx, DHL, or UPS. But in true government tradition, the instructions to Form 4868 give you only a Post Office Box address and then tell you that you need a street address to send the form by FedEx, DHL, or UPS. Good luck finding the street address. I would usually have some potty-mouth words right now but the NSA reads everything we write and records all of our telephone conversations, and winter is coming. I, for one, welcome our new IRS Overlords. Sigh.
So your best bet it to do this online. Start here and follow the links along the happy trail until you find Form 4868. I will help you with a couple of useless government-mandated clicks. Start here instead.
Or you can find all sorts of commercial establishments happy to do this for you online for a modest fee.
This will get you an extension of time until 15 October 2013. Read the instructions and get this done.
By 24 (WTF?) June 2013: File Form TD F 90-22.1
Yes. It is a weird date. The explanation is below.
This is the dreaded FBAR form, where you declare the existence of all of your financial accounts outside the United States. The filing deadline is 30 June 2013. The piece of paper must be physically received at the IRS office in Detroit, Michigan on or before the deadline.
Since the deadline of 30 June 2013 falls on a Sunday this year, I want you to think of 28 June 2013 as your filing deadline. We are going to be doing something terribly archaic–sending a piece of paper across the great, wide ocean. This takes time. I want you to ignore regular postal delivery. I want you to think of overnight courier service only. FedEx. DHL. That kind of thing.
Plan on getting your package picked up by FedEx or DHL (or whoever you use) no later than Monday, 24 June 2013. This will allow enough time for the package to get to the Internal Revenue Service before the deadline. Also, you will have proof that the package arrived and was received by the IRS. This is a Very Good Thing.
Download the form. Fill it in. The delivery address is in the instructions.
Alternatively, you can in theory file Form TD F 90-22.1 online. Whether you trust government IT systems is up to you. If it blows up (because government IT systems are of course well-engineered) and you miss a deadline, you are hosed. Do not expect mercy. And of course the closer you are to the filing deadline the more likely it is that the IT systems will crash.
Recommended: do your Form TD F 90-22.1 on dreary old paper. Give money to DHL, FedEx, or UPS to deliver it to Detroit. But it is up to you.
By 15 October 2013: File Form 1040
After you have solved the immediate and urgent problems, your next step is to prepare the income tax returns for filing. This is Form 1040. This job is individual to you. Each person’s tax return is different. This is where you need individual help to prepare the tax return properly.
Oh. And if you cannot make the deadline of 15 October 2013, it is possible to apply for a further extension of time until 15 December 2013 to file your 2012 income tax returns. But that’s a story for another day.
Decline of American Civilization, Form 8938 Edition
We’re working on a tax return project. It involves a 2012 Form 8938 (PDF).
Forty-six (multi-word obscenity deleted) pages long.
That’s how long the Form 8938 is, in draft form.
And we ain’t done yet, pardner. This here thing might be getting’ biggerer a’fore we’re done.
And of course there’s the FBAR that goes along with this project.
This is how American civilization dies–one spectacularly ill-conceived idea at a time, (ahem) emitted by Congress and the Treasury Department.
Let’s just bury the world in useless paperwork, shall we?