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Gifts, bequests, inheritances and expatriation
Phil Hodgen
Attorney, Principal
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Greetings from Toronto, where I am wrapping up this week's edition of Expatriation Only. Ordinarily I would write this on beautiful Air Canada flight 792 en route to Toronto, but I had the true pleasure of sitting beside a Professor from McMasters University, and we had an interesting and wide-ranging chat, ranging from Emacs to smart thermometers to teenage sons (we both have 'em). Also: Neil Young was on the flight. Not. Starstruck. At. All. Heh.
This Week's Question
This week's question came from reader N., who answered the question in the “Welcome to the Expatriation Only Newsletter” email I sent him with this:My biggest question regarding expatriation is regarding inheritance. How does taxation change upon renunciation?
Short Answer
Getting
Receiving an inheritance is no problem at all. No tax.Giving
Leaving an inheritance to someone depends on two factors: whether you are a covered expatriate (or not), and whether the recipient is a U.S. taxpayer (or not):- Noncovered expatriates can make gifts or leave bequests to anyone at all. The recipients do not have any U.S. tax burdens. The noncovered expatriate's assets are subjected to U.S. estate tax under the normal rules that apply to nonresident noncitizens (i.e., assets in the U.S. get taxed; assets outside the U.S. don't).
- Covered expatriates cannot make a gift or leave a bequest to a U.S. citizen or resident without a traumatic tax liability being imposed on the recipient. (A 40% tax, under current conditions). The covered expatriate's assets are also subject to the normal estate and gift tax rules (assets in the USA are at risk, while assets outside the USA are not).
The Default Rule of Estate and Gift Tax
The default rule of U.S. tax is that the recipient of a gift or an inheritance never pays a tax. Rather, the source gets taxed:- If you are a U.S. person and make a gift, you (the giver) are on the hook for paying gift tax, if there is any. The recipient pays no tax.
- If you are a U.S. person and you leave someone an inheritance when you die, your estate pays the estate tax (if there is any), and the recipient of the inheritance pays no tax.
Expatriates Receiving Inheritances
There is nothing built into the Internal Revenue Code that alters the default rule for expatriates who receive an inheritance. This is true whether someone is a covered expatriate or a plain old regular expatriate. (A covered expatriate is someone who expatriates and triggers that status by net worth, the amount of tax liability over the last five years, or by screwing up on tax return filing or tax payments).Take an expatriate whose parents remain in the United States, and eventually they die. The expatriate is the sole heir. To keep it simple, let's say that our expatriate's parents just had simple wills, and the expatriate inherits everything outright.- If the parents had a taxable estate (i.e., were rich enough that estate tax must be paid on the survivor's death), then the executor will file an estate tax return (Form 706) and pay the estate tax. Whatever is left will be paid to the expatriate living outside the United States.
- If the parents were not sufficiently rich to cause estate tax, the executor will simply transfer the assets to the sole heir (our expatriate) after paying off debts and probate expenses.
Gifts or Bequests By Noncovered Expatriates
There is nothing in the Internal Revenue Code that imposes any special tax on gifts or bequests made by noncovered expatriates. These people can make gifts to anyone, and leave money at death to anyone. The normal rules will apply to them:- They will be subject to U.S. estate tax on U.S. situs assets (real estate, tangible personal property, intangible personal property like those shares of Apple stock that you own);
- They will not be subject to U.S. estate tax on assets outside the United States; and
- The recipients of bequests will not pay any additional tax.
Gifts or Bequests By Covered Expatriates
The default rule (“the recipient of a gift or inheritance does not pay tax”) is modified for covered expatriates. In some circumstances the recipient of an inheritance or gift from a covered expatriate must pay tax.Tax Imposed
We find this rule in Section 2801(a) of the Internal Revenue Code, which identifies the elements that must be satisfied for a tax to be imposed:- The recipient is a United States citizen or resident; and
- The recipient receives a “covered gift or bequest”.
If, during any calendar year, any United States citizen or resident receives any covered gift or bequest, there is hereby imposed a tax equal to the product of--(1) the highest rate of tax specified in the table contained in section 2001 © as in effect on the date of such receipt (or, if greater, the highest rate of tax specified in the table applicable under section 2502 (a) as in effect on the date), and(2) the value of such covered gift or bequest.
Recipient Pays
The recipient pays the tax – a reversal of the normal gift tax or estate tax rules. Section 2801(b) says:The tax imposed by subsection (a) on any covered gift or bequest shall be paid by the person receiving such gift or bequest.
Covered Gift or Bequest Defined
The tax on the recipient is only for “covered gifts or bequests”. The concept is simple: look at the source of the gift or the bequest. Is that person a covered expatriate? If so, the gift or bequest will be in the “covered gift or bequest” category. Section 2801(c)(1) says:For purposes of this chapter, the term "covered gift or bequest" means--(A) any property acquired by gift directly or indirectly from an individual who, at the time of such acquisition, is a covered expatriate, and(B) any property acquired directly or indirectly by reason of the death of an individual who, immediately before such death, was a covered expatriate.
Exception: Non-U.S. Recipient
Not all gifts or bequests by a covered expatriate are “covered”.The first obvious condition is that the recipient's citizenship or residence matters. A U.S. citizen or resident must pay tax for the privilege of receiving a gift or inheritance from a covered expatriate. A non-U.S. person receiving that same gift or bequest from that same covered expatriate, however, would pay nothing.This is not really an exception to the definition of “covered gift or bequest” as much as it is a by-product of the definition itself. Yet, it is by far the most important way around the tax imposed on the recipient of gifts or bequests from a covered expatriate.Congress does not understand second order effects. The first order effect of a tax law is the result that Congress intended. The second order effect is the ripple effect. What happens as a result of the impact that Congress intended? Usually these are pretty easy to predict.Here's the simple second order effect to the “U.S. persons pay a tax to inherit from a covered expatriate” tax rule of Section 2801. It becomes expensive for the offspring of a covered expatriate to inherit wealth. We should expect the children of covered expatriates to renounce U.S. citizenship as well. If you are a child who stands to inherit a vast sum of money from your parents, who expatriated, you are likely to choose expatriation (and inheriting 100 cents on the dollar) vs. U.S. citizenship (and 60 cents on the dollar).Tax law encourages people to expatriate.Exception: Surviving Spouse or Charity
If a covered expatriate makes a gift or bequest to a surviving spouse who is a U.S. citizen or resident, that gift or bequest is not taxed. Similarly, a gift or bequest to a charity will not be taxed. These are defined out of the definition of “covered gift or bequest”.These gifts or bequests are excluded from the definition of “covered gift or bequest”, and to prove that I quote from the Holy Writ, from Title 26, Section 2801, Paragraph (e), Subparagraph (1), wherein the sacred word is written:Such term shall not include any property with respect to which a deduction would be allowed under section 2055, 2056, 2522, or 2523, whichever is appropriate, if the decedent or donor were a United States person.The reason behind this is simple: dollars are returning to the United States to be taxed.
Exception: Estate Tax or Gift Tax Applied
A gift or bequest is not a “covered gift or bequest” if the U.S. gift tax or estate tax applied to the gift or bequest. Section 2801(e)(2) tell us:Such term [namely, “covered gift or bequest”] shall not include--This is the Bastard Exception from Hell. Let me explain.(A) any property shown on a timely filed return of tax imposed by chapter 12 which is a taxable gift by the covered expatriate, and(B) any property included in the gross estate of the covered expatriate for purposes of chapter 11 and shown on a timely filed return of tax imposed by chapter 11 of the estate of the covered expatriate.
B.E.F.H.
Note the requirement of a “timely” tax return. This can cause all sorts of fun.ExampleA covered expatriate continues to own U.S. real estate after he expatriates. It is worth $10,000,000. He dies, and the terms of his will say that his U.S. citizen children inherit the property.For one reason or another, the estate tax return is not filed on time. Eventually it filed. Let's make up a number and say the estate tax is $4,000,000 (40%, the current estate tax rate). The estate pays the tax by selling the property for cash and paying the tax.Now it is time to follow the instructions of the will. The estate of the covered expatriate owns $6,000,000 in cash – the $10,000,000 it received from selling the real estate minus the $4,000,000 estate tax paid.That $6,000,000 is left to the U.S. citizen children – a bequest. From a covered expatriate. It is a covered bequest, on which they must pay a tax – 40% – for the pleasure of receiving the bequest. They pay $2,400,000 tax, and are left with $3,600,000.If, on the other hand, the estate tax return had been filed on time, the children would have received $6,000,000 cash.That's one mofo of a late filing penalty.Every time you see a qualification or limitation written into the Internal Revenue Code, know that someone thought it was immensely sensible (“Let's require people to file tax returns on time! Duh! Self-evident!”) and no one gave a second thought to the consequences.
Exception: Taxable Only Above the Small Gifts Limit
Another exception – or minimum threshold, really – exists for small gifts or bequests, as stated in Section 2801(c):Subsection (a) shall apply only to the extent that the value of covered gifts and bequests received by any person during the calendar year exceeds the dollar amount in effect under section 2503 (b) for such calendar year.This means that a covered expatriate can make a gift or bequest to a U.S. citizen or resident, but the first $14,000 (for 2015 gifts or bequests) will be tax-free and everything above that will be taxable. This makes the tax on covered gifts or bequests operate in the same way as the normal gift tax rules.
Something Like a Foreign Tax Credit
If a U.S. person receives a covered gift or bequest, the amount of tax paid to the Internal Revenue Service is reduced by any tax on that asset imposed by a foreign country. Section 2801(d) says:The tax imposed by subsection (a) on any covered gift or bequest shall be reduced by the amount of any gift or estate tax paid to a foreign country with respect to such covered gift or bequest.
Dear Congress, I'm Not Impressed
The “covered gift or bequest” tax encourages would-be heirs to renounce U.S. citizenship. That means that capital will not flow to the United States. Thank God that Congress had the foresight to chase people and investment capital away from the United States. Who need them? Good riddance.The “covered gift or bequest” tax unfairly taxes wealth that was created after the covered expatriate renounced citizenship.ExampleA covered expatriate has a net worth of $3,000,000 when he expatriates. Over the remaining decades of his life he increases his net worth to $30,000,000. He dies and leaves the whole amount to his U.S. citizen children. The entire amount is subjected to the “covered gift or bequest” tax.That is dumb. The “covered gift or bequest” tax is a substitute for the estate tax. The idea is that we don't want covered expatriates taking vast amounts of wealth with them when they renounce their citizenship. They are then exempt from the estate tax. They leave their wealth to their U.S. children. That's great estate planning – an infinite amount of wealth can be passed tax-free to your children, at a cost of a one-time exit tax paid on capital gain at the time of expatriation.I get that idea. But in the real world it doesn't work. The tax law is broken.
- In my example, the covered expatriate took $3,000,000 out of the reach of the U.S. estate tax system when he renounced. That is below the threshold for estate tax in the first place. So why should there be a punitive tax imposed when the money comes back to his heirs in the United States? They would have received the money tax-free had the father remained a citizen.
- In my example, the covered expatriate increased his wealth by $27,000,000 while he was a nonresident alien. Assuming that all of those assets are out of the United States, these are assets that would never be subjected to U.S. estate tax at all. So why should the “covered gift and bequest” tax be allowed to take a haircut on these asset when they are passed at death to his U.S. children?