Estate Tax for Noncovered ExpatriatesNovember 22, 2016 - Phil HodgenExpatriation
Hello and welcome to Expatriation Only.
Noncovered expatriates are people who – when they exit the U.S. tax system can answer “Yes” to all three of these questions:
- Is your net worth below $2,000,000?1
- Did you, on average over the previous five years, have a Federal income tax liability below $162,000?2
- Have you, for the previous five years, filed all of your required U.S. tax paperwork correctly and paid all of your U.S. tax?3
If you answer “no” to any one of those questions, you are a “covered” expatriate.4
Covered Expatriates and Punishing the Iniquitous
This discussion is only marginally accurate for covered expatriates – they face an additional bolus of tax rules designed to punish those who have sinned in the eyes of our Dear Leaders.
That additional punishment is enshrined in Section 2801 of the Internal Revenue Code. Here is the key idea: if you are a covered expatriate and you make a gift (or leave an inheritance) to a U.S. person, there is an additional (large) tax imposed on the recipient of that gift (or inheritance).
Sins of the fathers are visited upon the children. Fortunately, Congress has recognized that it is not God,5 so these tax sins are only visited unto the first generation, not the third and fourth.6
We are not going to talk about covered expatriates and their estate tax problems. That’s a conversation best left for another cocktail party.
Noncovered Expatriates and the Estate Tax
Noncovered expatriates are treated like any other noncitizen/nonresident of the United States when it comes to estate and gift tax.
If we go back to basics,7 the underlying philosophy of the estate tax system is clear: the United States will only impose the estate tax on assets located in the United States that are owned by noncitizen/nonresidents.8
The basic estate tax concept for nonresident/noncitizens9 is simple. Stuff in the United States owned by a nonresident/noncitizen when he/she dies will be taxed. There is a small exemption amount ($60,000, to be precise).
The Two Key Strategies
There are two key strategies that a noncitizen/nonresident can employ in order to avoid estate tax:
- Do not own anything that is “located in the United States”; or
- If you have an asset in the United States, don’t “own” it.
Located in the United States
The first of the two key strategies is “do not own anything that is ‘located in the United States’”. If all of your assets are “outside” the United States, the estate tax will not apply, because the U.S. only taxes things you own (at the time of your death) that are located inside the United States.10
The problem with this is to understand the peculiar definition of “located in the United States” that the tax laws use. The magic jargon is “U.S. situs asset” and it is similar to (but not quite exactly like) your common-sense notion of “Where is this thing?” This is especially true with the “thing” is abstract. It is easy to understand where to pin the location of a bulldozer. But where is money? And if you own a piece of a business, where is that business?
This is something you will need to figure out, but here is an easy way to start. If money appears to flow from the United States, assume the asset is a “U.S. situs” asset for estate tax purposes. If there are legal documents that say “created in the United States” (like a corporation), the asset is almost certainly a U.S. situs asset. If there is an account at a U.S. financial institution, assume that you have a U.S. situs asset.
Basically, if there is any connection with the United States, assume the worst. I’m not saying this is the definitive answer. Tax law is deliberately complicated, then bolloxed up with exceptions, and exceptions to the exceptions.
Here are some U.S. situs (i.e., “located in the United States” for estate tax purposes) assets that a normal covered expatriate might own:
- Real estate in the United States;
- Stock of a corporation organized in the United States (whether the corporation is Apple Inc. or Joe’s Corner Bakery, Inc.);
- Cash money, y’all. (But there is a special pre-wired exception to the rule that allows you to have a U.S. bank account as a nonresident/noncitizen and have no exposure to estate tax.)
Your objective should be to own no assets in the United States after you expatriate.
And if this is impossible … .
Own, But Do Not “Own” the U.S. Asset
The second strategy to avoid estate tax is to continue to own (in the common-sense meaning of the term) but not “own” (in the tax law jargon sense of the term) U.S. assets.
The tax law idea here is the concept of your “gross estate”. When someone dies, whatever they “own” is included in a big bucket of assets. The dead person’s big bucket of assets is called the “gross estate”.11 An asset is included in your gross estate if you have an “interest” in that asset.12
Your objective is to
have your cake and eat it, too enjoy the benefits of being an owner of an asset but not have an “interest” in that asset. This is the world in which tax lawyers live. How many angels can dance on the head of a pin?
Here is a simple illustration. This is probably not an optimal tax strategy to follow (hint! hint! don’t do this!) but it shows the legal principle at work.
You own real estate in the United States and you want to keep the real estate after you renounce your U.S. citizenship.
Before you renounce your U.S. citizenship, you transfer ownership of the real estate from your name to the name of a foreign corporation. You own 100% of the stock of the foreign corporation.
You then renounce U.S. citizenship.
If you die after renouncing your U.S. citizenship, we need to figure out which assets are included in your gross estate for U.S. estate tax purposes. We look at what you own, and we see stock of a foreign corporation.
Stock of a foreign corporation is treated as located outside the United States.
Therefore, even though the foreign corporation owns U.S. real estate, you do not have an “interest” in the real estate (which would be included in your gross estate). You have an interest in the foreign corporation stock, which is not included in your gross estate for U.S. estate tax purposes because it is treated as located outside the United States.13
Result: there is no estate tax on the value of the U.S. real estate when you die.
In short, think of the strategy like this: if I have a U.S. asset that would unquestionably be taxed if I die, is it possible for me to transfer ownership to an entity that I can own without estate tax risk?
Or put more simply: can I place a taxable asset inside a wrapper that makes it not taxable?
The answer is usually yes.
Your Secret Weapon: the Unified Credit
So. Your simple estate planning strategy, dear noncovered expatriate, is to either:
- liquidate all of your U.S. assets and take the money with you; or
- put the U.S. assets into an anti-estate tax wrapper and keep the assets after you renounce your U.S. citizenship.
Or maybe a bit of both.
Transferring assets from your name into a wrapper need not be (but might) be an event that triggers gift tax. For instance, you might transfer U.S. real estate from your name and into a trust for the benefit of your spouse and children. Your family continues to benefit from the real estate ownership economically, but you do not have an “interest” in the real estate and therefore it is out of bounds for estate tax.
The way to neutralize gift tax is to use the unified credit. In plain language, each U.S. citizen or resident may give away up to $5,490,000.14 A nonresident/noncitizen does not have this exclusion.
By definition, a noncovered expatriate has far less in assets than the unified credit amount. So, if the asset is suitable for giving away, you should think about giving it away so that when you renounce U.S. citizenship you do not have an “interest” in the asset. Note that I say before you renounce U.S. citizenship. This is so you can take advantage of the large tax-free gift exclusion.
You own real estate in the United States worth $1,500,000. You want to keep the real estate as an investment after you renounce U.S. citizenship. You are fine with the idea of putting the real estate into a trust for the benefit of your spouse and children.
- If you keep the U.S. real estate and die after you renounce U.S. citizenship, it is exposed to estate tax for all value above $60,000. The tax bill will be huge if you die.
- If you keep the U.S. real estate and give it to a trust for the benefit of your spouse and children after you renounce U.S. citizenship, you will pay a large gift tax. The $5,490,000 “give it away for free” exclusion will not apply.
- If you put the U.S. real estate into a trust for your spouse and children before you renounce U.S. citizenship, you will be able to eliminate all of the gift tax by using the “give it away for free” exclusion.
Before you run off and do this, please (1) read the disclaimer below; (2) don’t be a damned fool; and (3) figure out if there are hidden tax costs built into transferring the asset from your name and into a trust, corporation, or the like.
IRAs are a special case. You cannot put the IRA into a trust or a corporation. And if you die, the IRA’s value is exposed to estate tax. Ordinarily we do not care about this, because of the $5,490,000 exclusion – this shelters assets from gift tax if you give things away when you are alive, and it shelters assets from estate tax if you transfer assets at the time of your death.
But remember. As a nonresident/noncitizen you do not get the $5,490,000 exclusion, your IRA will be exposed to U.S. estate tax.
Your choices here are:
- Live long enough to take a distribution from your IRA without the early withdrawal penalty. If you make it to age 59 ½, my recommendation is to take a total distribution, pay whatever income tax is due, and get the money out of the United States.
- Liquidate the IRA and pay the early withdrawal penalty. This is especially true if the IRA balance is small. The cost of the penalty and income tax on the distribution will be far less expensive than the brain damage you incur by continuing to hold the IRA after you renounce citizenship.
- Look for an estate tax treaty to protect the value of the IRA from U.S. estate tax.
Stock Market Investments
If you have a generic investment account that holds U.S. stock (Google, Ford, whatever), these assets will be exposed to U.S. estate tax if you die. Also mutual funds, by the way.
- If you can, I suggest you liquidate your stock holdings and move the money out of the United States. Invest in non-U.S. stocks, bonds, and mutual funds. (Remember the first principle: no U.S. situs assets).
- If you want to keep U.S. stocks because it is a prudent investment strategy (and indeed it is), attempt to put the investments in a wrapper. (Remember the second principle: you do not have an “interest” in the assets). Form a foreign corporation. Put money into that foreign corporation. Have the foreign corporation buy the Google, Ford, etc. stock that you want to own.
Again, fair warning: (1) read the disclaimer; (2) don’t be an idiot; and (3) look for collateral damage caused by your work-around to the U.S. estate tax laws.
Other Stuff, and Your Game Plan
Mysterious are the ways of Divine Providence, and boundless are the vagaries of human behavior. Today is not the day to explore the infinite.
My suggestion is that you look at everything you own before you renounce your U.S. citizenship. Figure out what you can safely sell, and move those assets into cash. Later you will send the money to a bank account outside the USA.
For assets you cannot sell, figure out how you can safely give them away or keep them by wrapping them inside corporations, trusts, etc. so you do not have an “interest” in the assets. This is an exercise in exploiting tax law.
There are strategic considerations to think about as you do your planning, principally for U.S. capital gain tax on the eventual sale of the assets. Sometimes it is even desirable to deliberately become a covered expatriate – for tax saving purposes.
Then, after reconfiguring your life, renounce your U.S. citizenship or give up that long-held green card.
Pre-emptive Strike, Warning, Disclaimer
Kids, don’t try this at home. No matter what you do (keep assets, sell assets, give away assets) you are potentially triggering a tax event. Take no action until you know the direct/desired effect, as well as the second- and third-order effects.
Get some help from someone who knows stuff. You’re only going to expatriate once. Do it right.
Shameless plug: email me; we will be happy to help – we are cost-effective and efficient because we have done this so often.
- IRC §§ 877(a)(2)(B), 877A(g)(1)(A). ↩
- IRC §§ 877(a)(2)(A), 877A(g)(1)(A). The dollar value is adjusted annually for inflation. The amount given is for expatriations in 2017. Rev. Proc. 2016-55, § 3.32. ↩
- IRC §§ 877(a)(2)(C), 877A(g)(1)(A). ↩
- IRC § 877A(g)(1)(A). ↩
- Well, at least not an Old Testament-style God. ↩
- Exodus 20:5 (KJV). ↩
- Q: “How do governments successfully extract tax revenue from human beings?” A: “With credible threats of imprisonment or impoverishment.” ↩
- Threats of imprisonment are futile, because the nonresident is physically located outside the United States. The Federal government has limited success in imposing U.S. law in other countries. Post-colonial resentment and a standing army go a long way towards telling Uncle Sam to go stick his nose in a dead bear’s bum. This means that threats of impoverishment are the only things that give the U.S. government leverage. And since the only assets within reach of the Internal Revenue Service are those located in the United States, Congress has written the estate tax laws so that it will tax only what it can – as a practical matter – successfully collect against. ↩
- This concept has a specific definition, but I’m not going to chase that rabbit today. It is sufficient for our purposes, dear reader, to know that the person we are talking about does not hold U.S. citizenship and does not “really truly” live in the United States. ↩
- IRC § 2103. ↩
- IRC § 2031. ↩
- IRC § 2033. ↩
- IRC § 2104(a). ↩
- This number is for cumulative gifts through 2017; the IRS adjusts the amount annually for inflation. Rev. Proc. 2016-55, § 3.35. ↩