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August 29, 2017 - Phil Hodgen

Expatriates Receiving Inheritances from U.S. Persons

Let’s say you have expatriated (gave up U.S. citizenship or your green card) and you expect to receive an inheritance from a U.S. person–perhaps your parents.

How is that inheritance taxed?

Correspondent KP emailed me to ask exactly this question. (Hint: you can email ask a question, too; just hit reply and suggest a topic or ask a question for me to answer in the newsletter).

Perhaps you have already answered this in the expatriation blog and I just couldn’t find it (in which case, please send me a link), or it might be worth considering as a future topic:

If a person has renounced US citizenship, filed the 8854, and IS -for all intents and purposes- considered to be a non-resident non-citizen, what US tax/reporting obligations come into play if said person inherits a US estate from a US citizen & resident relative?

For example, I expatriated this year, but my parents live in the US and own a home there. I’m also an only-child, so somewhere down the road I am bound to be named as the sole beneficiary of their estate (which I would sell). What happens in this instance? What is the smartest course of action to avoid any IRS entanglements? How does one inherit US assets if you are a non-resident non-citizen? Can any possible tax unpleasantness be avoided by having the inheritance go to another kind of entity, e.g. a corporation or association etc.? And what implications would that have on how the will should be worded?

I’m really curious about how this works and what pitfalls there might be. I’m sure many other expats who still have US family wonder, too.

Summary

If you want to read less, here is the brief answer:

  • No Estate Tax on the Recipient. The U.S. tax system puts the tax burden on the estate of the deceased U.S. person, not on the beneficiary who receives an inheritance from the estate.
  • Expatriation Does Not Change the Result. As a result, everyone (U.S. citizen, U.S. resident, or nonresident of the United States) receives inheritances without any tax imposed. This rule also applies to expatriates (covered or noncovered).
  • Income Tax. However, an heir (including an expatriate or covered expatriate) will have potential U.S. income tax to pay. The estate of the deceased person will probably have income and expenses. The net income must be taxed to someone. That “someone” will be the heir(s) of the estate. The heirs get a Schedule K-1 from the estate so they can report their share of the estate’s income.

Basic Rule for Estate Tax

Let’s ignore tax rates, the amount of assets that can be transferred tax-free at death, and all of the other complexities of the estate tax.

Let’s just keep it simple. The estate tax: here’s how it works.

The Estate Tax is Imposed on Property

The estate tax is a tax on wealth that an individual owns at the time of death. This is the deceased person’s “estate”.

We could examine the technicalities of what is included in the estate of a deceased person for the purposes of property tax. “Owns” is a word that is far more expansive in meaning for tax purposes than it is in real live.

But for our purposes, this is not necessary. A deceased person has an “estate” consisting of assets owned at the time of death, and he estate tax is imposed on the estate–the property.

The reason for this is simple. The estate tax is a transfer tax: a tax on the privilege of transferring property from one person to another at the time of death. Since the taxable event is the transfer, it makes sense that the tax is computed by reference to the property itself.

Heirs are not Liable for Estate Tax . . .

Since the estate tax is imposed on the “estate” of the deceased person and paid from those assets, whatever is left (after tax payments) may be distributed to the heirs.

This system is unlike how many countries’ tax systems operate. Many countries impose a tax on the recipient who receives an inheritance. This is not the case with the U.S. estate tax. The U.S. system is a tax on the transfer of assets.

Since, under the U.S. system, the tax has been paid in full, the heirs will not pay tax on whatever they receive.

. . . Except in Certain Circumstances

In exceptional cases, an individual is personally liable for the estate tax. The executor of a deceased person’s estate will be personally liable if the estate tax is not paid in full from the deceased person’s assets.

And, the heirs of the estate will be personally liable for unpaid estate tax if they receive inheritances but the estate tax is not paid in full.

Basic Rule Summary

In summary, the basic rule for inheritances from U.S. persons is simple:

  • Pay the estate tax from the property owned by the deceased person.
  • Individual heirs are not responsible for the estate tax, unless they receive inheritances that were not properly taxed.

The Expatriation Rules Change Nothing

The basic concepts of estate tax apply to all taxable estates and all heirs who receive transfers from estates. There is no special exception for expatriates, covered or otherwise.

There are two Sections in the Internal Revenue Code that apply to the expatriation rules. Neither will change the basic rule.

  • Section 877A spells out the income tax rules that apply to expatriates. Income tax rules have no impact on estate tax, and vice versa. No worries.
  • Section 2801 spells out the tax rules that apply to U.S. persons who receive gifts or inheritances from covered expatriates. Here, the tax is imposed when the source of the gift or inheritance is a covered expatriate, not when the expatriate is the receipient of a gift or inheritance. No worries.

Since there are no special rules that apply to expatriates (covered or not), the basic concepts for estate tax will still apply. Everyone (including expatriates) will receive inheritances from deceased U.S. persons tax-free.

Income Tax on the Estate’s Income

All heir–citizens, residents, or nonresidents–will pay income tax on their share of the estate’s taxable income.

Allocation of Income Between Deceased Person and Estate

People only pay income tax while they are alive. Income they receive is reported on their personal income tax return (Form 1040).

After a person dies, the income payable to that person instead becomes payable to his or her estate, and is reported on the estate’s income tax return (Form 1041).

There are simplifications that can reduce paperwork burdens, but that is the basic idea.

Example

An individual owns Apple Inc. stock and receives a dividend at the end of every calendar quarter.

The individual receives a $100 dividend on June 30, 2017 while the individual is alive.

The individual dies on September 8, 2017.

At the end of the month, on September 30, 2017, another dividend of $100 is received. This dividend is received after the date of death.

The dividend received on June 30, 2017, while the individual was still alive, is reported on the final personal income tax return for that person (Form 1040).

The dividend received on September 30, 2017 belongs to the estate of the deceased person, and is reported on the income tax return for the estate (Form 1041).

Allocation of the Estate’s Income to the Heirs

The estate does not pay tax on its income. Rather, the income (and the associated tax liability) belongs to the heirs of the estate.

So the estate will allocate its income among all of the heirs of the estate. The heirs will each receive a Schedule K-1 that reports the taxable income allocated to each of them. The heirs take the income amounts from Schedule K-1 and report this on their individual income tax returns.1

Example

Dividend income of $100 is received from Apple Inc. on September 30, 2017 by the estate of a deceased person. There are two heirs, each of whom will inherit 50% of the estate.

The estate receives no other income for the rest of calendar year 2017, and has no expenses.

The estate prepares its 2017 income tax return and issues Schedule K-1 to each of the individual heirs, allocating $50 of dividend income to each of them.

Each heir will report $50 of dividend income on his or her U.S. income tax return.

Nonresident Alien Heirs

What if one of the heirs is a nonresident and noncitizen of the United States? An expatriate is precisely this kind of person.

Nonresident aliens (“alien” is Federal law jargon for “noncitizen of the United States”) pay U.S. income tax on income received from U.S. sources.

A nonresident alien heir of a U.S. estate will therefore look at the Schedule K-1 received from the estate every year, and determine whether the income reported there is from U.S. sources (or not). Income from U.S. sources is taxable. If the triggers for filing Form 1040NR are . . . uhhh . . . triggered, then a tax return is required.

Expatriates receive this treatment. An expatriate is almost always a nonresident alien for U.S. income tax purposes:

  • “alien” because the expatriate does not have U.S. citizenship, and
  • “nonresident” because the expatriate has (usually) assiduously avoided doing anything to make himself or herself a U.S. resident and thereby taxable on worldwide income.

Example

A nonresident alien heir of a U.S. estate is allocated $50 of dividend income, which was paid because the estate owns Apple Inc. stock.

Dividends paid by U.S. corporations are treated as U.S. source income.

Therefore, the nonresident alien will be taxable on $50 of dividend income. The only question to determine is the tax rate. It will either be 30% (the default tax rate on dividends paid to nonresident alien shareholders) or a lower rate permitted under the terms of an income tax treaty between the USA and the nonresident alien’s home country.

Conclusion

No Estate Tax on Distribution

An expatriate heir will inherit assets from a U.S. estate and will pay no U.S. estate tax on the inheritance. Any estate tax will be paid first, before the distribution is made to the expatriate heir.

Personal Liability for Estate Tax if Screwup Occurs

If the expatriate heir is the executor of the estate and screws up the estate tax obligations–the estate tax is not paid in full–then the expatriate heir has personal responsibility for the unpaid estate tax.

If the executor of the U.S. estate does not fully pay the estate tax before distributing assets to the expatriate heir, the U.S. has the right to claim that the receipient of the distributed assets–the expatriate heir–must pay the unpaid estate tax.

Memo to all personnel:

  • if you are the executor, don’t screw up the estate tax obligations (or indeed, tax obligations in general) for the estate, and
  • if you are an heir, don’t let the executor screw things up, either.

Income Tax

Expatriate heirs of U.S. estates should expect to file nonresident income tax returns to report their pro-rata share of the estate’s taxable income.

 


  1. Those of you who worship at the Church of the Almighty Subchapter J are experiencing cognitive dissonance. Your minds recall the teachings of the Saints, and rebel at my gross simplification of the received divine inspiration given to us by Enlightened Beings and inscribed in the True Book. “But but but . . . distributive net income!” My heresy is unrepentant in my quest to bring Light to the laity. Simple is better. Martin Luther is my role model. 
Expatriation