Everyone focuses on the income tax side of expatriation. Understandable. The year of giving up U.S. citizenship or permanent residence is a busy year and income tax is painful.
But estate tax problems can lurk, even after expatriation. Expatriates receiving inheritances from U.S. persons
is one side of the equation.
Let’s look at the other side of the equation: money flowing back to the U.S. when an expatriate dies.
An expatriate (covered or otherwise) leaves an inheritance to a U.S. person. Here are the questions to ask:
- What assets belonging to the expatriate (covered or noncovered) are hit with the U.S. estate tax?
- When must a U.S. estate tax return be filed for a deceased expatriate?
- Which U.S. heirs of an expatriate will be hit with a special inheritance tax?
- What paperwork must U.S. heirs file when they receive inheritances from expatriates, covered or otherwise?
Estate Tax on the Expatriate’s Assets
The estate tax is a wealth tax. It applies to all of the stuff that a person owns at the moment of death.
What if that person is an expatriate–a former citizen or permanent resident of the United States?
An expatriate is by definition someone who is not a U.S. citizen. And I think we can safely assume that an expatriate does not live in the United States.
Citizens and Residents
The estate tax is imposed on worldwide assets for a U.S. citizen or for a noncitizen who lives in the United States–is “domiciled” in the U.S., to use the peculiar jargon of tax law.
Domicile means physical presence (where you are) plus a state of mind (your intention is to keep your permanent home where you are). It has nothing to do with visa status.
- A green card holder living permanently outside the United States is domiciled outside the United States.
- A person living in the United States without benefit of legal immigration status (have I been sufficiently PC for you?) is domiciled in the United States.
Noncitizen Nonresidents (aka Expatriates)
Someone who is neither a citizen nor a resident of the United States (domicile, remember) is not exposed to the U.S. estate tax on worldwide assets.
Only assets that are located in the United States will be taxed. Assets located anywhere else in the world cannot be taxed.
This is the rule that applies to expatriates. Now we just need to know what assets the deceased expatriate owns, and where those assets are located.
Located in the United States
The common sense meaning of “located” overlaps–to an extent–the tax law meaning of the word. Real estate in the U.S. is obvious. Stock issued by U.S. corporations is semi-obvious–these are U.S. assets. Debts owed by U.S. persons are somewhat less obvious but still treated as located in the United States (and yes that includes bonds).
There are exceptions–some things that are “located in the United States” are nevertheless not subjected to the estate tax. Bank accounts are an example.
Expatriates + U.S. Assets = Estate Tax
I will not write an encyclopedia here. All you need to remember is that an expatriate’s U.S. assets are at risk of having U.S. estate tax imposed on them.
It does not matter who the heirs are–U.S. residents or not. The estate tax is imposed on the assets, not on the recipients of the assets.
The planning opportunity for the prudent expatriate (covered or not):
- Sell or give away U.S. assets; or
- Put U.S. assets into holding structures that protect against U.S. estate tax when the expatriate dies; or
- Get exceedingly clever and carefully set up estate plans and invoke the protection of an estate tax treaty to mitigate the damage of the U.S. estate tax.
Estate Tax Return for the Expatriate
If an expatriate (a noncitizen and nonresident of the United States, in the “domicile” sense of nonresident) dies with U.S. assets, an estate tax return will be required. This is true for both covered and noncovered expatriates.
This is Form 706-NA.
Tax on the Recipient
This is where the rules diverge for covered expatriates and noncovered expatriates. U.S. persons who inherit from covered expatriates have a tax problem; those who inherit from noncovered expatriates do not.
U.S. Person Inherits from a Covered Expatriate
People who inherit assets (or receive a gift, for that matter) from a covered expatriate must pay a tax. This is the reverse of the estate tax: here, the recipient
pays a tax because of the covered expatriate status of the deceased peson.
Like everything in tax, it’s not real unless you point to a Section of the Good Book–the Internal Revenue Code. In this case, it is Section 2801.
The tax rate is the highest gift tax rate in existence at the time of the inheritance.2
It is imposed on:
any property acquired directly or indirectly by reason of the death of an individual who, immediately before such death, was a covered expatriate.3
There are exceptions:
- If a bequest will simultaneously be subjected to the estate tax (because the covered expatriate had U.S. assets) and this “Section 2801 tax”,4 then you apply the estate tax only.5
- If the recipient is a U.S. person and surviving spouse, then the tax does not apply.6
- Gifts under the “small gifts” limit (currently $14,000 per year) will escape the Section 2801 tax.7
U.S. Person Inherits from a Noncovered Expatriate
The Section 2801 tax only applies to gifts or inheritances received by a U.S. person from a covered expatriate.
Therefore, a noncovered expatriate can make a gift or leave an inheritance to a U.S. person, without risk of tax being paid by the recipient of the gift or inheritance.
Paperwork for the Person Inheriting
Finally, let’s look at the paperwork situation for someone inheriting assets from a covered or noncovered expatriate.
From Covered Expatriates
Persons inheriting assets from covered expatriates will have to file Form 708 (not yet published by the IRS). In addition, the recipient must file Form 3520 to report receipt of an inheritance from a nonresident alien.8
From Noncovered Expatriates
Form 708 only applies to inheritances from covered expatriates. That leaves only Form 3520 to be filed by a U.S. person who receives an inheritance from a nonresident alien. The reporting threshold is $100,000 for Form 3520, and the recipient completes Part IV of that form.
In summary, an inheritance from a noncovered expatriate by a U.S. person is unremarkable: it is not taxed, and the paperwork is modest: Form 3520.
An inheritance from a covered expatriate inflicts a 40% (current tax rate, at least) tax on the recipient
of the inheritance, as well as a double-barreled blast of paperwork requirements: Form 708 and Form 3520.