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:
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.
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.
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.
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.
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):
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.
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.
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:
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.
Finally, let’s look at the paperwork situation for someone inheriting assets from a covered or noncovered expatriate.
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
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.