How nonresidents avoid generation-skipping transfer taxNovember 11, 2008 - Phil HodgenForeign Business Activities in the USA
A reader of my November, 2008 article in California CPA Magazine (hi, David) called me and asked a question about the article. He wanted to clarify a generation-skipping transfer tax question.
I didn’t have the space in the article to cover all of the nooks and crannies on the subject of estate taxation for cross-border families. And if there’s anything that has nooks and crannies, it’s the Internal Revenue Code. And one of the cranniest nooks is the generation-skipping transfer tax.
The question, simply put, is how you can make a foreign trust that later becomes a U.S. trust into a generation-skipping transfer tax exempt trust if you don’t allocate generation-skipping transfer tax exemption to it. [Ha! You call that a simple question? On what planet? ed.]
(Warning. Highly technical stuff follows. Causes brain damage.? You can read this charming little essay or you can skip this and go visit Internal Revenue Code Section 2663 and its progeny in the Treasury Regulations.)
U.S. citizens funding dynasty trusts–estate or gift tax
Start with normal U.S. estate tax planning for U.S. citizens. We’ll work around to noncitizens and foreign trusts. Trust me.
Let’s say your goal is to set up a dynasty trust–a trust that will hold assets for multiple generations. You don’t want an estate tax haircut as wealth passes from grandfather to child to grandchild to great-grandchild. As long as the assets stay inside the trust, that result is generally achievable.
The problem is getting the assets into that trust in the first place. Once the assets are inside the trust, we’re home free–that piece of real estate can stay in the family for generations without any estate tax.
There are only two ways for a U.S. citizen to get assets into such a trust:
- by dying (which means that first you pay the estate tax and whatever is left over goes into that trust), or
- by making a lifetime gift (which means you have to pay gift tax).
Plainly put–no matter which way you go, the IRS makes you pay a tax (estate tax or gift tax) in order to fund a dynasty trust.
U.S. citizens–generation-skipping transfer tax
The U.S. tax system is built on the idea that a tax should be paid on the transfer of wealth from one generation to the next.
If grandfather died and left money to his child, then the child died and left the money to the grandchild, there would be a tax when the grandfather died and when the child died.? The IRS takes two bites out of the family fortune.
Compare that to the simple scenario of the grandfather dying and leaving money to his grandchild.? There is estate tax on the grandfather.? The IRS gets one bite.
“Two taxes are better than one” is defined as “good” for purposes of the U.S. government. Reasonable people (i.e., all random semi-sentient multi-function humanoids who love their children more than they love supporting the Federal government’s profligacy) might define this result differently.
The generation-skipping transfer tax is set up so that if grandfather dies and leaves money to the grandchild, there will be a tax in about the same amount as if the grandfather had left the money to his child, then the child died leaving the money to the grandchild. Approximately, if not worse.
That’s the idea behind the generation-skipping transfer tax–make the grandchild’s after-tax inheritance the same, whether the money passes from grandfather to father to grandchild (two estate taxes) or from grandfather to grandchild (estate tax plus generation-skipping transfer tax).? So far, not too much brain damage.
Yeah, there are little fiddly exemptions for some things you do. Make the right elections and the generation-skipping transfer tax doesn’t apply. Congress has to give you that in order not to look too harsh. “The first million is on the house, buddy! Whee!”
Let’s ignore the exemptions temporarily. Where we’re going, we won’t need them.
Intruder alert! Intruder alert!
OK. I warned you. Now I really mean it. Your head is going to hurt in a second, so save yourself and get out while you can.
Why a nonresident noncitizen can avoid generation-skipping transfer tax
Up to now we’ve been talking about generic tax planning for U.S. citizens. Now let’s turn to what our law firm does, day in and day out — when the U.S. tax code reaches out to touch non-U.S. people.
Let’s say a nonresident noncitizen grandfather makes a simple gift to his U.S.-citizen grandchild. Grandfather wires $10,000,000 from his London bank account to the grandchild’s U.S. bank account. Done.
This looks suspiciously like a generation-skipping transfer, doesn’t it? It’s a great big gift that skips over a generation.
But there is no generation-skipping transfer tax.? Why?
No “transferor” = no generation-skipping transfer tax
In order to have a generation-skipping transfer tax, you have to have a “transferor” as defined in the rules. That’s at Section 2652(a) for you Internal Revenue Code buffs, which says that you have a transferor if the property transferred by that person would be subject to U.S. estate tax or subject to U.S. gift tax.
In my example, the gift by grandfather to U.S.-citizen grandchild would not be subject to U.S. gift tax. Therefore, grandfather is not a “transferor” as defined in Section 2652(a)(1)(B).
Here are the implications of having no “transferor.”
The gift I have described looks like a “direct skip”:
The term “direct skip” means a transfer subject to a tax imposed by chapter 11 or 12 of an interest in property to a skip person. Section 2612(c)(1).
The generation-skipping transfer tax will apply when money goes to a “skip person.” This is:
a natural person assigned to a generation which is 2 or more generations below the generation assignment of the transferor. Section 2613(a)(1).
Grandchild is a “natural person.”? Grandchild is 2 or more generations younger than the grandfather.? But the grandfather is not a “transferor.”? And if the grandfather isn’t a “transferor” then the whole definition falls apart because there is no starting point to define the number of generations.? So Grandchild can’t be a “skip person.”
Therefore, because grandfather is not a “transferor”, the grandchild can’t be a “skip person”.
Since the gift is made to someone who is not a “skip person”, the transfer can’t be a generation-skipping transfer. And the generation-skipping transfer tax can’t apply.
An even easier answer
Let’s look at the definition of a “direct skip” again. It’s a transfer that is subject to a tax imposed by chapter 11 (estate tax) or chapter 12 (gift tax) AND that transfer is made to a skip person.
When a nonresident makes a gift of cash from a foreign country to a U.S. citizen, that transfer is not subject to gift tax.
So even if the grandchild was a “skip person” the transfer would not be a “direct skip.” Which means that the transfer would not be subject to the generation-skipping transfer tax, because the transfer wasn’t subject to the gift tax.
Now let’s add trusts into the mix
So far I’ve been talking about the grandfather making a direct gift of cash to the grandchild.
What if the grandfather instead set up an irrevocable trust for the benefit of the grandchild? The same result would exist:? no generation-skipping transfer tax.
Because the post is so long already I won’t go into the “kneebone connected to the thigh bone, the thigh bone connected to the hip bone” explanation.
In brief, though, the distribution from the trust would either be a “taxable distribution” or a “taxable termination”.? But since these definitions require that the recipient be a “skip person”, we’re safe–the grandfather isn’t a transferor, so the grandchild isn’t a “skip person.”
Internal Revenue Code Section 2663
OK.? So you want the easy way out.? You don’t want my explanation, eh?
Go to Section 2663.? That’s where the application of the generation-skipping transfer tax to nonresidents is dealt with.
And go straight to Treasury Regulations 26.2663-2(b) which says that the generation-skipping transfer tax only applies if the original transfer (a straight gift or a transfer to a trust) was originally subject to U.S. estate or gift tax.
Moral of the story
A nonresident noncitizen may fund an irrevocable trust with non-U.S. assets without fear of the generation-skipping transfer tax.