Private Wealth Services

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1 Private Wealth Services Winter 2007 Volume 5, Issue 3 Estate Planning for the International Private Client Melinda Merk The laws governing estate plans of nonresident aliens and non-citizens of the United States are substantially different from those that apply to U.S. citizens. This article highlights many of the important distinctions and notes several estate planning tips (and potential traps) to be considered by non- U.S. persons. Resident vs. Nonresident Alien The test for determining whether an individual is a nonresident alien (NRA) for U.S. federal income tax purposes is different than the test for determining whether one is an NRA for transfer (i.e., estate, gift and generation-skipping transfer) tax purposes. As a result, it is possible for an individual to be considered a resident for income tax purposes but not for transfer tax purposes. U.S. Income Taxation Generally, a non-u.s. citizen will be considered a resident alien for income tax purposes if (1) he is a lawful permanent resident of the U.S. at any time during the calendar year (i.e., a green card holder), or (2) if he meets the substantial presence test. Subject to certain exceptions, an alien meets the substantial presence test for the current calendar year if he is physically present in the U.S. for at least 31 days during the current calendar year and for at least 183 days during the three-year period that includes the current calendar year and the two years immediately before that, counting (1) all the days he was present in the current calendar year, (2) one-third of the days he was present in the first preceding calendar year and (3) one-sixth of the days he was present in the second preceding calendar year. Certain individuals are exempt from the substantial presence test, including G-4 visa holders, diplomats, teachers temporarily present in the U.S. under a J or Q visa, and students temporarily present in the United States under an F, J, M or Q visa. An individual who is classified as a resident alien for income tax purposes is generally subject to U.S. taxation on his worldwide income in the same manner as a U.S. citizen. In It is possible for an individual to be considered a resident for income tax purposes but not for transfer tax purposes. contrast, an NRA is generally subject to U.S. income tax only on his U.S. source income. Income of an NRA that is considered to be effectively connected with a U.S. trade or business is generally taxed on a net basis, at the same rates that apply to U.S. persons after allowable deductions. Gains and losses from the sale or exchange of U.S. real property by an NRA are taxed as if the nonresident alien were engaged in a trade or business in the U.S. and are considered effectively connected income. Disposition of U.S. real property by an NRA may also be subject to the Foreign Investment in Real Property Tax Act (FIRPTA), which generally requires that 10 percent of the gross sales price be withheld at closing. Income of an NRA derived from sources in the U.S. that is not effectively connected with a U.S. trade or business (known as Fixed, Determinable, Annual, or Periodical (FDAP) income) is generally taxed on a gross basis and is required to be withheld by the payor at a flat 30 percent rate (or lower treaty rate). The 15 percent reduced rate for qualified dividends is not available to an NRA. Certain items of FDAP income are generally exempt from U.S. taxation, such as interest earned on U.S. bank deposits (including certificates of deposit) and portfolio interest. Capital gains on the sale of intangible property (such as stock in a U.S. company) by an NRA are generally exempt; however, if the NRA is physically present in the U.S. for 183 days or more during the year of sale, gains on the sale of such IN THIS ISSUE Estate Planning for the International Private Client... 1 Giving Tangible Personal Property to Charity: What You Need to Know... 5

2 property are generally taxed on a gross basis at a flat 30 percent rate (or lower treaty rate). This exception typically arises in the context of an exempt individual (such as a G-4 or F-1 visa holder) who is exempt from the substantial presence test but is otherwise present in the U.S. for at least 183 days in the year of sale. Currently, a U.S. person (U.S. citizen or resident alien) is entitled to a $1 million gift tax exemption and $2 million estate and GST tax exemptions.... In comparison, an NRA is subject to U.S. transfer tax only on his U.S. situs assets. U.S. Transfer Taxation A non-u.s. citizen will be classified as a resident alien for U.S. transfer tax purposes if his domicile is in the United States. This is a mostly subjective test based on one s intent to remain indefinitely in the United States. Various factors may be considered in determining the location of an alien s domicile, including: the duration of stay in the U.S. and other countries the frequency of travel both between the U.S. and other countries and between places abroad the size, cost and nature of the alien s houses or other dwelling places and whether those places were owned or rented the area in which the houses and other dwelling places were located (e.g., resort area vs. non-resort area) the location of expensive and cherished personal possessions the location of the alien s family and close friends the place where the alien maintained church and club memberships and participated in community affairs the location of the alien s business interests declarations of residence or intent made in visa applications, wills, deeds of gift, trust instruments, letters and oral statements motivation, especially health, pleasure and the avoidance of the miseries of war or political regression visa status An individual who is classified as a resident alien for transfer tax purposes is generally subject to U.S. transfer taxation on his worldwide assets, and is entitled to the same estate, gift and generation-skipping transfer (GST) tax exemptions as a U.S. citizen. Currently, a U.S. person (U.S. citizen or resident alien) is entitled to a $1 million gift tax exemption and $2 million estate and GST tax exemptions. Any taxable gifts made during one s lifetime will decrease the amount of estate tax exemption available at one s death. In comparison, an NRA is subject to U.S. transfer tax only on his U.S. situs assets. However, the estate tax exemption for an NRA is limited to $60,000, unless increased by a treaty. In addition, only a pro rata portion of an NRA s recourse debts and administration expenses are deductible for estate tax purposes, based on the value of the U.S. property and the value of the NRA s worldwide estate (which must be disclosed on the NRA s U.S. estate tax return). Both NRAs and U.S. persons are permitted to make annual exclusion gifts of up to $12,000 per donee per year under current law (or $24,000 per year, provided both spouses are U.S. persons and the donor s spouse consents to gift-splitting ) as well as unlimited gifts via direct payment of ABOUT THIS NEWSLETTER Please direct all inquiries to: R. Scott Johnston, Co-Editor 195 Broadway, 24th Floor New York, NY Fax scott.johnston@hklaw.com Todd J. Schneider, Co-Editor 131 South Dearborn Street, 30th Floor Chicago, IL Fax todd.schneider@hklaw.com Information contained in this newsletter is for the general education and knowledge of our readers. It is not designed to be, and should not be used as, the sole source of information when analyzing and resolving a legal problem. Moreover, the laws of each jurisdiction are different, and are constantly changing. If you have specific questions regarding a particular fact situation, we urge you to consult competent legal counsel. Holland & Knight lawyers are available to make presentations and represent clients on a wide variety of trust and estate matters. Our lawyers are experienced in all areas of asset protection and wealth preservation. They also represent clients in tax controversies, will contests and trust litigation. To ensure compliance with Treasury Regulations (31 CFR Part 10, 10.35), we inform you that any tax advice contained in this correspondence was not intended or written by us to be used, and cannot be used by you or anyone else, for the purpose of avoiding penalties imposed by the Internal Revenue Code. 2

3 medical and educational expenses which are gift tax-free and do not utilize any portion of the donor s gift tax exemption (if applicable). Gifts between spouses are generally non-taxable, provided the donee spouse is a U.S. citizen. An annual exclusion of $125,000 (as indexed annually for inflation) is available for gifts to a non-u.s. citizen spouse in Situs Rules Applicable to NRAs for Transfer Tax Purposes General Rules As stated above, an NRA is subject to U.S. transfer tax only on U.S. situs assets. The rules for determining what is U.S. situs property are somewhat different for gift tax purposes than they are for estate tax purposes. For gift tax purposes, U.S. situs property is generally comprised only of real property and tangible personal property located in the United States The Internal Revenue Service has previously ruled that a gift of cash from a U.S. bank account is a gift of tangible personal property. Therefore, gifts of cash by an NRA should be made from accounts located outside the United States. The definition of U.S. situs property for estate tax purposes is further expanded to include U.S. securities and deposits held by U.S. brokerage firms or other financial institutions that are not considered banks (such as money market accounts, but not including certificates of deposit). Generally, amounts on deposit with U.S. banks, savings and loan institutions, and credit unions (or foreign branches of U.S. banks) are exempt. Portfolio debt obligations (which include U.S. government and corporate bonds, debentures and notes issued after July 18, 1984) are also generally exempt. However, bank accounts and portfolio debt will not be exempt from U.S. estate taxation if the decedent was a resident of the U.S. for income tax purposes at his or her death. Proceeds from an insurance policy on the nonresident alien s life are not considered U.S. situs property, even if the policy is issued by a U.S. insurance company. Converting U.S. Situs Property to Non-U.S. Situs Property There are several ways an NRA can convert or remove U.S. situs property from his or her estate. For example, the NRA could sell his U.S. securities and reinvest the proceeds in non-u.s. situs assets prior to his or her death. As stated above, if the NRA is physically present in the United States for fewer than 183 days in the year of sale, any gain realized on the sale would generally be exempt from U.S. income tax. The NRA could also consider gifting his U.S. securities, which could be done without incurring any U.S. gift tax. An NRA might also consider transferring his or her U.S. securities to a foreign corporation, since stock in a foreign corporation is not subject to U.S. estate tax. With regard to interests in U.S. real property (such as a vacation home or other investment property located in the United States), an NRA should consider acquiring such property via a foreign corporation, which would convert the property to a non-u.s. situs asset for estate tax purposes. However, any gain or rental income from the U.S. real property owned by the foreign corporation would remain subject to taxation for U.S. income tax purposes. With regard to interests in U.S. real property (such as a vacation home or other investment property located in the United States), an NRA should consider acquiring such property via a foreign corporation. The NRA may also wish to consider purchasing term life insurance on his or her life, in order to cover any estate tax liability with regard to U.S. situs property that may be due at his or her death. As stated above, the proceeds from such a policy would be exempt from U.S. estate tax. Thus, it would not be necessary for the NRA to transfer the policy to an irrevocable life insurance trust (as is typically done by a U.S. person in order to prevent the proceeds from being includible in his or her estate). Estate Planning for Non-Citizen Spouses Qualified Domestic Trusts Generally, the availability of the estate tax marital deduction for both U.S. person and nonresident alien decedents will depend on whether the surviving spouse is a U.S. citizen. Current law generally provides for an unlimited marital estate tax deduction for outright and other qualified transfers to a surviving spouse, provided the surviving spouse is a U.S. citizen. If the surviving spouse is not a U.S. citizen, property passing to the surviving spouse generally will not qualify for the marital deduction, absent applicable treaty relief, unless the property is transferred to a qualified domestic trust (QDOT). One or more QDOTs can be created by the deceased spouse under his or her will, or by the surviving non-citizen spouse within a specified period of time after the deceased spouse s death. A QDOT cannot be used for gifts made to a non-citizen spouse during the donor s lifetime. QDOTs are subject to various limitations and tax reporting requirements. First, a QDOT must qualify as a marital trust for U.S. estate tax purposes. In addition, at least one trustee must be a U.S. citizen or domestic corporation. The trustee 3

4 Given the complexities of a QDOT, couples may wish to consider titling a significant portion of their non-u.s. situs property in the nonresident alien spouse s name. may also be required to furnish a bond or other security if the trust assets exceed a certain amount, to ensure collection of tax from the QDOT. Generally, distributions of principal from a QDOT, as well as assets remaining in the QDOT at the surviving spouse s death, are subject to a special QDOT tax based on marginal estate tax rate of the first deceased spouse. Most clients are surprised to learn that, even if the surviving non-citizen spouse is a U.S. resident, the surviving spouse s estate tax exemption (and any debts or administration expenses associated with his or her estate) cannot be used to offset the QDOT tax on assets remaining in the QDOT at the surviving spouse s death. Thus, if the surviving spouse intends to remain in the U.S. indefinitely, it may be advantageous for the spouse to become a U.S. citizen. In such a case, the QDOT will typically terminate without any QDOT tax and the assets will be distributed to the surviving spouse subject to inclusion in his or her estate. Given the complexities of a QDOT as described above, couples living outside the U.S. where one spouse is a U.S. citizen and the other is a nonresident alien may wish to consider titling a significant portion of their non-u.s. situs property in the nonresident alien spouse s name. This would generally avoid the necessity of a QDOT if the citizen spouse dies first. However, the spouses should be careful not to trigger any inadvertent gift on the retitling. Special Rules Regarding Jointly-Owned Property The estate and gift tax rules that apply with regard to jointly-owned property where either spouse is a non-u.s. citizen are different than the general rules that apply where both spouses are U.S. citizens. First, jointly-owned (non-community) property passing to a non-citizen spouse is generally 100 percent includible in the deceased spouse s estate; whereas, if the surviving spouse is a U.S. citizen, only one-half of the property would be includible. This presumption can be rebutted if the surviving spouse can trace the consideration provided by him or her toward the property; therefore, it is important that the couple maintain complete and accurate records in order to substantiate this information. Second, the gift tax rules that apply with regard to the creation and severance of joint tenancies where either spouse is a non-u.s. citizen are different than the general rules applicable to U.S. citizen spouses, which can often lead to unintended tax results. Generally, the creation of a joint tenancy (including tenancy by the entirety) in real property by a couple where either spouse is a non-u.s. citizen will not constitute a taxable gift. However, if the property is later severed into tenants in common, or is sold and the non-u.s. citizen spouse receives more than his or her pro rata share of the proceeds attributable to the consideration provided by the non-citizen spouse, a taxable gift to the non-citizen spouse will generally result. Thus, it is important to maintain accurate records tracing the consideration provided by each spouse. Similarly, the creation of a joint bank or investment account by a couple where either spouse is a non-u.s. citizen will not constitute a taxable gift. However, if the account is terminated or if one spouse withdraws or receives more than the pro rata portion of the account that he or she contributed, a taxable gift to the non-citizen spouse will generally result. Jointly-owned (non-community) property passing to a non-citizen spouse is generally 100 percent includible in the deceased spouse s estate; whereas, if the surviving spouse is a U.S. citizen, only one-half of the property would be includible. Other Special Rules As stated above, an unlimited gift tax marital deduction is not available for gifts to a non-citizen spouse. Instead, an annual exclusion of $125,000 in 2007 (as indexed annually for inflation) is available for such gifts. In addition, if either spouse is an NRA, the couple cannot elect to gift-split (i.e., treat all gifts made by one spouse during the calendar year as having been made one-half by each spouse, provided a qualified election is made on the donor spouse s gift tax return). Other Potential Estate Planning Traps Forced Heirship Rules NRAs, as well as U.S. persons who own property outside of the United States, should be mindful of the forced heirship rules that apply in most civil law countries (such as France). Generally, these rules require a portion of the estate to pass to the decedent s children at his or her death, regardless of the provisions contained in his or her will. This can frustrate the decedent s estate plan and can also prevent such 4

5 property from qualifying for the estate tax marital deduction. Therefore, it is imperative to consult with legal counsel in the foreign country in order to confirm the potential effect of such rules on the overall estate plan. U.S. real property should be removed from the revocable trust before it is sold, and the proceeds should be contributed to a newlycreated revocable trust. U.S. persons who own real property outside of the United States may avoid application of the forced heirship rules, and obtain additional asset protection and estate planning benefits, by contributing the foreign property to a domestic partnership or limited liability company. However, because the law of the foreign jurisdiction may look-through the entity for purposes of the forced heirship rules, one should seek advice from foreign counsel. Revocable Trusts Revocable trusts are commonly used in the U.S. to avoid probate and to provide for effective management of one s property in the event of incapacity. However, the use of a revocable trust by an NRA may result in unintended estate tax consequences. Specifically, if the nonresident alien transfers U.S. situs property (such as a vacation home located in the United States) to a revocable trust, the assets of the trust will generally be includible in the NRA s estate, even if the U.S. property is sold and converted to non-u.s. situs property (e.g., cash in a U.S. bank account) before the NRA s death. In order to avoid this result, the U.S. real property should be removed from the revocable trust before it is sold, and the proceeds should be contributed to a newlycreated revocable trust. Conclusion Planning to take advantage of unique opportunities afforded the international private client and, at the same time, avoid the many potential pitfalls that may befall such plans requires the assistance of professionals who regularly practice in this arena and who can (and will) coordinate with foreign counsel as needed. When identifying such professional advisors, take special care to inquire about their background and experience, not just in the area of estate planning, but also in the specialized world of international estate planning. For more information, Melinda Merk at melinda.merk@hklaw.com or call toll free, Giving Tangible Personal Property to Charity: What You Need to Know Lauren A. Jenkins The charitable income tax deduction generally allows a taxpayer to deduct the value of his contributions to charity on his federal income tax return. Although it is not difficult to value charitable contributions of cash or publicly traded securities, valuing contributions of tangible personal property, such as household contents, clothing and cars, may prove challenging. To ensure that taxpayers do not overvalue their donations to charitable organizations, the IRS imposes requirements for valuing such contributions for purposes of the charitable deduction. Charitable contributions may be deducted only if they are made to qualified organizations. Generally, qualified organizations are non-profit groups that (1) are religious, charitable, educational, scientific, or literary in purpose, or that work to prevent cruelty to children or animals, and (2) have favorable determination letters from the IRS, indicating tax-exempt status under Section 501(c)(3) of the Internal Revenue Code. Churches and similar religious organizations are generally not required to have an IRS determination letter. One can determine if a particular charity is considered a qualified organization by asking the charity itself or consulting IRS Publication 78, which lists most qualified organizations, and can be found at apps.irs.gov/app/pub78. The measure of the tax deduction available when property is donated to a qualified organization is generally its fair market value. Fair market value is defined in the Internal Revenue Code as the price at which property would change hands between a willing buyer and willing seller, neither being under any compulsion to buy or sell, and both having reasonable knowledge of relevant facts. In other words, it is the price that property would sell for on the open market. 5

6 A different set of rules applies when the contributed property has a fair market value that exceeds the taxpayer s basis in it. This situation rarely occurs in the case of clothing, household goods or used cars, but is more likely to apply to works of art, antiques and collectibles. If the donated property would give rise to a long-term capital gain when it is sold (e.g., collections, vehicles and other capital assets held for more than one year), the taxpayer may generally deduct the fair market value of the property if the charity will use it in a manner related to its tax-exempt purpose for example, if the donated work of art will be displayed by the recipient museum. If, however, the donated property is tangible personal property and it is going to a charity that will simply sell it for example, if a work of art is donated to a homeless shelter that will simply sell it for whatever price can be obtained then the taxpayer s deduction is limited to his basis in the property. If the donated property would give rise to ordinary income or short-term capital gain if sold (e.g., works of art created by the taxpayer, or capital gain assets held for one year or less), the taxpayer s deduction is generally limited to his basis in the property. Because of all these variations in the rules, the taxpayer should consult a tax professional. If the donated property is tangible personal property and it is going to a charity that will simply sell it then the taxpayer s deduction is limited to his basis in the property. Depending on the type and value of the property donated, the IRS may require the taxpayer to obtain a qualified appraisal prepared by a qualified appraiser. A qualified appraiser is generally someone who is regularly paid to perform appraisals, meets all of the educational and experience qualifications set forth by the IRS, and has not been included on the IRS s appraiser disqualification list during the past three years before the appraisal is performed. A qualified appraisal is generally an appraisal that is prepared by a qualified appraiser, follows IRS guidelines and is made not more than 60 days before the property is donated to the charity. In certain circumstances (discussed below), the taxpayer will have to submit the qualified appraisal with his tax return. Generally, the qualified appraisal should be kept with the taxpayer s other records that support the value of the donation if it is requested by the IRS. Although the charitable deduction does not include the fees paid to appraise the property, these fees may be eligible for a miscellaneous itemized deduction subject to the 2 percent limit on the taxpayer s income tax return. Depending on the type and value of the property donated, the IRS may require the taxpayer to obtain a qualified appraisal prepared by a qualified appraiser. Many taxpayers claim deductions for donations of clothing and household goods. This category includes furniture, electronics, appliances, furnishings and similar items, but not works of art, antiques, jewelry and collections. The fair market value of clothing and household items is typically the price that would be paid for such items in a consignment or thrift store. In 2006, new laws were enacted limiting the amount of deductions that could be taken for donations of clothing and household goods. In general, taxpayers may claim a charitable deduction for contributions of clothing and household items only if the items are in good used condition or better. A taxpayer does not need to obtain a qualified appraisal for donations of clothing and household items that are in good used condition or better unless the deduction exceeds $5,000. However, if a taxpayer donates a single household item or item of clothing that is not in good used condition or better, he may claim a tax deduction only if the item s value exceeds $500 and must submit a qualified appraisal with his tax return. Automobiles are another popular item donated by taxpayers, and charities typically sell the donated vehicles to raise funds. Generally, a taxpayer may deduct the lesser of (1) the gross proceeds received by the charity from the sale of the vehicle, or (2) the vehicle s fair market value on the date it was donated to the charity. The fair market value of an automobile can usually be determined by a car pricing guide. The taxpayer should use the price listed for the sale of a vehicle to a private party with the same specifications as the vehicle being donated. In addition, the charity will provide the taxpayer with a Form 1098-C (or similar statement), which will show the gross proceeds from the sale of the vehicle; it must be filed with the taxpayer s income tax return. Different rules apply if the charity does not resell the donated motor vehicle, but keeps it to be used in its charitable functions. If the charity uses the vehicle to further its charitable purposes, the taxpayer can generally deduct the vehicle s fair market value at the time of contribution. Examples of such uses include using the vehicle in its 6

7 regularly conducted activities, giving the vehicle to a needy individual, or selling the vehicle to a needy individual for a price significantly below fair market value. Paintings, antiques, and other works of art are frequently donated to charity. A taxpayer should obtain a qualified appraisal if he is claiming a deduction of over $5,000 for his donation of art. The taxpayer is required to submit the qualified appraisal with his income tax return if the value of his donation exceeds $20,000. If the value of the piece is $50,000 or more, the taxpayer may request a Statement of Value from the IRS. The taxpayer can then rely on the Statement of Value when claiming the charitable deduction on his income tax return. For donations of most other tangible items, including jewelry and collections, a taxpayer is required to obtain a qualified appraisal if he is claiming a deduction of over $5,000. However, the taxpayer is not required to submit the qualified appraisal with his income tax return. If the deduction is over $500,000, then the qualified appraisal must be submitted with the taxpayer s income tax return. In addition to the qualified appraisal requirements, a taxpayer must file a Form 8283 with his tax return if the amount of his deductions for all non-cash charitable contributions is more than $500. The charitable deduction allows taxpayers to receive a benefit on their income tax return by making donations to qualified organizations. Although this article summarizes some of the rules surrounding charitable deductions, there are many exceptions. Also, depending on the donor s tax situation, limitations or phase-outs may apply to reduce the tax benefit of a charitable contribution. It is important to enlist the assistance of tax professionals for advice regarding the tax implications of a particular donation. Below is a chart that shows when the taxpayer is required to obtain a qualified appraisal, and whether it must be filed with the taxpayer s income tax return: Type of Charitable Contribution Qualified Appraisal Appraisal Must Be Required Attached to Return Clothing and household items (that are not in good used condition or better) valued at more than $500 X X Art valued at $20,000 or more X X Donation of property (including clothing and household items in good used condition or better) valued over $5,000 Donation of property (including clothing and household items in good used condition or better) valued over $500,000 X X X For more information, Lauren A. Jenkins at lauren.jenkins@hklaw.com or call toll free,

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