Guest Article – The Taxation Of Non-Immigrant Estates: Think It Won’t Affect You? Think Again, By Steven Weiser

Steven Weiser is a tax lawyer with a practice focusing on international tax matters. His contact information and information on his practice can be found on his web site at http://www.lw-law.com/.

Let’s start with the following example:

T, admitted into the U.S. under a non-immigrant visa, purchases investment real estate in the U.S. for $5 million, paying $1 million down and financing the rest with a $4 million note. T dies before making any principal repayments. The remainder of T’s estate consists of assets located outside the U.S. worth $5 million. T’s estate has $10,000 of funeral and estate administration expenses. For U.S. purposes, T’s taxable estate is almost $3 million and the resulting U.S. estate tax liability is $1,255,350. More than T’s equity in the U.S. property!

The example illustrates the effect that U.S. estate tax may have on a nonresident alien owning property in the U.S. With marginal U.S. estate tax rates rising as high as 49-percent in 2003, the U.S. estate tax is quite burdensome. Couple that with the lack of deductions and tax credits otherwise available to U.S. citizens and resident aliens, and you have a disaster waiting to happen. In the above example, selling the U.S. real estate won’t even generate enough cash to pay the estate tax liability. Also not considered is the amount of estate or inheritance taxes imposed on the same property by T’s home country. Now let’s look at a similar, but more common scenario.

H, admitted into the U.S. under a non-immigrant visa, purchases a home in the U.S. for $200,000, financing it with a $180,000 mortgage loan and $20,000 down payment of his own funds. H dies before making any principal repayments. Immediately prior to his death, H owned a residence in his home country worth $200,000 (net of any foreign mortgage) that he rented out while living the U.S. H’s estate has $10,000 of funeral and estate administration expenses. For U.S. purposes, T’s taxable estate is $105,000 and the resulting U.S. estate tax liability is $12,300. More than half of the equity in the home is effectively lost to pay the U.S. estate tax liability.

Fortunately, in almost all instances the U.S. estate tax can be eliminated or reduced for non-immigrants owning U.S. property, real or personal. It simply takes careful planning and an understanding of the law.

The U.S. estate tax is generally imposed upon the value of all property comprising a decedent’s (deceased person’s) estate. In the case of a nonresident alien the taxable portion of the estate only includes property situated in the U.S. at the time of death. Before considering the impact the estate tax may have on a nonimmigrant alien, our analysis, as with all tax matters concerning foreign nationals, must begin with a determination of whether a decedent is a resident or nonresident alien for U.S. tax purposes. This analysis differs substantially from the resident/nonresident analysis we have considered in earlier income tax related articles.

Resident or Nonresident Status

For U.S. estate tax purposes, a resident alien is an individual, who at the time of death, is domiciled in the United States. Domicile refers to the place in which a person resides or intends to reside permanently, with no present intention of later moving therefrom. For example, a French national may be living in the United States at present, but it may be that person’s intent to someday return to France, her permanent home.

Obviously, while physical presence is easy to determine, an individual’s present intent is not. Some factors that indicate where a person is domiciled include: (1) the duration of stay in the U.S. and other countries, and frequency of travel between countries; (2) the nature of dwellings maintained and where those dwellings are located; (3) the location of personal possessions; (4) the location of family and close friends; (5) the places where church and club memberships are maintained; (6) the location of business interests; (7) residence declarations on visa applications, wills, or other legal documents; and (8) place where voter registration and driver’s licenses are maintained.

You might think that the existence of a non-immigrant visa necessarily indicates that the visa holder is not domiciled in the U.S. since the terms of the visa prohibit the individual from residing in the U.S. on a permanent basis. The Court of Federal Claims recently rejected this argument in a case concerning the estate of a Canadian veterinarian. In that case, the IRS was granted the opportunity to show that a Canadian doctor, admitted into the U.S. under a temporary professional visa, was domiciled in the U.S. at the time of death. The decedent veterinarian was first admitted into the U.S. in 1993 for a period of one-year and continually renewed his temporary professional visa until his death in 1996. (For a complete analysis of this case click here.)

If an alien decedent is determined to be a resident of the U.S., the estate tax applies in the same manner that it is imposed on U.S. citizens. However, if the alien decedent is a nonresident at death, special rules apply.

Estate Taxation of Nonresident Aliens

For nonresident aliens, the U.S. estate tax is imposed against those assets of the estate situated in the U.S. at the time of death. Different rules apply in determining where specific types of property are situated. For example, the situs of real property is always determined by its physical location. Situs of tangible personal property is determined by its physical location at the time of death, although exceptions to this rule exist (e.g., jewelry brought into the U.S. on a vacation). Stock in a domestic corporation is always deemed situated in the U.S. regardless of the location of stock certificates.

Once the total value of the estate’s assets situated in the U.S. is known, the estate is entitled to deduct certain expenses, indebtedness and losses in arriving at the total taxable estate. Unfortunately, in this area the benefits available to nonresidents decedents are not nearly as favorable as those available to U.S. citizens and resident aliens.

In the case of property subject to a recourse (other assets of the debtor may be used to satisfy the loan in the event of a default) mortgage, the full fair market value of the property must be included in the estate, but only a fraction of the debt is deductible equal to the ratio of U.S.-situs assets to worldwide assets. Therefore, in the first example above, T’s estate is only entitled to a deduction of $2 million for a $4 million mortgage. By contrast, if the mortgage is nonrecourse (the lender can only look to the secured property for satisfaction of the loan in the event of default) the full amount of the mortgage is deductible. The planning point to remember in the case of nonresident aliens choosing to own U.S. real property outright (rather than through a partnership or corporation), is to mortgage the property to the greatest extent possible and get the lender to accept a nonrecourse note.

Estates of nonresident decedents are also entitled to deductions for funeral and administrative expenses. However, these expenses are also limited by the proportion of U.S.-situs assets to worldwide assets.

A very significant deduction and planning tool available to estates of citizens and resident aliens is the so-called “unlimited marital deduction.” The unlimited marital deduction allows the estate a deduction equal to the value of all property passing to a surviving spouse. Therefore, if all estate assets pass to a surviving spouse no estate tax is due (although the assets may be subject to estate tax upon the later death of the surviving spouse). The estate of a nonresident decedent is entitled to the unlimited marital deduction only if the surviving spouse is a U.S. citizen.

If the surviving spouse is not a U.S. citizen, transfers qualify for the marital deduction only in two limited circumstances: (1) the surviving spouse becomes a U.S. citizen before the U.S. estate tax return is filed, and was domiciled in the U.S. between the date of the decedent’s death and the surviving spouse’s naturalization; or (2) the property passes to a qualified domestic trust (QDOT) or similar contractual arrangement for the benefit of the surviving spouse.

A QDOT is a trust meeting several statutory requirements and should only be drafted by qualified legal counsel. The statutory requirements generally necessitate that the trustee be a U.S. citizen or corporation, and that the trustee distribute nothing other than income from the trust, or that the trustee has the right to withhold tax imposed on such distribution. Other requirements exist that are beyond the scope of this article. It should be noted, however, that it is possible in the event property is transferred outright to a non-citizen surviving spouse, that the surviving spouse make an election to immediately transfer the property to a QDOT. In other words, although it is highly recommended, it is not necessary that the QDOT be created prior to the first spouse’s death.

The QDOT actually serves to defer the decedent’s estate tax due until a later triggering event. The actual taxation of the QDOT occurs at estate tax rates otherwise available to the decedent, thereby allowing the decedent’s estate to take advantage of the lower marginal rates. So in some respects the QDOT actually provides benefits not otherwise available to transfers to U.S. citizen surviving spouses. Triggering events resulting in taxation include the death of the surviving spouse, the termination of the trust as a QDOT, or any distribution from the QDOT during the surviving spouse’s life, except mandatory distributions required to qualify as a QDOT and distributions of trust principal “on account of hardship.”

The total taxable estate of a nonresident alien is subject to the same marginal estate tax rates applicable to U.S. citizens and resident aliens. However, a nonresident alien’s estate is entitled to an estate tax credit of $13,000. This credit effectively eliminates tax on the first $60,000 of assets included in the estate. This credit pales in comparison to the credit available to U.S. citizens and resident aliens that effectively exempts the first $1 million of assets from estate tax.

Effect of Tax Treaties

The U.S. has several estate, gift and inheritance tax treaties in effect with other countries. These treaties should always be consulted as they are designed to eliminate the double taxation of assets by the U.S. and the treaty partner country. Treaties often provide specific rules concerning the determination of domicile, situs of property or the marital deduction. Furthermore, treaties may increase the amount of allowable credit against the U.S. estate tax.

A Note on U.S. Probate

In order to effectively dispose of and transfer assets contained in a nonresident alien’s estate, it is often desirable to execute a will specifically covering the disposition of property located within the U.S. Often, an alien will have two wills, one concerning the disposition of assets located in her home country, and one concerning the disposition of assets located in the U.S. In the absence of a U.S. will, a foreign-executed will may be admitted into probate in the U.S., but state courts are generally not compelled to admit these wills into probate.

Conclusion

Estate planning for nonresident aliens is often an overlooked area, but should be considered particularly if the alien intends on acquiring or investing in U.S. property. Estate taxes and probate can often be avoided through the use of foreign entities that hold property, but doing so is not always practical, especially if the property has already been acquired by the nonresident alien.

During the estate planning process it is advisable for an alien to execute an Affidavit of Domicile, which serves as a statement of the alien’s intent to reside permanently within or without the U.S.

A well drafted will should include provisions designed to eliminate or minimize potential U.S. estate taxes. Wills should include credit shelter trust or QDOT provisions where appropriate.