In the past several years there have been a number of developments in the United States that have had significant implications for wealthy families and their advisers. These include, for example, the enactment of the Foreign Account Tax Compliance Act (FATCA) in 2010, which increased transparency by requiring the cross-border exchange of tax-related information, and the passage of estate and gift tax legislation that ‘permanently’ fixed tax rates and exemptions that had been in flux for a number of years. But after several years of notable activity, US law in these areas seems to have entered a period of relative stability.
Perhaps the most dramatic force of change in the international private client world in recent years, and one in which the United States is not a participant, is the enactment of the Common Reporting Standard (CRS), the reciprocal automatic information exchange agreement developed by the Organisation for Economic Co-operation and Development that was adopted recently in over 100 jurisdictions and will be phased into effect from 2016 through 2018. Under CRS, entities (including trusts and foundations) must report information on ‘controlling persons’. The broad reporting requirements will create significant compliance burdens and challenges for trustees and financial institutions dealing with trusts. For entities, the controlling persons generally are the individuals who exercise control over the entity or who have a direct or indirect controlling ownership interest in the entity. For a trust, the controlling persons are defined to include the settlors, the trustees, the protectors (if any), the beneficiaries or class of beneficiaries, and any other natural persons exercising, directly or indirectly, control over the trust.
Although the United States is not a party to CRS, the global reach of CRS will make cooperation of teams of advisers across multiple relevant jurisdictions much more important. For example, US citizens and residents who are ‘controlling persons’ of non-US trusts will be required by trustees and financial institutions to provide ‘self-certification’ information, including their country of tax residence and tax identification numbers. US advisers involved in cross-border structuring will need to be mindful of CRS requirements and the residences of the various individuals involved in trust, foundation and similar structures. Finally, some commentators have suggested that the United States has become an attractive jurisdiction for non-US persons wishing to maintain their privacy.
This chapter surveys tax liability, estate planning and wealth management under current US law. Section II of this chapter provides an overview of the US tax system for individuals, including income tax, transfer taxes, and reporting requirements for offshore assets. Section III, infra, summarises the laws of succession in the US, including the estate planning implications of marriage and divorce. Finally, Section IV, infra, discusses the different strategies of wealth management that can minimise US federal and state transfer taxes.
i Income tax
US citizens (regardless of where they reside) and residents (collectively, US persons) are subject to US income tax on worldwide income.2 On the other hand, individuals who are neither citizens nor residents of the United States (non-resident aliens) are subject to US income tax only on certain types of US-sourced income, income effectively connected with a US trade or business and gains on the sale of US situs real property.3
A non-citizen of the United States is considered a resident of the United States for income tax purposes if the individual:
- a is admitted for permanent residence (i.e., holds a ‘green card’);
- b elects to be treated as such; or
- c has a ‘substantial presence’ in the United States in a given calendar year.4
An individual satisfies the substantial presence test and is deemed a resident if he or she has been present in the United States for at least 31 days in the current year and for at least 183 days during a three-year period that includes the current year, determined based upon a weighted three-year average.5
The use of this ‘weighted average’ can become a trap for individuals who focus only on the total day count and who believe that they can spend up to 182 days each year in the United States without having a ‘substantial presence’ that will cause them to be considered a US resident for income tax purposes. Under the weighted average test, a person may spend, on average, up to 120 days in the United States each year without being treated as a US income tax resident under the substantial presence test. An individual who meets the substantial presence test but spends less than 183 days in the United States in a year can still avoid being treated as a US income tax resident if he or she can establish that the individual maintains his or her tax home in another jurisdiction and maintains a ‘closer connection’ to such foreign tax home by filing a Form 8840 ‘Closer Connection Exception Statement for Aliens’ with the Internal Revenue Service (IRS).6 It is also important to consider whether a non-US citizen may be entitled to protection under a tax treaty between the United States and the jurisdiction the individual considers to be his or her home.
ii Gift, estate and GST tax
There are three types of US federal transfer taxes: estate tax, gift tax and GST tax (collectively referred to as transfer taxes). US citizens and US residents are subject to transfer taxes on worldwide assets.7 The test to determine whether an individual is a US resident for transfer tax purposes is different from the test to determine whether an individual is a US resident for income tax purposes. Whereas the residence test for income tax purposes, as discussed above, is an objective test, residence for the purpose of transfer taxes is determined by a subjective domicile test, turning on the individual’s intentions. A person is a US resident for transfer tax purposes if he or she is domiciled in the United States at the time of the transfer.8 A person can acquire domicile in a place by living there, for even a short period of time, with the intention of remaining there indefinitely.9
Subject to provisions of an applicable treaty, a non-US citizen who is not domiciled in the United States is subject to US transfer taxes only on property deemed situated in the United States (US situs assets), including US real estate (which includes condominium apartments) and tangible personal property located in the United States. Shares in US corporations, debt obligations of US persons (subject to important exceptions for certain portfolio debt and bank deposits), and certain intangible property rights issued by or enforceable against US persons are subject to US estate tax but not US gift tax.
Current income and transfer tax rates
The American Taxpayer Relief Act of 2012 (ATRA) was enacted on 2 January 2013. ATRA allowed the reduced Bush-era income tax rates to sunset after 2012 for individuals with incomes over US$400,000 and married couples filing jointly with incomes over US$450,000. Under ATRA and currently, the top US individual income tax rate is 39.6 per cent for ordinary income and 20 per cent for qualified dividends and long-term capital gains. The lifetime exemption from US gift, estate and GST taxes for US citizens and residents is set at US$5 million (US$10 million for a married couple), indexed for inflation from 2010 for gifts made and for estates of decedents dying after 31 December 2011 (for 2016, the indexed exemption is US$5.45 million for an individual and US$10.9 million for a married couple). The top transfer tax rate is currently 40 per cent.
US citizens and residents for transfer tax purposes may also take advantage of ‘portability’, which permits such persons to use the unused transfer tax exemption amount of the taxpayer’s deceased spouse (if he or she died after 31 December 2010). If a taxpayer is predeceased by more than one spouse, the taxpayer may use the unused transfer tax exemption of the last deceased spouse only. The executor of the deceased spouse’s estate must make an election on the deceased spouse’s estate tax return to allow the surviving spouse to use the deceased spouse’s unused transfer tax exemption. The estate of an individual who was a non-resident alien of the United States for transfer tax purposes at the time of such individual’s death is not eligible to make a portability election, and thus such individual’s lifetime exemption from US transfer taxes (which is only US$60,000) cannot be passed on to his or her surviving spouse. More significantly, a non-resident alien surviving spouse may not acquire his or her deceased US spouse’s unused lifetime exemption (except to the extent allowed under a US treaty).10 However, a surviving spouse who becomes a US citizen after the death of the deceased spouse may elect to use the unused transfer exemption of the deceased spouse.11
iii Medicare surcharge
On 27 February 2014, guidance was provided to taxpayers on how to calculate the 3.8 per cent Medicare net investment income tax (NIIT) imposed on the net investment income of certain individuals, trusts and estates under the Patient Protection and Affordable Care Act (commonly known as Obamacare) in the form of finalised instructions to Form 8960, Net Investment Income Tax. The NIIT is part of the funding of Obamacare and dictates that citizens and residents of the United States (i.e., any individual other than a non-resident alien) must pay an additional 3.8 per cent Medicare tax on the lesser of the taxpayer’s ‘net investment income’, and the excess of the taxpayer’s modified adjusted gross income (as calculated for income tax purposes) for the taxable year over a certain threshold amount. Likewise, trusts and estates must pay an additional 3.8 per cent tax on the lesser of the trust’s ‘net investment income’, and the excess of adjusted gross income (as calculated by a trust or estate for other income tax purposes) over the dollar amount of the highest tax bracket for a trust or estate for the applicable tax year.12
In general, net investment income includes three broad categories of income: (1) gross income from certain interest, dividends, annuities (including annuities received from a charitable remainder trust), royalties and rents; (2) gross income derived from a business in which the taxpayer does not materially participate (income from a trade or business that is a passive activity is subject to the NIIT) or from trading in financial instruments or commodities; and (3) net gains attributable to the disposition of property, other than property held in a trade or business not described in category (1).
iv Reporting requirements and penalties
This section discusses a few of the US disclosure and reporting requirements that are of particular interest to individuals with both US and international interests, but is not an exhaustive list.
IRS Forms 3520 and 3520-A
A US person (including a US trust) who (1) engages in certain transactions with a foreign trust, including creating a foreign trust (whether or not the trust has US beneficiaries) or transferring money or property, directly or indirectly, to a foreign trust, (2) receives a distribution (including a loan) of any amount from a non-US grantor or non-grantor trust, or (3) receives more than US$100,000 in gifts or bequests from a non-US person or a foreign estate or more than a specified amount (in 2015, US$15,601) from foreign corporations or foreign partnerships in any year, must report such amounts on IRS Form 3520, Annual Return to Report Transactions With Foreign Trusts and Receipt of Certain Foreign Gifts.13 Such US person must file a Form 3520 for the year in which any such transfer, distribution, gift or bequest is made by the due date of such person’s federal income tax return for that year, even if the individual is not subject to US income tax on the amount.14 If an individual fails to file a required Form 3520, a penalty may be imposed in the amount of the greater of US$10,000 or (1) 35 per cent of the gross value of the property transferred to a foreign trust for failure by a US transferor to report the creation of or transfer to a foreign trust, (2) 35 per cent of the gross value of the distributions received from a foreign trust for failure by a US person to report receipt of the distribution, or (3) 5 per cent of the gross value of the trust. Additional penalties for subsequent filing failures may follow.
In addition, the trustee of a foreign trust with a US owner must file Form 3520-A (Annual Information Return of Foreign Trust a US Owner) in order for the US owner to satisfy its annual information reporting requirements.
If a US person has a financial interest in or signature or other authority over any bank, securities, or other type of financial account outside of the US, and if the aggregate value of all such accounts exceeds US$10,000 at any time during the calendar year, that person must report such interest for such calendar year. For calendar year 2016 accounts due in 2017 and subsequent years, such report is made on FinCEN Form 114 (referred to as an FBAR form) on or before 15 April of the succeeding year, with a potential six-month filing extension. For purposes of the FBAR rules, a US person is considered to have a financial interest in an account where title to the account is held by a grantor trust and such US person is the grantor of such trust. A US person is also deemed to have a financial interest in an account owned by a trust in which the US person has a present beneficial interest in more than 50 per cent of the assets or current income. Such beneficiary is, however, not required to report the trust’s foreign financial accounts on an FBAR form if the trust, trustee of the trust, or agent of the trust (1) is a US person and (2) files an FBAR disclosing the trust’s foreign financial accounts.
The IRS had initially taken the aggressive position that a beneficiary of a discretionary trust in which the trustee has discretion to distribute more than 50 per cent of the income or principal to the beneficiary (even if the trustee never has made any distributions to such beneficiary) has the requisite present financial interest to require the filing of an FBAR form. However, the preamble to the final regulations released on 24 February 2011, which became effective 28 March 2011, indicates that a beneficiary of a discretionary trust should not be considered as having a financial interest in such trust requiring an FBAR filing merely because of such person’s status as a discretionary beneficiary.
FATCA has helped accelerate the global drive towards greater transparency and scrutiny of offshore assets. Under FATCA, enacted in 2010 as part of the HIRE Act (see Section II.v, ‘The HIRE ACT’, infra) , foreign financial institutions (FFIs) are required to either enter into an agreement with the IRS under which they agree to report to the IRS certain details about their accounts directly or indirectly held by US persons (US accounts);15 or become ‘deemed compliant’ under the regulations. Non-financial foreign entities (NFFEs) that are publicly traded or engaged in active trading are not required to enter into or comply with an FFI agreement. However, FATCA does require certain ‘passive NFFEs’ (generally NFFEs earning mostly passive income that are not publicly traded) to report to withholding agents and participating FFIs with which the NFFE holds accounts, information on their ‘substantial US owners’ (described in footnote 16), or to certify annually that they have no substantial US owners.16 FATCA is being implemented in stages as provided in the final regulations released in 2013. Because the United States does not have direct jurisdiction over most FFIs, FATCA compels compliance by imposing a 30 per cent withholding tax on US-sourced income earned after 30 June 2014 and proceeds from the sale of US property after 31 December 2016 on all FFIs that do not agree to provide the IRS with the required information.17
The definition of an FFI is broad, including any entity that ‘accepts deposits in the ordinary course of a banking or similar business’, holds financial assets for the account of others ‘as a substantial part of its business’, or is engaged primarily in the business of investing, reinvesting or trading in securities, partnership interests, commodities or any interests therein18 and would include most investment vehicles unless a specific exception applies. Under this definition, foreign trusts with corporate trustees acting for different customers (including, in most cases, a private trust company that retains outside investment advisers or receives fees for its services) will be FFIs if, in general, 50 per cent or more of the trust’s gross income is attributable to investing in financial assets.19 A foreign trust that is not an FFI (for instance, a trust managed by an individual trustee) will generally be an NFFE.
Since the implementation of FATCA began, the Treasury Department has entered into many intergovernmental agreements (IGAs) to facilitate the implementation of FATCA. The purpose of IGAs is to remove domestic legal impediments to compliance with FATCA requirements and to reduce burdens on FFIs located in jurisdictions that enter into IGAs (partner jurisdictions). There are two models of IGAs. Under the Model 1 IGAs, covered FFIs report FATCA information to government agencies in their own jurisdiction, which then transmits the information to the IRS. Under the Model 2 IGAs, a partner jurisdiction agrees to facilitate FATCA compliance by its resident FFIs, but those FFIs generally must still register with the IRS and report information about US accounts directly to the IRS.
Despite early opposition to FATCA, in many cases, partner jurisdictions are entering into bilateral IGA agreements whereby they will provide information to the United States in exchange for an agreement from the United States to provide such partner jurisdiction with FATCA-like information regarding financial accounts held by the citizens of such partner jurisdiction in the United States. Despite early predictions from some that FATCA would isolate the United States, to a large extent FATCA appears to be evolving into one part of a global system of mutual information sharing, although the impact of FATCA on the willingness of non-US entities to invest in US assets remains to be seen.
Despite growing international acceptance of FATCA, aspects of its implementation remain contentious. For example, the National Taxpayer Advocate has urged the IRS to develop fact-specific guidelines that explain how benign non-filers can obtain a finding of reasonable cause. Critics continue to claim that the reporting requirements are too burdensome and inefficient, especially because some estimates indicate that the cost of enforcing FATCA may be higher than the revenue produced by it. Overall, the impact of FATCA is yet to be understood as the IRS has announced that some provisions will not take effect until as late as 2018.20 Additionally, some early signs of push-back are emerging, such as certain non-US financial institutions’ reluctance or flat-out refusal to take on new US clients.21
In addition to the reporting and withholding requirements discussed above, FATCA also requires certain individual taxpayers, including US citizens or green card holders permanently residing abroad, with interests in certain foreign financial assets with an aggregate value greater than US$50,000 on the last day of the tax year, or greater than US$75,000 at any time during the tax year, to file Form 8938, Statement of Specified Foreign Financial Assets, reporting the interest with such individual’s federal income tax return. The obligation to file Form 8938 is in addition to, not in replacement of, any filing obligation such individual may have under the FBAR rules. Whether a US person beneficiary of a discretionary non-US trust will be required to report his or her interest in the trust on a Form 8938 will depend on many factors, including whether such individual received a distribution from the trust in a given tax year and the value of the individual’s interest in other foreign financial assets.
Form BE-10 and BE-11
The BE-10 is a benchmark survey of US investment abroad conducted every five years. The last BE-10 reporting year was 2015 (with those reports including information with respect to 2014). Prior surveys had required only US persons contacted by the BEA to file, but a final rule promulgated by the Bureau of Economic Analysis (BEA) in the Federal Register on 20 November 2014 stated that any US person with a foreign affiliate is required to file a BE-10 report every five years. The final rule marks a significant expansion of US persons obligated to file a BE-10 report. The expansion does not apply to other BEA forms, such as the BE-11 form (Annual Survey of US Direct Investment Abroad), which entities are required to file annually, but only if requested to do so by the BEA. The term ‘US person’ means any natural person or entity resident in the United States or subject to the jurisdiction of the United States, and includes any individual, estate, trust, branch, partnership, associated group, association, private fund, corporation, or other organisation, regardless of whether it is organised under the laws of any state. A foreign affiliate is a foreign business enterprise in which a US person had direct or indirect ownership or control of 10 per cent or more of the voting stock or equivalent interest at any time over the US person’s fiscal year. Generally, a US person’s foreign operation or activity is considered a foreign business enterprise if it is legally separable from the domestic operations or activities of the US person.
v Scrutiny of non-US trusts by the US government
The environment in the United States continues to be hostile towards non-US trusts, as the US government perceives such trusts as potential tax avoidance vehicles.
The Stop Tax Haven Abuse Act
The Stop Tax Haven Abuse Act (STHAA), introduced in March 2009 (and reintroduced in the both the Senate and House of Representatives as recently as 13 January 2015), would establish rebuttable presumptions that (1) any US beneficiary who receives a distribution from a non-US trust ‘controls’ that trust (the tax implications of which are unclear, but could be disastrous), and (2) any distribution made from a non-US trust is taxable income to a US beneficiary. The STHAA has not been enacted. Although many commentators believe the proposed legislation will not be enacted, at least as currently drafted, it is important to be aware of the harsh measures that are being proposed by some legislators, many of which appear not to recognise legitimate estate planning strategies.
The HIRE Act
The Hiring Incentives to Restore Employment Act (HIRE), in effect since 2010, broadened the range of non-US trusts considered to have US beneficiaries, resulting in tax liability under the grantor trust rules where the trust had been created by a US grantor. Under the Internal Revenue Code, a non-US trust with US beneficiaries that is created by a US grantor is treated as a grantor trust for US income tax purposes, meaning that the US grantor must include the income of the trust in his or her personal income tax return. HIRE provides that a non-US trust is considered to have a US beneficiary even if a US person holds only a contingent interest and even if no US person is expected to receive any distribution, but a distribution (including by exercise of limited power of appointment) to a US person is permissible under the trust instrument. HIRE also establishes a presumption that a non-US trust to which a US person has transferred property has a US beneficiary unless the transferor furnishes information to the Treasury Department sufficient to rebut this presumption.
Importantly, HIRE treats the use of a non-US trust’s property by a US person as a distribution to such person equal to the fair market value of the use of such property, to the extent the US person does not pay fair market value rent for the use of such property.
vi Consequences of non-compliance with US tax and reporting requirements
There has been much publicity about the US government’s attempts to uncover tax non-compliance with respect to offshore assets, especially in light of the need for increased revenues.
Offshore voluntary disclosure programme
The IRS began an open-ended offshore voluntary disclosure programme (OVDP) in 2012 to encourage taxpayers to come forward to report previously undisclosed foreign accounts, assets and income for the most recent eight tax years for which the due date has already passed. OVDP is open to all taxpayers.
Participants in the OVDP, in addition to paying any taxes and interest due, along with applicable accuracy related and delinquency penalties, must generally pay an offshore penalty equal to 27.5 or 50 per cent of the highest aggregate balance in foreign bank accounts or entities, or value of foreign assets during the period covered by the voluntary disclosure.22 This value encompasses ‘all of the taxpayer’s offshore holdings that are related in any way to tax non-compliance, regardless of the form of the taxpayer’s ownership or the character of the asset’.23 It is important to note that certain taxpayers may qualify for reduced offshore penalties. The OVDP penalty structure applies in lieu of other applicable civil penalties, including penalties for failure to file an FBAR, failure to file information returns, fraud, failure to file a tax return, failure to pay the amount of tax shown on the return, and accuracy-related penalties on underpayments. Additionally, taxpayers who voluntarily enter the OVDP before the IRS has identified the taxpayer as delinquent may avoid criminal prosecution.
Streamlined filing compliance procedures
Since 2014, streamlined filing compliance procedures have expanded from applying only to non-resident US taxpayers to include US persons living inside the United States. Now, all individual taxpayers residing in the United States can participate in the streamlined filing compliance procedures. The individual must execute a ‘certification’ stating that his or her failure to file US tax returns, pay US tax, or report reportable assets was non-wilful.
Taxpayers outside the United States who qualify for this procedure will not be liable for any penalty, while those inside the United States will be subject to a 5 per cent ‘miscellaneous offshore penalty’ on the foreign assets that gave rise to the non-compliance. The 5 per cent penalty is in lieu of the standard 50 per cent OVDP penalty. The negative aspect of the streamlined procedure is that, unlike OVDP, it does not protect against criminal prosecution, and once a taxpayer makes a submission under this procedure, OVDP is no longer available.
If a taxpayer has not been previously contacted by the IRS regarding an income tax examination or a request for delinquent returns, the IRS will not impose a penalty for failure to file delinquent FBARs if the taxpayer (1) files the delinquent FBAR reports; (2) attaches a statement explaining why the reports are filed late; and (3) has no underreported tax liabilities. FBARs for tax years going forward must still be filed by their due date of 15 April (with the possibility of a six-month extension) of the succeeding year.
A taxpayer who failed to file Form 3520 or Form 5471 (information return of US persons with respect to certain foreign corporations) will not have a penalty imposed on him or her if the taxpayer (1) has reported and paid tax on all taxable income with respect to all transactions related to the controlled foreign corporations or foreign trusts; (2) files delinquent information returns with the appropriate service centre; and (3) files a statement explaining why the information returns are filed late. The top of the first page of each information return should be marked ‘OVD – FAQ #18’ to ensure proper processing.
In the United States, state law determines how and to whom property will be distributed upon death. Succession law thus varies from state to state, but the fundamental principle underlying American succession law is testamentary freedom, with some exceptions discussed below. The testator’s freedom to determine the disposition of property at death generally is manifested through a will and will substitutes (such as revocable inter vivos trusts, contracts, life insurance policies, pension plans and joint accounts). Intestacy statutes provide a default framework for assets not otherwise disposed of by the decedent.
Following an individual’s death, his or her will, if any, is submitted to a state probate court, which validates the will, confirms fiduciary appointments and generally supervises the administration of the estate. As part of the probate process, the will and ancillary documents, which may include a detailed inventory of probate assets, generally become a matter of public record, but this may vary among states. Assets that pass to the surviving joint tenants or by contractual beneficiary designation are considered non-probate assets and therefore are not subject to the probate court process, although such assets generally are still subject to estate tax.24
Because of the potential delay, cost and lack of privacy often associated with the probate process, Americans are increasingly relying on will substitutes, such as revocable inter vivos trusts, which function similarly to a will in that beneficiaries generally receive assets at the donor’s death but differ in that such assets pass pursuant to the existing trust deed, thereby avoiding the need for probate.
If an individual dies without a will and thus dies ‘intestate’, or dies with a will that fails to dispose of all probate assets, the relevant state court appoints an individual, typically the surviving spouse or children, to administer and distribute the intestate property pursuant to the state’s intestacy statute.
ii Property division at death
Elective share right of surviving spouse
While testamentary freedom is the linchpin of US succession law, that freedom is not unfettered. In fact, states have enacted increasingly generous provisions for surviving spouses, often at the expense of surviving children and notwithstanding the testator’s express declarations to the contrary. Virtually all US jurisdictions protect against spousal disinheritance either through community property concepts or elective share laws that entitle spouses to a ‘forced’ share of the decedent spouse’s estate.25 Although state law varies widely in the amount of the elective share and the variables (length of marriage, presence of minor children, surviving spouse’s net worth, etc.) used to determine such amount, most states set the amount between one-third and one-half of the decedent’s estate.26 Spouses in New York, for example, may choose to take the greater of US$50,000 (or, if the net estate is valued at less than US$50,000, the entire net estate) or one-third of the decedent spouse’s net estate in lieu of taking benefits under a will.27 The amount that passes as the elective share generally qualifies for the marital deduction for federal and state estate tax purposes.28
No forced heirship right of children
Unlike many civil law systems, no US jurisdiction (with the sole exception of Louisiana, whose laws are predominantly derived from the French Napoleonic Code)29 recognises ‘forced heirship’ rights of children. Thus, although testators cannot disinherit spouses, they can freely disinherit children. Even citizens or domiciled individuals of countries that recognise forced heirship rights (such as Switzerland and France) may be able to defeat forced heirship claims with respect to US situs assets by moving such assets to states like New York, New Jersey or Connecticut (to name a few) that permit non-domiciled individuals to elect to have local law govern the disposition of property located within that state.30 The decision In the matter of Renard, the seminal case involving forced heirship, illustrates this principle. In that case, New York’s highest court upheld a French-domiciled individual’s choice of law direction to have New York law govern the disposition of her assets situated in New York (where she resided for several decades before returning to her native France, leaving behind several financial accounts), thereby defeating her son’s claims to a forced share in such assets under French forced heirship law.31
Succession on intestacy
When the wishes of a decedent are not expressly known (that is, when the decedent dies without a will or has a will that fails to dispose of all probate property), state intestacy statutes mandate how the decedent’s estate will be divided. These statutes are intended to approximate the ‘presumed will’ of the decedent by enforcing a distributive scheme that the decedent likely would have chosen. Typically, surviving spouses receive a preferential disposition (in some cases, the entirety of the estate) and the balance thereafter, if any, passes to children, or, if there are none, to more remote descendants or other family members.
iii Applicable developments affecting succession
Definition of marriage
The Supreme Court in its 2015 decision in Obergefell v. Hodges held that states must license marriages between same-sex couples and recognise same-sex marriages performed in other states. (Two years earlier, in United States v. Windsor, the Supreme Court invalidated Section 3 of the Defence of Marriage Act (DOMA), which limited the definition of marriage for the purposes of federal law to opposite-sex couples.) Consequently, the tax benefits provided to married couples under state and federal laws are now available to same-sex couples. Under federal law, these benefits include the ability to utilise the unlimited marital estate tax deduction, split gifts and elect portability. Under state law, same-sex couples should now have succession rights, such as spousal elective share rights, intestate inheritance rights and fiduciary appointments over intestate estates. It should be noted that while this decision has nationwide impact, it must be implemented at the state level. In light of these changes, same-sex couples may wish to re-examine estate and tax planning done before the repeal of DOMA and the elimination of same sex-marriage bans. For example, same-sex couples may be able to amend past income tax returns for open tax years to elect married filing jointly status, which may result in a lower effective rate of tax. In addition, it is important to note that neither Obergefell nor Windsor altered the legal status of domestic partnerships or civil unions. Thus although civil unions and domestic partnerships confer spousal-like benefits in some states, same sex-couples must marry if they wish to guarantee that their partnerships are on equal footing with opposite-sex marriages.
Property division on divorce
Under the laws of most states, property acquired or earned by either spouse during marriage generally is considered marital property (or community property), whereas property acquired prior to marriage, acquired by gift or inherited (whether outright or in trust) is considered separate property. As a general rule, an individual’s separate property is not subject to equitable distribution in a divorce proceeding. But conceptions of what types of property should be taken into account in determining equitable distribution of marital property in the event of divorce have changed over time, with some courts taking into account the value of an individual’s separate property in determining what constitutes an equitable distribution of marital property and in setting the amount of spousal maintenance payments.
Moreover, in some states, ‘interests’ in trusts may be considered part of the marital estate in determining the equitable distribution award if the receiving party has a ‘sufficiently concrete, reasonable and justifiable expectation’ of a benefit attached to such interests.32 This is an evolving area of the law, and it is important to bear in mind that the protection of assets held in trust may be eroding in some states in the divorce context.
Notably, New York courts have in the past taken into account intangible assets, such as business goodwill, professional licences and educational degrees, for the purposes of measuring a spouse’s ‘increased earning capacity’ to value marital property and determine maintenance awards.33 In 2016, the New York legislature enacted a law that overturned case law that counted enhanced earning capacity as marital property, but the new law does permit courts to take contributions to a spouse’s enhanced earning capacity into account when deciding on the equitable distribution of marital property.34
IV WEALTH STRUCTURING & REGULATION
This section focuses on domestic planning strategies for US persons. It does not discuss ‘pre-immigration’ planning for non-resident aliens of the United States who wish to become US residents or citizens, which is a separate and complex area that is beyond the scope of this chapter.
There are several planning strategies that can be utilised to minimise the effect of US federal and state estate taxes. Lifetime irrevocable trusts are the most popular tool because of the many advantages to making gifts during life, including, for example:
- a the avoidance of state transfer tax in jurisdictions with an estate tax, but no gift tax;
- b the federal gift tax is tax-exclusive, which means that an individual does not pay tax on the gift tax, whereas the federal estate tax is tax-inclusive, which means a decedent’s estate pays tax on the portion of the estate used to pay estate tax; and
- c all of the appreciation on assets after the gift is made is outside of the taxable estate at death.
The uncertain future of the US$5 million exemption from US gift, estate and GST taxes caused many individuals to make lifetime exemption gifts before year-end 2012. While ATRA made the exemption amount ‘permanent’ (indexed for inflation), the experience of the past decade shows that Congress could always change course.
i Grantor trusts
Many high net worth individuals choose to set up trusts for their children and further descendants and fund them with some or all of the lifetime gift and GST tax exemption. The benefits of such trusts can be leveraged if they are structured as grantor trusts, which are trusts over which the individual funding the trust (the grantor) retains certain powers (e.g., the power to substitute assets of equal value for the trust assets) that cause the grantor to be treated as the owner of the trust assets for income tax purposes (but not for estate and gift tax purposes).35 Because the grantor of such a trust is legally responsible for payment of the income taxes on the trust’s income, the payment of such taxes would not be deemed a further gift to the trust, thereby enabling the trust to grow on an income tax-free basis.36 If properly drafted, the grantor trust status may be cancelled at any time if the tax burden becomes too great.
Making a loan to a grantor trust at a low rate of interest is another means to leverage the benefits of such a trust. If the trust’s investments perform better than the applicable interest rate set by the IRS, the excess appreciation remains in the trust with no gift tax consequences. In addition, the grantor may sell to the trust assets that are expected to appreciate in exchange for consideration of equal value (including the trust’s promissory note). A transfer by sale would remove the assets sold to the trust and any appreciation thereon from the grantor’s estate, although the sale proceeds paid to the grantor would remain part of his or her estate. If the assets sold to the trust appreciate at a greater rate than the sale proceeds, the appreciation would have been passed to the grantor trust without the imposition of estate or gift tax. Because a grantor trust is considered to be owned by the grantor for income tax purposes, there would be no income tax consequences on the sale to the trust, or on the payment of interest under a loan during the grantor’s lifetime.37
President Obama’s revenue proposals for fiscal year 2017 (commonly known as the Green Book), released in February 2016, would eliminate the tax advantages of sales to grantor trusts, if enacted.38 In essence, the proposal would impose transfer tax on the appreciation on assets sold by the grantor to the trust. This proposal has appeared in the Green Book in prior years but has never been included in proposed legislation in Congress. Furthermore, the IRS has made attempts to challenge the use of sales to grantor trusts. To date, those attempts have generally been unsuccessful, but the IRS seems to have renewed its efforts in two companion cases before the Tax Court, Estate of Donald Woelbin v. Commissioner and Estate of Marion Woelbing v. Commissioner.39 Accordingly, practitioners should be aware of the dialogue on this subject.
ii Grantor-retained annuity trusts
A grantor-retained annuity trust (GRAT) is a statutorily authorised trust that allows a grantor to transfer the appreciation in the value of property above a fixed interest rate during a specified period at a nominal gift tax cost.40 The grantor retains the right to receive an annuity for a specified period of years (for example, two years) equal to the value of the assets transferred to the GRAT at the time of funding, plus a fixed interest rate set by the IRS.41 The annuity can be paid in cash or in kind. At the end of the term of years, the remaining assets of the trust (i.e., the appreciation in the value of the GRAT assets during the GRAT term over the fixed interest rate), pass to the designated remainder beneficiaries (usually one or more trusts for the grantor’s children). If the assets appreciate at a higher rate than the statutory rate of return, that appreciation is transferred at the end of the GRAT term to the designated remainder beneficiaries with no estate or gift tax. If the GRAT is unsuccessful, the grantor (or the grantor’s estate) receives back the remaining GRAT assets and the remainder beneficiaries have no obligation to repay any shortfall.42 GRATs are powerful tools because they may pass assets with very little added risk. However, the need to pay annuity amounts requires a valuation of the asset used to fund the GRAT at formation and on each annuity date. For this reason, GRATs are often (though not always) funded with marketable securities, the value of which is easy to determine and not likely to be challenged by the IRS.
President Obama’s 2017 Greenbook also proposes to limit the tax benefits associated with GRATs by recommending three key changes. First, the Obama Administration proposes a minimum 10-year term.43 A longer term would increase the risk of the grantor’s death during the term, in addition to making it more difficult to predict the performance of the assets used to fund the GRAT. Second, the Obama Administration proposes that all GRATS have a non-zero value so that creating a GRAT triggers reporting obligations on a gift tax return. Specifically, the proposal would require that all GRATS have a minimum remainder equal to the greater of 25 per cent of the value of the assets contributed to the GRAT or US$500,000 (but not more than the value of the assets contributed).44 Third, the proposal would ‘prohibit the grantor from engaging in a tax-free exchange of any asset held in the trust,’45 including, for example, by exercising a substitution power to exchange cash for the trust’s appreciated assets. Again, these proposals have not become law.
Interests in partnerships may be either given or sold to family trusts to facilitate the transfer, ownership and management of certain assets. Such partnerships are often referred to as ‘family limited partnerships’ (FLPs) because they permit several family members and entities to pool their assets and make investments that might not be available to some family members or entities (e.g., due to securities laws that require investors in certain products to have a certain minimum net worth). In the case of a sale or gift of an FLP interest, the value of the transferred interest should be determined by a professional appraiser. It can be expected that the FLP interest given or sold would be valued by an appraiser at a lower value than the sum of the underlying assets to reflect that the interest being transferred is a minority, unmarketable interest, and also to reflect illiquidity caused by any restrictions placed on the transfer of such interests by the FLP’s operating agreement.
FLPs generally are not appropriate vehicles for residences or other personal assets that will be used by family members. They continue to be scrutinised by the IRS and may cause adverse tax consequences if they are found to have no apparent business or other non-tax purpose, or where the individual funding the FLP exercises control over the underlying assets without respecting the entity formalities.46 However, when an FLP is properly structured and administered, taxpayers have been successful in defeating these challenges.47 Moreover, the IRS may assert that the discount applied to the FLP assets is overstated.48 In fact, some estate planners speculate that the US Treasury Department may release Treasury Regulations addressing discounts in the valuation of certain interests in family-owned entities before the end of 2015 that could significantly limit or even eliminate the availability of discounts in certain transactions (including outside of the FLP context).49
V CONCLUSIONs & Outlook
The urgent need for tax revenue, coupled with the US government’s distrust of the offshore world, shows no sign of abating. As many governments worldwide share those driving forces, all indicators point to an increasingly global system of information sharing and enforcement.
1 Basil Zirinis is a partner, and Katherine DeMamiel is an associate, in the London office of Sullivan & Cromwell LLP. Elizabeth Kubanik and Susan Song are associates in the New York City office of Sullivan & Cromwell LLP.
2 IRC Section 61. The top federal individual income tax rate for ordinary income in 2016 is 39.6 per cent, with a lower 20 per cent rate applied to long-term capital gains and qualified dividends. Net investment income may also be subject to an additional 3.8 per cent Medicare surtax.
3 IRC Sections 871, 897.
4 IRC Section 7701(b)(1)(A).
5 The weighted average test takes into account all of the days of presence in the United States in the current calendar year, one-third of the days in the first preceding calendar year and one-sixth of the days in the second preceding calendar year. Treas. Reg. Sections 301.7701(b)-1(c)(1), (4).
6 Treas. Reg. Section 301.7701(d)-1.
7 I.R.C. Sections 2031(a), 2511(a), 2612.
8 Treas. Reg. Sections 20.0-1(b)(1), 25.2501-1(b), 26.2663-2(a).
9 Treas. Reg. Section 20.0-1(b)(1).
10 See Fed. Estate and Gift Tax Reporter Section 1450.08; Treas. Reg. Section 20.2010-3.
11 Treas. Reg. Section 20.2010-3.
12 US$12,300 for 2015.
13 If the trust owns an interest in a controlled foreign corporation (CFC) or a passive foreign investment company (PFIC), a US beneficiary may have additional reporting requirements.
14 US law requires a US beneficiary of a non-US trust to obtain from the trustee of a non-US trust a detailed statement of distributions made from the trust to enable the US beneficiary to complete the Form 3520. If such a statement is not filed with the IRS, the distribution could be treated for US income tax purposes as being a distribution of undistributed net income.
15 US accounts include accounts held by US-owned entities. IRC Section 1471(d)(1). A US-owned entity is an entity with ‘Substantial US Owners’. IRC Section 1471(d)(3). Generally, an entity has Substantial US Owners if a US person owns more than a 10 per cent interest in the entity. IRC Section 1473(2)(A). However, in the case of investment entities, any US ownership will cause it to be a US-owned foreign entity. IRC Section 1473(2)(B). A foreign non-grantor trust would be a US-owned entity if any specified US person holds, directly or indirectly, more than 10 per cent of the beneficial interest in the trust. IRC Section 1473(2)(A)(iii).
16 IRC Section 1473(2)(A); Treas. Reg. Section 1.1471-4(d)(iii)(B)(3). As an alternative, the regulations permit an NFFE to report directly to the IRS certain information about its direct or indirect substantial US owners, rather than to a withholding agent, by electing to become a ‘direct reporting NFFE’.
17 IRC Section 1471 (a)-(b). Withholding on certain non-US sourced payments will eventually be required, but these rules have not yet been finalised and such withholding will not begin before 1 January 2017. Although FATCA imposes significant compliance and administrative burdens on trustees of non-US trusts, there should be no additional tax burden imposed if trustees comply with all reporting requirements.
18 IRC Section 1471(d)(4)-(5).
19 Treas. Reg. Section 1.1471-5(e)(4).
20 See IRS Notice 2016-08, available at: www.irs.gov/pub/irs-drop/n-16-08.pdf.
21 A 2014 report to the Senate Finance Committee by Democrats Abroad details refusals to take on American clients or closures of U.S. citizen accounts in Belgium, Israel, France, Switzerland, and Germany. See Democrats Abroad, October 2014 FATCA Research Project, available at: www.finance.senate.gov/download/att-5-democrats-abroad-2014-fatca-research-stories&download=1. Several media sources have documented foreign banks closing down or refusing accounts held by US citizens (CNN: http://money.cnn.com/2013/09/15/news/banks-americans-lockout/; New York Times: http://www.nytimes.com/2015/05/14/opinion/an-american-tax-nightmare.html?_r=0; Wall Street Journal: www.wsj.com/articles/the-law-that-makes-u-s-expats-toxic-1444330827; Time Magazine: http://world.time.com/2013/12/20/swiss-banks-tell-american-expats-to-empty-their-accounts/.
22 The increased 50 per cent penalty applies to taxpayers who submitted OVDP pre-clearance letters to the IRS after 4 August 2014 and where there has been a public disclosure prior to the preclearance letter that either ‘(a) the foreign financial institution where the account is held, or another facilitator who assisted in establishing or maintaining the taxpayer’s offshore arrangement, is or has been under investigation by the IRS or the Department of Justice in connection with accounts that are beneficially owned by a US person; (b) the foreign financial institution or other facilitator is cooperating with the IRS or the Department of Justice in connection with accounts that are beneficially owned by a US person or (c) the foreign financial institution or other facilitator has been identified in a court- approved issuance of a summons seeking information about U.S. taxpayers who may hold financial accounts (a ‘John Doe summons’) at the foreign financial institution or have accounts established or maintained by the facilitator.’ Taxpayers who disclosed to OVDP before 4 August 2014 or did not use a financial institution or facilitator that featured in one of the above public disclosures will be penalised at 27.5 per cent. See Offshore Voluntary Disclosure Program Frequently Asked Questions and Answers, IRS, (8 February 2016), available at: www.irs.gov/individuals/international-taxpayers/offshore-voluntary-disclosure-program-frequently-asked-questions-and-answers-2012-revised.
24 Examples of non-probate assets include the following: property owned and held in joint tenancy, tenancy by the entirety or, in certain states, community property with the right of survivorship; property transferred into an inter vivos trust prior to the settlor’s death; real property subject to transfer under a transfer-on-death deed; assets held in a pay-on-death account or ‘Totten trust’ bank account; proceeds of a life insurance policy; and individual retirement accounts with a named beneficiary.
25 Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington and Wisconsin have community property laws, while the remaining states have elective share laws (Alaska is an opt-in community property state that gives both parties the option to make their property community property). Georgia currently is the only state that does not recognise dower or curtesy, community property or elective share concepts. See Community Property, I.R.S. Pub. No. 555 (2016), available at: www.irs.gov/pub/irs-pdf/p555.pdf; Terry L Turnipseed, ‘Community Property v. The Elective Share’, 72 La. L. Rev. 161, 162 (2011).
26 Note that in the event of intestacy, each state’s intestacy statute will determine the amount to which the surviving spouse is entitled. Elective share laws are thus generally relevant only when a surviving spouse receives less under the decedent spouse’s will than what he or she is entitled to receive as the elective share.
27 NY Estates, Powers and Trusts Law (EPTL) Section 5-1.1-A(a)(2).
28 Diane Hubbard Kennedy, ‘Using the Marital Deduction’, ALI-ABA Estate Planning Course Materials Journal at 27 (April 2000).
29 Article 1493 of the Louisiana Civil Code.
30 See, e.g., NY EPTL 3-5.1(h); Conn. Gen. Stat. Section 45a-287(c); 755 Ill. Comp. Stat. 5/7-6; NJ Stat. Ann. 3B:3-33.
31 Matter of Renard, 108 Misc. 2d 31, 437 NYS.2d 860 (Sur. Ct. New York County 1981), aff’d mem. 85 AD.2d 501, 447 NYS.2d 573 (1st Dep’t 1981), aff’d mem. 56 NY.2d 973, 453 NYS.2d 625, 439 NE.2d 341 (1982).
32 Bender v. Bender, 258 Conn. 733, 747-49 (2001) (where court stated that ‘sources of deferred income, such as pension benefits and trust interests, whether vested or not, constitute property subject to distribution, ‘provided that the contingent nature of the interest does not render the interest a mere expectancy’); see also SL v. RL, 55 Mass. App. Ct. 880, 884, 774 N.E.2d 1179, 1182 (2002) (where court held that the wife’s future interest in certain non-marital trusts ‘[was] subject only to her surviving her [then living] mother, a condition [that Massachusetts precedent] considered not to bar inclusion within the marital estate); In re Marriage of Rhinehart, 704 N.W.2d 677 (Iowa 2005) (where court held that undistributed income from an irrevocable trust was not a marital asset that was subject to division, but that the wife’s future interest in such trust could be considered when determining equitable division of property).
33 See O’Brien v. O’Brien, 66 N.Y.2d 576 (1985).
34 New York Domestic Relations Law 236B(5)(d)(7), which took effect on 23 January 2016.
35 See IRC Sections 671–79.
36 IRC Section 671.
37 Rev. Rul. 85-13, 1985-1 CB 184.
38 Department of the Treasury, General Explanation of the Administration’s Fiscal Year 2016 Revenue Proposals, at 197–99, available at: www.treasury.gov/resource-center/tax-policy/Pages/general_explanation.aspx.
39 Estate of Donald Woelbing v. Comm’r, TC Docket No. 30261-13; Estate of Marion Woelbing v. Comm’r, TC Docket No. 30260-13 (both filed 26 December 2013). Settlement was reached in Donald Woelbing on 24 March 2016 and in Marion Woelbing on 28 March 2016.
40 See IRC Section 2702.
41 IRC Section 2702(b); Treas. Reg. Section 25.2702-3.
42 Treas. Reg. Section 20.2036-1(c)(2)(i).
43 General Explanation of the Administration’s Fiscal Year 2015 Revenue Proposals, at 197–98.
44 Id. at 198.
46 See, e.g., Estate of Turner II, 138 TC 306 (2012) (consolidated asset management generally is not a significant non-tax purpose for taxpayer’s formation of FLP).
47 See, e.g., Estate of Stone, TC Memo 2012-48 (holding that the decedent had two non-tax motives for the establishment of an FLP owning woodland parcels: (i) to create a family asset which would later be developed and sold by the family and (ii) to protect the land from partition actions).
48 Estate of Koons v. Comm’r, TC Memo 2013-94 (rejecting estate expert’s regression analysis as overstating the marketability discount as 31.7 per cent and adopting IRS’s expert discount of 7.5 per cent instead); Holman v. Comm’r, 130 T.C. 170 (2008) (IRS successfully argued that the appropriate discount for lack of control and lack of marketability should be roughly half the discount claimed by the taxpayers).
49 Such speculation resulted from comments made by Cathy Hughes of the Treasury Department’s Office of Tax Policy. Ms Hughes reportedly indicated that proposed Treasury Regulations under Code Section 2704 are forthcoming. See, e.g., U.S. Trust, Tax Alert 2015-3: Possible Limitations on Family Discounts, available at: www.ustrust.com/publish/content/application/pdf/GWMOL/USTp_NWPSTA03_2016-05.pdf; Steve R Akers, Speculation About Upcoming Section 2704 Proposed Regulation (June 2015).