The global pandemic has resulted in the deaths of hundreds of thousands of individuals worldwide and created an unprecedented economic crisis. Many countries have responded by providing stimulus packages to protect their economies, incurring considerable debt in the process. The uncertainty generated by the pandemic has drawn attention to personal planning, with private clients affected by travel restrictions and considering the appropriate balance between moving assets out of their estates and having access to such assets in times of financial hardship.
The United States has been particularly affected by the covid-19 pandemic. On 27 March 2020, the Coronavirus Aid, Relief, and Economic Security (CARES) Act was enacted, providing a US$2 trillion economic stimulus package in response to the pandemic. The CARES Act provides relief payments for certain eligible individual citizens and establishes loan programmes and other types of economic relief for small business and impacted industries. Of particular importance to private clients, the CARES Act increased the deductions available for some charitable giving in 2020, allowing donors to deduct charitable contributions of cash to a public charity up to 100 per cent of the donor's adjusted gross income.2
Notably, 2020 is an election year in the United States with the possibility of political party turnover in the White House and Congress. The massive debt incurred in response to the pandemic combined with the potential political shift could result in significant tax law changes in the coming years. The United States recently underwent major tax reform in 2017 with the enactment of the Tax Cuts and Jobs Act (TCJA). The TCJA significantly changed individual and corporate income taxation. For example, many deductions previously available to individual taxpayers have been temporarily eliminated or limited, the top individual income tax rate was decreased from 39.6 per cent to 37 per cent, and the lifetime exemption from estate, gift and generation-skipping transfer tax was essentially doubled for US citizens and domiciliaries to US$11.58 million for 2020. (The lifetime exemption for non-resident individuals, however, remains at US$60,000.) With respect to entity taxation, significant changes include the reduction of the maximum corporate income tax rate from 35 per cent to 21 per cent, and substantial modifications to the rules regarding controlled foreign corporations (CFCs). These changes have effect from 2018 until 2025. However, depending on the outcome of the 2020 elections, there could be increased tax rates and a reduction of the lifetime exemption as early as 2021.
A number of developments in the past several years aimed at increasing transparency have had significant implications for wealthy families and their advisers. A well-known example is 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. Another example is the 2016 Internal Revenue Service (IRS) regulation that imposes additional disclosure requirements for a US disregarded entity wholly owned, directly or indirectly, by a non-resident alien. The disclosure rules are particularly relevant for non-resident aliens who wish to purchase real estate through a disregarded entity for privacy reasons. Such non-resident aliens should also be aware of the US Department of the Treasury Financial Crimes Enforcement Network's (FinCEN) Geographic Targeting Order (GTO) that requires the disclosure of identifying information by any title company involved in a real property transaction for qualifying transactions.
The pursuit of transparency has expanded on a global scale. Two dramatic examples are the Common Reporting Standard (CRS), of which the United States is not a participant, and the EU Council Directive 2011/16 (DAC6). CRS is a reciprocal automatic information exchange agreement developed by the Organisation for Economic Co-operation and Development. Under CRS, entities (including trusts and foundations) must report information on 'controlling persons,' which are broadly defined. DAC6 requires tax, accounting and legal professionals to report their clients' cross-border planning arrangements if such arrangements involve one of 18 specified hallmarks, including, in some circumstances, the movement of funds to a jurisdiction that does not participate in CRS, such as the United States. The global reach of CRS and DAC6 will make cooperation among teams of advisers across multiple relevant jurisdictions much more important.
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 summarises the laws of succession in the United States, including the estate planning implications of marriage and divorce. Finally, Section IV 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.3 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.4
A non-citizen of the United States is considered a resident of the United States for income tax purposes if the individual:
- is admitted for permanent residence (i.e., holds a 'green card');
- elects to be treated as such; or
- has a 'substantial presence' in the United States in a given calendar year.5
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.6
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 IRS.7 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.
Travel restrictions implemented in response to the covid-19 pandemic could impact an individual's residency determination under the substantial presence test. In response to these concerns, the IRS published Revenue Procedure 2020-20, allowing an eligible individual to exclude up to 60 consecutive calendar days of presence in the United States beginning on or after 1 February 2020 and on or before 1 April 2020, if certain criteria are met. Such relief is referred to as the COVID-19 Medical Condition Travel Exception. An eligible individual is someone who:
- was not a US resident at the close of the 2019 tax year;
- is not a lawful permanent resident at any point in 2020;
- was present in the United States on each day of such 60-day period; and
- does not become a US resident in 2020 due to days of presence in the United States outside of the 60-day period.8
To claim the COVID-19 Medical Condition Travel Exception, an eligible individual required to file a Form 1040-NR (US Nonresident Alien Income Tax Return) for 2020 must include Form 8843 (Statement for Exempt Individuals and Individuals with a Medical Condition) as an attachment to the Form 1040-NR. An eligible individual who is not required to file a Form 1040-NR for 2020 does not need to file Form 8843 to claim the COVID-19 Medical Condition Travel Exception, but should retain records justifying reliance on the exception and be prepared to produce such records and complete a Form 8843 if requested by the IRS.9
ii Gift, estate and GST tax
There are three types of US federal transfer taxes: estate tax, gift tax and generation-skipping transfer (GST) tax (collectively referred to as transfer taxes). US citizens and US residents are subject to transfer taxes on worldwide assets.10 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.11 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.12
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 TCJA modified the income limits and respective rates of the seven individual income tax brackets, mostly with the effect of decreasing the tax rate for each bracket. The top marginal rate was decreased from 39.6 per cent to 37 per cent for single filers with income in excess of US$518,400, and for married couples with income in excess of US$622,050, in 2020, indexed for inflation. The TCJA also increased the standard deduction from US$6,350 to US$12,400 for single filers, and from US$12,700 to US$24,800 for married couples, in 2020, indexed for inflation.
While the aforementioned changes implemented by the TCJA may reduce the federal tax liability of many taxpayers, other changes, such as the elimination of deductions previously available to taxpayers who itemise deductions, may increase federal taxes, especially for taxpayers who live in states and cities that have their own income taxes. For example, the TCJA limits the mortgage interest deduction for mortgages incurred after 15 December 2017, such that the deduction is now allowed only for the interest on up to US$750,000 of the principal, including a home equity loan used to buy or improve a qualified residence.13 In addition, whereas individual taxpayers were previously able to take a deduction against their federal income tax liability for state and local taxes paid (including property taxes), the TCJA limits the allowable deduction for such taxes to US$10,000 for both single filers and married couples.
The TCJA increased the deductions for some charitable giving to public charities. Charitable contributions of cash to a public charity may be deducted up to 60 per cent of the donor's adjusted gross income.14 Non-cash contributions to a public charity may be deducted up to 50 per cent of the donor's adjusted gross income, with the exception that contributions of capital gain property, such as appreciated stock, are subject to a 30 per cent limit. Special rules apply when a donor makes both cash and non-cash contributions to a public charity in the same year.15
The lifetime exemption from US gift, estate and GST taxes for US citizens and residents was doubled by the TCJA to US$10 million (US$20 million for a married couple), indexed for inflation (for 2020, the indexed exemption is US$11.58 million for an individual and US$23.16 million for a married couple). The exemption reverts back to US$5 million (US$10 million for a married couple), indexed for inflation, after 2025. The top transfer tax rate remains at 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).16 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).17 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.18
iii Medicare surcharge
The net investment income tax (NIIT) is part of the funding of the Patient Protection and Affordable Care Act enacted in 2010 and provides that citizens and residents of the United States (i.e., any individual other than a non-resident alien)19 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.20
In general, net investment income includes three broad categories of income:
- gross income from certain interest, dividends, annuities (including annuities received from a charitable remainder trust), royalties and rents;
- 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
- net gains attributable to the disposition of property, other than property held in a trade or business not described in (a).
iv Retirement plans
The Setting Every Community Up for Retirement Enhancement (SECURE) Act was signed into law on 20 December 2019, making significant changes to retirement planning. With respect to individual retirement accounts (IRAs), the age at which required minimum distributions must start was increased from age 70 ½ years to 72 years, and the restriction on making contributions after age 70 ½ years has been eliminated.21 Under the SECURE Act, if the original owner of an IRA dies after 31 December 2019, a beneficiary of the inherited IRA who is not an 'eligible designated beneficiary' (i.e., a beneficiary who is not the surviving spouse or a minor child of the original owner, who is not disabled or chronically ill or who is more than 10 years younger than the original owner) must withdraw all the funds in the inherited IRA within 10 years from the original owner's death, reducing the amount of tax-deferred growth.22 Before the SECURE Act, beneficiaries of such inherited IRAs could stretch out disbursements over their lifetimes, allowing the funds in such inherited IRAs to grow tax-deferred potentially for decades. A detailed discussion of the SECURE Act is beyond the scope of this chapter.
v Investment in non-US corporate entities
US citizens and income tax residents are subject to an anti-deferral tax regime if they invest (directly or indirectly) in non-US companies that are treated as CFCs or passive foreign investment companies (PFICs).
Controlled foreign corporation
A foreign corporation is a CFC if, at any time during the tax year, more than 50 per cent of its stock (by vote or value) is held by US taxpayers who directly, indirectly or by attribution hold 10 per cent or more of the voting power or value of the CFC. A CFC owned by a non-US trust is treated as owned by the trust's respective beneficiaries, or, in the case of a grantor trust, by the trust's grantor.
The TCJA modified the rules regarding who is considered a US shareholder and who is a substantial shareholder, and introduced the concept of global intangible low-taxed income (GILTI). Prior to the implementation of the TCJA, the rules only looked at voting power (as opposed to voting power or value) to determine if a taxpayer held a 10 per cent interest in the corporation. The TCJA also expanded the 'downward attribution' rules that must now be considered in determining if an entity is owned 50 per cent or more by US taxpayers. These new rules may make 'accidental' CFCs more common.
Significant US shareholders (i.e., US shareholders who own 10 per cent or more of the vote or value) of a CFC are required to include in their gross income each year as ordinary income their pro rata share of the CFC's passive income (generally, dividends, interest, royalties, gains from the sale of certain types of property), regardless of whether such US shareholders actually receive any distributions. The TCJA also added a 'dry' tax with respect to GILTI.
In addition, under the pre-TCJA rules, a CFC had to be considered a CFC for at least a 30-day period for significant US shareholders to be subject to the special tax charge described above. The TCJA eliminated this provision, which has had significant impact on cross-border CFC planning.
Passive foreign investment company
A foreign corporation is a passive foreign investment company (PFIC) if either 75 per cent of more of the gross income of such corporation for the taxable year is passive income (the 'income test'), or the average percentage of the assets held by such corporation during the taxable year that produces passive income or is held for the production of passive income is at least 50 per cent (the 'asset test'). For this purpose, passive income generally includes interest, dividends, rents and royalties, and similar income and net gains from the sale of property producing such income. For example, an investment in a non-US private equity fund could be treated as an investment in a PFIC.
When US shareholders of a PFIC dispose of their PFIC shares or receive an 'excess' distribution23 from the PFIC, any gain realised and any 'excess' distribution received is treated as ordinary income and apportioned retroactively over the shareholder's holding period; and an interest charge is imposed with respect to tax payable on any gain attributed to prior years. Importantly, this tax applies even where a US taxpayer holds his or her interest in a PFIC indirectly (e.g., through a US or non-US flow-through entity). For example, stock in a PFIC owned by a non-US non-grantor trust will be considered as owned proportionately by its beneficiaries.
vi 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 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; receives a distribution (including a loan) of any amount from a non-US grantor or non-grantor trust; or 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 2019, US$16,388) 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).24 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.25 An individual who fails to file a required Form 3520 may be subject to very significant penalties.
In addition, the trustee of a foreign trust with a US owner must file Form 3520-A (Annual Information Return of Foreign Trust with a US Owner) 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 United States, 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. Such report is made on FinCEN Form 114 (referred to as an FBAR form) on or before 15 April of the succeeding year, subject to an automatic 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 is a US person and files an FBAR disclosing the trust's foreign financial accounts.
A beneficiary of a discretionary trust generally 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 helped accelerate the global drive towards greater transparency and scrutiny of offshore assets. Under FATCA, enacted in 2010 as part of the Hiring Incentives to Restore Employment Act, 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)26 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 26), or to certify annually that they have no substantial US owners.27 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 and proceeds from the sale of US property on FFIs that do not agree to provide the IRS with the required information.28
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 therein29 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.30 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).
Despite early opposition to FATCA in many cases, FATCA has expanded and become increasingly accepted in the international sphere, with partner jurisdictions entering into bilateral IGAs whereby they agree to 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. Nevertheless, aspects of FATCA's implementation remain contentious. 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. Additionally, some signs of push-back are emerging, such as certain non-US financial institutions' reluctance or flat refusal to take on new US clients.31
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.
Generally, except in the case of corporations (or entities that elect to be treated as corporations), a US entity that has a single owner is disregarded as separate from its owner. However, in late 2016, the IRS finalised regulations that treat a US disregarded entity wholly owned, directly or indirectly, by a non-resident alien as a domestic corporation separate from its owner for Internal Revenue Code Section 6038A disclosure purposes.32 Such entities are now required to make additional disclosures when participating in certain transactions.
Under the current rule, these entities must file IRS Form 5472 (which requires an employer identification number) when reportable transactions occur during the tax year and must maintain records of reportable transactions involving the entities' non-resident alien owners or other foreign parties. The regulation classifies transactions such as any sale, lease or other transfer of any interest in or a right to use any property as reportable transactions. To acquire an employer identification number, the owner may have to obtain an individual taxpayer identification number (as they also would when buying property individually), which many non-resident aliens hope to avoid. These disclosure rules are particularly relevant for non-resident aliens who wish to purchase real estate through a disregarded entity for privacy reasons.
Non-resident aliens should also be aware of a revised FinCEN GTO that requires the disclosure by the title company involved in the transaction of identifying information on a FinCEN Currency Transaction Report, filed within 30 days of a qualifying transaction.33 The GTO's disclosure requirements are applicable to all residential real estate purchases paid for, in whole or in part, by cash, cheque, money order, funds transfer or virtual currency (and without a bank loan or other similar form of financing) of US$300,000 or more in:
- Bexar, Tarrant or Dallas counties in Texas;
- Miami-Dade, Broward or Palm Beach counties in Florida;
- the boroughs of Brooklyn, Queens, Bronx, Staten Island or Manhattan in New York City, New York;
- San Diego, Los Angeles, San Francisco, San Mateo or Santa Clara counties in California;
- Clark county in Nevada;
- King county in Washington;
- Suffolk or Middlesex counties in Massachusetts;
- Cook county in Illinois; and
- the city and county of Honolulu in Hawaii.
A currency transaction report must include information about the identity of the purchaser, the purchaser's representative, and the beneficial owners, as well as information about the transaction itself, including the closing date, payment amount, payment method, purchase price and address of the real property involved in the transaction. In addition, the form requires disclosures about the entity used to purchase the property, including the names, addresses and taxpayer identification numbers for all members. The reporter must obtain copies of driver's licences, passports or similar documents from the purchaser, the purchaser's representative and the beneficial owners.34
The purpose of the GTO is to provide law enforcement with data to improve efforts to address money laundering in the real estate sector. The GTO is a temporary measure that is effective for only 180 days, but has been extended several times, with the current extension set to expire on 5 November 2020.
Form 5471, Information Return of US Persons with Respect to Certain Foreign Corporations, must be filed by, among others, US persons who own or acquire certain interests in foreign corporations, including CFCs.
A US shareholder who directly or indirectly owns shares in a PFIC at any time during such person's taxable year must file a Form 8621. The filing requirement is imposed on the first US person in the chain of ownership (i.e., the lowest-tier US person) that is a PFIC shareholder (including an indirect shareholder).
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 US succession law is testamentary freedom, with some exceptions discussed below. The testator's freedom to determine the disposition of property at death generally manifests 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.35
Because of the potential delay, cost and lack of privacy often associated with the probate process, US citizens 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.36 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.37 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 a third of the decedent spouse's net estate in lieu of taking benefits under a will.38 The amount that passes as the elective share generally qualifies for the marital deduction for federal and state estate tax purposes.39
No forced heirship right of children
Unlike many civil law systems, no US jurisdiction (with the sole exception of Louisiana, the laws of which are predominantly derived from the French Napoleonic Code)40 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 such as 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.41
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 would likely 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 tax benefits provided to married couples under federal law are now available to same-sex couples.42 These benefits include the ability to utilise the unlimited marital estate tax deduction, split gifts and elect portability. While the Supreme Court decision in Obergefell v. Hodges held that states must license marriages between same-sex couples and recognise same-sex marriages performed in other states, the treatment of same-sex marriages under state laws is a developing area of the law.43
Property division on divorce44
Under the laws of most states, property acquired or earned by either spouse during marriage is generally 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. However, 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.45 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.46 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.47
IV WEALTH STRUCTURING AND REGULATION
This section focuses on domestic planning strategies for US persons. It provides a short discussion of 'pre-immigration' planning for non-resident aliens of the United States who wish to become US residents or citizens. Pre-immigration planning is a separate and complex area and an in-depth discussion 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:
- the avoidance of state transfer tax in jurisdictions with an estate tax, but no gift tax;
- 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
- all the appreciation on assets after the gift is made is outside of the taxable estate at death.
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).48 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.49 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.50
The IRS has made attempts to challenge the use of sales to grantor trusts. To date, those attempts have generally been unsuccessful, but 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.51 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.52 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.53 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.
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., owing 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.54 However, when an FLP is properly structured and administered, taxpayers have been successful in defeating these challenges.55 Moreover, the IRS may assert that the discount applied to the FLP assets is overstated.56
iv Pre-immigration planning
Non-US residents who plan to become US residents in the future should undertake pre-immigration planning to protect their assets from the potential application of US tax laws. Pre-immigration planning is a complex area that often involves both US and non-US trusts, careful planning to obtain a step-up in capital gains basis of assets, and other sophisticated planning tools. Pre-immigration planning should begin as soon as possible for individuals planning to become US residents. If a non-US grantor of a non-US trust, with one or more US beneficiaries, becomes a US resident within five years of funding the trust, the grantor becomes subject to US income tax on all of the trust's income and on capital gains for any year in which the trust had a US beneficiary. The trust also becomes subject to increased reporting obligations.
V OUTLOOK AND CONCLUSIONS
The urgent need for tax revenue, coupled with the US government's distrust of the offshore world, shows no sign of abating, and may be intensified by the covid-19 pandemic. 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 Elizabeth Kubanik is European Counsel in the London office of Sullivan & Cromwell LLP. Susan Song is Special Counsel in the New York City office of Sullivan & Cromwell LLP.
2 Coronavirus Aid, Relief, and Economic Security (CARES) Act, Pub. L. No. 116-136, Section 2105 (2020). A full discussion of the CARES Act is beyond the scope of this chapter.
3 IRC Section 61. The top federal individual income tax rate for ordinary income in 2020 is 37 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.
4 IRC Sections 871, 897.
5 IRC Section 7701(b)(1)(A).
6 The weighted average test takes into account all of the days of presence in the United States in the current calendar year, a third of the days in the first preceding calendar year and a sixth of the days in the second preceding calendar year. Treas. Reg. Sections 301.7701(b)–1(c)(1), (4).
7 Treas. Reg. Section 301.7701(d)-1.
8 Rev. Proc. 2020-20.
9 Form 8233 (Exemption From Withholding on Compensation for Independent (and Certain Dependent) Personal Services of a Nonresident Alien Individual) must be provided to an employer or other withholding agent to claim an exemption from withholding on income from dependent personal services pursuant to a US income tax treaty in accordance with Revenue Procedure 2020-20. If the withholding agent currently treats the income as exempt based on a previously submitted Form 8233, an additional Form 8233 is not required.
10 IRC Sections 2031(a), 2511(a), 2612.
11 Treas. Reg. Sections 20.0-1(b)(1), 25.2501-1(b), 26.2663-2(a).
12 Treas. Reg. Section 20.0-1(b)(1).
13 Prior to the TCJA, the mortgage interest deduction was limited to the interest on up to US$1 million in mortgages to acquire or improve a qualified residence, in addition to the interest of up to US$100,000 on any home equity loan. Outstanding indebtedness may not be grandfathered for a home equity loan used for a purpose other than acquiring or improving a qualified residence.
14 As noted in Section I, the CARES Act allows individuals to deduct cash contributions up to 100 per cent of their adjusted gross income on itemized tax returns for 2020.
15 The deductibility limit on the non-cash contribution is reduced by the amount of the cash contribution. The non-cash contribution may be deducted up to 50 per cent of the donor's adjusted gross income (or 30 per cent in the case of appreciated stock), less the cash contribution subject to the 60 per cent limit. IRS Pub. No. 526 (12 March 2019).
16 The current portability regulations provide that the deceased spouse's unused exemption amount is based on the exemption amount in effect at the time of the first spouse's death, such that, if the first spouse died prior to 2025, the higher exemption amount would be available to the surviving spouse even after the exemption amount has been reduced. Treas. Reg. Section 20.2010-2(c)(1). However, IRC Section 2010(c)(4) applies the exemption amount of the surviving spouse. Further clarification is needed to resolve this ambiguity.
17 See Fed. Estate and Gift Tax Reporter Section 1450.08; Treas. Reg. Section 20.2010-3.
18 Treas. Reg. Section 20.2010-3.
19 A dual-resident US citizen (per IRC Section 301.7701(b)-&(a)(1)), who declares resident status in a foreign country for tax purposes pursuant to an income tax treaty between the United States and that country and claims benefits of the treaty as a non-resident of the United States, is considered a non-resident alien with respect to the NIIT.
20 US$12,500 for tax years beginning after 31 December 2016.
21 Setting Every Community Up for Retirement Enhancement (SECURE) Act of 2019, Pub. L. No. 116–94, Sections 107, 114.
22 id., Section 401.
23 Generally, any distributions received by a US shareholder on PFIC stock in a taxable year that are greater than 125 per cent of the average annual distributions received by the US shareholder on the shares in the three preceding taxable years (or, if shorter, the US shareholder's holding period in the shares) are excess distributions.
24 If the trust owns an interest in a CFC or a PFIC, a US beneficiary may have additional reporting requirements.
25 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.
26 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).
27 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'.
28 IRC Section 1471(a)–(b). Withholding on the gross proceeds from the sale or other disposition of property of a type that can produce interest or dividends or dividends that are US-source fixed, determinable, annual or periodical income will begin for sales occurring after 31 December 2018. 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.
29 IRC Section 1471(d)(4)–(5).
30 Treas. Reg. Section 1.1471-5(e)(4).
31 A 2014 report to the Senate Finance Committee by Democrats Abroad details refusals to take on US clients or closures of US 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/2016/10/20/investing/swiss-banks-americans-fatca-switzerland/index.html; New York Times: 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/).
32 Treatment of Certain Domestic Entities Disregarded as Separate from Their Owners as Corporations for Purposes of Section 6038A, 81 Fed. Reg. 89,849 (13 December 2016) (to be codified at 26 C.F.R. pt. 1, 301).
33 United States Department of the Treasury Financial Crimes Enforcement Network, Geographic Targeting Order (8 May 2020), available at www.fincen.gov/sites/default/files/shared/
34 Businesses are also required to report identifying information relating to transactions that involve cash payments over US$10,000 by filing an IRS Form 8300.
35 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.
36 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).
37 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.
38 NY Estates, Powers and Trusts Law (EPTL) Section 5-1.1-A(a)(2).
39 Diane Hubbard Kennedy, 'Using the Marital Deduction', ALI-ABA Estate Planning Course Materials Journal at 27 (April 2000).
40 Article 1493 of the Louisiana Civil Code.
41 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. The decision in 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. 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).
42 See United States v. Windsor, 570 U.S. 744 (2013) (invalidating Section 3 of the Defense of Marriage Act, which limited the definition of marriage for the purposes of federal law to opposite-sex couples).
43 See, e.g., Pidgeon v. Turner, 538 SW3d 73, 86–87 (Tex. 2017) ('The Supreme Court held in Obergefell that the Constitution requires states to license and recognize same-sex marriages to the same extent that they license and recognize opposite-sex marriages, but it did not hold that states must provide the same publicly funded benefits to all married persons.'), cert. denied, 138 S. Ct. 505 (2017).
44 The TCJA eliminated the deduction for alimony paid under a divorce settlement executed or modified in 2019 or later. Alimony payments will no longer be taxable income for their recipients.
45 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).
46 See, e.g., O'Brien v. O'Brien, 66 N.Y.2d 576 (1985).
47 New York Domestic Relations Law 236B(5)(d)(7).
48 IRC Sections 671–79.
49 IRC Section 671.
50 Rev. Rul. 85-13, 1985-1 CB 184.
51 See IRC Section 2702.
52 IRC Section 2702(b); Treas. Reg. Section 25.2702-3.
53 Treas. Reg. Section 20.2036-1(c)(2)(i).
54 See, e.g., Estate of Turner II, 138 TC 306 (2012) (consolidated asset management generally is not a significant non-tax purpose for a taxpayer's formation of an FLP); Powell v. Comm'r, 148 TC 18 (2017) (holding that the FLP assets were includable in the decedent's estate under IRC Section 2036(a)(2) because the decedent retained the ability, acting with the other partners, to dissolve the partnership).
55 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: (1) to create a family asset that would later be developed and sold by the family; and (2) to protect the land from partition actions).
56 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); Estate of Streightoff v. Comm'r, TC Memo 2018-178 (denying discount for lack of control and rejecting estate expert's 27.5 per cent discount for lack of marketability in favour of IRS's expert discount of 18 per cent).