PRE-IMMIGRATION & TAX PLANNING
Introduction. It is becoming easier for people and money to move across international borders. Most of the time, this movement will not have an impact on a person’s tax situation, and a nonresident of the United States would have few, if any, interactions with the Internal Revenue Service (“IRS”). But upon becoming a “resident” of the U.S. for tax purposes, the rules change dramatically, and if not planned for, the tax consequences can be severe.
Residency Starting Date. Pre-immigration tax planning and restructuring is usually done with the understanding that the individual is not yet subject to U.S. federal income tax in connection with such planning and restructuring. Accordingly, a clear understanding of the residency starting date of an individual that qualifies as a U.S. person in a particular year is crucial. If an alien is classified as a resident alien for the year and was not a resident alien at any time in the previous year, Code § 7701(b)(2)(A) provides “residency starting date” rules to determine on which day in the year the alien’s residency begins.
Gift and Estate Tax Purposes. Pre-immigration tax planning also requires an understanding of whether (and if so, when) the individual who is seeking to immigrate into the United States will become a resident of the United States for U.S. estate and gift tax purposes.
Residence/Domicile. For U.S. estate and gift tax purposes, the term “residency” means “domicile.” Although the U.S. income tax concept of residency relates only to physical presence in a place for more than a transitory period of time, domicile relates to a permanent place of abode. For U.S. estate and gift tax purposes a person can have (and must have) only one place of domicile, while for U.S. income tax purposes a person may have more than one place of residence, or none.
Although an alien may be classified as a resident alien for U.S. income tax purposes, such classification is not determinative of the alien’s domicile for U.S. estate and gift tax purposes.
The concept of domicile is subjective, focusing on the intentions of the alien as manifested through certain lifestyle-related facts. Treas. Regs. §§ 20.0-1(b)(1) and 25.2501-1(b) offer only limited guidance, stating: “A person acquires a domicile in a place by living there, for even a brief period of time, with no definite present intention of later removing therefrom. Residence without the requisite intention to remain indefinitely will not suffice to constitute domicile,
nor will intention to change domicile effect such a change unless accompanied by actual removal.”
Accordingly, to be domiciled in the United States physical presence must be coupled with the requisite intent to remain indefinitely.
Pre-Immigration Planning Strategies. Prior to an alien becoming a U.S. person for U.S. income and/or estate and gift tax purposes, various strategies can be implemented to minimize or even eliminate various U.S. tax consequences. Below is a summary of some techniques to be considered by practitioners in the pre-immigration tax planning context.
- Step up cost basis in appreciated assets
- Transfer assets to US estate tax exempt trusts
- Make advance, completed lifetime gifts
- Accelerate gain recognition on appreciated assets
- Defer recognition of losses on depreciated assets
- Dispose of PFICs (passive foreign investment companies)
- Plan for future foreign tax credits from foreign activities
- Convert and/or check the box on foreign eligible entities, if recommended.
- Maintaining Non-domiciliary Status
- U.S. Estate and Gift Tax Pre-Immigration Planning
- Once an N.R.A. becomes a U.S. domiciliary, transfers of substantial assets outside the U.S. that could have been accomplished all at once before the establishment of domicile in the U.S. may require years to complete, because of strict limits on annual and lifetime gifts. Hence, it is generally best for wealthy in¬dividuals and families who intend to immigrate to the U.S. to implement tax plans before they immigrate, when they can still make unlimited transfers of property that does not have its situs within the U.S. without incurring U.S. taxes and without sub¬stantial delays.
- One primary goal of pre-immigration planning is to minimize post-immigration expo¬sure to U.S. transfer taxes by removing non-U.S.-situs property from the N.R.A.’s taxable estate before the N.R.A. establishes U.S. domicile.
- This goal is often accomplished by having the N.R.A. create a properly structured irrevocable offshore trust that the N.R.A. funds with foreign property before immigration. This type of trust is sometimes referred to as a drop-off trust.
- Private Placement Life Insurance
- Private placement life insurance (“P.P.L.I.”) can offer a unique pre-immigration plan¬ning solution and relieve drop-off trust grantors of the burden of paying trust income tax after the grantors move to the U.S.
- From an income tax perspective, the owners of life insurance policies do not realize taxable income from the policy’s underlying investment accounts. Thus, investing a drop-off trust’s assets in life insurance can reduce some, or all, of the trust’s taxable income because income earned inside the policy is not taxed currently to the policy owner. Moreover, death benefits paid out of the policy to the drop-off trust are not subject to U.S. income tax and effectively enjoy a stepped-up basis, despite not being included in the grantor’s estate.
- However, a traditional life insurance policy ordinarily comes at a relatively high cost, comprised of commissions and fees, and offers somewhat limited investment op¬tions. Both factors often outweigh the tax benefits of the policy, and funds locked up in a traditional life insurance policy may not be readily accessible.
Overview of US Tax Rules. Outlined below are two tax systems that an individual considering spending more time in the United States should plan for: The Federal Income Tax and the federal “Wealth Transfer” taxes, comprised of the Estate & Gift taxes and the Generation-Skipping Transfer tax. Although U.S. law provides rules for non-residents, a treaty may change those rules, such as reducing the rate of tax on certain types of income or treaty tiebreaker rules for determining US residents. Because of the complexity involved in planning for any one of these taxes, it is not possible to provide anything more than a cursory introduction to the concepts involved in pre-immigration tax planning. For that reason, many concepts have been abbreviated or left out entirely to provide a brief overview of the complexities involved in US Pre-Immigration & Tax Planning.
Federal Income Tax. The U.S. uses a worldwide taxation system, which means that U.S. citizens and residents are subject to U.S. income tax on their worldwide income. This is dramatically different than most countries, which use a territorial system to impose income tax only on the income generated within that country’s own borders. To offset potential double taxation, the U.S. allows taxpayers to use worldwide expenses to reduce worldwide income and grants a foreign tax credit for foreign income taxes paid on income generated outside of the United States.
Because of the dramatic differences between worldwide taxation for U.S. purposes, and the territorial taxation system that a nonresident may be accustomed to, nonresidents must know how and when they will be treated as residents for U.S. tax purposes.
For income tax purposes, non-citizens are divided into two groups: residents and nonresidents. An income tax resident is a person who satisfies one of two tests: the lawful Permanent Resident test and the Substantial Presence test.
- The lawful Permanent Resident test (also known as the “green card test”) is satisfied if a person is a lawful permanent resident of the United States (because they have been granted a “green card,” and with it, the right to legally reside in the United States) at any point during the tax year.
- The Substantial Presence test, although more complicated, is satisfied if a person is present in the United States for at least 31 days during the calendar year, and for 183 or more total days during the current year and the previous two years (with only a fraction of each day from the prior two tax years being counted). A person who can demonstrate a closer connection to another country can qualify for an exemption to the substantial presence test.
Both of these objective tests produce a clear result based on bright-line rules. Once determined to be a resident under either test, residents must file income tax returns to report and pay tax on their Worldwide Income.
Unlike citizens and residents, nonresidents are only subject to income tax on income derived from sources within the U.S. Instead of a single set of tax rules applicable to all income, the income derived by a nonresident is subject to four broad categories of taxation.
• Effectively Connected Income (“ECI”)—Income from U.S. sources that is “effectively connected” with a U.S. trade or business is taxed at graduated rates on a net basis. Income is generally treated as effectively connected with a U.S. trade or business if the taxpayer is engaged in a business located in the U.S., and the “effectively connected” income is generated by that business.
• Fixed, Determinable, Annual, or Periodical Income (“FDAP” Income)—FDAP Income is generally defined as all income other than gains derived from the sale of real or personal property, and certain items excluded from gross income. But any FDAP Income that is not “effectively connected” with a U.S. trade or business (e.g., dividends, interest, and royalties) is taxed at a flat 30% rate. A significant drawback to being taxed at a flat rate is that a taxpayer is taxed on the gross amount received and is not allowed deductions for the expenses of producing such income.
• Sales of U.S. Real Property and the Foreign Investment in Real Property Tax Act of 1980 (“FIRPTA” Income)—A nonresident’s disposition of a U.S. real property interest is treated as effectively connected with a U.S. trade or business, and is subject to mandatory tax withholding at 10% or 15% rates, depending on the taxpayer.
• Income Not Subject to Income Tax—A few types of income, such as interest generated by assets held in a bank account, escape income tax entirely.
One of the biggest surprises for a nonresident considering immigration to the U.S. is the foreign asset reporting requirements. While nonresidents are not subject to these requirements, U.S. taxpayers must disclose their ownership of certain foreign assets to the IRS. While it is not possible to list all of the reporting obligations here, below are just a few of the information returns that may need to be filed:
- FinCEN 114—Foreign Bank Account Report (the “FBAR”)
- IRS Form 926—Return by a U.S. Transferor of Property to a Foreign Corporation
- IRS Form 3520—Annual Return to Report Transactions him Foreign Trusts and Receipt of Certain Foreign Gifts
- IRS Form 3520-A—Annual Information Return of Foreign Trust With a U.S. Owner
- IRS Form 5471 - Information Return of U.S. Persons With Respect to Certain Foreign Corporations
- IRS Form 8621—Information Return by a Shareholder of a Passive Foreign Investment Company or Qualified Electing Fund
- IRS Form 8858—Information Return of U.S. Persons With Respect to Foreign Disregarded Entities
- IRS Form 8865—Return of U.S. Persons With Respect to Certain Foreign Partnerships
- IRS Form 8938—Statement of Foreign Financial Assets
These forms do not require the payment of any additional tax, but significant penalties can be imposed for failing to file them. Additionally, the failure to file these returns may allow the taxpayer’s return to remain open to inspection by the IRS until the information returns have been filed. A potential immigrant must consider these additional reporting requirements that will be imposed after immigrating to the U.S.
Wealth Transfer Taxation. As with the income tax, U.S. citizens and residents are subject to worldwide taxation by the three wealth transfer taxes: the estate tax, the gift tax, and the generation-skipping transfer tax. Nonresidents are only subject to wealth transfer taxation on their U.S. situs assets. So, while these taxes are different from the income tax, the principle that nonresidents are taxed only on assets that are located in the U.S. is similar to the principal in income taxation that the U.S. only taxes income that is connected with the U.S.
Unlike the objective tests for income tax residence, the test for estate and gift tax residence is subjective and is satisfied if a person is domiciled in the U.S. at the time of his or her death or transfer by gift, as applicable. A person acquires U.S. domicile by residing in the U.S. for any period of time with no definite present intention of leaving. Absent that intention, a person will not acquire domicile for the purposes of wealth transfer taxation. As a result, the determination of residence for wealth transfer tax purposes requires a determination of an individual’s state of mind at the requisite moment.
To determine whether you are a US domiciliary, the following factors are considered:
- Statement of intent (in visa applications, tax returns, will, etc.)
- Length of US residence
- Green card status
- Style of living in the US and abroad
- Ties to former country
- Country of citizenship
- Location of business interests
- Places where club and church affiliations, voting registration, and driver licenses are Maintained
A person is considered a non-US domiciliary for estate and gift tax purposes if he or she is not considered a domiciliary under the facts and circumstances test described above. It is possible that two or more countries will consider the same person a domiciliary, and/or that certain assets may be subject to estate or gift tax in more than one country.
Once determined to be a resident under this subjective test, a resident is required to file returns to report gifts or to have an estate tax return filed if the resident’s estate is required to file a return.
Because this test is different than the residence test for the income tax, it is possible for an individual to be a resident for income tax purposes without being a resident for wealth transfer tax purposes, and vice versa.
Nonresidents are subject to wealth transfer taxation only on assets that are U.S. situs property.
For example, a nonresident will be subject to estate tax only on U.S. situs property owned at death, which includes U.S. real property and stock in U.S. corporations.
- Cash deposits in a U.S. bank,
- insurance on the life of a nonresident, or
- stock in a non-U.S. corporation
are generally not treated as U.S. situs assets, though they would be subject to estate tax in a resident’s estate.
Nonresidents are entitled to only limited deductions and exemptions for estate tax purposes. The unlimited marital deduction for assets that pass to a surviving spouse is not available for transfers to spouses who are not U.S. citizens. General expenses of administration, debts, taxes, funeral expenses, and losses of the worldwide estate are only deductible from the U.S. estate in the proportion that the U.S. estate bears to the worldwide estate.
So, if a nonresident decedent has a worldwide gross estate valued at $1,000,000, of which the U.S. gross estate is valued at $100,000, only 10% of their debts, taxes, and funeral and administration expenses would be deductible, regardless of whether they are directly attributable to the administration of the U.S. estate. But to obtain these deductions, the nonresident’s estate must disclosure the decedent’s worldwide estate on the estate tax return.
A nonresident is only allowed a $13,000 estate tax credit (effectively a $60,000 exemption amount), as opposed to the $11,180,000 estate tax exclusion amount available for U.S. citizens in 2018. Because the exemption amount available to nonresident is so low, even nonresidents with few U.S. assets can face a significant estate tax burden.
Like the estate tax, the gift tax only applies to a nonresident’s gifts of U.S. situs real estate and tangible property, and not worldwide transfers. A nonresident’s gifts of intangible property are not subject to U.S. gift tax. A nonresident is also granted the same annual $15,000 exclusion per donee exemption for 2018 that is granted to U.S. citizens and residents on transfers of U.S. situs assets. But a nonresident is not granted the same $11,180,000 lifetime exemption from gift tax that is granted to U.S. citizens and residents in 2018. However, there is a gift tax annual exclusion for gifts to a non-citizen spouse of $152,000 in 2018.
In addition to the estate tax and the gift tax, nonresidents are subject to the generation-skipping transfer tax (“GST”). The GST serves as a backstop to the estate tax and the gift tax by taxing transfers that “skip” a generation (e.g., a gift from a grandparent to a grandchild) if the transfer is subject to either the estate tax or gift tax. A nonresident is granted an exemption from GST, but it is not clear if the exemption amount is $1,000,000 or if it is $11,180,000, the amount granted to U.S. citizens and residents.
If the surviving spouse is not a US citizen, in general, the portion of jointly owned property that is taxed in the estate of the first spouse to die is based upon who provided the “consideration” to purchase the property (i.e. whose assets were used to purchase the property). If the surviving spouse is a US citizen, then in general one-half the value of the jointly owned property will be
included in the estate of the first spouse to die.
If the surviving spouse is a US citizen, there is an unlimited marital deduction, in other words, an
unlimited amount of assets can pass to your spouse without being subject to US estate tax. An election can also be made on a timely-filed estate tax return to pass any exemption amount not utilized to the surviving spouse for use in addition to his or her own exemption.
If your surviving spouse is not a US citizen, the marital deduction is generally not allowed. However, a deferral of US estate tax for assets passing to a non-US citizen surviving spouse may be obtained if US property passes through a Qualified Domestic Trust. Some estate and
gift tax treaties also allow for some form of a marital deduction in cases where such a deduction would not normally be available.
Even this brief introduction to the U.S. income tax and the wealth transfer taxes shows the varied rules, exceptions, requirements, and exemptions that apply to both U.S. residents and nonresidents. These rules are complicated and present many traps for the unwary.
Pre-Immigration Tax Planning Is Needed
To Avoid These US Tax Traps For The Unwary!
Contact Marini & Associates PA Today!
To schedule a consultation, call us in Miami at (305) 374-4424 or toll free at (888) 882 9243 or contact us online.