Advising the Foreign Private Client on Fundamentals of Us Estate, Gift And

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STILL THINKING OF COMING TO AMERICA? ADVISING THE FOREIGN PRIVATE CLIENT ON FUNDAMENTALS OF U.S. ESTATE, GIFT AND GST TAX PLANNING

M. Katharine Davidson, Esq. Henderson, Caverly, Pum & Charney, LLP 12750 High Bluff Drive, Suite 300 San Diego, California

13th Annual International Estate Planning Institute NYSB and STEP New York March 23, 2017 New York, New York

Page

I. WHO IS SUBJECT TO TAXATION BY THE U.S.? ...... 1 A. Reach of U.S. Citizenship...... 1 B. U.S. Tax Residency...... 2 C. U.S. Transfer Tax Treatment...... 2 1. Domicile...... 3 2. Estate and Gift Tax Rules for NRAs...... 4 3. Use Of Entities...... 8 D. Problems Associated with Noncitizen Spouses...... 8 1. Lifetime Transfers...... 8 2. Transfers Upon Death...... 9 3. Problems with Joint Property Interests Held by Spouses...... 15

II. U.S. TRANSFER TAX TREATMENT OF NONRESIDENT ALIENS...... 16 A. U.S. Estate Tax...... 16 B. Gift Tax...... 17

III. FOREIGN TRUSTS...... 18 A. Classification as a Foreign Trust...... 18 1. Court Test...... 18 2. The Control Test...... 18 B. Reversing Unintended Loss of Domestic Status...... 19 C. Taxation of Foreign Trusts...... 19 1. Foreign Grantor Trusts...... 19 2. Foreign Nongrantor Trusts...... 19 D. Foreign Trusts with U.S. Grantor under FATCA...... 20 1. Grantor Trust Status...... 20 E. Loans From Foreign Trusts...... 21 F. Use of Foreign Trust Property...... 21 G. Reporting Obligations for Foreign Trusts...... 21 1. Reportable Events...... 21 2. U.S. Beneficiaries...... 22 3. Annual Reporting...... 22 4. Penalties...... 22

i TABLE OF CONTENTS

Page H. Pre-Immigration Trusts...... 22

IV. INDIRECT TRANSFERS FROM FOREIGN ENTITIES...... 23

V. PRE-IMMIGRATION PLANNING CONSIDERATIONS...... 24 A. Selected Income Tax Minimization Techniques...... 25 1. Timing Visits to the United States and Interim Residence in Third Country...... 25 2. Basis Step-up...... 25 3. Accelerate Income...... 25 4. Retain Loss Property and Postpone Deductions...... 25 5. Shift Income to Family Members...... 25 6. Foreign Transfer of Property...... 25 7. Corporate Issues...... 25 8. Currency Issues...... 26 9. Evaluation of Trusts...... 26 B. Selected Potential Transfer Tax Techniques...... 26 1. Gifts...... 26 2. Gifts Between Spouses...... 26 3. Powers of Appointment...... 27 4. Joint Tenancy Property...... 27 5. Any properties held by an NRA in joint tenancy with a spouse should be severed...... 27

VI. PLANNING FOR RETENTION OF NONRESIDENT AND NON- DOMICILIARY STATUS...... 27

VII. SUCCESSION TAX APPLICABLE TO GIFTS AND BEQUESTS FROM COVERED EXPATRIATES...... 27 A. Tax Treatment Under Section 2801...... 28 1. Definition of Covered Gift or Bequest...... 28 2. Taxation of Covered Gift or Bequest ...... 28 B. Special Rules for Domestic and Foreign Trusts under Section 2801 ...... 28 C. Form 708 ...... 29 D. Penalties ...... 29

STILL THINKING OF COMING TO AMERICA?

ADVISING THE FOREIGN PRIVATE CLIENT ON FUNDAMENTALS OF U.S. ESTATE, GIFT AND GST TAX PLANNING

M. Katharine Davidson, Esq. Henderson, Caverly, Pum & Charney, LLP 12750 High Bluff Drive, Suite 300 San Diego, California

The United States tax rules have become more and more complex over the years, especially with respect to foreign persons who come to the United States to live or work, whether temporarily or permanently, or who otherwise have ties to the United States. More and more foreign persons are looking to the United States as a safe place to invest. Repeated changes in the United States tax laws make the task of advising a foreign client all the more daunting. Perhaps even more imposing is the string of new compliance rules that have been enacted by the United States in recent years that have dramatically increased the costs of compliance and greatly expanded the required disclosures.

The United States, as well as other governments, has increased monitoring and scrutiny of cross- border transactions and have put “real teeth” into the enforcement of international and financial compliance. These efforts have been successful in identifying and prosecuting illicit offshore activities and continue to make headlines in the press.

Individuals involved in cross-border activities must stay attuned to these continuing developments with a clear understanding of the rules as they develop and the penalties that may result from inadequate or improper planning and reporting. Moreover, the United States advisor to the foreign client must work with knowledgeable local counsel to integrate any non-U.S. tax and transfer planning with U.S. advice.

The scope of this paper is limited to planning for U.S. transfer taxes for foreign persons; it does not address applicable U.S. income taxes.

I. WHO IS SUBJECT TO TAXATION BY THE U.S.?

A. Reach of U.S. Citizenship. The United States is one of a very few countries in the world that imposes its tax (both on transfers and on income and gains) on the basis of U.S. citizenship alone. This means that if an individual is a U.S. citizen, he is fully subject to U.S. income tax on a worldwide basis, as well as gift, estate and generation-skipping transfer (“GST”) tax on a worldwide basis. Thus, any transfer of property made by a U.S. citizen during his lifetime is potentially subject to U.S. gift tax; all of the assets forming part of his estate at his death under U.S. tax laws are potentially subject to U.S. estate tax; and any transfers he makes during life or at death which skip a generation are potentially subject to U.S. GST tax.

Generally, any individual born in the United States is a U.S. citizen even if his parents are non-U.S. citizens or are present in the United States illegally.1 In addition, certain individuals born outside the United States of a U.S. citizen parent are U.S. citizens. We have all heard of the “Accidental American.” A person may be a U.S. citizen and not even know it and his citizenship can pass through several generations of children and grandchildren born outside of the United States without any of them being aware of their status. It is important to note that the rules on citizenship are technical and have changed over the years, and one must consult with an immigration attorney if there is any question about a client’s citizenship. Merely looking at a person’s passport is not sufficient.

In addition, many non-U.S. citizens find themselves living in the United States for sustained periods of time and thereby become subject to U.S. taxes in the same manner as U.S. citizens.

While individuals may renounce or lose U.S. citizenship, until the conclusion of required administrative and reporting procedures, the individual remains a U.S. citizen subject to all U.S. tax laws. Moreover, the burden of proof is on the person asserting his loss of citizenship.

These rules may come as a surprise to many clients who come from countries that tax an individual on a worldwide basis only if the taxpayer is domiciled or resident in that country, apart from citizenship alone. Thus, it is important to note that the existence of U.S. citizenship, even in combination with other nationalities, is sufficient to subject an individual to worldwide taxation by the United States.

B. U.S. Tax Residency. Apart from U.S. citizenship, the United States also taxes on the basis of residency. A U.S. person is subject to U.S. income tax on his worldwide income. A person who is not a U.S. citizen or resident2 (i.e., a person who is a “nonresident alien” or ”NRA”) is generally taxed by the United States only on certain specified items of income from sources in the United States or which are connected with his trade or business activities in the United States.3 Certain “bright line” objective tests are applied to determine whether a person is a U.S. income tax resident, specifically, lawful permanent residents (green card holders), deemed residents under the “substantial presence test” and residents who make a first year election to be treated as a U.S. income tax resident.4 The Internal Revenue Code (“Code”) also uses the term “resident” in the application of transfer taxes. Under the Treasury Regulations (“Regulations”), however, it is clear that the actual meaning of residency for transfer tax purposes is that of “domicile”. Under the Regulations, a resident decedent is:

“. . . a decedent who, at the time of his death, had his domicile in the United States. . . . 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.”5

C. U.S. Transfer Tax Treatment. Like the U.S. income tax, U.S. transfer taxes apply to U.S. citizens and U.S. residents on a worldwide basis. Unlike the mechanical test for

determining U.S. income tax residency, however, residency for U.S. transfer tax purpose is much less straightforward, and is essentially a subjective test. For U.S. transfer tax purposes, residency determination is based on common law principles of domicile. Moreover, if an alien is a resident for U.S. income tax purposes, he may not be treated as a resident for U.S. transfer tax purposes. Similarly, an alien who is treated as a U.S. domiciliary for transfer tax purposes may not be treated as a resident for U.S. income tax purposes.

1. Domicile. For purposes of U.S. transfer taxes, an alien is considered a U.S. resident if he is domiciled in the United States at the time of the inter vivos or testamentary transfer event. Whether a person is a U.S. domiciliary depends on the person’s intent.6 If an alien physically moves to the United States, even for a brief period, and has no definite or present intention of leaving the United States, he will be a U.S. domiciliary for estate, gift and GST tax purposes.7 Similarly, holding an intention to change domicile will not effect such a change unless accompanied by actual removal.

Along with a person’s intent to make the Unites States his permanent home, the person must have the ability to make an informed and intelligent decision as to his domicile and be present in the United States when he makes that decision and. The determination of intent for establishing domicile is one of facts and circumstances that may turn on many factors, none of which is determinative. The authority in this area is sparse and highly fact- specific. Some factors on which the Internal Revenue Service (“IRS”) and courts have focused are: (i) the length of time spent in the United States and abroad and the amount of travel to and from the United States and between other countries; (ii) the value, size, and locations of the individual’s homes and whether he owned or rented them; (iii) visas, work permits and similar immigration documents; (iv) whether the individual spends time in a place due to poor health, for pleasure, to avoid political problems in another country, etc.; (v) the location of valuable or meaningful tangible personal property; (vi) the location of the individual’s family and close friends; (vii) the location of the individual’s religious and social affiliations or participation in civic affairs; (viii) the location of the individual’s business interests; (ix) the places where the individual states that he resides in legal documents; (x) the jurisdiction where the individual is registered to vote; (xi) the jurisdiction that issued the individual’s driver’s license; and (xii) the individual’s income tax filing status.8

The U.S. Tax Court has held that an individual who acquires the immigration status of a “permanent resident of the United States” (i.e., acquires a green card, rather than a non- permanent visa) will be presumed to have acquired U.S. domicile for U.S. transfer tax purposes.9 In Estate of Khan v. Commissioner, the court found that a Pakistani citizen was a U.S. resident when he died even though he had lived in Pakistan for five years before his death.10 The Tax Court held that such U.S. domicile, once acquired, will continue even if the individual subsequently leaves the United States for an extended period (in Khan, five years) unless it can be shown that the individual never intended to return to the U.S. to reside.11 Note that in Khan, the taxpayer took the position that the decedent was a U.S. resident so that the estate would be entitled to a larger estate tax credit. The issue has not arisen in published authority as to whether the position would be sustained against a taxpayer just as it was used in the decedent’s favor in Khan.

Despite the importance of holding a green card as expressed in Khan, there is other authority that indicates that immigration status is not necessarily conclusive of domicile. The IRS ruled that a foreign decedent who was an employee working in the United States for an international company on a G-4 Visa and who remained in the United States until his death was a U.S. domiciliary because he resided in the United States and had formed the intent to remain in the United States indefinitely.12 The IRS also ruled that a decedent illegal alien had U.S. estate tax domicile status where he had the legal capacity to acquire domicile, he was physically present in the United States at the time of death and he had a current intention to make his home in the United States.13

In Estate of Jack v. U.S. 14, the Federal Claims Court considered the immigration documents of a decedent Canadian citizen who was employed in the United States at his death under a temporary visa. The court rejected the estate’s argument that the formation of the requisite intent would be in violation of the terms of the visa, so as to preclude the IRS from attempting to show that the decedent had the intent to establish domicile. Although the case does not hold that the decedent was in fact domiciled in the United States, the fact that he was present in the United States on a temporary, non-immigrant visa did not preclude the IRS from proceeding to show that he was domiciled in the United States.15

2. Estate and Gift Tax Rules for NRAs. The estate of an NRA who is not domiciled in the United States is subject to estate taxes only on certain limited assets. Generally, NRAs are subject to U.S. estate tax only on U.S. situs property, with no credit for foreign death taxes paid.16 Gifts by an NRA of interests in U.S. real estate and tangible personal property located in the United States are subject to U.S. gift taxes, but gifts of intangible property are not.17

a. Federal Estate Tax Rules.

(1) U.S. Situs Assets. U.S. situs property for federal estate tax purposes includes the following: (1) real property located in the United States18; (2) tangible personal property located in the United States, including cash19; (3) certain debt obligations of a U.S. person or governmental agency and short term OID obligations20; (4) shares of stock issued by a U.S. corporation (irrespective of the location of stock certificates)21; and (5) certain partnerships that engage in U.S. trades or businesses or have property deemed to have a U.S. situs22.

If U.S. real estate owned by a non-domiciled alien is subject to recourse debt, then the full fair market value of the real estate is reported on the federal estate tax return with a corresponding deduction for a portion of the debt. This portion is equal to a fraction, the numerator of which is equal to the value of the decedent’s total U.S. situs property and the denominator of which is equal to the value of the decedent’s worldwide estate. In order to obtain the deduction for a portion of the debt, however, the non-domiciled alien must disclose the value of the decedent’s worldwide assets and debt.23 Foreign persons often encumber their U.S. real estate to minimize federal estate tax reporting of their U.S. assets.

With respect to real estate subject to nonrecourse debt, only the equity value of the property is included on the federal estate tax return and no disclosure of worldwide assets is required.24

(2) Non-U.S. Situs Assets. Certain assets that one might think would have a U.S. situs do not, including demand deposits in U.S. banks and many debt instruments of U.S. issuers. The policy behind these exceptions is to encourage foreign investment in corporate and government debt instruments. The portfolio debt exception effectively exempts most publicly-traded debt securities of U.S. companies and most U.S. governmental obligations owned by non-domiciled aliens from federal estate tax. Debt obligations of non-U.S. persons are considered to be non-U.S. situs assets. Shares of stock in a foreign corporation are deemed to be situated outside of the United States and thus, not subject to 25 U.S. estate tax. Similarly, proceeds from an insurance policy on the life of a non-domiciled alien are considered to be situated outside of the United States, even if the policy is issued by a 26 U.S. life insurance company. If a non-domiciled alien owns a life insurance policy on the life of another person, and that policy is a U.S. situs asset, the value of the policy (as opposed to the proceeds) will be includable in the alien’s U.S. estate.

The law is not clear on whether an interest in a partnership is included in the U.S. gross estate of a non-domiciled alien. Based on existing authority, there are several approaches to the determination of the situs of a partnership interest owned by an NRA: (1) situs based upon the holder’s domicile; (2) situs based upon the partnership’s assets; or (3) situs based upon the location of the trade or business of the partnership. If the law of the place of creation does not treat the partnership as a legal entity, or if the partnership dissolves upon the death of a partner, then the non-domiciled alien’s gross estate will include his or her pro rata share of the underlying partnership property which is deemed situated in the United States.27

If the law of the place of creation treats the partnership as a legal entity which survives the death of a partner, then the partnership interest will be treated as the unit of ownership and the situs of such interest is not clear under current law. If the partnership interest is treated as intangible personal property, then the situs should depend upon the domicile of the decedent under Blodget v. Silberman.28 The IRS, however, disagreed with the Blodget decision in Revenue Ruling 55-701,29 finding instead that the situs of a partnership interest was the location of the partnership’s business, but citing Blodget with approval for the idea that the determination of situs does not depend on the location of the partnership’s underlying assets.

Another case, however, supports the aggregate theory. In Sanchez v. Bowers, the Second Circuit ruled that the dissolution of a foreign entity upon the death of one of its owners caused the underlying assets to be included in the decedent’s estate to the extent that they consisted of U.S. situs assets.30

Treaties will often decide the issue, generally in favor of treating the partnership interest as an intangible asset taxable by the jurisdiction where the decedent was domiciled. If the partnership enterprise is at least 50 percent invested in real property, the interest may be taxed by the jurisdiction of the situs of the property.

Similarly, an NRA decedent’s interest in a trust holding U.S. situs assets will be subject to estate tax to the extent the interest is of a type that would cause the trust to be includable in the estate of a U.S. citizen or resident, as discussed below.

A nonresident may be deemed to own property situated in the United States at death as a result of certain transfers of U.S. situs property during life. Property of a nonresident decedent will be deemed to be situated in the United States, and potentially taxable pursuant to this rule, if such property was transferred at a time when it was situated in the United States, and if the deceased transferor retained sufficient rights in or powers 31 over the property after making the transfer. Under this rule, regardless of where the property is situated at the time of the transferor’s death, the property is included in the transferor’s estate for 32 U.S. tax purposes, at its then fair market value. This deemed situs rule is often a trap for the unwary.

For U.S. estate tax purposes, a U.S. citizen may claim a credit for the amount of death taxes actually paid to any foreign country attributable to property 33 situated in that county and included in the gross estate of the decedent. It is important to check whether the credit may be affected by any estate or gift tax treaty between the United States and the foreign country imposing the tax.

b. Gift Tax Rules. The definition of taxable U.S. situs gifts is more limited than that for property subject to estate tax. Only gifts of U.S. real property and tangible personal property situated in the United States are subject to gift tax if made by non-domiciled aliens.34 Transfers of U.S. situs intangible personal property are not subject to gift tax even if the intangible property has a U.S. situs, unless the donor is a non-domiciled alien who previously expatriated from the United States.35 Further, transfers by a nonresident noncitizen of intangible property situated in the United States are exempt from gift tax.

Gifts of currency that take place in the United States and gifts of amounts on deposit in a U.S. bank36, whether by check drawn on a U.S. bank account or by electronic transfer of funds from one U.S. bank account to another U.S. bank account, are taxable gifts of tangible personal property. It is less clear whether a check drawn on a U.S. bank account but deposited in a foreign bank account for the donee or whether the payment of funds from an NRA’s foreign bank account to a U.S. bank account would be a gift of currency made within the United States. To avoid the risk that a cash gift has U.S. situs, structure such gifts by an NRA from his foreign bank account to the donee’s foreign bank account. Alternatively, the donor might purchase securities or other assets with the intended cash gift and make gifts of those assets to the donee. It is possible that the IRS could assert such gifts are taxable under the step- transaction doctrine if the donee sells the assets shortly after the gift and retains the sales proceeds.37

c. GST Tax Rules. The GST tax applies to transfers at death or by gift by an NRA to the NRA’s grandchildren or other individuals assigned to a generation more than one generation removed from the NRA’s own generation.38 The GST tax applies to such transfer by an NRA only if the transferred property is deemed to be situated in the United States for U.S. gift or estate tax purposes.

d. Application of Treaties Unless an applicable estate or gift tax treaty applies, lifetime transfers and all assets owned at death by a U.S. citizen or domiciliary who is also a citizen of another country or countries, will be subject to double taxation, absent tax credits or treaty relief that may be available. As of January 2016, the United States has entered into estate, gift and combined estate and gift tax treaties with 16 countries.39 These treaties may mitigate the potential for double taxation on transfers by individuals who are subject to two transfer tax systems. Such treaties may define domicile, resolve issues of dual domicile, reduce or eliminate double taxation, provide deductions and other tax relief.

However, in virtually all such treaties, the United States reserves the right to tax its citizens and domiciliaries based on its own domestic law and regardless of the provisions of the treaty (apart from provisions requiring the United States to provide relief against U.S. tax for certain foreign taxes paid with respect to the same taxation event). Where no such treaty exists between the country in which the U.S. citizen resides or is domiciled and the United States, the individual must rely on the domestic laws of both countries to avoid double taxation.

Benefits among these treaties vary and, depending upon when the treaty was negotiated, the treaty may give the primary right to tax to the jurisdiction of situs or to the jurisdiction of domicile. Prior to 1966, treaties applied estate tax based upon the situs of property. After that time, most treaties generally apply the estate tax on the basis of domicile.

Generally, immovable property is taxed only in the country where the property is located. Similarly, where there is business property conducted by a permanent establishment, it is taxed where the permanent establishment is located.

An individual must have been domiciled in one of the two contracting states at the time of his death or at the time he made the gift in order to be eligible for the benefits of an estate or gift tax treaty. In the case of a dual domiciliary, the treaties contain tie-breaker provisions to make the determination of domicile. Under the tie-breaker provisions of Article 4 of the United States-United Kingdom estate tax treaty, a modern domicile based treaty, a person who has dual domicile will be deemed to be domiciled as follows: A United Kingdom national is domiciled in the United Kingdom if he has not been resident of the United States for income tax purposes in seven out the ten U.S. tax years ending with the year of transfer; similarly, the seven of ten year rule applies to U.S. nationals who have not been resident of the United Kingdom during such time. If domicile cannot be determined, then domicile will be in the country where he has a permanent home, or if he has one in both countries or in neither country, the country where his personal and economic relations are closer (“center of vital interests”). If his center of vital interests cannot be determined, he will be deemed domiciled in the country where he has a habitual place of abode, and if he has a habitual place of abode in both countries or in neither country, he will be deemed domiciled in the country where he is a citizen.

In order to rely on the treaty, an individual must provide notice of the treaty-based return position to the IRS under Section 6114.

3. Use Of Entities. Because of the above rules concerning the situs of U.S. assets for estate and gift tax purposes, many foreign persons acquire or hold U.S. assets through a foreign corporation or other foreign entity, thus transforming the interest from that which is included in a U.S. gross estate, or a potentially taxable gift if transferred, into that which is excluded from such treatment.

An important area for U.S. transfer tax planning is that of structuring foreign investments in U.S. real property. With proper planning, a foreign investor should be able to avoid U.S. estate and gift taxation, as wells as minimize his U.S. income tax liability on net income that the investment may generate. Many structures have drawbacks, and there is no perfect structure from both an income and transfer tax perspective. For example, the use of a foreign corporation to own U.S. real property will shield the foreign shareholder from U.S. estate tax, but likely increase U.S. income tax payable on the income from the property.40 Under FIRPTA, a capital gains tax is imposed on the transfer of U.S. real property by NRAs even if no consideration is paid for the property.

In order to assure exclusion from the U.S. gross estate, the foreign corporation must be a corporation for U.S. income tax purposes. However, the foreign corporation must not be the alter ego of the non-domiciled alien. In Swan v. Commissioner41, the court found that the Stiftung in that case was a revocable trust for purposes of the federal estate tax, not a foreign corporation, because the founder of the Stiftung retained the right to amend the governing documents and controlled all the economic benefits of the entity. In this case it was irrelevant that the Stiftung was recognized for U.S. income tax purposes.

In Fillman v. U.S.42, the court found that foreign corporations were the alter ego of the decedent because corporate formalities had not been observed and the decedent retained all practical and beneficial ownership of the underlying securities. The court noted that every action of the corporations was performed only by a custodian or nominee for the decedent.

D. Problems Associated with Noncitizen Spouses. Generally, the United States does not allow a marital deduction for gifts and bequests to noncitizen spouses.43 For this purpose, it is immaterial whether the noncitizen spouse is a U.S. resident or an NRA. In contrast, a marital deduction is available to an NRA for gifts and bequests to a U.S. citizen spouse to the same extent as a U.S. citizen or resident donor.

1. Lifetime Transfers. While the lifetime transfer of any assets to a U.S. citizen spouse receives an unlimited marital deduction from the U.S. gift tax, the outright transfer of U.S. situs assets to a noncitizen spouse does not qualify for the marital deduction for U.S. gift tax purposes. There is no provision comparable to those for testamentary QDOTs.44 Consideration should be given as to whether planning should be undertaken to have more assets in the name of the non-U.S. citizen spouse’s name, particularly if he or she may ultimately leave the United States.

Equal consideration should be given to the non-tax consequences in this type of planning. Gifts of assets that do not have a U.S. situs may be ideal for this purposes since they are not includable in the donee spouse’s estate (e.g., shares of foreign corporation, foreign real estate). Planning for gifts between spouses often includes avoidance of claims by

creditors of the donee spouse and for minimizing estate taxes. Careful consideration must be given as to whether a couple’s estates should be equalized for these purposes since the surviving spouse will lose a stepped-up basis in his or her one half of community property upon the death of the first spouse.45 It may also be advantageous for any foreign real estate to be transferred to the non-U.S. citizen spouse so as to avoid the QDOT rules for large estates.

A major word of warning should be remembered when considering transfers of foreign property between spouses, whether by intervivos or testamentary gift. In some countries, such as Canada, the lifetime transfer by one spouse to the other will be subject to nonrecognition treatment for income tax purposes under law only if both are Canadian residents at the time of transfer. On the other hand, a testamentary gift of Canadian property to a surviving spouse will not be subject to Canadian income tax.

Lifetime transfers to noncitizen spouses are subject to a special “annual exclusion” provision that limits such gifts to an inflation-adjusted amount of $149,000 (2017) per year. Such lifetime gifts may be used in planning to free the noncitizen spouse of the QDOT restrictions on these assets. No gift tax return is required to be filed for the annual gift tax exclusion for gifts to a non-U.S. citizen spouse, provided the gifted amount does not exceed the annual exclusion amount.46

Unlimited gifts made by a U.S. citizen spouse to his or her noncitizen spouse in joint tenancy with right of survivorship or tenancy by the entirety will not be subject to gift tax at the time of the gift, although such gifts may be subject to gift tax upon a future event (e.g. sale, withdrawal). Nevertheless, upon the death of the U.S. citizen spouse, the assets that were the subject of this form of gift will be subject to U.S. estate tax if the subject assets were deemed situated in the United States either at the transferor’s death or at the date of the gift.47

a. Gifts By a Spouse to Third Parties. In some U.S. community property states, such as California and Washington, one spouse may not make a gift of community property without the consent of the other spouse.48 In other states, gifts by one spouse of excessive amounts of community property may be void or voidable and possibly incomplete for gift tax purposes.49 If a gift of community property is made to a third party, the gift is treated as made one-half by each spouse.50 Generally spouses can agree on their rights to make gifts in premarital and post marital agreements. Spouses are permitted to split gifts for gift tax purposes, even though only one spouse contributed the gift property.51 However, if either spouse is a non-U.S. domiciliary, gift splitting is not allowed.

2. Transfers Upon Death.

a. Basic Rules for the Marital Deduction for Estate Tax Purposes. A marital deduction is not allowed for property passing from a decedent to his or her noncitizen spouse at the decedent’s death unless one of two exceptions applies. These rules assure that assets that pass free of tax for the benefit of a surviving noncitizen spouse will ultimately be subject to U.S. estate tax upon the surviving spouse’s death.

The first exception permits a marital deduction if the surviving spouse becomes a U.S. citizen before the deceased spouse’s federal estate tax return is filed.52 In addition, the surviving spouse must have been a U.S. resident at all times after the death of the deceased spouse and before becoming a U.S. citizen. Further, no tax may have been imposed with respect to any distributions from a qualified domestic trust (“QDOT”) before the spouse becomes a citizen or the surviving spouse must have elected to treat any QDOT distributions on which tax was imposed as a taxable gift from the deceased spouse (thereby reducing the credit allowed under Section 2505).53As a practical matter, it may be quite difficult for the surviving spouse to acquire U.S. citizenship within the requisite timeframe unless the process is already underway at the time of the decedent’s death. The second exception allows a marital deduction if the property passes from the deceased spouse to a QDOT.54

b. Use of a QDOT. The property passing to a QDOT must be transferred to the QDOT before the deceased spouse’s federal estate tax return is filed or the property is irrevocably assigned to a QDOT before the return is filed.55 To qualify for the marital deduction, a QDOT must otherwise comply with the general marital deduction requirements, specifically entitling the surviving spouse to all of the income from the trust by way of a life estate with a power of appointment, a QTIP trust, a charitable remainder trust or meeting the requirements of an estate trust.56 It must also permit principal distributions only to the surviving spouse, require that at least one trustee be an individual U.S. citizen or domestic corporation57, and give the U.S. trustee the power to withhold the estate tax that may be imposed on any principal distribution from the trust. In addition, the executor must make a timely, irrevocable QDOT election.58 No election may be made on a return filed more than one year after the time prescribed for filing the return, including extensions.59 The QDOT to which such property is transferred may be one previously established by the deceased spouse, one created by the decedent’s executor or one created by the surviving spouse to transfer or irrevocably assign property he or she receives after the deceased spouse’s death.60

Only property owned by the deceased spouse may be transferred to the QDOT; thus, the QDOT may not include the surviving spouse’s interest in any community property asset. For example, if only a portion of a property interest in joint tenancy property by application of the rules under Section 2010(a) is includable in the deceased spouse’s estate, only that portion may be transferred to the QDOT.

It is also possible to reform a QDOT. Reformation may enable the surviving spouse to exercise a power to withdraw assets from the trust and treat the transfer as an outright transfer from the decedent. A reformed trust may be revocable by the surviving spouse or subject to his or her general power of appointment, provided that no person, including the surviving spouse, has the power to amend the trust in a way in which it would no longer qualify as a QDOT. A nonjudicial reformation must be completed by the deadline for filing the decedent’s federal estate tax return, including extensions. Even an irrevocable trust, such as a QTIP trust, may be reformed by judicial reformation if the reformation is completed by the filing due date for the decedent’s return, irrespective of the date the return is actually filed. However, the trust must be treated as a QDOT prior to the time the judicial reformation has been completed.

Estate tax is payable from principal distributions from the QDOT to the noncitizen spouse.61 The estate tax is based on the decedent’s tax bracket.62 Distributions of income from a QDOT are not subject to estate tax.63 Distributions of principal on account of “hardship” are not subject to estate tax.64 The determination of “hardship” is a question of fact. Under the Regulations, a distribution made in response to an immediate and substantial financial need relating to the spouse’s health, maintenance, education or support, or such needs for any person that the surviving spouse is legally obligated to support, will satisfy the hardship exception.65 The spouse must use liquid assets available to him or her outside of the QDOT before the hardship exception will apply.66

If the QDOT consists of $2 million or more of assets, other than a personal residence and related furnishings with a value of up to $600,000, and without reduction for any indebtedness with respect to the assets as of the decedent’s date of death67, the trust instrument establishing the QDOT must include provisions that will allow the trustee to comply with additional security requirements to ensure the collection of the estate tax.68

The trust instrument can allow the trustee of such QDOT to choose from one of these alternate security arrangements:

(i) The trust instrument can require a U.S. bank (as defined in Section 581) to act as trustee69;

(ii) The trust instrument can require the trustee to post a bond in an amount equal to 65% of the value of the QDOT assets as of the decedent’s date of death; or70

(iii) The trust instrument can require the trustee to furnish a letter of credit issued by a bank to the IRS for an amount equal to 65% of the fair market value of the QDOT’s initial assets.71

The trust instrument can allow for the trustee to choose among these options and to switch among them.72

If the QDOT assets, without reduction for any indebtedness relating to the assets, have a value of $2 million or less (excluding a personal residence and related furnishings with a value up to $600,000), the trust instrument must provide that either no more than 35% of the fair market value of the trust assets, determined annually on the last day of the tax year, will consist of real property located outside of the United States, or that the trust will satisfy the above security requirements.73

The Regulations contain extensive rules relating to the additional security provisions and allow a trust instrument to incorporate the rules by reference.74

The QDOT election must be made by the executor on the decedent’s estate tax return, and once made is irrevocable.75 As noted above, no election may be

made on any return filed more than one year after the due date for the return, including extensions.76 If the trustee makes a distribution from a QDOT subject to estate tax, the trustee must generally file a Form 706-QDOT reporting the distribution and paying the tax on April 15 of the year following the year of the taxable distribution.77

The remaining assets of the QDOT are taxable on the death of the surviving spouse. The tax is calculated as follows:

(i) Calculate the estate tax resulting from the decedent’s death—i.e., the tax based on the decedent’s taxable estate, including prior adjusted taxable gifts, taxable transfers at death, and prior taxable QDOT principal distributions.

(ii) If the assets of the QDOT are includable in the surviving spouse’s gross estate for estate tax purposes, the spouse’s estate must calculate the resulting estate tax based on the surviving spouse’s brackets, adjusted taxable gifts, and credits.

(iii) If the QDOT assets are includable in the surviving spouse’s gross estate, his or her estate will receive a full credit under Section 2013 (credit for tax on prior transfers) for the estate tax payable by reason of the surviving spouse’s death.78 The usual time and percentage limitations applicable under Section 2013 do not apply in this situation.79

The net result is that the couple will pay death taxes on the QDOT assets at the highest marginal rate, whether that is the decedent’s or the surviving spouse’s rate. This approach also effectively deprives the surviving spouse of his or her applicable credit if he or she does not have sufficient assets outside of the QDOT to use the credit.

If an individual U.S. trustee has chosen a bond or letter of credit for the security arrangement and reports the QDOT has having assets of $2 million or less, the marital deduction will be disallowed in full if there is an understatement of 50% or more absent a showing of reasonable cause and good faith.80

Caution should be taken in drafting a QDOT, taking into consideration the rules applicable to foreign trusts, which impose stringent reporting obligations on U.S. beneficiaries and may subject the trust to additional U.S. taxes. For example, by appointing a foreign person as co-trustee of a QDOT, the trust can be treated as a foreign trust. By giving an NRA the power to veto trust decisions, withdraw assets or remove and replace a trustee, the trust can be deemed a foreign trust.81

Consideration should be given to whether a QDOT election is advisable in a particular situation, keeping in mind that a QDOT is only a transfer tax deferral mechanism. The cost and expense of establishing and maintaining a QDOT, the necessary

meticulous attention to the QDOT requirements, the potential appreciation of the assets and the loss of control that comes with the requirement of having a U.S. trustee for a QDOT, and reporting requirements are all factors to consider in weighing the benefits verses the burdens of a QDOT. All in all, depending upon the circumstances, advisors often opt in favor of advising to avoid a QDOT.

An estate tax treaty may provide adequate relief from taxes through the allowance of a credit in lieu of a QDOT election, such as that provided under the U.S.-Canada tax treaty, depending upon the size of the decedent’s estate. In such cases, the treaty benefits may outweigh the QDOT election since in such case, the assets qualifying for the marital deduction will never be subject to U.S. transfer tax. If the treaty benefit is claimed, the executor cannot also make a QDOT election.82 Alternatively, payment of the tax may be more desirable than establishing and maintaining a QDOT so as to give the surviving spouse more freedom to leave the United States without burdening him or her with the U.S. transfer tax system (subject to Section 877A expatriation issues that may apply).

A QDOT may also be unnecessary for certain German Nationals. Under the U.S.-Germany Estate and Gift Tax Treaty (the “German Treaty”), property, other than community property, that passes to the surviving spouse from a deceased spouse who was domiciled in, or a citizen of Germany, and which is subject to tax in the United States solely as a result of situs taxation in Germany (such as in the case of real estate) is includable in the decedent’s U.S. estate only to the extent that its value exceeds 50% of the value of all property included in his U.S. taxable base.83 In addition, the German Treaty allows a full marital deduction equal to the lesser of the applicable exclusion amount (without regard to any gifts previous made by the decedent) or the value of property that would qualify for the marital deduction if the surviving spouse had been a U.S. citizen.84 To qualify for this treatment, the decedent must have been domiciled in Germany or the United States at the time of death, the surviving spouse must have been domiciled in Germany or the United States at such time, or if both the decedent and the surviving spouse were domiciled in the United States at such time, at least one of them must have been a German citizen.85 A prorata credit is allowed under the German Treaty equal to the greater of (i) a proportionate share of the unified credit then in effect for U.S. residents based on a fraction of the property of the decedent situated in the United States over the worldwide property of the decedent and (ii) the unified credit allowed to the estate of a NRA under U.S. law.86 An executor who elects benefits under the German Treaty must waive the benefits of any federal estate tax deduction under U.S. law on an estate tax return filed by the deadline for making a QDOT election.87

There are special rules for annuities and other arrangements that cannot be assigned under federal, state or foreign law, which allow such assets to be treated as passing to a QDOT if the surviving spouse exercises one of two options with respects the “corpus portion” of the annuity or other arrangement.88 Under the first option, the surviving spouse must agree to pay the deferred QDOT tax annually on the corpus portion of each annuity or arrangement payment that the surviving spouse receives. Under the second option, the surviving spouse must agree to transfer or roll over the corpus portion of each payment to a QDOT within sixty days of the surviving spouse’s receipt of the payment.89 However, to the extent that all or a part of the corpus portion of the annuity or other arrangement would be

eligible for a hardship exemption if paid from a QDOT, a corresponding portion of the payment is exempt from the payment or rollover requirements.90

c. Portability and Non-Citizen Spouses. Section 2010 allows the estate of a decedent who is survived by a spouse to make a portability election, allowing the surviving spouse to apply the decedent’s “deceased spouse unused exclusion amount” (“DSUEA”) to the surviving spouse’s own transfers during life and at death. Portability generally permits a surviving spouse to use the most recent deceased spouse’s DSUEA so as to avoid the loss of a first-to-die spouse’s remaining exclusion amount.91

However, portability is not available to all decedents and the availability of the portability election will depend upon the citizenship of the decedent spouse. The unified credit of a nonresident non-citizen is not governed by Section 2010; rather, Section 2101 imposes the federal estate tax on U.S. assets of a non-U.S.citizen who is not a resident of the United States. No portability amendment was made to Section 2101. An executor of a nonresident non-citizen decedent’s estate may not elect portability on behalf of that decedent.92 Further, the estate of a nonresident non-citizen surviving spouse may not take into account the DSUEA amount of his or her last deceased spouse, except to the extent a treaty applies.93

Special portability rules apply when property passes to a noncitizen in a QDOT. The amount of the deceased spouse’s DSUEA amount cannot be calculated until the death of the surviving spouse or when the QDOT makes its final distribution and terminates.94 As a result, a non-citizen surviving spouse for whom a QDOT was created will only be able to use the DSUEA amount from the deceased spouse against the surviving spouse’s estate tax liability. Generally, the non-citizen surviving spouse cannot use the deceased spouse’s DSUEA as part of his or her own exclusion amount for lifetime transfer unless the gift is made before he or she dies, or the QDOT terminates in a year before the year of his or her death. In the case where the QDOT terminates during the non-citizen surviving spouse’s lifetime, then the DSUEA amount can be used by the surviving spouse for gift tax purposes after the termination date.95

d. Use of Foreign Tax Credit. The estate of a U.S. citizen or resident decedent is entitled to claim a credit against estate tax for foreign death taxes actually paid to another country with respect to property located in that country.96 A credit is allowed for death taxes imposed by a foreign country that are substantially equivalent to an “estate, inheritance, legacy, or succession tax.”97 In essence, the tax must be imposed on the value of property (as opposed to the appreciation) transferred by a decedent to a beneficiary. As a practical matter, local counsel should be engaged to determine whether the taxes, including those imposed by political subdivisions, are imposed on the transfer of property at death.

The credit for foreign death taxes is subject to two computational limits, which are designed to (a) limit the credit to the taxes attributable to the property located in the foreign country imposing the tax and (b) to limit the credit to the proportion that the foreign property bears in relation to the total gross estate less the charitable and marital deduction. The credit is limited to the lesser of the amounts calculated under the two limitations.98

The first limitation limits the credit to the product of (a) the foreign death tax paid to the particular foreign country and (b) the ratio of foreign property both situated in that country and included in the gross estate to the value of all foreign property subject to foreign death taxes in that same jurisdiction. For purposes of this limitation, the location of such property is generally determined under the principles used to determine the situs of property owned by a decedent who is nonresident not a citizen.99 The foreign property and death tax paid is based on foreign values converted into U.S. dollars using the exchange rate in effect as of the date of valuation and payment respectively.100 If death taxes are imposed by two or more foreign countries this limitation must be calculated separately for each country. Further, if a foreign country imposes more than one kind of death tax or imposes taxes at different rates, such amounts are to be calculated separately and totaled to determine the first limitation for that country.

The second limitation limits the credit to the product of (a) the federal estate tax less the applicable credit and (b) the ratio of the value of foreign property that is both subject to tax in a foreign country and included in the gross estate to the value of the decedent’s entire gross estate less any marital and charitable deduction. Unlike the first limitation, the second limitation uses the federal estate tax values of the foreign property.

Care should be taken in drafting testamentary documents to specifically direct that specific bequests to a surviving spouse be funded with property not subject to foreign tax. If a fractional share formula is used to fund a marital trust, any assets that will be taxed by a foreign jurisdiction should be disposed of so they will not qualify for the marital deduction.101

3. Problems with Joint Property Interests Held by Spouses. Joint tenancy with rights of survivorship and tenancy by the entirety are common methods of titling assets for married individuals. Generally, property owned by spouses is assumed to be owned one-half by each spouse.102 However, special rules apply to the creation and termination of joint interests between spouses when one or both spouses are not U.S. citizens.

a. Estate Tax Treatment. In general, Section 2040(b) provides that half of the value of a property jointly owned is included in the estate of the predeceasing tenant of a “qualified joint interest.” An interest so qualifies only if the only co-owners are spouses and there is a right of survivorship. Note that the definition of a “qualified joint interest” also includes “tenants by the entirety” property.

Section 2040(b) does not, however, apply to property owned jointly with a right of survivorship if the surviving spouse of the decedent is not a U.S. citizen. 103 Accordingly, the total value of such property is includable in the first decedent’s estate for estate tax purposes except to the extent the executor can substantiate the contributions of the surviving spouse to the acquisition of the property. This may require complex accounting to trace contributions made by each spouse. In the case of community property, one-half of the community property is included in the deceased spouse’s estate.104 Where property was acquired jointly by gift, bequest or devise from a third party, only one-half of the property is included in the decedent’s estate.105

b. Gift Tax Treatment. The gift tax consequences of the creation or termination of a joint tenancy where there is a lifetime transfer by a donor to a noncitizen spouse generally depends on the character of property. In the case of personal property, the spouse who provided the funds to acquire the property will be treated as making a gift of half the value of the property to the noncontributing spouse on the creation of the joint tenancy.106 This rule applies, however, only to extent that gift tax principles would treat the creation of the joint tenancy as a completed gift. For example, in many states the contributing spouse has the unilateral right to withdraw all the funds from the bank or brokerage account without the consent of the noncontributing spouse. In that event, the gift to the noncontributing spouse is complete only upon a withdrawal of funds by the noncontributing spouse. If severability of the tenancy may occur only by joint action of the parties, for example in a tenancy by the entirety, the amount of the gift is based on the parties’ relative life expectancies.107

If the property is real property, there is generally no gift on creation of the joint interest by a citizen and noncitizen spouse. 108 However, upon termination of the joint interest (for example upon sale) the donor spouse is deemed to make a gift to the extent that the proportion of the total consideration furnished by the donor spouse multiplied by the value of the proceeds on termination (whether in cash or property) exceeds the value of the proceeds of termination received by the donor spouse.109

As discussed above, a gift by a spouse to a non-citizen spouse is eligible for the special annual exclusion. Following such gift, opportunities exist for the noncitizen spouse to avoid or minimize U.S. estate tax. First, if the non-citizen spouse resides in the United States at the time of the gift, he or she can avoid U.S. estate tax by removing the gifted property from the United States and establishing residence outside of the United States before his or her death. In addition, a non-citizen spouse who is a U.S. domiciliary may use his or her applicable exclusion amount to benefit his or her U.S. citizen spouse and thereby reduce the estate tax on property otherwise included in his or her estate. This advantage is not available for assets transferred to a QDOT. Also, if the non-citizen spouse does not reside in the United States at the time of the gift, he or she will avoid U.S. estate tax on the gift unless the gifted property has a U.S. situs at the non-citizen spouse’s death. (e.g., a NRA noncitizen spouse of a U.S. citizen domiciled abroad).

There are other planning possibilities available to minimize U.S. estate tax with respect to lifetime gifts of jointly-held property to the non-citizen spouse. With planning for a U.S. citizen spouse to gift joint property to his or her non-citizen spouse over time, using the annual lifetime exclusion, gift tax may be avoided when the non-citizen spouse later sells or transfers the gifted property. As noted above, gift tax will be imposed to such transfers to the extent the non-citizen spouse receives proceeds in excess of his or her proportionate share of any contribution to acquire the property. But be careful to trace all assets when changing title to jointly held assets where one spouse is a non-U.S. citizen.

II. U.S. TRANSFER TAX TREATMENT OF NONRESIDENT ALIENS.

A. U.S. Estate Tax. For 2017, the maximum U.S. Federal estate and gift tax rate is 40%, and in the case of U.S. citizens and domiciliaries, the lifetime exclusion amount for transfer

tax purposes is $5,490,000 (adjusted for inflation thereafter). In sharp contrast, the exemption amount allowed to non-U.S. citizens and non-U.S. domiciliaries remains at only $60,000 (not adjusted for inflation) for estate tax purposes, absent treaty benefits.110 The rates of tax on an NRA’s estate are identical to those for citizens and resident aliens.111

As discussed above, in order to qualify for the marital deduction for property passing to a U.S. citizen spouse, the Section 2056 requirements must be satisfied, and if the spouse is not a U.S. citizen, additional requirements must be met.

B. Gift Tax. The rates of tax on lifetime transfers by an NRA are the same as those for U.S. domiciliaries and resident aliens. An NRA is entitled to the benefit of the annual exclusion for transfers of a present interest in property which for 2017 is $14,000 per donee. A gift of $149,000 (for 2017) to a noncitizen spouse of tangible personal property within the United States will not be subject to gift tax.112

An NRA donor may not take advantage of “gift splitting” with the donor’s spouse under Section 2513. In addition, an NRA donor is not entitled to any unified credit against his gift tax liability.113 An NRA is not entitled to a gift tax charitable deduction for gifts made to charities unless the charities are organized in the U.S. or the funds are for use in the United States.114

A donee who acquires property from an NRA generally takes a basis in the property equal to the NRA’s basis in the property.115

A U.S. citizen or resident who receives a gift from an NRA or a bequest from a foreign estate must report the receipt of a gift or bequest to the IRS on Form 3520. A U.S. person is required to report gifts from an NRA or bequest from a foreign estate only if the aggregate amount of gifts received in a calendar year from a particular NRA or foreign estate donor exceeds $100,000.1 In computing the amount of aggregate gifts received from an NRA donor, a U.S. person must aggregate gifts from that donor and persons related to that donor for the calendar year. A U.S. person must also report any gifts from foreign corporations and foreign partnerships that collectively exceed $10,000 (adjusted for inflation).2 For 2009 returns, the reporting threshold amount for gifts from foreign corporations or partnerships is $14,139.

The gifts are reported on Form 3520, due at the same time as the U.S. person’s federal tax return, including extensions. The Form is filed separately from the tax return.

If the U.S. person, without reasonable cause, fails to disclose a foreign gift or bequest, the IRS has the right to determine the “proper” tax treatment of the gift, and may treat the entire transfer as taxable income. For each month that the gift or bequest is not reported, the U.S. person is subject to a penalty of five percent of the gift for each month, up to a 25 percent maximum.

1 IRC § 6039(F)(a); IRS Notice 97-34. 2 IRC § 6039F.

The IRS must issue a notice of deficiency and follow deficiency procedures in making any determination regarding the proper tax treatment of the gift, but it may summarily assess the five percent additional penalty.

III. FOREIGN TRUSTS.

An NRA may wish to establish a foreign trust to hold gifts or bequests for the benefit of foreign and/or U.S. beneficiaries. Note that if the NRA subsequently establishes U.S. domicile, careful planning is required to prevent the trust assets from being subject to U.S. transfer taxes. U.S. taxation of such a trust will depend upon whether the trust is a foreign trust (rather than a domestic trust) and whether it is treated as a grantor or nongrantor trust as to the foreign grantor. Finally, if the foreign trust is created by a U.S. grantor, certain additional provisions will apply under the Foreign Account Tax Compliance Act (FATCA).116

A. Classification as a Foreign Trust. The rules governing the classification of a trust as domestic or foreign were dramatically changed in 1996. This law greatly simplified the classification process and also is heavily weighted towards the conclusion that a trust is foreign. Any trust that is not a domestic trust is a foreign trust.117 A trust is a foreign trust unless (1) a U.S. court is able to exercise primary supervision over the trust’s administration; and (2) one or more U.S. persons have the authority to control all substantial decisions of the trust.118

1. Court Test. To be treated as a domestic trust, a court within the U.S. must have the authority under applicable law to supervise administration of the trust.119

A safe harbor is provided whereby a trust is a domestic trust if it meets the following criteria:120

(i) The trust instrument does not direct that the trust be administered outside of the United States;

(ii) The trust is in fact administered exclusively in the United States; and

(iii) The trust is not subject to an “automatic migration” provision described in the Regulations.

Four types of trusts (though nonexclusive) that satisfy the court test are described in the Regulations: (i) trusts registered in a U.S. Uniform Probate Code jurisdiction; (ii) testamentary trusts where all fiduciaries have been qualified as trustees by a U.S. court; (iii) inter vivos trusts where the fiduciaries and beneficiaries have caused the trust administration to be subject to primary supervision by a U.S. court; and (iv) trusts that are subject to primary supervision by a U.S. court as well as a foreign court.121

2. The Control Test. Upon passing the court test, a trust must also pass the control test to prevent the imposition of foreign trust status. Under the control test, one or more U.S. persons must have the authority to control all “substantial decisions” of the trust.122 “Substantial decisions” are all decisions other than “ministerial decisions,” and the power to make them may or may not be subject to a fiduciary duty. A non-exhaustive list of what

constitutes “substantial decisions” under the Regulations includes the power to determine the timing and amount of distributions, investment decisions, selection of a beneficiary, allocations to income or principal, decisions regarding claims, the power to remove, replace or add a trustee and whether to terminate the trust.123

A non-U.S. person may serve as an investment advisor to the trust if the U.S. person who appointed the investment advisor has the power to terminate the investment advisor’s services at will.124 “Ministerial decisions” such as bookkeeping, collection of rents and executing investment decisions are not considered “substantial decisions.”125

B. Reversing Unintended Loss of Domestic Status. A trust treated as a domestic trust may lose its status by the inadvertent appointment of a foreign trustee or by the loss of U.S. person status by the acting trustee. The trust has twelve months to rectify the situation so that all substantial decisions are again made by U.S. persons.126 If no change is made, the trust will have become a foreign trust on the date the loss of domestic status occurred.

C. Taxation of Foreign Trusts. A complete discussion of the many nuances of the foreign grantor and nongrantor trust rules and how they and their beneficiaries are taxed is beyond the scope of this paper; however, a thorough understanding of this area of the law is essential when advising on this subject matter.

1. Foreign Grantor Trusts. Income from a foreign grantor trust is generally taxed to the trust’s grantor, rather than to the trust or its beneficiaries. If the trust is treated as a grantor trust for U.S. tax purposes, non-U.S. source income of the trust may not be subject to U.S. tax, and distributions of the trust’s income to its U.S. beneficiaries may be free from U.S. income and transfer taxes, with the exception of distributions of U.S. real property or certain U.S. situs assets.

Under pre-1996 law, if an NRA created a foreign grantor trust, the trust’s income from foreign sources escaped U.S. income tax. Moreover, distributions to U.S. beneficiaries of the foreign trust were not taxed to the beneficiaries. Under current law, however, grantor trust status is denied to trusts with non-U.S. grantors unless (1) the grantor retains the right to revoke the trust unilaterally, or with the consent of a related or subordinate party who is subservient to the grantor; or (2) the grantor or his or her spouse are the sole beneficiaries of the trust during the grantor’s life.127 At the death of the grantor, the trust ceases to be a grantor trust. Furthermore, where the owner of any portion of a trust is a foreign person and there is a U.S. beneficiary, then under a special rule, the U.S. beneficiary will be treated as the grantor to the extent such beneficiary has made, directly or indirectly, transfers of property to the foreign grantor.128 This special rule does not apply if the transfer is a sale for full and adequate consideration.129

2. Foreign Nongrantor Trusts. All distributable net income (DNI) and undistributed net income (UNI) from a foreign nongrantor trust is required to be included in the gross income of U.S. beneficiaries. Distributions of UNI to a U.S. beneficiary are subject to the “throwback” tax. When a foreign nongrantor trust does not distribute all of its DNI in any tax year, UNI is created. Any subsequent distributions by such trust to U.S. beneficiaries in excess of DNI are deemed to be accumulation distributions from DNI. Such distributions are subject to

the throwback rules and any capital gains are taxed as ordinary income.130 In addition, an interest surcharge is imposed.131

If a foreign nongrantor trust with accumulated income makes distributions in excess of its DNI for a particular year, the accumulated income is carried out to the U.S. beneficiaries and is fully taxed.132 In addition, all capital gains realized by the trust in prior years will be taxed at ordinary income rates133 and a nondeductible interest charge is imposed at market rates on the tax due by the beneficiary on the accumulated income from the date the income was originally earned by the trust. Further, under the “throwback” rules, such income may be taxed to the beneficiary at his or her tax bracket for the years in which the income was accumulated.134

A distribution in satisfaction of a gift of a specific amount of money or specific property described in Section 663(a)(1) is not an accumulation distribution.135

D. Foreign Trusts with U.S. Grantor under FATCA. FATCA significantly amended Section 679 in order to clarify (and expand) when a foreign trust with a U.S. grantor will be treated as having a U.S. beneficiary.

1. Grantor Trust Status. Under Section 679, when a U.S. person transfers assets to a foreign trust that has U.S. beneficiaries, the trust is deemed to be a grantor trust, and the U.S. transferor is responsible for reporting the trust’s income.136 The Regulations under Section 679 are codified to treat a U.S. taxpayer who transfers property (whether directly or indirectly) to a foreign trust with U.S. beneficiaries, as the grantor of the portion of the trust assets transferred to the trust in accordance with the grantor trust rules.137 The provisions are designed to find a U.S. beneficiary of the foreign trust.138 The provisions include the following:

a. Section 679(c)(1) treats amounts accumulated in a foreign trust as being for the benefit of a U.S. person even if the U.S. person’s interest in a foreign trust is contingent on a future event.

b. Section 679(c)(4) provides that if any person has the discretion to make a distribution from a foreign trust to, or for the benefit of, any person (U.S. or otherwise), the trust will be treated as having a U.S. beneficiary unless the terms of the trust specifically identify the class of persons to whom the distributions may be made and none of those persons can be U.S. persons during the taxable year.

c. Section 679(c)(5) provides that if any U.S. person who directly or indirectly transfers property to a foreign trust is directly or indirectly involved in any agreement or understanding that may result in the trust’s income or corpus being paid or accumulated for the benefit of a U.S. person, the agreement or understanding will be treated as a term of the trust. Any discretion held by a trustee or protector to make a distribution or accumulate income for a U.S. person will be deemed to have been exercised.

d. Section 679(c)(6) provides any loan of cash or marketable securities (or the use of any other trust property) directly or indirectly to or by any U.S. person will be treated as paid or accumulated for the benefit of such U.S. person. This provision will

not apply to the extent that the U.S. person repays the loan at a market rate of interest or pays the fair market value of the use of the property within a reasonable period of time.

e. While Section 679(c) lists several instances in which a foreign trust will be deemed to have a U.S. beneficiary, Section 679(d) makes a conclusive determination that a foreign trust has a U.S. beneficiary provided a U.S. person transfers property to the trust. Section 679(d) provides that if a U.S. person transfers property (whether directly or indirectly) to a foreign trust, the trust will be presumed to have a U.S. beneficiary unless the transferor submits information, as requested by the IRS, to demonstrate that no part of the income or trust may be paid or accumulated to or for the benefit of a U.S. person.

E. Loans From Foreign Trusts. A loan of cash or marketable securities by a foreign trust to a U.S. beneficiary is treated as a distribution to the beneficiary of the full amount of the loan even if the loan is later repaid.139 This prevents a U.S. beneficiary from avoiding tax on accumulated income in a trust by receiving a loan from the trust as opposed to an actual distribution. If the loan meets the requirements of a “qualified obligation,” however, then the loan will not be treated as a distribution.140

F. Use of Foreign Trust Property. The FATCA provisions expanded Section 643(i) such that any use of trust property after March 18, 2010 by a U.S. grantor, U.S. beneficiary, or any U.S. person related to a U.S. grantor or U.S. beneficiary is treated as a distribution. The individual utilizing the trust property will deemed to have income equal to the fair market value on the use of the property or loan.141 This rule does not apply to the extent that the foreign trust is paid fair market value for the use of the property within a reasonable period of time following the use. “A reasonable period of time” has not yet been defined. A subsequent return of the property to the foreign trust will be disregarded for tax purposes under Section 643(i)(3). Notwithstanding, consistent with Section 679, the transferor of the property would qualify as a grantor and, consistent with Section 6048, the transfer would be a reportable event that would be required to be reported on a Form 3520.

G. Reporting Obligations for Foreign Trusts. U.S. persons who transfer assets to a foreign trust or who receive a distribution from a foreign trust, including deemed distributions, are required to file Form 3520.

1. Reportable Events. Generally, a U.S. person who creates a foreign trust, transfers any property to a foreign trust, receives a distribution from a foreign trust or is treated as the owner of a foreign trust must comply with stringent reporting requirements. A grantor, transferor or executor is required to notify the IRS of certain “reportable events.”142 A reportable event is generally defined as the creation or funding (with money or property) of a foreign trust by a U.S. person, including transfers by death. It also includes the death of a U.S. person if the person was an owner of the foreign trust or any portion of the trust is includable in his gross estate.143 Transfers for fair market value are excluded.

The Form 3520 is used to file these reports. This return is due at the same time as the person’s U.S. income tax return, including extensions, and is filed separately with the transferor’s tax return, along with a copy to the IRS Philadelphia Service Center.144

2. U.S. Beneficiaries. A U.S beneficiary who receives a distribution from a foreign trust must file Form 3520 in the year of the distribution. The return must be filed at the same time the beneficiary files his individual tax return. The requirement applies even though a distribution from a grantor trust is treated as a gift and will not carry out DNI or UNI to the beneficiary.

3. Annual Reporting. Form 3520 is filed within 90 days of initial trust formation. Thereafter, this form is filed annually to report transactions with foreign trusts. The Form 3520 is to be filed by the U.S. person who is treated as the owner of a foreign trust under the grantor trust rules. Form 3520 is attached to the U.S. person’s income tax return and is due on that return’s due date, as extended.

The trust reports on Form 3520-A a full and complete accounting of all annual trust activities, trust operations, and other relevant information.145 This information is furnished to U.S. owners and U.S. beneficiaries. The Form 3520-A return is due on the 15th day of the third month after the end of the year of the trust. For calendar year trusts, the return is due March 15th.

4. Penalties. A penalty generally applies if Form 3520 is not timely filed or if the information is incomplete or incorrect. If Form 3520 is incomplete, the entire amount of any trust distribution will also be deemed an accumulation distribution and taxed as ordinary income.146 The penalty for failure to file is 35 percent of the gross reportable amount (generally the amount transferred to the trust or received from the trust).147 This penalty provision was amended by FATCA such that a failure to file Form 3520 has a minimum penalty of $10,000. This results in a penalty equal to the greater of $10,000 or 35 percent of the gross reportable amount. The penalty increases by $10,000 for each 30-day period following notification from the IRS that the filing is delinquent. There is a 90-day grace period following notification before the additional $10,000 penalties are imposed. The total penalty assessed for failure to file Form 3520 may not exceed the gross reportable amount.

A penalty of five percent of the gross value of the trust’s assets may be imposed for failure to file Form 3520-A.148

H. Pre-Immigration Trusts. An NRA who becomes a U.S. person within five years after directly or indirectly transferring property to a foreign trust will be treated as making a transfer to a foreign trust on the date that the NRA ceases to be treated as the owner of the trust under the grantor trust rules.149 Income accruing before the U.S. residency date will not be subject to U.S. tax, except to the extent of U.S. source income.150 Unless no U.S. person could ever benefit from the trust and no other grantor trust powers are retained, the NRA who became a U.S. person will be subject to U.S. income tax on all of the trust income earned after the residency date. If a foreign beneficiary first becomes a U.S. person more than five years after the trust is funded, the trust will not be treated as having a U.S. beneficiary for this purpose.151 The exception is not available if the individual had previously been a U.S. resident.152

IV. INDIRECT TRANSFERS FROM FOREIGN ENTITIES.

If a U.S. person receives a gift or bequest directly or indirectly from a domestic or foreign partnership, the gift or bequest must be included in the U.S. person’s ordinary income.153 If a U.S. person receives a gift or bequest directly or indirectly from a foreign corporation, the gift or bequest must be included in the U.S. person’s income as a distribution from a foreign corporation.154 These rules will not apply if the U.S. person can demonstrate that (1) another U.S. person who holds an interest in the domestic or foreign partnership or the foreign corporation already treated the purported gift as a distribution from the partnership and a subsequent gift to the U.S. donee155; (2) a nonresident alien reported to his or her resident taxing authorities the transfer as a distribution from the entity followed by a gift to the U.S. person, as long as the U.S. person reported any reportable gift from foreign sources pursuant to Section 6039F156; (3) the U.S. person is a corporation and the transfer was a contribution to capital157; or (4) the transfer was a charitable contribution.158

If a U.S. person receives a distribution from a foreign trust, whether grantor or nongrantor, to which a domestic or foreign partnership or a foreign corporation has made a gratuitous transfer, the U.S. person must treat the distribution as a purported gift or bequest from the entity as described above. But, if the federal income tax payable on a trust distribution would exceed the amount that would be due if the distribution were instead treated as a purported gift or bequest from a foreign corporation or partnership, tax is calculated in accordance with the rules governing trust distributions.159

The U.S. beneficiaries of a foreign nongrantor trust may be subject to tax on income earned by “controlled foreign corporation” (CFC) or a “passive foreign investment company” (PFIC) whose shares are held by the trust. The tax regimes applicable to CFCs and PFICs are designed to eliminate the deferral of U.S. income tax that generally exists for U.S. shareholders of domestic corporations. These anti-deferral regimes require certain types of passive income of CFCs and PFICs to be taxed to their U.S. shareholders currently, whether or not distributions are made to them.

A foreign corporation is classified as a CFC if, on any day of the tax year, more than 50 percent of the vote or value of its stock is owned or constructively owned, directly or indirectly, by U.S. shareholders who own at least 10 percent of the voting stock.160 For purposes of determining whether a U.S. shareholder meets the 10 percent test, the constructive ownership rules of Section 318, as modified by Section 958(b) apply.161 A U.S. shareholder in a CFC must include in gross income his pro rata share of the CFC’s Subpart F income.162 A shareholder’s pro rata share of a CFC’s Subpart F income is that amount which would have been distributed with respect to the stock which the shareholder directly or indirectly, but not constructively, owns if, on the last day of the taxable year, the CFC had distributed all of its Subpart F income pro rata to its shareholders.163 Subpart F income includes foreign base company income, insurance income, international boycott income and foreign bribe-produced income.164 Generally, foreign base company income includes dividends, interest, royalties, rents, annuities, gains from the sale or exchange of certain types of property, gains from commodities, foreign currency gains, profits from certain purchases and sales of certain types of personal property, and income from the performance of certain services for or on behalf of a related person outside the CFC’s country of incorporation.165

If the shares of the foreign corporation are held by a foreign nongrantor trust, then Subpart F income would be includable in the gross income of the trust’s U.S. beneficiaries who are considered U.S. shareholders.166 Stock in a foreign corporation held by a foreign nongrantor trust is considered as owned proportionately by the beneficiaries of the trust.167

A foreign corporation is a PFIC if either (1) 75 percent or more of its gross income for the taxable year is passive income; or (2) the average percentage of assets by value held during the taxable year that produce passive income is at least 50 percent.168 Passive income generally includes income which would be foreign personal holding company income under Subpart F.169 If a foreign corporation is both a CFC and a PFIC, and the shareholder is a U.S. shareholder, the CFC rules will apply.170

If a U.S. person, directly or indirectly, disposes of stock in a PFIC, or receives certain distributions from the PFIC, then that person must allocate such gain and income (“excess distributions”) over their holding period of the PFIC stock. Such income is included in ordinary income and is subject to a non-deductible interest charge.171 A qualified electing fund (QEF) election may be made to cause the income to be taken into the shareholder’s gross income 172 each tax year. These rules are designed to discourage deferral of U.S. tax on foreign income through the rise of very high rates. A complete discussion of the U.S. tax treatment of PFICs is beyond the scope of this paper.

Indirect (but not constructive) ownership rules apply to treat the stock of a PFIC as owned by a U.S. person. A U.S. person is deemed to own such person’s proportionate share of the stock of the PFIC owned by any foreign partnerships, trusts or estates of which the U.S. person is a partner or beneficiary and owned by any foreign corporation of which the U.S. person owns at least 50 percent of the value of the foreign corporation’s stock.173

FATCA requires persons owning shares in a PFIC to file an annual information return disclosing ownership of the PFIC (IRS Form 8621).

V. PRE-IMMIGRATION PLANNING CONSIDERATIONS.

With proper planning, an NRA who is contemplating a move to the United States may be able to minimize the U.S. tax impact of his change in residence. The nature and extent of planning will depend upon the NRA’s intent to reside in the United States only temporarily or permanently or indefinitely. The effect of any planning must also take into consideration the potential tax and other legal consequences in the NRA’s pre-immigration country of residence. When rendering advice to an alien who is a tax resident or domiciliary of a country with which the U.S. has an income and/or estate or gift tax treaty, the planning alternatives may be broader than where no such treaty is in place. It is important to carefully review each treaty for the potential impact to the planning structures that may be available to an NRA.

Further, it is important to coordinate tax and estate planning issues with non-tax issues such as access to assets, family relationships, and financial and ownership disclosure laws and to involve qualified local counsel in the planning process.

A. Selected Income Tax Minimization Techniques.

1. Timing Visits to the United States and Interim Residence in Third Country. An NRA should carefully plan his visits to the United States and maintain his closer connections with his home country so as to avoid becoming a U.S. resident under the Substantial Presence Test. Consideration should also be given to establishing an interim residence in a third country while restructuring and concluding the ownership of the NRA’s assets so as to avoid triggering adverse tax consequences in the NRA’s foreign residency jurisdiction.

2. Basis Step-up. Assets brought into the United States by an NRA do not obtain a fair market value tax basis in the U.S. (“landed basis”) upon a change of U.S. tax status from that of an NRA to a U.S. resident. Consideration should be given to selling appreciated property between related parties to recognize accrued gain outside of the United States so as to eliminate the built-in gain potential for property. There may be opportunities for making a sale to an NRA spouse so as to recognize gain on the property transferred to an NRA spouse that would otherwise have the adjusted basis of the transferor spouse under U.S. income tax rules.174 Of course, the transaction must be respected.

3. Accelerate Income. Consideration should be given to accelerating the realization of income that is not subject to U.S. income tax by a cash method NRA, such as receivables, licensing fees, royalties or deferred compensation, or by exercising stock options. For example, it might be advantageous for the immigrating alien to realize capital gains on the sale of his personal property and on the sale of foreign real estate. If such sales are made on an installment basis, the receipt of the principal portion of payments after the individual becomes a U.S. resident is not subject to U.S. tax.175 Disposition of the note prior to the change in residency should also be considered. Any income on the note after attaining residency would be taxable in the U.S. and potentially subject to withholding tax. In such a case, an election out of installment sales treatment may be appropriate on his first U.S. income tax return.

4. Retain Loss Property and Postpone Deductions. Consideration should be given to retaining any depreciated property of the NRA that may generate a loss upon sale. Ordinary and necessary payments of expenses may be postponed until after U.S. residency is established so that deductions are available for U.S. income tax purposes.

5. Shift Income to Family Members. Sales might be possible between related parties to recognize gain accrued outside of the United States, provided that the transactions will be respected for U.S. tax purposes. Similarly, receivables and rights to dividends could be sold to family members.

6. Foreign Transfer of Property. To the extent that foreign assets may be acquired, those assets should be maintained outside of the United States so as to avoid potential outbound transfer taxes imposed on a U.S. person.176

7. Corporate Issues. Consideration should be given to accelerating corporate dividends of a foreign corporation so as to reduce earnings and profits and thereby minimize future taxable distributions.

Appreciated assets of a foreign business could be transferred to a foreign corporation or foreign trust so as to avoid recognition of gains under Section 367 on the transfer of certain assets by a U.S. taxpayer to a foreign taxpayer, or under Section 684 on the transfer of assets by a U.S. taxpayer to a foreign trust. Although the income of the foreign corporation would not be subject to U.S. income tax unless the corporation is engaged in a U.S. business, the CFC provisions may be applicable to cause the income to be recognized by the shareholder after he becomes a U.S. resident. The foreign corporation might also be a PFIC so as to cause the shareholder to be subject to the PFIC rules upon the receipt of certain distributions or the sale of PFIC stock. Consider decontrolling the ownership of foreign corporations by gifting or selling shares.

It may be advisable to make a check-the-box election on eligible foreign entities.

8. Currency Issues. Appreciated foreign currency holdings should be converted to U.S. dollars before the individual acquires U.S. residency.

9. Evaluation of Trusts. Trusts should be analyzed for tax consequences and possible planning considerations including: changing the situs of the trust (U.S. to foreign or vice-versa) or the classification of the trust (grantor or nongrantor); avoiding undesirable investments from a tax perspective, such as interests in passive foreign investment companies (PFICs); and adjusting the investment strategies and the patterns of the distributions during a non-U.S. residency period and avoiding the throwback rules applicable to foreign trusts with U.S. beneficiaries.

B. Selected Potential Transfer Tax Techniques.

1. Gifts. Because of the limited scope of the U.S. gift tax applicable to non U.S. domiciliaries, it may be desirable to make irrevocable tax free gifts to individuals or in trust prior to becoming a U.S. domiciliary. Similarly, funding of a dynasty trust may be accomplished without U.S. transfer taxes through gifting by a non-domiciliary.177 Consideration should be given to making irrevocable gifts to U.S. persons and trusts for the benefit of U.S. persons so as to avoid subsequent gift, estate and GST taxes. Any gifts made in trust should be made at least five years before the NRA becomes a U.S. resident. Income from assets transferred to a trust within five years of immigrating to the United States may, upon establishment of U.S. residency of the grantor, be attributed to the grantor of the trust if the trust has U.S. resident or citizen beneficiaries.178

Consideration should be given to making irrevocable gifts to non-U.S. persons either as outright gifts or in the form of a trust that precludes U.S. beneficiaries and that will not otherwise be treated as a U.S. domestic grantor trust so as to avoid subsequent gift, estate and GST taxes. However, if the donee then establishes a foreign grantor trust for the benefit of the NRA doner, the NRA doner will be treated as the grantor of the trust for U.S. income tax purposes.179

2. Gifts Between Spouses. Consideration should be given to making gifts of non-U.S. assets to a non-U.S. spouse before entering the United States, otherwise, after

becoming a U.S. domiciliary (and not U.S. citizens), any gifts between the spouses in excess of the annual spousal exclusion amount will be subject to U.S. gift tax.

3. Powers of Appointment. An NRA should renounce or exercise any general powers of appointment over property held in trust before becoming a U.S. domiciliary.

4. Joint Tenancy Property. Any properties held by an NRA in joint tenancy with a spouse should be severed.

VI. PLANNING FOR RETENTION OF NONRESIDENT AND NON-DOMICILIARY STATUS.

A. Obtain life insurance coverage for projected U.S. estate tax liability not avoidable through other alternative planning. Note that most foreign insurance is not compliant for U.S. tax purposes.

B. Mortgage out equity on a nonrecourse basis of all U.S. situs real property that cannot be practically transferred to a foreign holding corporation or other structure that will shield U.S. estate tax exposure.

C. Hold all U.S. situs assets directly or indirectly through a foreign holding structure.

D. Use partnerships (including LLCs) holding U.S. situs assets to create “frozen interests,” i.e., all future value shifted to other owners.

E. Establish residency in a country that does not impose estate, gift or inheritance tax.

VII. SUCCESSION TAX APPLICABLE TO GIFTS AND BEQUESTS FROM COVERED EXPATRIATES.

This paper does not cover the expatriation rules under Section 877A. It is limited to a summary of the tax imposed under Section 2801 for gifts and bequests received by a U.S. citizen or a resident from a “covered expatriate” as defined under Section 877A(g)(1).

Effective for “covered gifts and bequests” received by a U.S. citizen or resident after June 17, 2008, Section 2801 imposes a tax on such gifts and bequests at the maximum gift or estate tax rate in effect at the time.180 Since its imposition, the tax has been the subject of much uncertainty due to the lack of Regulations as well as the lack of a final Form 708 required to file and pay the tax.181 The IRS released proposed Regulations for Section 2801 in September 2015, and requested comments on the proposed Regulations in 2016, but as of this writing in 2017 the regulations have not been finalized.182

A. Tax Treatment Under Section 2801.

1. Definition of Covered Gift or Bequest. Section 2801 imposes a tax on the receipt of any covered gift or bequest of any U.S. citizen or resident.183 A “covered gift or bequest” means any property acquired directly or indirectly by gift or by bequest from a covered expatriate.184 For purposes of Section 2801, a “covered expatriate” is given the same meaning as under Section 877A(g)(1).185

Under the proposed regulations, the term “covered gift” has the same meaning as “gift” under the U.S. gift tax laws but without regard to certain notable exceptions including, among others, the transfer of intangible property by a nonresident alien under Section 2501(a)(2); the annual per-donee exclusion under Section 2503(b); and transfers for medical and educational expenses under Section 2503.186 Similarly, the term “covered bequest” includes any property that would have been includible in the gross estate of the covered expatriate if he or she had been a U.S. citizen at the time of death.187 Covered gift or bequest does not, however, include property that is either shown as a taxable gift timely reported by the expatriate for U.S. gift tax purposes188, or included in such person’s gross estate for Federal estate tax purposes.189 Furthermore, the tax does not apply to transfers to spouses and charities if at the time of transfer the marital deduction or a charitable deduction, respectively, would have been allowed if the covered expatriate had been a U.S. citizen.190

2. Taxation of Covered Gift or Bequest Section 2801 imposes a significant change from the general Federal estate and gift principle that the donee or heir does not pay tax on the receipt of gifts and bequests. In a departure from this rule, Section 2801 imposes the tax liability on the U.S person who receives the covered gift or bequest.191 In order to impose the tax on the U.S. person, the proposed regulations state that the U.S. citizen or resident receiving the gift has the responsibility for determining whether the transferor is a covered expatriate and whether the transfer is a covered gift or bequest.192

The tax is calculated by multiplying the fair market value of the covered gift or bequest in excess of the annual exclusion amount ($14,000 in 2017) by the maximum gift or estate tax rate in effect on the date of receipt.193 Although the provision references the annual exclusion amount under Section 2503(b), this reference is only to provide a dollar amount and therefore only one subtraction of this amount from the total covered gift or bequest amount is allowed (i.e., cannot reduce the amount further by including additional U.S. persons who receive property in the transfer).194 The amount of tax calculated under Section 2801 is then reduced by any estate or gift tax paid to a foreign country based on such transfer.195 Finally, the proposed regulations state that the U.S. recipient’s basis in the property received is determined under Sections 1014 and 1015, but no upward basis adjustment is granted as to an tax paid under Section 2801 for covered gifts.196

B. Special Rules for Domestic and Foreign Trusts under Section 2801. Gifts or bequests made to domestic or foreign trusts are subject to special rules under Section 2801. With respect to gifts or bequests to domestic trusts, the tax applies as if the trust is a U.S. citizen and the trust must pay the tax.197 Where the gift or bequest is made to a foreign trust, the tax applies to any distribution to a U.S. person from the income or corpus of the trust attributable to the

covered gift or bequest.198 The amount of a distribution attributable to the covered gift or bequest is defined in the proposed regulations by using the Section 2801 ratio. This ratio is a fraction where the value of the trust attributable to covered gifts and bequests immediately prior to their contribution is added to the portion of the value of any current contribution that constitutes a covered gift or bequest.199 This number is divided by the fair market value of the trust immediately after the current contribution.200 The Section 2801 ratio is multiplied by the value of the current distribution to a U.S. recipient in order to determine what portion of the property is attributable to a covered gift or bequest.201 After the Section 2801 tax is determined, the U.S. recipient is entitled to deduct the amount of such tax for income tax purposes to the extent such tax is imposed on the portion of such distribution that is included in the gross income of the recipient. 202

The Section 2801 ratio must be maintained by the trustee and updated frequently to reflect any additional contributions to the trust corpus. If any tax under Section 2801 has been timely paid on property that remains in the foreign trust, such property is no longer considered to be attributable to a covered gift or bequest for purposes of calculating the Section 2801 ratio.203 Should a trustee wish to ease these administrative burdens, a foreign trust may elect to be treated as a domestic trust, with such election being irrevocable without the consent of the Treasury Secretary.204 This election would cause the Section 2801 tax to be immediately payable upon the receipt of the covered gift or bequest rather than upon the distribution. In making this election, the foreign trust will be liable for the Section 2801 tax for the portion of trust property attributable to covered gifts and bequests from prior years.205

C. Form 708. No form has yet been issued by the IRS for the Section 2801 succession tax. However, the IRS is developing a new form for the succession tax, Form 708 (U.S. Return of Tax for Gifts and Bequests Received From Expatriates).206 The IRS intends to issue Form 708 once the proposed regulations are finalized. Consistent with Announcement 2009-57, the proposed Regulations state U.S. recipients will be given a reasonable period of time after the proposed Regulations are finalized to file Form 708 and to pay the Section 2801 tax.

D. Penalties. The IRS will impose a penalty of $10,000 for failure to timely comply with the reporting requirements under Section 6039G, unless the covered expatriate can show that such failure is due to reasonable cause and not willful neglect.207

1 U.S. v. Wong Kim Ark, 169 U.S. 649 (1898). 2 Internal Revenue Code § 7701(b)(1)(B). All section references are to the Internal Revenue Code of 1986, as amended (“IRC”), and Treasury Regulations promulgated thereunder, unless otherwise indicated. 3 IRC §§ 871(a), (b). 4 An exception to residency status under the substantial presence test may be available to an individual who meets certain requirements so as to have a closer connection in a foreign country which is also his tax home. IRC § 7701(b)(3)(B); Treas. Reg. § 301.7701(b)-2(b)(2)(a). 5 Treas. Reg. § 20.0-1(b)(1). 6 Treas. Reg. § 20.0-1(b). 7 Treas. Reg. §§ 20.0-1(b); 25.2501-1(b). 8 See Estate of Valentine v. Commissioner, 21 B.T.A. 197 (1930), acq. X-1 C.B. 4., 67; Jellinek v. Commissioner, 36 T.C. 826 (1961), acq. 1964-1 C.B. 4.; Estate of Bloch-Sulzberger, 6 T.C.M. 1201, 1203 (1974); Estate of Nienhuys, 17 T.C. 1149, 1159 (1952); Estate of Paquette, T.C. Memo. 1983-571.

9 Estate of Khan v. Commissioner, 75 T.C. Memo. 22 (1998). 10 Id. 11 Id. 12 Rev. Rul. 80-363, 1980-2 C.B. 249. 13 Rev. Rul. 80-209, 1980-2 C.B. 248. 14 54 Fed. Cl. 590 (2002). 15 Id. The court in Jack denied the taxpayer’s motion for summary judgment and ordered trial to proceed on the determination of domicile. 16 IRC §§2101; 2103; 2106. 17 IRC §§ 2501(a)(1)-(2); 2511. 18 IRC §2103; 2031; Treas. Reg. §20.2104-1(a)(1). 19 IRC §2102; 2103; 2106; Treas. Reg. §20.2104-1(a)(2). 20 IRC §2104(c); Treas. Reg. §§20.2104-1(a)(7). 21 IRC §2104(a); Treas. Reg. §§20.2104-1(a)(5). 22 See Rev. Rul. 55-701, 1955-2 C.B. 836; Sanchez v. Bowers, 70 F.2d 715 (2d Cir. 1934). 23 IRC § 2106(b); Estate of Fung v. Comm’r., 117 T.C. 247 (2001), aff’d 91 AFTR 2d 2003-1228 (9th Cir. 2003). 24 IRC § 2106(b); Estate of Johnstone v. Comm’r., 19 T.C. 44 (1952), acq., 1953-1 C.B. 5. 25 IRC § 2104(a); Treas Reg § 20.2104-1(a)(5). 26 IRC § 2105(a); Treas Reg § 20.2105-1(g). 27 Sanchez v. Bowers, 70 F.2d 715 (2d Cir. 1934). 28 277 U.S. 1 (1928). 29 1955-2 C.B. 836. 30 See note 60 supra. 31 IRC § 2104; Treas Reg § 20.2104-1(b). 32 See TAM 9507044 (Feb 17, 1995). 33 IRC § 2014. 34 See IRC § 2501(a)(2). 35 IRC §§ 2501(a); 2511. If the donor is an NRA who expatriated from the United States, then the gratuitous transfers to a U.S. donee will be subject to an income tax in the hands of the donee equal to the highest gift or estate tax rate. IRC §2801. 36 See GCM 36860 (Nov. 24, 1976). 37 See DeGoldschmidt-Rothchild v. Comm’r, 168 F2d 975 (2d Cir 1948). 38 IRC § 2601 et. seq. 39 Australia, Austria, Canada (through income tax treaty), Denmark, Finland, France, Germany, Greece, Ireland, Italy, Japan, Netherlands, Norway, South Africa, Switzerland and United Kingdom. In contrast, the United States has more than 60 income tax treaties. 40 See foreign Investment in Real Property Tax Act of 1980, Pub. L. No. 96-499 (1980) (“FIRPTA”) 41 24 T.C. 829 (1955), acq., 1956-2 C.B. 8, aff’d in part, rev’d in part, 247 F.2d 144 (2d Cir. 1957). 42 Fillman v. U.S., 355 F.2d 632 (Ct. Cl. 1966). 43 IRC § 2056. 44 IRC § 2523(a). 45 Id at 1014(b)(6). 46 IRC §§ 6019, 2523(i)(2), 2503. 47 IRC § 2523(i)(3) (The principles of former IRC §§ 2515 and 2515A (which were repealed in 1981) shall continue to apply to transfers by a U.S. spouse to a noncitizen spouse as far as tenancies by the entirety and joint tenancies with rights of survivorship are concerned). 48 CA Fam. Code § 1100; Wash. Rev. Code § 26.16030(2). 49 Kelly Est v. Commissioner, 31 T.C. 493 (1958). 50 Roeser v. Commissioner, 2 T.C. 298 (1943), acq. 1943 C.B. 19. 51 IRC § 2513. 52 IRC § 2056(d)(4). 53 Id. 54 IRC § 2056(d)(2)(A). 55 IRC § 2056(d)(2)(B).

56 IRC §§ 2056(b)(5), (7), (8); Treas Reg § 20.2056E-2(B)(i–ii). 57 If the U.S. trustee is an individual, he or she must have a tax home in the U.S. as defined in IRC § 911(d)(3). 58 IRC § 2056A(a)(d); Treas Reg § 20.2056A-2(b)(1). 59 IRC § 2056A(d). 60 IRC § 2056(d)(2)(B); Treas Reg §§ 20.2056A-2(b)(2), (3). 61 IRC § 2056(A)(b). 62 Treas Reg § 20.2056A-6(a). 63 IRC § 2056A(b)(3)(A). Income does not include capital gain. Treas Reg § 20.2056A-(c)(2). 64 IRC § 2056A(b)(3)(B). 65 Treas Reg § 20.2056A-5(c)(1). 66 Id. 67 Treas Reg § 20.2056A-2(d). The residence may not be rented to third parties even if it is not in use. 68 Treas Reg § 20.2056A-2(d)(1). 69 Treas Reg § 20.2056A-2(d)(1)(A). 70 Treas Reg § 20.2056A-2(d)(1)(B). 71 Treas Reg § 20.2056A-2(d)(1)(C). 72 Treas Reg § 20.2056A-2(d)(1). 73 See Rev Proc 96-54, 1996-2 CB 386. A look-through rule is provided for entities owning foreign real property. 74 Treas Reg § 20.2056A-2(d)(1). 75 Treas Reg § 20.2056A-3(a). 76 IRC § 2056A(d). 77 IRC § 2056A(b)(5). 78 IRC § 2056(d)(3). 79 Id.; Treas Reg § 20.2056A-7. 80 Treas Reg § 20.2056A(d)(1)(i)(D). 81 Treas Reg § 301.7701-7(d)(4). 82 Treas Reg § 20.2056A-1(c). 83 1980 Estate, Inheritance, and Gift Tax Convention, as Amended, U.S.-Ger., art. 10 ¶ 4, Dec. 3, 1980 (hereafter German Treaty). Deduction is not available if the U.S. citizen spouse is domiciled in Germany. Id. 84 Id. at art. 10(6). 85 Id. 86 Id. at art. 10(5). 87 Id. at art. 10(6). 88 Treas Reg § 20.2056A-1(a)(1)(iv); Treas Reg § 20.2056A-4(c). 89 Treas Reg § 20.2056A-3(c)(3). 90 Treas Reg § 20.2056A-4(c)(2)(i); Treas Reg § 20.2056A-4(c)(3)(i). 91 IRC §§ 2010(c)(4), (5)(A). 92 Treas Reg § 20.2010-2T(a)(5). 93 Treas Reg §§ 20.2010-3T(e); 25.2505-2T(f). 94 Temp Treas Reg §§ 20.2010-2T(c)(4), 20.2010-3T(c)(2), 25.2505-2T(d)(2). 95 Temp Treas Reg § 25.2505-2T(c)(2)(ii). 96 IRC § 2014. 97 Rev. Rul. 82-82, 1982-1 C.B. 127 (ruling that a Canadian tax on capital gains was levied on the appreciation and not transfer of property at death). 98 § 2014(b). 99 § 2014(a); see IRC §§ 2104, 2105. 100 Treas Reg § 20.2014-2(a); Rev. Rul. 75-439, 1975-2 C.B. 359. 101 Treas Reg § 20.2014-3(b). 102 IRC § 2040(b). 103 IRC §§ 2040(a); 2056(d)(1)(B). 104 IRC § 2033. 105 IRC § 2040. 106 IRC §§ 2503(b); 2523(a); 2523(i)(2); Treas Reg § 25.2523(i)-2(c)(1). 107 Treas Reg § 25.2523(i)-2(c)(2). 108 IRC § 2523(i)(3).

109 Treas Reg § 25.2523(i)-2(b)(1). 110 IRC § 2102(b) 111 IRC §§ 2101(b); 2001(c). 112 IRS § 2523(i); Rev. Proc. 2009-50, IRB 2009-45. 113 IRC § 2505(a). 114 IRC § 2522(b). No gift tax exemption applies for gifts of art located in the U.S. for exhibition purposes. Treas. Reg. § 25.2511-3(b)(1). 115 See IRC § 1015. 116 Pub. L. No. 111-147 (2010). 117 IRC § 7701 (a)(31)(B) 118 IRC §§ 7701(a)(30)(E), (31)(B); Treas. Reg. § 301.7701-7(c)(3). 119 IRC § 7701(a)(30)(E)(i); Treas. Reg. § 301.7701-7(c)(3). 120 Treas. Reg. § 301.7701-4(c)(1). 121 Treas. Reg. § 301.7701-7(c)(4)(A)-(D). 122 IRC § 7701(a)(30)(E)(ii). 123 Treas. Reg. § 301.7701(d)(1)(ii). 124 Treas. Reg. § 301.7701(d)(ii)(j). 125 Treas. Reg. § 301.7701-7(d)(1)(ii). 126 Treas. Reg. § 301.7701-7(d)(2)(i). 127 IRC § 672(f). 128 IRC § 672(f)(5) 129 Id. 130 IRC § 662(b); Treas. Reg. § 1. 662(c)(4) 131 IRC § 668 132 IRC §§ 643, 663, 665, 667. 133 IRC § 667. 134 IRC § 668. 135 Treas. Reg. § 1.665(b)-1A(c)(1). 136 IRC § 679. 137 IRC § 679(c) (effective for transfers to a foreign trust after March 18, 2010). 138 Id. 139 IRC § 643(i)(1). 140 Notice 97-34, 1997-1 C.B. 422. 141 IRC § 643(i)(1) 142 See generally, IRC § 6048. 143 IRC § 6048(a)(3). 144 But see IRC § 679(a)(3). 145 IRC § 6048(b)(i)(A). 146 IRC § 6048(c)(2)(A). 147 IRC § 6677 (effective for Forms 3520 filed after March 31, 2009). 148 IRC § 6677(b). 149 IRC § 679; Treas. Reg. § 1.679-5(b). 150 IRC § 679. 151 Treas. Reg. § 1.679-2(b). 152 Treas. Reg. § 1.679-2(a)(3), Example 2. 153 Treas. Reg. § 1.672(f)-4(a). 154 Treas. Reg. § 1.672(f)-4(b). 155 Treas. Reg. § 1.672(f)-4(b)(1)(i). 156 Treas. Reg. § 1.672(f)-4(b)(1)(ii). 157 Treas. Reg. § 1.672(f)-4(b)(3). 158 Treas. Reg. § 1.672(f)-4-(b)(4). 159 Treas. Reg. § 1.672(f)-4-(c)(2). 160 IRC §§ 951(b); 958(a), (b). 161 IRC §§ 958; 318(a), (c)(i). 162 IRC §§ 957; 951(a). See IRC §958(b) for rules related to constructive ownership.

163 IRC § 951(a)(2). 164 IRC § 952(a). 165 IRC §§ 954(a), (c). 166 Treas. Reg. § 1.958-2(c). 167 IRC § 958(a)(2). 168 IRC § 1297. 169 IRC § 1297(b). 170 IRC § 1297(e). 171 IRC § 1291. Indirect (but not constructive) ownership rules apply to treat the stock of a PFIC as owned by a U.S. person. A U.S. person is deemed to own such person’s proportionate share of the stock of the PFIC owned by any foreign partnerships, trusts or estates of which the U.S. person is a partner or beneficiary and owned by any foreign corporation of which the U.S. person owns at least 50 percent of the value of the foreign corporation’s stock. 172 IRC §§ 1293; 1294; 1295. 173 IRC § 1298(a)(2)(A). 174 IRC § 1041. 175 Ltr. Rul. 8708002 (deemed election out of installment sale reporting for a pre-residency sale on basis of nonreporting of payments when received, even though prior country of residence allowed deferral of gain). See also Ltr. Rul. 9412008 (to the same effect); cf., Treas. Reg. § 15A.453-1(d)(3) (reporting the gain in the year of sale will be treated as an election not to use installment reporting). 176 See IRC § 367 (transfer of appreciated assets to a foreign corporation). 177 Treas. Reg. § 26.2663-2. GST tax does not apply to gifts made by a nondomiciliary if the gift itself was not subject to U.S. gift tax. 178 IRC § 679(a)(4). 179 IRC § 672(f). 180 IRC § 2801(a). 181 See Announcement 2009-57, 2009-29 IRB 158. 182 See REG-112997-10 (Sept. 10, 2015). 183 IRC § 2801(a). 184 IRC § 2801(e)(1). 185 IRC § 2801(f). 186 Prop. Reg. § 28.2801-3(a). 187 Prop. Reg. § 28.2801-3(b). 188 IRC § 2801(e)(2)(A); Prop. Reg § 28.2801-3(c)(1). 189 IRC § 2801(e)(2)(B); Prop. Reg. § 28.2801-3(c)(2). 190 IRC § 2801(e)(3); Prop. Reg. §§ 28.2801-3(c)(4); 28.2801-3(c)(3). 191 IRC § 2801(b). 192 Prop. Reg. § 2801—7(a) 193 IRC §§ 2801(a), (c); Prop. Reg. § 28.2801-4(c). 194 REG-112997-10, Preamble; Prop. Reg. § 28.2801-4(b)(2). 195 Prop. Reg. § 28.2801-4(e). 196 Prop. Reg. § 28.2801-6(a). 197 IRC § 2801(e)(4)(A). 198 IRC § 2801(e)(4)(B)(i); Prop. Reg. § 28.2801-4(a)(3)(i); Prop. Reg. § 28.2801-5(a). 199 Prop. Reg. §28.2801-5(c)(1). 200 Id. 201 Prop. Reg. §28.2801-5(c)(1)(i). 202 Prop. Reg. § 28.2801-4(a)(3)(ii)(C). 203 Prop. Reg. § 28.2801-5(c)(2). 204 IRC § 2801(e)(4)(B)(iii); Prop. Reg. § 28.2801-5(d). 205 Prop. Reg. §28.2801-5(d)(2)(i). 206 REG-112997-10, Preamble. 207 IRC § 6039G(c)(2); see also Form 8854