Estate and income tax planning for multinational families 2010-07-20

H O D G E N L A W G R O U P P C I N T E R N A T I O N A L A N D U . S . T A X

[email protected]

Glendale Estate Planning Council July 20, 2010

Estate and Income Tax Planning for Multinational Families

Philip D. W. Hodgen Hodgen Law Group PC

140 South Lake Avenue, Suite 248 Pasadena, California 91101

Tel 626-‐689-‐0060 Fax 626-‐577-‐2230

Mobile 626-‐437-‐2500 Email [email protected]

H O D G E N L A W G R O U P P C I N T E R N A T I O N A L A N D U . S . T A X Glendale Estate Planning Council July 20, 2010 Estate and Income Tax Planning for Multinational Families

[email protected] m 626-437-2500 1

1. Introduction

Who are we talking about?

• Families with members in more than one country

• Families with assets in more than one country

• One of those countries is the United States

The typical family

• Parents are outside the United States, children live in United States. Assets are (mostly) in the parents’ hands at the moment, but the children will receive substantial lifetime gifts and will eventually inherit the assets

Objectives

• Minimize or eliminate U.S. estate tax on death of nonresident/noncitizen parents

• Minimize or eliminate U.S. estate tax on death of U.S.-‐resident children

• Minimize worldwide income tax on assets.

• Normal cost/benefit and “K.I.S.S.” stuff

Three common situations we will look at

• Transfer of foreign portfolio assets (stocks and bonds) to the U.S.-‐resident children upon death of the parents (see #3, below)

• Lifetime gifts (typically of cash) to the U.S.-‐resident children (see #5)

• Parents buy a house in the United States for a U.S.-‐resident child to live in (see #8)



2. Resident vs. nonresident: definitions

How they’re taxed: resident vs. nonresident

• Income tax: residents/citizens taxed on worldwide income

• Income tax: nonresident-‐noncitizens taxed on U.S.-‐source income

• Estate tax: residents/citizens taxed on worldwide assets

• Estate tax: nonresident-‐noncitizens taxed on U.S. assets

You’re a resident for income tax when…

• You are a U.S. citizen; or

• You have a permanent resident visa (AKA “green card”) and have stepped foot in the U.S. while holding that status; or

• You have stayed in the U.S. at least 183 days in the current year; or

• You have stayed in the U.S. a sufficient number of days in the current and prior two years so the math adds up to 183 (days of presence in the U.S. in 2010 plus one-‐third of the days of presence in the U.S. in 2009 plus one-‐sixth of the days of presence in the U.S. in 2008).

• You didn’t opt out of residency status using an income tax treaty (see Form 8833) or the “closer connection test” (see Form 8840).

• Other weird odds-‐and-‐ends: students, diplomats, medical conditions (see Form 8843), etc.

You’re a “resident” for estate, gift, generation-‐skipping transfer taxes when…

• You are a U.S. citizen; or

• You are domiciled in the United States: where do you live, REALLY? (Amorphous list of considerations, not one of which is determinative

• The income tax test does not apply



3. How U.S. kids inherit foreign assets tax-‐free, with stepped-‐up basis

This is the first scenario we will cover. It is a cleverly-‐disguised way to give you an introduction to foreign trusts, grantor trusts, and a peculiarity in the basis step-‐up rules.

Use a foreign grantor trust during the parents’ lifetime

• Income is taxed to the parents, not the U.S.-‐resident children;

• Financial benefits flow to parents (income, access to principal);

• They have control over their own assets.

Upon the parents’ death, the trust becomes a foreign non-‐grantor trust

• Distribute the assets outright to the heirs (U.S.-‐resident children); or

• Migrate the trust to the United States for continued administration; or

• Decant the assets from the foreign non-‐grantor trust into a new domestic non-‐grantor trust for continued administration.



Why a foreign trust during the parents’ lifetime?

• No U.S. tax paperwork problems. Eliminate the possibility of taxation and screwing up on filing the right obscure form with the right obscure information at the right time.

• No U.S. income tax. No U.S. assets means no U.S.-‐source income, so nothing for the IRS to touch.

How do you make a trust into a “foreign” trust?

• The Internal Revenue Code has a bias towards “foreignness” for a trust. There are two tests in the Internal Revenue Code:

The “Court Test” - can a U.S. judge exercise control over the trust and its assets?

The “Control Test” - are ALL of the administrative powers for the trust held by U.S. persons? (Trivial powers excepted).

Must satisfy BOTH tests in order to have a domestic trust. If you fail one or both, you have a foreign trust.

• See what this does: you can take any trust in your inventory right now, give fiduciary power to a foreigner, and cause it to be a foreign trust. (So be careful when you name those successor trustees!)

Grantor vs. non-‐grantor?

• “Grantor” and “non-‐grantor” have the same meaning in the context of a foreign trust as they do generally.

• A grantor trust is one where the person who contributes an asset to the trust will bear the income tax burden on the trust’s income attributable to that asset.

• A non-‐grantor trust is one where the ultimately the tax burden falls on the beneficiary—either explicitly or because the trust pays the income tax and there is less in the trust to be distributed to the beneficiary.



Foreign grantor trust

• In situations with a trust created by a nonresident, the Internal Revenue Code is biased against grantor trust status. The normal kit of triggers that cause grantor trust status will not apply. You can get grantor trust status if:

The grantor has the power to revest assets in himself/herself (this is functionally identical to a power to revoke or amend the trust); or

The grantor and the grantor’s spouse are the only people who can receive distributions from the trust during their lifetimes.

I like to use the power to revoke the trust.

It is crystal-clear;

Clients like to retain control over their assets;

Flexibility is retained in the event that circumstances change.

Only foreign assets in the trust: income tax reasons

• The foreign grantor trust is designed to hold non-‐U.S. assets only. Portfolio assets—foreign stocks and bonds—are ideally suited for holding in this trust. But other non-‐U.S. assets can be held, too

• The U.S. has two hooks by which it asserts the power to tax income

Personal status as a citizen or resident of the United States (the IRS can reach out, grab you, and make you pay); or

The income is derived from a source in the United States (the IRS can reach out, grab the asset generating the income, and make you pay).

• Since the parents in our example are nonresidents and noncitizens of the United States, the IRS can only tax U.S.-‐source income, and there is none.

Only foreign assets in the trust: estate tax reasons

• The estate tax is an additional reason why you don’t hold U.S. assets in this trust. The trust is revocable. That makes the trust assets includable in the grantor’s estate upon death. If you have U.S. assets in this trust, there will be U.S. estate tax. Nonresidents have a unified credit which shelters the first $60,000 of assets.



Why there is step-‐up in basis upon the parents’ death

• You have someone who is not a U.S. taxpayer, holding assets outside the United States. There is no estate tax return, and no estate tax paid. Why would the assets receive a step-‐up in basis upon the death of the parents?

• The IRS is here to help. See Revenue Ruling 84-‐139, 1984-‐2 C.B. 168 for the analysis. It deals with real estate but the same theory applies to foreign portfolio assets.



4. Mini-‐tutorial: how to hold U.S.-‐situs portfolio assets for a nonresident

If your nonresident client wants to buy U.S. stocks and bonds, here’s how you do it.

• Create a foreign corporation (Bahamas, British Virgin Islands, etc.).

• Open an account at your favorite institution in the name of the foreign corporation.

Tax results:

• No estate tax upon death of your client. (The decedent owns stock in the foreign corporation at the time of death; this is a nonresident owning a foreign-‐situs asset).

• Capital gains are tax-‐free.

• Interest income in almost every case will be tax-‐free.

• Dividends are taxed at 30%.



You don’t have a step-‐up in basis, but since there is no capital gains taxation you can have frequent sales to recognized built-‐in capital gain. (Give your asset manager permission to churn the account!)



5. Lifetime gifts from parents (avoid trust distributions)

Gifts from the parents to their U.S.-‐resident children can made without gift tax.

• In the structure I have outlined above, I recommend that the trust distribute cash to the parents individually, and the parents then make the transfer from a foreign bank account to the U.S.-‐resident child’s U.S. bank account. Done this way, the gift is tax-‐free.

The child may have to file Form 3520 to report the gift, if the amount received is high enough

• Threshold is $100,000 (is not inflation-‐adjusted) per human donor per year

• Threshold is $14,165 (for calendar year 2010; is inflation-‐adjusted) for gifts from foreign corporations or partnerships

• Watch out for IRS’s ability to reconfigure gifts from foreign corporations or partnerships as taxable income



6. Mini-‐tutorial on cash gifts by nonresidents

Gift taxation for nonresidents: gifts of two things only are taxed in the U.S.

• Transfers of interests in U.S. real estate; and

• Transfers of tangible personal property physically located in the United States.

Cash is tangible personal property, says the IRS. So if the cash is outside the U.S., then its transfer by a nonresident into the United States will be outside the scope of the definition of a “taxable gift”.

A nonresident should never use a U.S. bank account to make a gift of cash. The money is located in the United States, and its transfer (in any form at all-‐-‐folding green bills, a check, ACH transfer, wire transfer) is a taxable gift, regardless of the identity of the recipient.

A nonresident doesn’t have the $1,000,000 lifetime exclusion for gifts. He or she does have the $13,000 per year/per donee exclusion. The nonresident cannot transfer unlimited amounts to his or her noncitizen spouse. There is a $134,000 per year exclusion for those transfers (this is the 2010 amount; it is inflation-‐adjusted annually).

When money is in a U.S. account, the safer practice is to wire the funds overseas and make the gift from there, unless the amount involved is small (i.e., within the $13,000 per year/per donee exclusion).

Mini-‐tutorial on U.S. real estate gifts by nonresidents

7. Gift by nonresident of direct ownership of U.S. real estate is taxable.

Gift of intangible personal property by a nonresident is not a taxable gift.

Your roadmap: Suzanne J. Pierre v. Commissioner, T.C. Memo 2010-‐106. (Real estate into LLC, give LLC interests).



8. How parents can help their U.S.-‐resident kids buy real estate

The final thing we will talk about is the way nonresident parents can help their U.S.-‐resident children buy real estate-‐-‐whether this is a personal residence or is investment property.

We can’t use the concept outlined before-‐-‐a grantor trust-‐-‐because it carries with it a retained interest that the foreign parents hold, which makes them taxable on death on the value of the real estate.

Here we use an irrevocable trust. Parents are the settlors. Kids are the beneficiaries.

How it works

• Parents dump $5,000,000 into the trust as an outright gift. There is no gift tax. (Nonresident-‐noncitizens are only subject to U.S. gift tax if they make a gift of U.S. real estate or tangible personal property located in the United States. Here we have



them fund the trust with cash in a foreign bank, which is tangible personal property located outside the United States.

• The trust buys real estate and the beneficiaries (the children) use it.

Estate taxation results

• No estate taxation on the death of the parents, because they made an outright gift to the trust, with no retained interests.

• No estate taxation upon the death of the children, because they have life interests in the trust.

Income taxation

• Long term capital gain is taxable at whatever the long term capital gain tax rate ends up being.

The real problem is the human problem: the parents don’t necessarily want to part company fully and forever with the money. One way to deal with this is to have the parents fund the trust partly with a gift and partly with an arms-‐length loan which will be repaid upon sale of the real estate.

The human problem leads to discussions about things in the trust which start to look a lot like retained interests. The parents want to retain some control, or they want the ability to receive benefits from the trust.

Foreign or domestic trust?

• I use Nevada or Delaware trusts frequently. Why not? Keep it simple. :-‐) You have a domestic asset, a domestic beneficiary, and perhaps a desire to have this trust operate over multiple generations

• Foreign irrevocable non-‐grantor trusts are B.A.D. As of March, 2010, the HIRE Act says that a U.S. beneficiary who uses assets owned by a foreign trust is deemed to have received a trust distribution to the extent of the fair market value of the property’s use

• Also bad about foreign non-‐grantor trusts: accumulated long term capital gains are taxed at ordinary rates, and the tax is accompanied by an interest charge. The fact that Congress found it necessary to include a provision in the Code saying “The most you will have to pay is 100% of the distribution of accumulated income” tells you everything you need to know.



9. Mini-‐tutorial: portfolio interest loan for real estate acquisition

Foreign taxpayers receiving interest payments from U.S. persons are subject to tax at 30%. There are exceptions. (This is tax law, after all!) One is interesting here.

If we can arrange for a foreign lender to make the mortgage loan on the property, then payments of interest can generate a mortgage interest deduction in the U.S. for the borrower, and the foreign lender can receive the interest payments free of U.S. tax.

Key to making this work?

• The lender can’t be too closely related to the borrower (the Code has its usual attribution rules and constructive ownership rules to navigate); and

• The paperwork has to be right.

Look at this idea—using the portfolio interest exception—as an additional piece of the structure in making the acquisition work.

Economy & Finance

Estate and income tax planning for multinational families 2010-07-20