Pre-Immigration Planning Considerations for Nonresident Aliens
By Patrick J. McCormick, Drucker & Scaccetti, P.C.
For a multitude of reasons, some foreign individuals of significant wealth will desire to establish domicile in the United States – either through citizenship or otherwise establishing a long-term presence in the country. One major drawback is the tax ramifications associated with such United States presence.
As most practitioners are aware, significant disparities exist between how the United States taxes its citizens/residents and how it taxes nonresident aliens, with these disparities present both in the income tax and estate/gift tax realms. Because of these differences, significant planning opportunities arise for high net worth individuals contemplating prospective United States residency/citizenship; an outline of considerations and common techniques are covered below.
Options Prior to United States Taxpayer Status
The level of tax imposed by the United States is dramatically altered by commencement of citizenship or residency, incentivizing planning prior to becoming a United States-based taxpayer. Vitally, individuals do not receive a step-up in basis of their assets upon becoming United States citizens or residents, meaning that asset gains which previously accrued are subject to United States tax if sold after United States taxpayer status commences. Conversely, assets with a basis in excess of fair market value can create losses for United States tax purposes if disposed of after United States residence/citizenship.
To this end, sales of assets with built-in gain prior to United States residency can be beneficial, as it allows avoidance of United States tax on the built-in gain upon ultimate disposition (though this approach is contingent upon tax ramifications in other jurisdictions, i.e. where the assets are located and/or where the individual presently resides). Where a desire exists to keep holding the asset at issue, the asset can be sold then reacquired, or be the subject of other transactions which achieve a step-up while still allowing ownership to be retained (with the proper transaction type often dictated by the laws of the jurisdiction where the asset is held). An option often useful is sales between spouses; while transfers between spouses typically do not result in gain recognition under United States law, this rule is inapplicable where the purchasing spouse is a nonresident alien. Other options include check-the-box elections for foreign corporations and sales to trusts.
Transfers made by nonresident aliens of intangible assets and non-United States tangible assets are not subject to United States transfer tax imposition; conversely, United States citizens and residents are subject to transfer taxes on worldwide assets. For high net worth individuals, this incentivizes transfers of intangible/non-U.S. tangible assets prior to becoming subject to United States transfer tax, particularly when a long-term stay is contemplated (i.e. where there is potential for federal estate tax at death). Options include outright gifts of assets and transfers to trusts. For the former, gifts to noncitizen spouses are especially beneficial; while gifts to United States citizen spouses are not subject to transfer tax, gifts to noncitizen spouses are subject to a $152,000 annual limitation (for 2018; the annual limitation is subject to inflation).
For transfers to trusts, “drop-off” trusts are often recommended. Under this approach, a portion of the nonresident alien’s assets are transferred into an irrevocable trust. Transfers made to irrevocable trusts (where both the transfer and the trust are properly structured) constitute completed gifts, thereby removing transferred assets from the transferor’s taxable estate. Consideration is always required of the tax ramifications in the current country of residence of these transfers. While the drop-off trust can be either domestic or foreign, it is usually better for the trust to be domiciled in the United States if the trust will (or could) have United States persons as beneficiaries, based on the application of “throwback” rule (discussed in more detail below).
If the irrevocable “drop-off” trust is domiciled in the United States, it is subject to tax on its worldwide income. Additionally, where income of a trust (or any part thereof) may either be paid or accumulated for the grantor or her spouse by the grantor or a nonadverse person, the grantor is treated as the owner of the trust (or portion of the trust) for income tax purposes (with actual distributions unrequired). Significant prospective income tax liabilities can thus exist for transfers to drop-off trusts, even though these trusts protect assets from transfer tax imposition.
Life insurance is sometimes recommended as a drop-off trust holding, given its ability to alleviate United States income tax consequences. Owners of life insurance policies are not required to recognize income from a policy’s investments, and death benefits are also not subject to income tax. Investing the trust’s assets in life insurance can thus minimize income tax obligations for the trust. Private placement life insurance policies have become especially popular in the drop-off trust context, as they offer a larger range of investment options and easier access to funds than traditional life insurance policies.
Foreign trusts can cause significant issues both for their grantors and beneficiaries. Foreign trusts are defined under the Code as any trusts which are not domestic. A number of special tax provisions exist for foreign trusts which cause negative United States tax impact; some of the most severe exist for foreign nongrantor trusts with United States beneficiaries. Importantly, for post-1996 transfers, only citizens and residents of the United States or domestic corporations can typically be treated as trust grantors for United States tax purposes. Exceptions apply in limited circumstances, primarily where (1) the grantor maintains the ability to revoke the trust, and (2) only the grantor and/or the grantor’s spouse are permitted beneficiaries during the grantor’s life. Foreign trusts not treated as owned by the grantor are instead subject to tax rules applicable to nongrantor trusts.
United States beneficiaries of foreign nongrantor trusts are subjected to the “throwback” rule for taxation of accumulated income distributions. This rule requires accumulation distributions to be taxed to the beneficiary as ordinary income, and subjects those distributions to an interest charge as if there were a tax underpayment from the date income was earned. The throwback rule is designed as an anti-deferral mechanism – an effort by the United States to disincentivize storing income overseas (and outside the United States’ tax jurisdiction). Given the throwback rule, it is often advisable to have a foreign nongrantor trust pay out its income as earned (as the throwback rule applies only to accumulation distributions).
Special rules can also cause income to be taxed to the prospectively United States-based grantor. For foreign trusts created by a nonresident alien grantor who becomes a United States citizen or resident within five years of transfers to the trust, the trust is treated (for income tax purposes) as a grantor trust if it has any United States beneficiaries. For nonresident aliens, it is often beneficial to establish a foreign grantor trust while a nonresident if the nonresident has United States persons they seek to benefit, as grantor trust status enables avoidance of the aforementioned throwback rules (and is thus hugely preferable to United States beneficiaries). The benefits of this approach, however, greatly diminish when the nonresident alien grantor becomes a United States taxpayer.
Patrick J. McCormickDrucker & Scaccetti, P.C., Philadelphia, PA, USA
T: +1 215 665 3960
Patrick is a principal and attorney at Drucker & Scaccetti (D&S) who focuses on international taxation and related issues for domestic businesses and individuals. He has extensive experience in handling complex tax planning and tax controversy issues as well as the design, drafting and implementation of estate and gifting plans for American citizens and residents with foreign assets. He also helps clients with retroactive disclosures and assessments related to international assets.
Published: November 2018 l Photo: Sean Pavone - stock.adobe.com