By Patrick J. McCormick, JD, LLM
A growing number of nonresidents (those who, for U.S. tax purposes, are classified neither as citizens nor U.S. residents) are seeking ownership of American-based assets since the United States is an appealing jurisdiction for investment by foreign taxpayers. A consideration of American tax consequences, however, must be part of their investment exploration. The tax results for nonresidents can be stark when compared to U.S. taxpayers. Critically, differences in transfer tax exemptions for nonresidents make estate planning vital.
The Tax Cuts and Jobs Act doubled the lifetime gratuitous transfer exclusion for U.S. taxpayers (to $11.58 million in 2020). The need for tax-focused estate planning for domestic individuals may have been eroded, but for nonresidents, the need for transfer tax planning has grown. A stagnant, miniscule exemption of $60,000 for estate tax and no specific nonresident exemption for gift tax makes effective planning a necessity.
Income Tax – Default Rules
Nonresident aliens are taxed by the United States on income effectively connected with the conduct of a U.S. trade or business and non-U.S. trade or business income sourced to the United States (commonly referenced as “FDAP income” – fixed or determinable annual or periodic income). Critically, default rules applicable to nonresidents are subject to significant modification for qualified residents of countries with which the United States maintains an income tax treaty.
A relevant subset of the effectively connected income (ECI) rules is provided in Section 897 and pertain to foreign investment in U.S. real property. A nonresident disposing of a U.S. real property interest (USRPI) is subject to tax on gains associated with the interest, with these gains automatically classified as income effectively connected with a U.S. trade or business.1 Withholding rules are applicable: a transferee of a USRPI must withhold from the transfer at a rate of 15% of the amount realized (the sum of cash paid/property received and any liabilities assumed) on the transaction if the transferor is a foreign party.2
A major focus among nonresident clients typically is the potential for transfer tax liability – tax amounts owed to the United States for U.S.-sitused gifts and bequests. While nonresidents are subject to estate and gift tax on a much more limited scope of assets than U.S. citizens/residents, they are provided only a fraction of the exemption amounts available to U.S. taxpayers. Exposures can exist in unanticipated ways. For example, an intrafamily transfer of a U.S. vacation home can create transfer tax consequences. High tax rates result in enormous tax consequences from these (innocuous) transfers, with tax amounts typically avoidable if ownership of the asset is properly structured.
For nonresidents, estate tax is assessable on all property – tangible or intangible – located within the United States and owned individually at death, subject to listed exceptions.3 The exceptions are for bank accounts not used in connection with a U.S. trade or business (importantly, this exception does not extend to accounts not held with banking institutions - brokerage accounts are subject to estate tax, even if holding only cash), securities generating portfolio interest, and insurance proceeds. Where these exceptions do not apply, asset situs rules determine whether an asset is subject to American transfer tax. Real property and tangible personal property is sitused in accordance to where the assets are physically located; shares of a corporation are sitused to the country in which the corporation is formed.4 For partnership interests, the IRS has taken the position that the situs of a partnership interest is determined by where the partnership conducts business.5
Nonresidents receive a $60,000 estate tax exclusion, with a maximum 40% rate of tax applicable once a nonresident’s U.S. assets reach $1 million. Referencing the aforementioned intrafamily U.S. real estate transfer, say a testamentary transfer of a U.S. property worth $5 million occurs and the transferring decedent is an individual nonresident. The first $60,000 of value is exempted from tax; tax is then imposed so that the first $1 million of value is taxed at $345,800 and additional amounts are taxed at a flat 40%. In the example, if a $5 million real estate asset is transferred, the resulting U.S. estate tax is $1,921,800. The effective rate of tax (roughly 38.5%) is enormous, and is imposed against a U.S.-sitused asset – one which is ripe for IRS enforcement if required.
U.S. gift tax is assessed on lifetime gratuitous transfers of real property and tangible property within the United States by nonresident aliens. Importantly, intangible property (such as an interest in a U.S.-based corporation) is not subject to gift tax for nonresident donors. Nonresident aliens receive no specific lifetime exclusion, though they are permitted to use the annual gift exclusions of $15,000 per donee (an exception also available for U.S. taxpayers).6
Transfer taxes – both estate and gift – can be modified by estate and gift tax treaties, though transfer tax treaties are typically limited in scope and availability than income tax treaties.
Considerations for U.S. Investments
Nonresident aliens investing in the United States maintain a number of options for investment ownership. Generally, the party directly taxable for a U.S. asset will be an individual, a corporation, or a nongrantor trust, with flow-through entities and grantor trusts amongst the structures functionally “looked through” until one of the three types of aforementioned taxpayers are found (but which are often beneficial for nontax purposes – such as liability protection). Nonresidents contemplating U.S. investments seek to minimize U.S. tax exposure (whether income tax or transfer tax), but are also motivated to minimize disclosures to the United States and, where possible, maintain a simplified ownership structure.
The most basic structure (ownership directly by the investing individual) offers simplicity, but it also poses clear issues. The most glaring are estate and gift tax exposures: if held individually, common assets like real estate and corporate interests will be subject to estate tax (and, in the case of the former, gift tax as well). Income is subject to tax based on the aforementioned ECI and FDAP rules; the former usually requires the filing of a U.S. tax return. The filing requirement requires exposure of the individual’s identity to the IRS; in the minds of some nonresidents, this risks additional inquiry into the individual’s financial affairs. A significant benefit to individual ownership for non-ECI assets is the exemption of capital gains from U.S. tax, particularly appealing where the investor resides in a country where foreign-sourced capital gains are not subject to tax. A detriment, however, is that ordinary income tax rates apply to income earned by the investment’s operations.
Ownership through a structure using a foreign corporation offers protection from U.S. transfer tax, but it requires income tax tradeoffs. Specifically, a foreign corporation holding U.S. income-producing assets is taxed at corporate rates, irrespective of the underlying character of income. But it is subject to the branch profits tax, with the underlying owner of the foreign corporation (i.e., the investing individual) required to be disclosed if the foreign corporation has U.S. business profits. Incorporating a domestic corporation into this ownership structure (i.e., having a U.S.-based investment owned by a domestic corporation, with the aforementioned foreign corporation now owning the domestic corporation rather than the actual U.S. investment target) removes branch profits exposure and investor disclosure (as the foreign corporation – now owning only a passive interest in a U.S. corporation – no longer has U.S. business profits). This structure precludes use of the exemption from capital gains for non-ECI assets. This consequence can be minimal, based on the targeted type of investment. U.S. real property interests, which are automatically classified as ECI and subject to U.S. tax, are a common example.
Foreign nongrantor trusts provide an appealing option for many, but one with critical caveats. As a foreign-sitused taxpayer, the trust is subject to U.S. tax only on U.S.-sourced income. Long-term capital gains rates also apply to qualifying taxable income items, a benefit when compared to corporate ownership (though a benefit which has been reduced with the Tax Cuts and Jobs Act reduction in corporate tax rates). Detriments exist where beneficiaries are U.S. taxpayers – or (often importantly) where beneficiaries could become U.S. taxpayers in the future. Tax rates on ordinary income are also a drawback, at least when compared to corporate structures – nongrantor trusts can be taxed at rates up to 37%, with corporate income taxed at a non-graduated 21% rate.