Foreign Inheritance and Gift Tax Planning and Strategies

The IRS headline Aliens with any U.S. Assets Must File Estate Tax Returnsis shocking to their adult children.

And, it gets worse for those decedents owning foundations, foreign trusts, foreign companies, Stiftung, and Anstalts.   The heirs could owe the IRS both estate taxes and income taxes on their inheritance.

The label of the entity (such as trust) does not decide the entities IRS tax classification.     An entity labeled a “trust” can be classified for tax law a corporation.  Similarly, a foreign corporation can be categorized by the IRS as a trust.

Suzan’s father is a French citizen.  When he passed away, he was residing in Spain.  To avoid French and Spain taxes, he formed a Panama foundation.  In our telephone calls, Suzan labeled the foundation as a Panama trust.

As you expect, U.S. taxation of a foreign trust is very different from a foreign corporation.  Two factors differentiate corporations from trusts.  They are:
(1) the presence of associates; and
(2) the objective to carry on business and divide the gains.

One court case held that term “associates” does not mean plural.  The court held that a trust with a single beneficiary has associates.   Because of this case, the IRS seems to be focusing on the objective to carry on business.   An IRS legal opinion, on this link, highlights this.

Focusing on the concept of carrying on business, started almost a century ago. At the beginning of last century, doctors ran their medical practices using Massachusetts business trust.  These trusts were (and are) taxed as corporations.

Suzan wanted to know if she would owe U.S. taxes when the Panama foundation was liquidated and she received her share.   Two facts need to be known.  First, did the foundation distribute all of its income to Suzan father?  If so, then Susan will not owe U.S. income taxes upon the liquidation of the foundation.

The reason is that the foundation (taxed as a trust or a corporation) must have income accumulated and retained for Suzan to have income.   A foreign trust would tax Suzan using a tax law called the “throwback rule”.

Corporate taxation is very different.  A distribution out of retained earnings is a taxable dividend.  In some cases, (and not discussed on this blog), the complete liquidation could be tax-free.

 Lastly, if the foreign corporation owned mostly investments, the completed liquidation could be taxable (this is called a “passive foreign investment company”).

Suzan has one more inheritance tax problem.  The foundation owned shares of corporations on the U.S. stock exchanges.  Her dad was the primary beneficiary and had the right to the income and other distributions.  Because he could enjoy the income, U.S. tax code section 2036 requires her dad’s foundation to file an IRS Form 706NA and pay estate taxes.  The foundation reduces the value of its assets by a $60,000 (Americans have almost $5.5 million reductions).

For example, the foundation has $2,000,000 of assets.  Half are U.S. stocks, and half are foreign stocks.   The taxable U.S. estate is $970,000.  The $1,000,000 is less one-half of the $60,000.  This equal $970,000.

Suzan is responsible for all of the estate taxes as a “transferee” from the foundation.  Suzan will report the inheritance on Form 3520.

U.S.  ASSETS

U.S. property includes real estate located in the U.S,  promissory notes due from an American, tangible personal property and stocks and bond of U.S. companies.

A foreign person’s stock ownership of U.S.  companies is subject to estate taxation despite the aliens holding the share certificates abroad or in the name of a nominee.

Exempt Assets:  Some assets that are exempt from U.S. estate tax include bonds that generate portfolio interest, bank accounts not used in connection with a trade or business in the U.S., and insurance proceeds.

The U.S. has estate tax treaties with a few other countries.  The treaties provide more favorable tax treatment.  They limit the type of asset subject to U.S. estate taxation. Executors for nonresident estates should consult such treaties where applicable.

Foreign Gifts Increases the Amount of Estate Taxes for the Non-resident Alien

When the non-resident alien decedent made substantial lifetime gifts of U.S. property, a U.S. estate tax return is required even when the value of the decedent’s U.S. property is less than $60,000 at the date of death.

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