Taxation of the Estate of Nonresidents under U.S. Domestic Law

Taxation of the Estate of Nonresidents under U.S. Domestic Law

Deceased nonresidents who were not American citizens are subject to U.S. estate taxation with respect to their U.S.-situated assets. This article analyzes the tests used by the I.R.S. to determine the residence status for purposes of the U.S. federal estate tax and outlines the special tax rules for the estate of a nonresident alien`s estate.

U.S. Federal Estate Tax under U.S. Domestic laws

IRC § 2101 imposes a tax on the transfer of the taxable estate of a nonresident who is not a citizen of the U.S. at the time of death. The tax is computed at the same rates as the tax that is imposed on the transfer of the taxable estate of a citizen or resident of the U.S. However, some special rules apply with regard to some aspects, including 

Domicile

Under the estate tax regulations, a “resident” decedent is a decedent who, at the time of his death, had his domicile in the U.S. See Treas. Regs. (26 C.F.R.) §20.0-1(b)(1)

The domicile test is fact based and extremely subjective. The goal of the test is to characterize persons as domiciled in the U.S. when that individual enters the U.S. with no present intention of later leaving. As these taxes are typically applied to deceased individuals, practitioners, courts and I.R.S. representatives are left to determine from whatever limited evidence remains whether the individual was domiciled in the U.S. at the time of death. The test is factually based and considers many factors, however, none of the factors are determinative and the weight each factor receives is unclear. The factors include:

  • the length of time spent in the U.S. and abroad and the amount of travel to and from the U.S. and between other countries;
  • the value, size, and locations of the donor’s or decedent’s homes and whether he or she owned or rented them;
  • whether the alien spends time in a locale due to poor health, for pleasure, to avoid political problems in another country, etc.;
  • the situs of valuable or meaningful tangible personal property;
  • where the alien’s close friends and family are situated;
  • the locales in which the alien has religious and social affiliations or in which he or she partakes in civic affairs;
  • the locales in which the alien’s business interests are situated;
  • visa status;
  • the places where the alien states that he or she resides in legal documents;
  • the jurisdiction where the alien is registered to vote;
  • the jurisdiction that issued the alien’s driver’s license; and
  • the alien’s Income tax filing  status.

Please note: The I.R.S utilizes somewhat different tests to determine residency for income tax purposes. Such tests include the “substantial presence test” or “Green Card test”. (See IRC §7701(b)) Accordingly, an individual could be deemed a resident for purposes of the estate tax under the extremely subjective domicile test while characterized as a non-resident for income tax purposes based on the more rigid “substantial presence test”.

Assets of a Non-Resident`s Estate subject to U.S. Federal Estate Tax

If the decedent was a non-resident alien, only U.S. situs assets are subject to U.S. federal estate tax. See IRC § 2103.

U.S. situs property includes:

  • real property and other tangible personal property physically located in the U.S.
  • Shares in U.S. corporations (IRC §2104);
  • Transfers of U.S. situs property made within 3 years of death (IRC §2104(b)); and
  • Debt obligations issued by a person, institution or government (federal, state or municipal) of the United States (IRC §2104(c)).

Some intangible assets are exempt from inclusion in the non-resident alien`s estate, including:

  • Life insurance death benefits paid on the death of a non-resident alien (IRC §2105(a)).
  • Bank deposits and money earning interest held by life insurance companies, where the interest earned is not effectively connected with a trade or business carried on in the U.S. (IRC §2105(b))

Deductions of Debts

A nonresident alien`s estate benefits from limited deductions that include a portion of the expenses, losses, indebtedness, and taxes set forth in IRC §§ 2053 and 2054. These deductions are limited to funeral and administration expenses, claims against the estate, mortgages on, and indebtedness with respect to, property included in gross estate, and uninsured casualty losses suffered by the estate. The deductible portion of the expenses is determined by multiplying the expenses by a fraction, the numerator of which is the value of gross estate situated in the United States, and the denominator of which is the value of all property, wherever situated, included in the gross estate.

Whether the deductible amounts were incurred in the U.S. is irrelevant for purposes of the deduction. Thus, a property note secured by a mortgage on U.S. situs property is only partially deductible, despite the fact that the market value of mortgaged property is included in full.  However, this unusual application is qualified by the fact that if the property is subject to a mortgage as to which the mortgagor has no personal liability, only the value of the property less the mortgage or indebtedness is included in the gross estate, thereby effectively resulting in a deduction for 100% of the mortgage.

Please note: A property note secured by a mortgage on U.S. situs property is only partially deductible, despite the fact that the market value of mortgaged property is included in full.

Estate Tax Credits

The estate of a nonresident alien receives a minimal credit of only $10,000 (indexed for inflation) against the U.S. federal estate tax, which is effectively the equivalent of a $60,000 exemption. 

Marital Exemption

The estate of a nonresident alien may deduct from the gross estate the value of property passing to the decedent’s surviving spouse, to the same extent that as the estate of a resident alien or U.S. citizen.  Accordingly, the U.S. citizen spouse of a nonresident alien will trigger the marital deduction if all of the requirements of IRC § 2056 (covering bequests to surviving spouse) are satisfied.

Should the surviving spouse not be a U.S. citizen (regardless of U.S. residency), as with the estate of a resident alien or U.S. citizen, in order for the estate of the nonresident alien to take advantage of the marital deduction, the provisions of IRC § 2056(d) must be satisfied. Specifically, IRC § 2056(d) provides that a bequest to a surviving spouse will not qualify for the marital deduction unless the property is held in a qualified domestic trust (QDT), as provided in IRC § 2056A, or unless the surviving spouse becomes a U.S. citizen within a specified period of time after the decedent’s death. In addition, the gift tax marital deduction is generally not allowed for property passing to a spouse who is not a U.S. citizen, save for the fact  that a donor can give his or her non-U.S. citizen spouse up to $100,000 per year (indexed for inflation) without the imposition of any gift tax.

Please note: Other jurisdictions (e.g. Germany) have unfavorable taxation rules for a transfer to a QDT. The estate planning attorney therefore should not make the QDT election unless this has been discussed with an estate planning lawyer from the other jurisdictions to which the matter has a nexus.  

Special Rules Applicable to Gifts or Bequests from Covered Expatriates

U.S. citizens and long-term residents who relinquished their U.S. citizenship or ceased to be U.S. lawful permanent residents (green card holders) and who meet specific average tax or net worth thresholds on the day prior to their expatriation are considered “covered expatriates” – subject to IRC § 877A.

U.S. citizens and residents who receive gifts or bequests from covered expatriates under IRC 877A may be subject to tax under new IRC § 2801.

In addition, covered expatriates under IRC § 877A are not considered U.S. expatriates for U.S. federal estate tax purposes. 

Application of the Germany-U.S. Estate and Gift Tax Treaty

The Germany-U.S. Estate and Gift Tax Treaty (“Treaty”) reduces and/or eliminates the harsh treatment of NRAs as discussed above by providing additional deductions and tax relief. The Treaty defines “domicile” in order to avoid some of the subjectivity that is an inherent aspect of the IRC test. Further, the Treaty defines the assets that can be subject to taxation by the two member States. Importantly, the Treaty provides additional tax relief in the form of a higher unified tax credit and the ability to deduct expenses which would otherwise be disallowed. Accordingly, individuals who benefit from the Treaty (e.g. U.S. citizens/German domicilaries) are in a superior position to the NRAs who do not benefit from the Treaty. For additional information on the Treaty, please refer to our article entitled U.S. Federal Estate Tax on the U.S. Estate of German Citizen resident in Germany

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