U.S. Income Tax and Estate Tax Planning for Resident Aliens
U.S. FEDERAL INCOME TAX
Foreigner as U.S. Resident for Tax Purposes. If a foreigner is considered a U.S. resident for federal income tax purposes, he is subject to U.S. federal income taxation on his worldwide income. Generally, a foreigner is deemed to be a U.S. resident if he (1) becomes a U.S. citizen, (2) becomes a lawful permanent resident by obtaining a “green card,” or (3) meets the “substantial presence test” by being present in the U.S. (i) for at least 31 days during the calendar year, and (ii) for 183 days or more (determined by adding all the days of the current calendar year and 1/3 and 1/6 of the days of the first preceding calendar year and the second preceding calendar year, respectively). A person can avoid meeting the substantial presence test by staying in the U.S. for 121 days or less each year.
Exceptions to Substantial Presence Test. One exception is if a foreigner can establish that he has a closer connection to a foreign country. A foreigner can qualify for this exception if: (1) he was present in the U.S. for less than 183 days in the current calendar year; (2) he has a tax home in a foreign country; (3) he can establish that he has a closer connection to the same foreign country where his tax home is located; (4) he has not applied for a green card or taken any affirmative steps to obtain a green card; and (5) he files a Form 8840 with a Form 1040NR, his non-resident alien income tax return. The third element is a facts and circumstances test. Some of the facts that the IRS will consider are where the taxpayer votes, receives his health care, registers his vehicles, and operates his businesses. A foreigner’s income tax consequences may change if the U.S. has entered into an income tax treaty with the foreigner’s home country.
New laws have been passed in Puerto Rico, which has made Puerto Rico a tax haven for wealthy American investors. For example, Puerto Rico’s Export Services Act offers incentives to certain service businesses (including, investment and hedge fund managers) to relocate to Puerto Rico and export their services. The Act taxes corporate profits at a flat 4%, while making the dividends paid from profits on exported services to individual recipients exempt from tax. Also, unlike other tax havens, U.S. residents of Puerto Rico are still considered U.S. citizens even though they are subject to different tax laws. So, an American who moves to Puerto Rico does not have to renounce her citizenship or pay an exit tax when she moves to Puerto Rico.
U.S. FEDERAL ESTATE AND GIFT TAX
A foreign person is subject to U.S. federal transfer taxes if she is a domiciliary of the U.S. A foreign person is deemed a U.S. domiciliary for transfer tax purposes if she is physically present in the U.S. and intends to reside in the U.S. indefinitely.
U.S. domiciliary. If a U.S. domiciliary, the foreign person is subject to U.S. federal estate tax on her worldwide assets and U.S. federal gift tax on gratuitous transfers made during her lifetime.
Non-U.S. Domiciliary. If a foreign person is not deemed a U.S. domiciliary for transfer tax purposes, she is subject to transfer taxes on real property or tangible personal property located in the U.S. The foreign person only receives an exemption of $60,000 on death transfers. Because this exemption amount is low, modest estates can be subject to significant estate tax. A foreigner’s transfer tax exposure may change if the U.S. has entered into an estate or gift tax treaty with the foreigner’s home country.
While an estate may qualify for a marital deduction for federal estate tax purposes even if the surviving spouse is not a U.S. resident, the deduction is limited if the surviving spouse is not a U.S. citizen. The limitations are imposed to avoid the foreign surviving spouse (whose estate will not be subject to the U.S. estate tax unless she is a U.S. resident or owns property located in the U.S. at the time of her death) from removing property tax-free from the U.S.
Generally, a transfer to a surviving spouse that would otherwise qualify for the marital deduction is ineligible for the marital deduction if the spouse is not a citizen of the United States. Even if the surviving spouse is a resident of the U.S. at the time of her spouse’s death, the deduction is denied because the U.S. estate tax jurisdiction terminates if the spouse simply leaves the country after her husband’s death. Section 2040(b) is similarly inapplicable if the surviving spouse is not a U.S. citizen.
A marital deduction is, however, allowed for a transfer to a non-citizen spouse if the executor makes a timely QDOT election and the transfer satisfies one of the following conditions:
The transfer is to a qualified domestic trust (a “QDOT”);
The transfer is to a trust that does not meet all of the requirements for a QDOT, but the trust is reformed after the decedent’s death to meet the requirements of a QDOT;
The transfer goes directly to the surviving spouse, rather than in trust, and the surviving spouse either actually transfers the property to a QDOT or irrevocably assigns the property to a QDOT; or
The transfer is pursuant to a plan or other arrangement, payment under which is not assignable or transferable to a QDOT, if the transfer would have qualified for the marital deduction were the spouse a U.S. citizen and various other requirements are satisfied.
QDOTs which function strictly as a tax deferral mechanism. Whenever a principal distribution is made from a QDOT, the estate tax on the decedent’s estate is recomputed by increasing the taxable estate by the amount distributed, and, when the surviving spouse dies, a further recomputation is made by including the remaining assets of the QDOT in the decedent’s taxable estate. The increase in estate tax is payable when each recomputation is made. The taxes are imposed on the decedent’s estate, not the surviving spouse or the surviving spouse’s estate, which is in line with the basic purposes of the QDOT rules to avoid the practical difficulties of imposing and collecting tax on property distributed to a non-citizen spouse who may be outside the U.S.
A QDOT must satisfy the following requirements:
The trust instrument must require that at least one of trustees be a citizen of the United States or a domestic corporation (U.S. trustee);
Under the trust instrument, the U.S. trustee must have the right to withhold any estate tax imposed by the QDOT rules from any distribution from the trust (other than a distribution of income);
The trust must be maintained under the laws of a state of the United States or the District of Columbia, and the administration of the trust must be governed by the laws of such state or the District of Columbia;
The trust must be an “ordinary trust” and not, for example, a “business entity;
The executor must elect to have the trust treated as a QDOT; and
The trust must meet such requirements as Treasury “may by regulations prescribe to ensure the collection of” estate tax imposed under the QDOT rules.
A QDOT election must be made on the estate tax return, in accordance with the instructions to the Form 706. The election may be made on any return (including an amended return) filed before the due date (including extensions), but if no timely return is filed, it can only be made on the first return that is filed. The election can only be made for the entire trust, and, once the election is made, it is irrevocable.