By Anthony Diosdi
For an individual not domiciled in the United States, the gross estate subject to the estate tax consists of tangible and intangible assets located in the United States. Except as discussed below, a nonresident’s (for purposes of this article, the term “nonresident” refers to an individual not domiciled in the United States) gross estate is composed similar to that of a U.S. resident’s estate for purposes of the estate tax. That is, a nonresident’s gross estate for estate tax purposes consists of revocable transfers, transfers taking effect on death, transfers of a retained life interest and in some cases, transfers of U.S. situs property within three years of death are includible in the gross estate of estate tax purposes. With respect to jointly held property between spouses, a different rule applies to nonresidents.
The gross estate of a nonresident includes the value of all U.S. situs property which the decedent and another held as joint tenants with rights of survivorship (“jointly held property”) to the extent that the surviving joint owner cannot prove the property originally belonged to the survivor or was acquired by the survivor from the decedent for adequate and full consideration in money or money’s worth.
Internal Revenue Code Section 2040(a) includes the entire value of the joint tenancy property in the nonresident decedent’s gross estate if the survivor cannot prove contribution, even though immediately prior to the decedent’s death the decedent’s interest, under state property law, was limiteds to one-half of the property. Section 2040(a) applies to all forms of jointly held property, including interests in real estate, securities, and bank accounts, irrespective of when the interests were created.
The principal source of dispute with the Internal Revenue Service or “IRS” under Section 2040(a) concerns the amount to be included in the gross estate of the joint tenant that dies first for purposes of the estate tax. This article discusses how jointly held property held by nonresidents is taxed for purposes of the estate tax. We will begin this discussion with an explanation of the differences as to how a U.S. resident is subject to the estate tax compared to a nonresident (that is not domiciled in the U.S.).
The Tax Cut and Jobs Act of 2017 currently excludes $12.92 million of assets from estate and gift taxes of a U.S. citizen or resident from the federal estate and gift tax. The way the estate tax is computed on the gross estate of a decedent which includes “the value at the time of his death of all property, real or personal, tangible or intangible, wherever situated.” See IRC Section 2031. After the taxable estate has been determined by subtracting deductions from the gross estate, the tax is determined by applying the rates and computation method of Internal Revenue Code Section 2001 to the base: the taxable estate. The estate tax is payable by the executor of the estate. Estate and gift (gift taxes will be discussed in more detail below) taxes the two parts of a “unified” transfer tax system. Currently, the top estate and gift tax rate is 40 percent. The “unified credit” (sometimes known as the “estate tax credit” or “gift tax credit,” as the case may be) allows an individual to make certain amounts of taxable transfers free of the transfer tax. This amount is currently $12.92 million per individual.
Gift tax is a companion to the estate tax. Contrary to common misconception, the transfer of an asset as a gift does not subject the donor or recipient to income tax liability. However, a donor (a person who makes a gift during his lifetime is called a “donor”) of property may recognize gift tax liability after the allowance of certain exclusions and deductions. Gift tax rates are cumulative based on how much the donor has given away. Like the estate tax, the current top rate is 40 percent.
The Internal Revenue Code permits an individual to disburse up to $17,000 worth of assets every year to as many people as he likes, gift-tax free without reporting the transfer. Under the annual exclusion, a U.S. person may exclude from “the total amount of gift” for a calendar year (the starting point of taxable gifts) gifts up to $17,000 to an individual or as many individuals as she wishes. To illustrate, an individual could make $17,000 gifts to every person in San Francisco during the current calendar year without incurring a gift tax. However, any gift that exceeds the annual exclusion is considered a taxable gift, and must be netted against a taxpayer’s lifetime exclusion (currently $12.92 million). If several gifts are made to the same donee in the same year, only $17,000 of exclusion is available, but applies to the total gifts to that donee which exceeds $17,000 should be reported to the Internal Revenue Service or “IRS” on Form 706 (the regular gift tax return form).
Whether an individual who transfers anything above this “annual exclusion” will owe any gift tax on the transfer depends on whether he or she has used up her lifetime exemption. As discussed above, currently, the lifetime exemption is $12.92 million.
The Computation of the Federal Estate Tax Computation is Different for Nonresidents
The U.S. estate and gift tax is applied differently to nonresidents aliens. For U.S. federal estate and gift tax purposes, the term “residency” means “domicile.” While the U.S. federal income tax concept of residency relates only to physical presence in a place for more than a transitory period of time, domicile relates to a permanent place of abode. For U.S. federal estate tax purposes a person can have only one place of domicile, while for U.S. federal income tax purposes there may be more than one place of residence. While an alien may be classified as a permanent resident alien for immigration purposes and treated as a resident alien for U.S. federal income tax purposes, these classifications are not determinative of the alien’s domicile for U.S. federal estate and gift tax purposes. Although the definition of residency for income tax purposes is well defined in the Internal Revenue Code and its regulations, the concept of domicile is subjective. The estate and gift tax regulations offer the only indication as to the definition of domicile for estate and gift tax purposes.
“a person acquires a domicile in a place by living there, even for a brief period of time, with no definite present intention of later removing therefrom. Residence without the requisite intention to remain indefinitely will not suffice to constitute domicile, nor will intention to change domicile effect such a change unless accompanied by actual removal.” See Treas. Reg. Section 20.0-1(b)(1) and 25.2501-1(b).
According to the regulations, to be domiciled in the United States for estate and gift taxes, physical presence must be coupled with the requisite intent to remain indefinitely or permanently, or at least abandon the old domicile. In cases where domicile is not entirely clear, the IRS looks at the following factors to determine the domicile of an alien for estate and gift tax purposes:
1. The duration of stay in the United States and in other countries, and the frequency of travel both between the United States and other countries;
2. The size, cost and nature of the decedent’s houses or other dwelling and whether those places are owned or rented;
3. The location of important personal possessions;
4. The location of family and close friends;
5. The places where church and club memberships are maintained;
6. Declarations of residency or intent made in visa applications or re-entry permits, wills, deeds of gift, trust instruments or letters, or in oral statements;
7. The use of a locally issued or international driver’s license;
8. The location of an individual’s investment assets;
9. The individual’s mailing address;
10. The location of the individual’s business interests;
The gross estate for purposes of determining the estate tax differs from that of a U.S. citizen or resident. For a nonresident alien not domiciled in the U.S., the gross estate under Internal Revenue Code is limited to his or her U.S. gross estate. Thus, the estate tax is limited to U.S. situs property at either the time of the transfer or the time of his or her death. See IRC Section 2104(b). Situs is determined by the physical location of the property. U.S. gift tax for nonresident aliens applies only to the transfer of tangible property (real property and tangible personal property, including currency) physically located in the United States at the time of the gift. Unlike for U.S. citizens and residents who are entitled to exclude $12.92 from the estate and gift tax, nonresident aliens are only entitled to claim a unified credit of $13,000, equivalent to a $60,000 exemption, unless an applicable estate and/or gift tax treaty allows a greater credit.
Section 2040. The Estate Taxation of Joint Interests of Nonresidents
As discussed above, U.S. situs property of a nonresident is included in his or her estate for purposes of the estate tax. Section 2040(a) of the Internal Revenue Code includes in a nonresident decedent’s gross estate the value of jointly owned property, except to the extent that the surviving tenant or tenants contributed to the cost of the acquisition of the property. The general effect of this policy is to treat property owned jointly by the nonresident decedent and another as if it were owned outright by the one who was financially responsible for its acquisition. In other words, if the decedent furnished the entire consideration for the purchase price of the jointly held property and capital additions, then under Section 2040(a) the entire value thereof at the decedent’s death is included in the gross estate. On the other hand, if the non-contributing joint tenant dies first and the survivor can prove he or she was the sole contributor to the acquisition of the property, nothing is included in the gross estate of the first joint tenant to die.
If the nonresident decedent and the survivor each contributed to the purchase price of the jointly held property, only a proportionate part of the property is included in the gross estate of the first joint tenant to die. In determining the amount to be excluded, the regulations provide the portion to be excluded is determined by the following ratio:
|Survivor’s contribution not|
|X (Amount excluded)||attributable to decedent|
|Value of jointly held property||Total cost of acquisition and capital |
It is important to note that the ratio obtained is applied to the value of the property at the date of death or the alternative valuation date.
It must be emphasized, however, that the nonresident survivor must prove contribution to the jointly held property. Unfortunately, the exclusionary rules of Section 2040(a) inject into the statute an irksome tracing problem. Section 2040(a) specifically disregards any contribution toward the acquisition of jointly held property by the surviving tenant out of property gratuitously acquired from the nonresident decedent. The main thrust of the statute is that only contributions from separate funds of the survivor are taken into account under the exclusionary rules. Section 2040 adopts a tracing rule by requiring a determination whether a contribution to the purchase price by the surviving tenant was from the surviving tenant’s own funds. More precisely, the statute says the consideration provided by the survivor must never have been “acquired….from the decedent for less than adequate and full consideration in money or money’s worth.” The burden of showing contribution to the purchase price by the survivor falls upon the estate. Section 2040(a) specifically requires inclusion of the entire value of jointly held property.
This can be a difficult burden. The estate of a nonresident decedent may be called upon through records, memorandum, and other documentary evidence to establish the time at which the respective contributions to the property took place. As in most areas of tax controversy, inadequacy of records usually works to the disadvantage of the individual attempting to claim a beneficial position with the IRS.
In addition to establishing the respective contributions to the initial cost of acquisition, it may be necessary to take account of amounts subsequently contributed. The regulations state that the total cost of acquisition includes the cost of “capital additions.” See Treas. Reg. Section 20.2040-1(a)(2). For example, assume that D and A each contribute $100 to the purchase of unimproved real estate, taking title in the name of D and A as joint tenants. Assume that the property appreciates over time to a value of $1,100. If D then makes a capital improvement at a cost to him of $100 and thereafter dies, how much is includable in his gross estate?
Applying the exclusionary rules of Section 2040(a), D should be treated as having contributed the following sums: $100 (his share of the original cost), $450 (one half of the appreciation from the time of acquisition until the time of improvement), and $100 (his share of the original cost), and $450 (one half of the pre-improvement appreciation), for a total of $550. The total cost of acquisition should be treated as $1,200 (fair market value after the improvement) for purposes of the exclusionary rule. Thus, the amount to be excluded from D’s estate may potentially be 550/1200 multiplied by $2,400, or $1,100 (the portion of date-of-death value commensurate with the survivor’s contribution to total cost), as a result of A’s “contribution,” and only $1,300 may potentially be included in the taxable gross estate. See Estate of Peters v. Commissioner, 386 F.2d 404 (4th Cir. 1967).
The rules discussed above do not typically apply to U.S. citizens. For purposes of the estate tax, U.S. citizens typically take advantage of so-called “qualified joint tenancies.” A qualified joint tenancy is a property interest held by the decedent and the decedent’s spouse as either joint tenancy or as tenants by the entirety. See IRC Section 2040(b)(2). In the case of a qualified joint tenancy, one half the value of the property is included in the gross estate of the joint tenant to die. See IRC Section 2040(b)(1).
There is one exception to the Section 2040(b) rules. Concerned about collecting tax revenues from a surviving spouse who is not a U.S. citizen, Congress has generally made the Section 2040(b) rule inapplicable where the surviving spouse is not a U.S. citizen. See IRC Section 2056(d)(1)(B). Thus, with respect to a joint tenancy held only by spouses or a tenancy by the entirety where the surviving spouse is a noncitizen, the above discussed Section 2040(a) tracing rules generally apply.
Furthermore, the estates of nonresidents are generally not entitled to a marital deduction for U.S. estate tax purposes other than for property passing to a qualified domestic trust or a surviving spouse that is a U.S. citizen. With that said, sometimes a nonresident can take advantage of an unlimited or limited marital deduction contained in an estate and gift tax treaty to avoid an estate tax consequence upon the passing of a spouse. Unless a nonresident can take advantage of such a treaty position, foreign residents holding real property jointly should seriously consider the estate tax consequences to holding U.S. situs property jointly and plan accordingly, as early as possible.
We have substantial experience advising clients ranging from small entrepreneurs to major multinational corporations in foreign tax planning and compliance. We have also provided assistance to many accounting and law firms (both large and small) in all areas of international taxation.
Anthony Diosdi is one of several tax attorneys and international tax attorneys at Diosdi Ching & Liu, LLP. Anthony focuses his practice on domestic and international tax planning for multinational companies, closely held businesses, and individuals. Anthony has written numerous articles on international tax planning and frequently provides continuing educational programs to other tax professionals.
He has assisted companies with a number of international tax issues, including Subpart F, GILTI, and FDII planning, foreign tax credit planning, and tax-efficient cash repatriation strategies. Anthony also regularly advises foreign individuals on tax efficient mechanisms for doing business in the United States, investing in U.S. real estate, and pre-immigration planning. Anthony is a member of the California and Florida bars. He can be reached at 415-318-3990 or firstname.lastname@example.org.
This article is not legal or tax advice. If you are in need of legal or tax advice, you should immediately consult a licensed attorney.