Estate and Gift Tax for Foreign Investors

We have significant experience in providing tax planning advice to foreign investors.

Foreign investors generally have the same goal of minimizing their tax liabilities from their U.S. real estate and other U.S. investments, as do their U.S. counterparts, although their objective is complicated by the very fact that they are not domiciled in the U.S. The U.S. has a special estate and gift tax regime that is applicable to foreign investors that are not domiciled in the U.S. This article summarizes the basic estate and gift tax issues that affect foreign investors investing in the U.S. This article also discusses international tax planning opportunities that may be available to individuals that are not-U.S. citizens.

An Overview of the Estate and Gift Tax for Foreign Investors

U.S. federal law imposes a transfer tax upon the privilege of transferring property by gift, bequest, or inheritance. During an individual’s lifetime, this transfer tax takes the form of a gift tax. For gift tax purposes, a gift is defined as the transfer of property for less than adequate and full consideration in money or money’s worth, other than a transfer in the “ordinary course of business.” No U.S. gift tax would be owed on a gift to a beneficiary until the gifts made to the beneficiary in a calendar year exceed an applicable exclusion amount for that year ($18,000 for calendar year 2024). Upon an individual’s death, the tax takes the form of an estate tax. The tax is measured against a tax base that includes all the assets owned at death.

The U.S. estate and gift tax is assessed at a rate of 18 to 40 percent of the value of an estate or gift. A unified credit is available to minimize the impact of the transfer tax. The unified credit gives a set dollar amount that an individual can gift during their lifetime and pass on to the beneficiaries before a gift or estate tax applies. U.S. citizens and resident individuals are permitted a unified credit that exempt $13.61 million (for the 2024 calendar year) to their heirs without being assessed a gift or estate tax. The unified credit is significantly smaller for foreign individuals that are not domiciled in the U.S. The current unified credit for non-domiciliaries is equivalent to a $60,000 exemption, unless an applicable treaty allows a greater credit. In addition to its smaller size, the unified credit available to non-U.S. citizens and non-U.S. domiciliaries cannot be used to reduce their U.S. gift tax. The credit can only be used by their estates upon their deaths to reduce U.S. estate tax.

There are also significant differences as to how the estate and gift tax is calculated for individuals domiciled in the U.S. compared to individuals not domiciled in the U.S. The worldwide estate of a decedent is subject to U.S. estate tax only if the individual was either a U.S. citizen or resident at the time of death. In contrast, the estate of a non-U.S. citizen not domiciled in the U.S. is subject to estate tax solely on his or her U.S. situs assets. Similarly, all property gifted by a U.S. citizen or domiciliary is subject to U.S. gift tax regardless of where the property is situated. However, in the case of a donor who is neither a U.S. person nor a U.S. domiciliary, only gifts or real property or tangible personal property situated in the U.S. are subject to U.S. gift tax.

Determining Domicile for U.S. Estate and Gift Tax

Because individuals domiciled in the U.S. are permitted a unified credit of $13.61 million, for most U.S. citizens, the estate and gift tax is not an issue. This situation is different for foreign persons who are not domiciled in the U.S. Instead of a unified credit that would shelter up to $13.61 million in lifetime gifts, individuals not domiciled in the U.S. are only provided a credit equivalent to an exemption of just $60,000 against the estate tax. Given the differences in the way the U.S. estate and gift tax is calculated, it is crucial to understand when an individual can be classified as being domiciled in the United States. An individual is presumed to have a foreign domicile until such domicile is shown to have changed to a U.S. domicile. A person acquires a U.S. domicile by living in the United States, potentially even for a brief period of time, with no definite present intention of leaving. To be domiciled in the United States, for estate and gift tax purposes, an individual must be physically present in the U.S. coupled with the intent to remain in the U.S. indefinitely or permanently. For U.S. estate and gift tax purposes, an individual can be domiciled in one country. The term “domicile” for estate and gift tax purposes should not be confused with the terms “resident” or “residence” used in the income tax context. A foreign investor may be characterized as a resident of the U.S. for income tax purposes through either the green card test or substantial presence test. Just because a foreign person is classified as a U.S. resident for U.S. federal income tax purposes, does not mean the individual is domiciled in the U.S. for estate and gift tax purposes.

How the Estate Tax and Gift Tax is Computed for a Decedent Not Domiciled in the U.S.

The estate tax for a decedent that was not domiciled in the U.S. is only assessed on its gross estate. The gross estate is made up of property or assets situated in one of the U.S. states or the District of Columbia at the time of death. This is often referred to as U.S. situs assets or property. The gross estate is composed of revocable transfers taking effect at death, transfers with retained life interest, or (to a limited extent) transfers within three years of death are includible in the U.S. gross estate if the subject property was U.S. situs property at either the time of the transfer or the time of death. In the case of corporate stock, the stock of a U.S. is U.S. situs and stock of a foreign corporation is foreign situs, regardless of place of management or location of stock certificates.

The rules for determining gift tax for an individual not domiciled in the U.S. differ from the estate tax. As a general rule, the gift tax applies only if the transfers of tangible property (real property and tangible personal property, including currency) are physically located in the United States at the time of the gift. The gift tax does not apply to intangible property such as stock in U.S. or foreign corporations even though such property may be includible in the U.S. gross estate for federal estate tax purposes. Since the gift tax is not assessed on the transfer of securities, non-domiciliaries often transfer securities prior to death for planning purposes.

Overview of Structuring Alternatives to Hold U.S. Real Property or U.S. Businesses for Estate and Gift Tax Planning

We will now discuss various ways foreign investors who are not domiciled in the U.S. may hold U.S. assets. In particular, this article will look at the estate and gift tax consequences of holding U.S. assets in a corporate structure, partnership, or trust. We will begin by examining the estate and gift tax consequences of the foreign investor directly holding a U.S. asset. The simplest estate and gift tax planning option available to a foreign investor is to own real property or business directly and sell the asset before he or she dies. In many cases, this type of planning is not realistic due to the fact it is impossible to predict one’s demise. However, in some cases direct ownership of U.S. assets by a non-U.S. domiciliary may be appropriate because of the availability of an estate tax and gift treaty.

Planning opportunities may also be available to non-U.S. domiciliaries that wish to directly hold U.S. real estate through the portfolio debt rules. Properly structured, the value of loan subject to the portfolio debt will be fully deductible from the taxable estate of a foreign investor. As a result, the portfolio debt rules may permit individuals not domiciled in the U.S. to reduce or eliminate equity in the real property through financing. The portfolio debt rules may also eliminate U.S. withholding on any interest payments associated with the financing. As a general matter, the U.S. imposes a 30 percent withholding tax on U.S. sourced payments of interest to foreign persons if such interest income is not effectively connected with a U.S. trade or business of the payee. Interest paid to a foreign person or persons with respect to a “portfolio debt instrument” is not subject to the 30 percent withholding rules. Portfolio debt can be a very useful tool in inbound estate and gift planning. There are however three important exceptions to the portfolio debt rules. First, the portfolio debt rules do not apply to interest paid to a bank. Second, portfolio debt cannot be paid to a “10 percent shareholder.” Under this rule, if the borrower is a corporation, the 10 percent shareholder rule provides that the recipient of the interest does not own 10 percent or more of the combined voting power of all classes of the stock of such corporation. When the borrower is a partnership (or an LLC taxed as a partnership), the 10 percent shareholder requirement is measured by capital or profits interest. Third, the portfolio debt rules prohibit payments of interest to controlled foreign corporations or CFCs that are considered related parties. Finally, Section 163(j) can potentially apply to limit deductions of interest payments on portfolio debt loans.

Holding U.S. Assets through a Foreign Corporation

Historically, foreign investors have made their direct investments in the U.S. principally through corporate ownership structures. Frequently, a foreign corporation was used as either the direct investment owner or as a holding company for a U.S. subsidiary (which, in turn, owned the direct U.S. real property). Individual foreign investors have frequently preferred use of corporate structures to avoid the U.S. estate and gift tax. Holding U.S. property through a foreign corporation will typically enable the foreign investor to avoid U.S. estate and gift tax because shares in a foreign corporation are not U.S. situs assets. However, there are significant U.S. income tax consequences with investing in the U.S. real estate through a foreign corporation.

In many cases, the direct ownership of U.S. businesses or U.S. real estate is not advisable because of the branch profits tax. The branch profits tax specifically treats the deemed repatriation of already taxed profits from the United States by a foreign corporation as an occasion to impose a second tax under Section 884 of the Internal Revenue Code. Internal Revenue Code Section 884 describes this second tax as the “dividend equivalent amount” of the “effectively connected earnings and profits” with certain adjustments. The branch profits tax is intended to be the functional equivalent of earnings distributed as dividends by a subsidiary either out of current earnings not invested in subsidiary assets or out of accumulated earnings withdrawn from such investment. The branch profits tax imposes a tax equal to 30 percent of a foreign corporation’s dividend equivalent amount for the taxable year. The “dividend equivalent amount” is defined as the earnings and profits from the effectively connected taxable income for the year. The “dividend equivalent amount” includes the gain from the sale of U.S. real property or a business. In other words, gains on U.S. assets held by foreign corporations are not taxed at favorable capital gains rates. Gains on U.S. assets such as real estate or businesses are typically taxed at the 30 percent branch profits tax rate.

In some limited cases, the branch profits tax typically will be reduced or are inapplicable if the foreign investor is from a favorable U.S. treaty country and the foreign investor utilizes a home-country/treaty company. A careful review of applicable income tax treaties should be done to determine if the branch profits tax can be reduced or eliminated through an income tax treaty. If a foreign investor is from a favorable U.S. treaty jurisdiction and the foreign investor is prepared to utilize a home-country/treaty company, then the use of such a company to directly own the U.S. real estate or business usually will produce the best overall U.S. tax results.

In many cases, foreign corporations or the shareholders of foreign corporations are subject to a second 30 percent tax on “FDAP” income. Most forms of U.S.-source income received by a foreign corporation not effectively connected with a U.S. trade or business will be subject to a flat tax of 30 percent on the gross amount of the income received. The term “trade or business” is used throughout the Internal Revenue Code in many different contexts. Regardless of the consequences of its application, the term is always employed to describe the process of producing or seeking to produce income from actively engaging in business activities, as distinguished from merely owning income-producing property. Under the FDAP rules, any passive income received by a foreign corporation such as income received from rents or investment income could be subject to a 30 percent flat tax. Special withholding rules also apply to foreign corporations that hold U.S. real property interests under Section 897 of the Internal Revenue Code.

A foreign corporate structure should never be utilized as part of an estate plan in any case where there are U.S. beneficiaries. This is because a U.S. beneficiary may receive shares of a foreign corporation that will either become a CFC if one or more U.S. persons constructively, indirectly or directly owns 10-percent or more of the shares of the entity or a passive foreign investment company or PFIC.

Holding U.S. Assets through a Domestic Corporation

Given the disadvantages of placing U.S. assets in a foreign corporation, foreign investors may consider contributing U.S. assets to a domestic corporation. There are a number of other income tax consequences that must be considered before placing a U.S. asset into a domestic corporation. This is particularly the case when U.S. real estate is transferred to a domestic corporation. If a foreign investor is a shareholder of a domestic corporation and makes use of the real property held by the domestic corporation for personal reasons, the IRS may impute taxable rental income from the domestic corporation to the foreign investor. If the real property placed into the domestic corporation is a primary residence, and if the real property increases in value, the appreciation will not qualify for a Section 121 exemption. As a result, any increase in the value of real property held as a primary residence will be taxed at the corporate level. A second layer of tax will be assessed at the shareholder level as FDAP income potentially subject to the 30 percent flat tax.

Sometimes foreign investors will place real property into a domestic corporation to avoid the FIRPTA withholding rules. To ensure collection of FIRPTA tax, acquiring a U.S. real property interest must deduct and withhold a tax equal to 15 percent of the amount realized on the disposition. Section 897 imposes FIRPTA withholding on real estate placed in a domestic corporation. Section 897 provides that the tax on real property gains will apply to the sale of stock in U.S. corporations that hold 50 percent or more of specified assets in the form of U.S. real property.

In certain cases, a domestic corporation can be an effective tool for estate and gift tax planning. Recall that the U.S. federal gift tax applies to non-domiciliaries when they make transfers of tangible property physically located in the U.S. at the time of the gift. Thus, the gift tax may not apply when domestic stocks are transferred through a gift.
The consequence of the death of the foreign owner depends on the structure of the ownership of the domestic corporation. If a non-domiciliary directly owns shares of a domestic corporation, the domestic corporate shares will be subject to the U.S. estate tax. This is because stock in the domestic corporation has a U.S. situs for estate tax purposes. In some cases, shares of domestic stock holding U.S. assets can avoid the U.S. estate tax as a result of a treaty.

Holding U.S. Real Property through a Multi-Tiered Blocker Structure

Many non-domiciliaries investing in U.S. real property are advised to hold property through multi-tiered structures. These multi-tiered corporate blocker structures typically consist of U.S. corporations which in turn are owned by foreign corporations. Individuals not domiciled in the U.S. are sometimes led to believe that multi-tiered corporate structures can be utilized to avoid the U.S. estate and gift tax. Prior to 2004, multi-tiered corporate structures could be utilized to protect foreign investors from the U.S. federal estate and gift tax.This is no longer the case.

All this was possible because prior to 2004, a U.S. corporation was able to reincorporate in a foreign jurisdiction and thereby replace the U.S. parent corporation with a foreign parent corporation. These transactions were commonly referred to as asset inversion transactions. In asset inversions, a U.S. corporation generally recognized gain (but not loss) under Section 367(a) of the Internal Revenue Code as though it had sold all of its assets, but the shareholders generally did not recognize gain or loss, assuming the transaction met the requirements of a reorganization under Section 368. To remove the incentive to engage in corporate inversion transactions, Congress included several provisions in the 2004 JOBS Act aimed at corporate inversions. One of these provisions was Section 7874 to the Internal Revenue Code.

The anti-inversion rules are designed to prevent corporate inversions by providing different methods of taxation depending on whether the former U.S. shareholders own at least 80 percent of the new foreign corporation or at least 60 percent (but less than 80 percent) of the shares of a new foreign corporation.

The anti-inversion rules apply if pursuant to a plan or series of related transactions: (1) a U.S. corporation becomes a subsidiary of a foreign-incorporated entity or otherwise transfers substantially all of its properties to such an entity in a translation; (2) the former shareholders of the U.S. corporation hold (by reason of holding stock in the U.S. corporation) 80 percent or more (by vote or value) of the stock of the foreign-incorporated entity after the transaction; and (3) the foreign-incorporated entity, considered together with all companies connected to it by a chain of greater than 50 percent ownership (i.e., the “expanded affiliated group”), does not have substantial business activities in the entity’s country of incorporation, compared to the total worldwide business activities of the expanded affiliated group. The provision denies the intended tax benefits of this type of inversion by deeming the top-tier foreign corporation to be a domestic corporation for all purposes of the Internal Revenue Code.

In determining whether a transaction meets the definition of an inversion, stock by members of the expanded affiliated group that includes the foreign incorporated entity is disregarded. For example, if the former top-tier U.S. corporation receives stock of the foreign incorporated entity (e.g., so-called “hook” stock), the stock would not be considered in determining whether the transaction meets the definition. Similarly, if a U.S. parent corporation converts an existing wholly owned U.S. subsidiary into a new wholly owned controlled foreign corporation, the stock of the new foreign corporation would be disregarded.

Although there are many variations of inversions, as a general rule, when a domestic corporation holding U.S. real estate merges into a foreign corporation to avoid U.S. estate and gift taxes, the transaction can be classified as inversion. This is because the U.S. corporation holding the real estate becomes a subsidiary of a foreign corporation and the former shareholders of the U.S. corporation will ultimately hold at least 80 percent (by vote or value) of a foreign corporation by reason of holding stock in the U.S. corporation. This type of a structure will not likely trigger the recognition of the inversion gain. However, it will deny the intended tax benefit by treating the foreign corporation as a domestic corporation for all purposes of the Internal Revenue Code.

Section 7874 of the Internal Revenue Code will result in adverse U.S. federal estate and gift tax consequences because the transfer of shares of a domestic corporation to a foreign corporation is an inversion. The foreign investor who directly owned the shares in the U.S. corporation now owns all of the shares of the foreign corporation, which holds the stock of the U.S. corporation. Because multi-tiered corporate structures that hold U.S. real property trigger the inversion rules, the foreign corporation (acquiring the U.S. corporation holding U.S. real estate) will be treated as a U.S. corporation for all U.S. federal tax purposes. This means, a foreign investor (who is not a U.S. domiciliary) is treated as holding shares in a U.S. corporation rather than stock in a foreign corporation. Since U.S. corporate stock is treated as U.S. situs property for purposes of the estate tax, utilizing a multi-tiered corporate structure described above to hold U.S. real property is completely worthless for purposes of avoiding the estate tax.

Holding U.S. Assets through a Partnership

Foreign investors can form a partnership or an entity classified as a partnership to acquire and hold U.S. property. The U.S. estate tax rules for non-U.S. citizens or non-U.S. domiciliaries with respect to partnerships are somewhat more complex and less certain than the rules governing corporate stock. A partnership provides a vehicle for making U.S. tax-exempt gifts of the partnership’s underlying asset through transfer of the partnership interest itself. In contrast, if a non-U.S. domiciliary were to own U.S. real estate or business directly and transfer that asset, the transfer would be subject to the U.S. gift tax. However, the gift tax on non-U.S. domiciliaries is not applicable to gifts of intangible property, such as a partnership interest.

The use of a partnership (regardless of whether it is domestic or foreign, general or limited) has the very significant advantage of enabling the individual foreign investor not to be subject to two layers of tax (as with corporate structures). The extent to which the U.S. estate tax rules apply to partnerships and other pass-through entities held by foreign investors are not totally free from doubt. There is at least some risk that the IRS might assert that a partnership holding a U.S. asset is a U.S. situs asset for purposes of the U.S. estate tax, regardless of whether it is a domestic or foreign partnership.

However, if a partnership holding U.S. real estate or a U.S. business is formed in a jurisdiction outside the United States (regardless of whether it is engaged in a U.S. trade or business) it is more likely not to be classified as U.S. situs property for purposes of U.S. estate tax. It may be argued that under applicable foreign law, a foreign partnership interest is an entity separate from its partners and is not a U.S. situs for purposes of estate tax. If a foreign investor is considering holding U.S. assets through a partnership, the investor should either form the entity outside the U.S. or establish a multi-tiered partnership held by a foreign partnership.

For income tax purposes, the Internal Revenue Code adopts an aggregate approach to partnerships for some purposes and an entity approach for other purposes. For example, under the aggregate approach, a partnership is treated as a conduit which passes income through to the partners to be reported on their individual returns. A partnership is considered an entity, however, for purposes of determining the amount, character, and timing of partnership items. Unlike corporations, partnerships are typically only subject to one layer of tax and as a result, the partners of a partnership are taxed more favorably than shareholders of C corporations. However, foreign partners of U.S. partnerships are subject to a complex set of withholding rules.

In Notice 2018-29, 2018-16 I.R.B. 495, the IRS and the Department of Treasury published interim guidance for addressing partnership withholding tax treatment. Under Section 864(c)(8), the disposition either directly or indirectly by a nonresident interest in a partnership engaged in any U.S. trade or business, results in gain or loss on the sale or exchange to be statutorily treated as income effectively connected with the conduct of a U.S. trade or business. This means that the amount treated as effectively connected income is the portion of the partner’s distributive share that would have been effectively connected income if the partnership had all of its assets at fair market value as of the date of the sale of the partnership interest. If the partnership is receiving income that is not effectively connected with a trade or business, the partnership may need to withhold 30% of the tax on U.S. sourced payments to foreign persons.

Ownership of U.S. Property through a Trust

A non-U.S. domiciliary foreign investor may hold U.S. property in an irrevocable trust. The trust can be domestic of foreign. An irrevocable trust is potentially an attractive vehicle for newly acquired U.S. real property or a U.S. business as long as there are no U.S. beneficiaries of the trust. This type of planning depends on avoiding triggering of the grantor trust rules of Internal Revenue Code. If a trust were treated as a grantor trust, the U.S. estate tax rules may result in the trust being taxed to the grantor’s estate for U.S. federal estate tax purposes. If properly planned, an irrevocable trust will avoid U.S. estate tax.

Trusts are taxed at rates applicable to individuals, although the tax brackets are compressed. In the case of a foreign trust, a trap lurks for amounts distributed to any U.S. beneficiaries from the trust within a year following the year of sale. This is because of the “throwback rule.” Although repealed in 1997 for domestic trusts, this rule continues to apply to foreign trusts. Under this rule, distributions of a foreign trust’s “undistributed net income” or (“UNI”) to a U.S. beneficiary are taxed as if the beneficiary received the income in the year in which it was earned by the trust. The UNI for any particular year is equal to the amount by which its “distributable net income” or (“DNI”) for such year exceeds the sum of:

(1). the amount of trust accounting required to be distributed in such year;

(2). the amount of any other amount properly paid or credited or required to be distributed for such year; and

(3). the amount of any taxes imposed on the trust that are attributable to its DNI for the year.

The throwback rule effectively results in federal tax being levied at the recipient’s highest marginal income tax rate for the year in which the income tax rate for the year in which the income or gain was earned by the trust. This means any capital gains accumulated by a foreign trust for distribution in a later taxable year will lose its favorable rate and instead be taxed at ordinary income rates. In addition, the throwback rule adds an interest charge to the taxes on a throwback distribution in order to offset the benefits of tax deferral. The interest charge accrues for the period beginning with the year in which the income or gain is recognized and ending with the year that the UNI amount is distributed. The interest charge assessed at the rate applicable to underpayments of tax, as adjusted compounded daily. As per the Internal Revenue Code, the interest rate charged on the throwback tax is the rate applied under Internal Revenue Code Section 6621 to underpayments of federal income tax. This interest is also compounded daily. The number of years over which interest is calculated is determined by a process which is said to produce a “dollar-weighted” number of years.

Given the harsh tax consequences to the U.S. beneficiaries of a foreign trust, foreign trusts are not recommended vehicles for use in cross-border estate planning involving U.S. beneficiaries.