This article discusses the planning techniques relevant to when the U.S. estate tax is reinstated in 2011. The hypothetical presented in this article is intended to demonstrate the myriad issues that can arise when formulating an estate plan for people with connections to various jurisdictions outside of the United States. An increasing number of people are found to have such connections. It is imperative that their advisors have the requisite background to identify these issues and recommend the appropriate solutions.
Iain and Charlene Burgess have come to see their attorney for their estate planning. They proclaim that their situation is “simple and straightforward” as they have three children together and a long and stable marriage.
The attorney starts to gather relevant information on family and finances. The attorney is advised that Iain was born in South Africa while his father was working in Johannesburg on a project for his U.K. employer. Iain’s father is a British citizen and his mother is a South African national, and Iain holds both South African and British passports. Iain became a U.S. permanent resident (“green card” holder) in the 1980s shortly after he and Charlene married at St. Joseph’s Church in Paris, France. Charlene is a U.S. citizen and was born in New York to an American father and a French mother. She expects to inherit additional assets in southern France which have been in her mother’s family for generations. Iain and Charlene now reside in McLean, Virginia. They have three adult children who live in three different jurisdictions: Germany, Chicago and South Korea. Iain’s and Charlene’s net worth is approximately $10 million – comprised of real property and other assets in the U.S., the U.K. and France.
The attorney’s initial inclination is to recommend pour over wills and revocable trusts (with bypass provisions and a qualified domestic trust (QDOT) in Charlene’s documents for assets passing to Iain) together with durable general and medical powers of attorney. As Iain and Charlene have foreign assets and Iain is not a U.S. citizen, their estate planning will need to be adjusted from the estate plan recommended for the typical domestic client.
1. Determine Tax Jurisdiction. First, it must be determined whether Iain and Charlene will be exposed to estate and inheritance taxation in more than one jurisdiction. Each jurisdiction taxes based on certain connectors. Such connectors include nationality, domicile, residency, situs of property and religion (e.g., Sharia law). The U.S. taxes based on nationality, domicile and situs of property. In general, the U.S. federal estate, gift and generation-skipping transfer taxes apply to U.S. citizens and residents on a worldwide basis. On the other hand, nonresidents who are not U.S. citizens are generally subject to these transfer taxes only with respect to transfers of property located or deemed located in the U.S. (“U.S. situs assets”). For U.S. federal transfer tax purposes (as distinguished from U.S. federal income tax purposes), a “resident” is an individual who is domiciled in the U.S. A “nonresident” is an individual who is not a U.S. citizen and who is not domiciled in the U.S. In general, a person acquires a domicile in a jurisdiction by living there, even for a brief period of time, with no definite present intention of later removing from that jurisdiction. Residence without the requisite intention to remain indefinitely will not suffice to constitute domicile, nor will the intention to relocate to a different jurisdiction change domicile unless accompanied by actual removal. It is possible for an individual to be a “resident” of the U.S. for U.S. federal income tax purposes by reason of holding a green card or meeting the substantial presence test, and yet remain a nonresident/non-domiciliary of the U.S. for purposes of the U.S. federal estate, gift and generation-skipping transfer taxes. It is also possible for an individual to be a nonresident of the U.S. for income tax purposes and a resident of the U.S. for transfer tax purposes.
As a U.S. citizen, Charlene will be subject to U.S. taxation regardless of her domicile or residence. Given that Iain has a green card, there is a strong presumption that he is U.S. domiciled; however, Iain may be able to rebut the U.S. domicile presumption. Even if the U.S. considers Iain U.S. domiciled, we must also determine whether Iain may be considered domiciled in another country, i.e., England (as his father was English domiciled) or South Africa (his place of birth).
England applies a “domicile of origin” test which is based on the domicile of the taxpayer’s father at the time of the taxpayer’s birth. In Iain’s case, his father, although living in South Africa, was English domiciled as his intention was to return to England. Iain’s father was in South Africa for a limited period of time due to his employment. Hence, Iain has an English domicile of origin under English law. However, an illegitimate child or a child born after the death of his father takes the domicile of his mother.
Iain could change his domicile of origin to a domicile of choice, e.g., to the U.S. Under English law, if Iain is English domiciled, England will subject him to the equivalent of an estate tax on his worldwide assets. If both the U.S. and England claim Iain’s domicile to be in their respective countries, one must look to the U.S.-U.K. Estate and Gift Tax Treaty to examine the treaty tie-breaker rules. The U.S. and a number of foreign countries have entered into transfer tax treaties which limit the ability of the U.S. to impose such taxes. The U.S. has a combined gift and/or estate tax treaty with 16 countries. In several of these treaties, the country of domicile (as determined under the treaty) has the primary right to tax transfers by a domiciliary of that particular country on a worldwide basis. In such treaties, the non-domiciliary country retains the right to tax certain property situated within its borders, including real property, assets related to a fixed place of business within the non-domiciliary country, or certain partnership interests located in the non-domiciliary country. In addition, under the saving clause of most treaties, the U.S. retains the right to tax its citizens on a worldwide basis; however, the U.S. is required to grant a credit against U.S. tax for any taxes imposed by the treaty partner country on the basis of situs or domicile under the terms of the treaty.
Similarly, under the U.S.-U.K. Estate and Gift Tax Treaty, the country of domicile generally has the primary right to tax. However, the foregoing rule does not apply if the donor or decedent in question is a national of the other country. In such cases, double taxation is avoided by means of a credit system set out in the treaty. With respect to real property and certain business property of a permanent establishment, however, the property is taxable only by the country in which the property is situated.
Although more than one jurisdiction may claim to be an individual’s domicile, an individual can only have one domicile and always must have a domicile. Iain may be able to overcome U.K. domicile and only be taxed on his English situs real property (which will be exempt from tax if its value is less than the nil rate band (akin to the U.S. applicable exclusion amount) of £325,000 (in 2010). Assuming Iain can overcome the English domicile issue, Iain will be subject to U.S. taxation on his worldwide assets if he is considered U.S. domiciled. As a U.S. domiciliary, Iain will be entitled to the higher $1 million applicable exclusion amount in 2011 (as opposed to the $60,000 applicable to non-U.S. domiciliaries). Thus, from a transfer tax perspective, Iain, undoubtedly, will want to be considered a domiciliary of the U.S.
Based on the facts presented, Charlene will be taxed by the U.S. on a worldwide basis for estate tax purposes because she is a U.S. citizen. Charlene will also be exposed to French inheritance tax on her French situs real property and subject to U.K. inheritance tax on her U.K. real property. Iain may be able to overcome U.K. claims of domicile and be subject to estate taxation only on his worldwide assets by the U.S. and situs taxation by the U.K. and France (for the real property located in those countries). Based on the treaty tie-breaker rules for determining domicile in Article 4 of the U.S.-U.K. Estate and Gift Tax Treaty, it is likely that Iain will be deemed domiciled in the U.S. because that is the center of his vital interests. Iain will not be subject to estate tax in South Africa because he does not have any South African situs assets, and is neither a South African resident nor domiciliary. Iain’s South African nationality will not affect his estate tax exposure as South Africa does not tax based on nationality.
2. Marital Regime and Spousal Issues. Next, we must determine the couple’s marital regime and its effect on their estate plan. If Iain and Charlene have a prenuptial agreement, we will need to review it to determine their marital regime. Couples married in the U.K. seldom have premarital agreements (e.g., Paul McCartney and Heather Mills, and Madonna and Guy Ritchie). However, couples married in France typically enter into a “contrat de mariage” or marriage contract. The three major marital regimes in France (and in most civil law jurisdictions) are: (i) universal community (communauté universelle avec attribution de la communauté conjoint au survivant); (ii) ganancial community property or community property of acquets (communauté de biens reduite aux acquets); and (iii) separate property (separation de biens). If a couple fails to select a regime, the default regime of ganancial community property (communauté de biens reduite aux acquets) will apply.
- Universal Community. The universal community (communauté universelle) regime treats all assets as community property. Under the universal community property regime, all assets of the two spouses, including those acquired by gift or inheritance and those acquired prior to marriage (with the possible exception of some personal items), are considered to be jointly held. If the assets are characterized as community property, then one-half of all of the community property will be deemed to be owned by each spouse. The U.S. income tax advantage of this regime is there will be a 100 percent step up in basis for the community property at the death of the first spouse to die. In addition, couples under the universal community regime should not have to retitle assets between each other to ensure each spouse is fully utilizing his or her applicable exclusion amount. Thus, the couple is able to avoid the constraints of the marital annual exclusion for assets gifted to a non-U.S. citizen spouse (currently $134,000 in 2010). In addition, community property can be left to a spouse without taking into consideration forced heirship rules applicable in most civil law jurisdictions (such as France, by which it is known as “reserve legale”). Forced heirship is the entitlement of certain family members to a portion or forced share of a decedent’s estate. A constraint on testamentary freedom, it ensures a minimum share and protection of certain reserved heirs from disinheritance. Forced heirship is prevalent in most civil law jurisdictions and under Islamic law. However, in France, if one has remarried and there are children from a previous marriage, the children from the previous marriage generally would still have a reserve legale and could make a forced heirship claim. Finally, only one-half of the assets would be includible in the deceased spouse’s estate for U.S. tax purposes, because under the universal community property regime each spouse is deemed to own one-half of the assets. The estate of the first spouse to die would not have to rely on the contribution rules generally applicable to property owned jointly by a husband and wife where one is a non-U.S. citizen.
- Ganancial Property Community. The ganancial property community or community property of acquets, is the most common community property regime. Under the ganancial property community, assets acquired before marriage or received by gift or inheritance are separately owned, and assets acquired during the marriage (other than by gift or inheritance) are jointly owned. This is the more typical regime not only in civil law jurisdictions, but also in the 10 U.S. states adopting the community property regime.
- Separate Property. The third regime, the separate property regime (la separation de biens) treats all property as separate property for inheritance tax purposes (but not for marital dissolution purposes where one must still determine marital property). With the separate property regime, all assets are individually owned, including assets obtained before the marriage and assets obtained during the marriage.
It is imperative that we determine the couple’s marital regime and then categorize the assets to distinguish the community property from the separate property. Once we have categorized each asset, one-half of the value of the community property assets and all of the deceased spouse’s separate property will be includible in the estate of the first spouse to die.
Since Iain and Charlene were married in France, it is possible that they entered into a “contract de mariage.” If they did not, then under French law (the law governing their marriage), one must look to their first country of residency as a married couple and apply the default marital regime of that jurisdiction. If Iain and Charlene fall under the universal community regime, only one-half of their assets will be includible in the estate of the first spouse to die as the surviving spouse is already deemed to own one-half of the assets. Under this scenario, the marital regime could significantly reduce the number of assets that would need to be held in the qualified domestic trust (QDOT) if Charlene were to predecease Iain. Given the advantages of the community property regime, it may be appropriate for clients to change their marital regime to accomplish their estate planning objectives. The advisability of changing the marital regime will also depend upon the stability of the marriage and the children of each spouse. Some countries will not permit a couple to change their marital regime if one of the spouses has a child born outside of the marriage, or the laws of the country will provide that the child may still enforce his or her forced heirship claim despite the change in marital regime. In any case, the marital regime analysis and asset categorization between community property and separate property is an integral part of Iain’s and Charlene’s estate planning.
3. Examining the Treaty and Planning for the QDOT. The unlimited marital deduction does not apply to transfers made at death to a surviving spouse who is not a U.S. citizen except to the extent the property is transferred to a QDOT in a timely manner. This rule applies regardless of whether the deceased spouse is a U.S. or foreign person. In addition, the rule applies even if the surviving non-U.S. citizen spouse is a permanent resident of the U.S. (where the spouse holds a valid green card).
A QDOT is essentially a security device for ensuring that, either upon the distribution of principal from the trust during the surviving spouse’s lifetime, or at the surviving spouse’s death, the trust principal will be subject to U.S. federal estate tax as if it were included in the estate of the transferor spouse. A QDOT can be established by the transferor spouse, by the transferee spouse, or by the executor of the transferor spouse. Only property which passes from the deceased spouse to a QDOT, or which passes to the surviving spouse and is then irrevocably transferred or assigned to the QDOT in a timely manner, qualifies for the estate tax marital deduction. Subject to any treaty considerations, if Iain settles assets into a QDOT (as opposed to Charlene creating it under her will) and he is English domiciled, then he will have a liability to U.K. inheritance tax (IHT) if he exceeds the tax allowance because he will be treated as creating a lifetime trust. Thus, it is preferable for Charlene to create the QDOT rather than relying on Iain’s doing so at her death.
However, before assuming all assets in excess of the decedent’s applicable exclusion amount should be transferred into a QDOT, one should examine the applicable treaty. Given Iain’s British citizenship, the U.S.-U.K. Estate and Gift Tax Treaty may apply to assets passing from Charlene to Iain. Examining the applicable treaty will assist with determining the tax treatment upon Charlene’s death if Iain survives her.
4. Choice of Documents. As Iain and Charlene have foreign assets and Iain is not a U.S. citizen, the choice of estate planning documents could have a significant impact on the ease of managing the assets during their lives, the distribution of their assets at death and the tax treatment of such transfers. Thus, unlike domestic-based clients, it is not initially clear if Iain and Charlene should have a revocable trust with pour over wills.
- The U.K. There could be disastrous tax results if U.K. situs property is transferred to a revocable trust. Under U.K. law, assets transferred into a revocable trust could incur an entry charge, a maintenance charge and an exit charge. Hence, a will (even with testamentary trust provisions) is usually preferable to using a revocable trust to dispose of the U.K. situs assets. It is not necessary to have a separate U.K. will to dispose of the U.K. situs assets. Generally speaking, the U.S. will can effectively deal with the U.K. situs property since it will be drafted in English and the U.K. is also a common law jurisdiction. If the will is executed with the formalities required under the Washington Convention on Laws and Wills (the International Will Statute), then it should be accepted on its face in other jurisdictions that have adopted the convention, one of which is the U.K.
- France. The French real property cannot be transferred into a revocable trust because France is a civil law jurisdiction. Many civil law jurisdictions acknowledge the concept of a trust and have signed the 1985 Hague Convention on the Law Applicable to Trusts and on their recognition (“The Hague Convention on Trusts”), which attempts to coordinate choice of law rules so that one country will recognize a trust that is valid in another country. Although a country has adopted The Hague Convention on Trusts, one should not assume that using a trust in such a jurisdiction will be advantageous.
France, as most civil law countries, does not have the distinction between legal and equitable title in an asset for the benefit of the third party as applies to trusts. Consequently, the actual tax treatment of a trust in a civil law jurisdiction can be confusing. The treatment of a trust under French law depends, in part, on the interpretation of the trust by the notaire. The notaire could analyze the trust and decide either that: (i) the assets are actually owned by the ultimate beneficiaries; or (ii) that the trust is a separate entity and the trustee is the owner of the assets. Depending upon the terms of the trust, the analysis could become quite complex and the notaire may need to consult with the Centres for Notarial Research, Information and Documents (the “CRIDON”) for its interpretation of the trust. Not only may a trust cause confusion with respect to the devolution of title, but the tax treatment of the trust may be ambiguous.
Charlene wishes for Iain to own the French real property at her death. However, if their marital regime is not universal community, Charlene will be unable to devise the property to Iain because of the French forced heirship rules. Under the forced heirship rules, title to three-fourths of the real property must pass to their three children even if Charlene wishes for Iain to have sole title to the French real property.
Currently, each parent has a 156,974 (2010) exemption (or “abatement”) per child in France. Any assets in excess of the exemption amount are subject to the French inheritance tax at a rate ranging from 20 percent to 40 percent. Since the French real property is valued at 2 million ($3.3 million based on an exchange rate of $1.5USD to 1), approximately 1.5 million (or $2.2 million) (three-quarters of the property) must pass to the children under the forced heirship rules. Under this scenario, the amount that would pass to each of their three children far exceeds the current French exemption amount per child. After the three exemptions at 156,974, a French inheritance tax will be imposed upon approximately 1.5 million less 470,922 or 1,029,078 ($1,543,617) 470,922. Further, the $2.2 million passing to the children exceeds Charlene’s U.S. applicable exclusion amount ($1 million in 2011) and she will be exposed to the U.S. estate tax at 55 percent (in 2011).
French advisors may recommend the following planning technique for Charlene. Charlene would give the nu propriete or remainder interest in the French real property to her children using the 156,974 exemption per child every six years and retain the usufruit interest or life estate for herself. Following this advice may prove problematic from the U.S. perspective. First, Charlene would exceed her U.S. annual exclusion of $13,000 per person with a gift of 156,974 per child. If Charlene gifts more than $13,000 per year, she would be required to use part of her $1 million lifetime exemption. Second, the retention of the usufruit interest would cause the full value of the French real property to be brought back into her U.S. estate at Charlene’s death under I.R.C. § 2036. Thus, Charlene would not achieve the desired tax goal of a “freeze” using the often recommended French estate plan.
Charlene must circumvent the French forced heirship rules if she wishes to take advantage of the spousal exemption under French law. By changing their marital regime to universal community for their French assets (which is permissible under French law), Charlene could avoid forced heirship and devise the French real property to Iain. The devise of the French real property to Iain would be exempt from French inheritance tax due to the spousal exemption. However, the devise of real property would not qualify for the U.S. marital deduction because (i) Iain is not a U.S. citizen and (ii) the real property cannot be transferred to a QDOT as French law does not permit real property to be owned by trusts.
Although Charlene should not title the French real property in a trust, there is a way for Charlene to avoid the French forced heirship rules while providing for Iain’s use of the real property at her death. From a U.S. perspective, since the French real property would need to be transferred into a QDOT for assets passing to Iain to qualify for the U.S. marital deduction, Charlene could convert her French real property into intangible property by transferring it into a company. This could be accomplished by transferring the property into a societe civile immobiliere (SCI) or other entity. The costs associated with a notaire transferring the real property into the SCI would be approximately 7 percent to 10 percent of the value of the real property. The SCI shares could then be transferred into Charlene’s revocable trust. Under the U.S.-France Estate and Gift Tax Treaty, the shares of such company would still be subject to French inheritance tax, if the SCI assets consist of 50 percent or more French real property. However, Charlene could avoid the French forced heirship rules because her country of domicile (the U.S.) would govern the devolution of title to her intangibles.
Although the French real property would still be subject to French inheritance tax at Charlene’s death, under the U.S.–France Estate and Gift Tax Treaty, the assets passing to the surviving spouse would not be taxed due to the French marital spousal exemption. Hence, Charlene could avoid French inheritance tax, but she would still need to use some of her U.S. applicable exclusion amount on the transfer of the company shares to Iain because he is a non-U.S. citizen, or she would need to transfer the shares to a QDOT at her death. Iain could thereafter sell the French real property and avoid French inheritance tax altogether. This technique would accomplish Charlene’s objective of avoiding forced heirship rules (not to disinherit her children, but to minimize the French inheritance tax). Charlene and Iain will still need to balance the objectives accomplished by implementing the SCI against the costs associated with creating the SCI. However, if Charlene desires to maintain the French real property in the family, then this may not be an appropriate solution as Iain would have complete control over the shares. She could consider leaving the shares in a QDOT for Iain, but it would need to be properly drafted so that it would still qualify for the spousal exemption under French law.
If the real property remains titled in Charlene’s individual name, Charlene should execute a French will specifically addressing the disposition of the French real property. Absent a French will, Charlene should provide for the disposition of the French real property through a foreign assets clause in her U.S. will. If Charlene disposes of the French real property in the residuary clause of her U.S. will (thereby pouring all assets into Charlene’s revocable trust), she may cause unnecessary confusion and expense in France. However, even if the real property is addressed in a foreign assets clause in the U.S. will, France will require the U.S. will to be translated into French and accompanied by an apostille, resulting in additional expense. Given the translation expenses, it may be more appropriate for Charlene to dispose of her French real property through a French will which can be a holographic will registered with the Fichier Central de Dispositions de Dernieres Volontes.
Finally, Charlene should consider minimizing the value of the French property included in her estate. Given that only the net value of the French real property will be includible in Charlene’s estate for French inheritance tax purposes, she could encumber the French real property in order to decrease its net value taxable at her death.
- Germany. Germany imposes an inheritance tax on the recipient based on the relationship to the decedent. If Iain and Charlene wish to leave assets to their German resident son and his wife (their daughter-in-law) the distribution may be exposed to German inheritance tax. In the case of a distribution to their daughter-in-law, such distribution will fall into Class Three. Class Three (“Steuerklasse III”) is the “catch-all” class of inheritance (estate) tax covering all other recipients at a personal exemption amount (“Persönlicher Freibetrag”) at 20,000.00 and at inheritance tax rates ranging from 30 to 50 percent. Thus, it would be preferable for the distribution from Iain and Charlene to go only to their son (a Class I distribution and taxed at rates from 7 percent to 30 percent) rather than to their daughter-in-law (a Class III distribution and taxed at rates from 30 percent to 50 percent).
- South Korea. It is necessary to examine the South Korean tax implications of Iain’s and Charlene’s estate planning as one of their children lives in South Korea. South Korean inheritance tax is imposed upon (a) all assets (wherever located) of the deceased in case of the death of a person who was domiciled in South Korea or resided in South Korea continuously for at least one year immediately prior to his death (hereinafter referred to as a “South Korean resident”) and (b) all property located in South Korea which passes on death (irrespective of the tax residency of the deceased). South Korean gift tax is imposed upon (x) all assets (wherever located) received, as a donation, by the donee if at the time of donation he is a South Korean resident and (y) all property located in South Korea (irrespective of the tax residency of the donor) if the donee is not a South Korean resident. The tax rates under both the gift and inheritance tax are as follows: (i) 10 percent – the first .1 billion Korean Won; (ii) 20 percent – the amount between .1 billion Korean Won and .5 billion Korean Won; (iii) 30 percent – the amount between .5 billion Korean Won and 1 billion Korean Won; (iv) 40 percent – the amount between 1 billion Korean Won and 3 billion Korean Won; and (v) 50 percent – the maximum rate on amounts over 3 billion Korean Won. Although South Korea does not offer general gift tax deductions, there is a general inheritance tax deduction of .5 billion Korean Won, which is applicable only to the death of a South Korean resident.
Thus, given the jurisdictions in which the children of Iain and Charlene reside, great care must be taken to avoid additional inheritance and estate tax considerations.
Iain’s and Charlene’s estate plan is complicated due to their foreign assets, Iain’s status as a U.S. permanent resident and the location of their children in foreign jurisdictions. It is necessary to examine their domicile, marital regime, all of their assets, the laws relating to each jurisdiction and applicable treaties to construct a plan that addresses their concerns while minimizing tax implications. Any time a client is not a U.S. citizen, has a non-U.S. resident heir and/or has foreign assets, the estate and tax planning analysis becomes more complicated. So, as it turns out, Iain’s and Charlene’s estate plan is not “simple and straightforward” after all.
A version of this article has appeared in the Virginia State Bar Association Newsletter.