Some Cautionary Comments on 'Drop-Off Trusts' for Incoming Aliens

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By Thomas S. Bissell, CPA  

Celebration, Florida

High-net-worth aliens who plan to immigrate to the United States
are frequently advised to create a trust - often called a "drop-off
trust" - in the hope that when they eventually die the trust assets
will not be included in their gross estate for U.S. estate tax
purposes. The advice is based on the fact that if the alien does in
fact remain permanently in the United States (either as an
immigrant alien or eventually as a naturalized U.S. citizen),
whatever assets are directly owned on the date of death will be
subject to U.S. estate tax based on the individual's U.S.
domiciliary status or U.S. citizenship status. However, if the
alien is still domiciled outside the United States on the date the
assets are transferred into the drop-off trust, the transfer into
the trust is likely to be exempt from U.S. gift tax (except to the
extent of U.S.-situs tangible property, if any1), and
if the trust can avoid the "string" provisions of §§2035-2038
between that date and the date of death, U.S. transfer tax will be
avoided in full on the value of the trust upon death.2 If the trust can be
maintained as a so-called "dynasty trust," it may also be possible
to keep the trust alive for successive generations while still
avoiding U.S. transfer tax on the value of the trust in each

The advice is certainly excellent, but in many cases it may be
fatally flawed. If the alien has decided to move permanently to the
United States, and if the reason for creating the trust is
primarily or exclusively to avoid eventual U.S. estate tax, it is
quite possible that he or she may already be
U.S.-domiciled on the basis of his or her intention to move to the
United States and live there permanently. If the alien is already
U.S.-domiciled, then the transfer to the trust will be potentially
subject to U.S. gift tax, even though it may consist of
foreign-situs assets and U.S.-situs intangible assets, none of
which would be subject to U.S. gift tax if the alien were still
domiciled in a foreign country. Unfortunately, there is no "safe
harbor" that can be relied upon with certainty to know whether the
alien is U.S.- or foreign-domiciled - in sharp contrast with the
very mechanical rules that apply for U.S. income tax purposes under
§7701(b) in determining whether an alien is a "resident alien" or a
"nonresident alien".

In determining whether an alien is U.S.-domiciled or not on the
date that he or she creates the trust, the principal guidance is in
a brief IRS regulation that applies for gift tax, estate tax, and
generation-skipping transfer tax purposes. The gift tax regulation
(Regs. §25.2501-1(b)) states:

A resident is an individual who has his domicile in the United
States at the time of the gift… All other individuals are
nonresidents. A person acquires a domicile in a place by living
there, for even a brief period of time, with no present intention
of moving therefrom. Residence without the requisite intention to
remain indefinitely will not constitute domicile, nor will
intention to change domicile effect such a change unless
accompanied by actual removal.3

The last sentence is crucial, because if the alien has never
visited the United States, a clear intention to move permanently to
the United States cannot cause the alien to become U.S.-domiciled
so long as he or she continues to live in the foreign country where
the alien is currently domiciled without physically leaving that
country. This can be important, for example, if under U.S. law the
alien is eligible to apply for U.S. permanent immigrant status (for
example, on the basis of a family relationship, under the
"immigrant investor" rules, or under some other special procedure),
and if the application procedure is started while the alien is
still living in his or her home country. The problem, however, is
that typically a high-net-worth alien who decides to move
permanently to the United States will in fact have visited the
United States in the past, often many times, and in many cases the
alien's "intention of moving" to the United States may have been
formed during one of those visits. The fact that the alien
typically would have visited the United States on a non-immigrant
visa (such as a tourist visa or a business visitor visa) or
pursuant to the visa-waiver program (which is in effect between the
United States and a number of developed countries) may not prevent
the alien from having become U.S.-domiciled as of that earlier date
in the eyes of the IRS. If the alien owns real property in the
United States (such as a U.S. vacation home), as will often be the
case, that fact may further strengthen the IRS' argument.

Prior to 1980, it was believed by most tax professionals that
the division between U.S. non-immigrant visas and immigrant
(permanent residence) visas did in fact operate as a "safe harbor"
in determining whether an alien was U.S.-domiciled for U.S.
transfer tax purposes - in other words, that an alien who did not
hold a U.S. permanent residence visa (or at least who had not
applied for one) did not have the legal capacity to "intend" to
remain indefinitely within the United States, within the meaning of
the various U.S. transfer tax regulations. In that year, however,
on the strength of a U.S. Supreme Court case in a non-tax case, the
IRS ruled that an alien working in the United States for an
international organization on a non-immigrant "G" visa was
U.S.-domiciled for U.S. estate tax purposes, where the alien had
lived and worked in the United States for 13 years with a G-visa up
to the date of his death.4 The IRS took the
position that because the G-visa had no time limit attached to it,
the alien had the legal capacity under the law to form an intention
to remain "indefinitely" in the United States within the meaning of
the IRS regulation. In the same year, the IRS ruled that an
"illegal alien" who had lived in the United States illegally for 19
years up to the date of his death also had the "intent to remain
indefinitely" in the United States immediately before he died, and
also had the legal capacity under the U.S. immigration laws to have
that intent.5

After 1980, however, it was still unclear whether an alien who
was legally present in the United States on a non-immigrant visa
that had a fixed time period (as is typical of most non-immigrant
visas) was legally capable of forming the intent to "remain
indefinitely" within the United States. However, in the 2002 case
of Estate of Jack v. United States,6 where a
non-immigrant alien with a fixed-term visa died before the term of
his visa expired, the court held that it was proper for the lower
court to determine whether the deceased alien had formed the intent
prior to his death to remain "indefinitely" within the United
States for U.S. estate tax purposes. The court held that if he had,
then he was U.S.-domiciled for U.S. estate tax purposes upon death,
despite the fixed term of his non-immigrant visa.

Based on the present interpretation of the transfer tax
regulations by the IRS and by the courts, therefore, it may well be
possible for an alien who is physically present in the United
States on a non-immigrant visa - such as a tourist visa (which is
typically limited to 183 days) - to legally have the intent to
remain "indefinitely" within the United States. What is not clear
is whether a finding of U.S. domicile could be sustained if the
alien must first return to his or her home country and after that
initiate proceedings in order to return to the United States either
with a permanent residence (immigrant) visa, or with a
non-immigrant visa having a longer term which might then permit him
or her to apply after arriving in the United States for "adjustment
of status" so as to become an immigrant. However, in view of the
expansive interpretations since 1980, an alien who, while visiting
the United States, begins to consider seriously moving permanently
to the United States should probably take as many "self-serving"
steps as possible to try to show that the decision to move is not
made until after returning to the home country. To this end, the
alien should avoid making verbal or written statements to other
persons about a possible move, and in addition the alien should
minimize contacts with the United States and continue to maximize
contacts with the home country.7

An interesting question arises if the alien first forms the
intention to move indefinitely to the United States while he or she
is in the home country and then travels to the United States, but
first stops off in a third country (such as a low-tax or no-tax
jurisdiction) in order to create the drop-off trust and to transfer
assets into it. The IRS regulation quoted above states in effect
that if an individual is living in the foreign country where he or
she is domiciled and while there decides to move indefinitely to
the United States, the individual's domicile cannot change "unless
accompanied by actual removal." Query whether the individual's
domicile would change upon leaving the foreign country of domicile,
or only upon entering the United States, or possibly somewhere in
between. Although there seems to be no clear answer in the IRS
rulings or court decisions, §19 of the Restatement Second of
Conflict of Laws states that if an individual decides to move his
or her domicile to a new jurisdiction and is traveling to that new
location, the individual's domicile remains in the first location
until he or she arrives in the location of the new domicile.
However, because of the absence of clear authority on the issue for
U.S. tax purposes, it may be wise for an alien who needs to visit a
third country in order to create the drop-off trust to then return
to the home country before then departing for the United States.
Ideally, of course, the alien should create the drop-off trust and
transfer assets to it before departing from the home country, if
that is possible under the applicable law.

To the extent that the alien could be exposed to potential U.S.
gift tax, the fact that the lifetime gift tax exemption was
increased from $1,000,000 to $5,000,000 in 2011 (and to higher
inflation-adjusted amounts in subsequent years) offers some relief
to aliens who could be exposed to an IRS challenge on the
issue.  In addition, it might be possible to start the statute
of limitations running with respect to this issue if the alien were
to make a gift that was clearly subject to gift tax for the same
taxable year and to file IRS Form 709 to report it - for example,
by making a gift of U.S.-situs tangible property if the alien is
arguably still non-U.S.-domiciled, or after clearly becoming
U.S.-domiciled by making a gift of any property that must be
reported on Form 709.

It should be noted that if the alien moves to the United States
from one of the six countries that have so-called "domicile" estate
tax treaties with the United States, the applicable treaty may
grant a "safe harbor" so as to prevent the alien from becoming
U.S.-domiciled for a period of between five and 10 years (depending
on the terms of the treaty), even though under internal U.S. law
the alien would be classified as U.S.-domiciled. The treaties that
contain this provision are those with Austria, Denmark, France,
Germany, the Netherlands, and the United Kingdom. Aliens from other
countries, and their U.S. tax advisors, should always make sure
that the domicile issue is carefully addressed by the individual's
U.S. estate plan before the U.S. move takes place.

This commentary also will appear in the November 2013 issue
of the
 Tax Management International Journal.
 For more information, in the Tax Management Portfolios,
see Heimos, 837 T.M.
, Non-Citizens - Estate, Gift and
Generation-Skipping Taxation, Bissell, 903 T.M., Tax
Planning for Portfolio Investment into the United States by Foreign
Individuals, and in Tax Practice Series, see ¶6310, The
Nonresident Alien's Estate.



  1 Although §2501(a)(1) imposes U.S. gift tax on all
gifts made by all individuals, §2511(a) only taxes
non-U.S.-domiciled aliens on transfers of U.S.-situs property
(thereby exempting from U.S. gift tax all transfers by them of
non-U.S.-situs property), and §2501(a)(2) further exempts
non-U.S.-domiciled aliens from gift tax on the transfer of
"intangible property" (whether U.S.-situs or non-U.S.-situs). Thus,
a non-U.S.-domiciled alien is only subject to gift tax on the
transfer of U.S.-situs tangible property, i.e., U.S.-situs real
estate and items of U.S.-situs tangible personal property (such as
cars, jewelry, art objects, and other tangible items that are
physically located within the United States on the date of

  2 For guidelines on how to minimize the risk that
§§2035-2038 might apply after the formation of the trust, see
Bissell, 903 T.M., Tax Planning for Portfolio Investment into
the United States by Foreign Individuals
, at VII.B.4.a.
Whether the drop-off trust should be formed as a "domestic trust"
or as a "foreign trust" within the meaning of §7701(a)(30)(E) and
(a)(31)(B) depends on a number of questions that are beyond the
scope of this commentary.

  3 Identical language is contained in the estate tax
regulations at Regs. §20.0-1(b)(1), which defines the term
"resident" for purposes of §2001(a)(1) and, indirectly, the term
"nonresident not a citizen of the United States" for purposes of

  4 Rev. Rul. 80-363, 1980-2 C.B. 249.

  5 Rev. Rul. 80-209, 1980-2 C.B. 248.

  6 54 Fed.Cl. 590 (2002), discussed in Heimos, 837
T.M., Non-Citizens - Estate, Gift and Generation-Skipping
, at III.C.4.b.

  7 See Bissell, 903 T.M., at IX.B.2.