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By Edward Tanenbaum
Alston & Bird LLP, New York, NY
Much to the dismay of estate planning professionals and, more so, their clients, §2801, enacted as part of the Heroes Earnings Assistance and Relief Tax Act of 2008, has not gone away. In fact, proposed regulations (REG-112997-10) have recently been issued as if to remind people of that fact. While the proposed regulations provide guidance on various aspects of the statute, they, nevertheless, highlight the statute's "trap for the unwary" provisions.
Section 2801 basically provides that if a U.S. citizen or resident receives a "covered gift" or "covered bequest," a gift or estate tax applies to the value of such gift or bequest which tax is borne by the person receiving the gift or bequest. This, of course, is the one exception to the rule that donees of gifts, and legatees of bequests, do not pay tax on the receipt of gifts or bequests, even if they are U.S. citizens.
The tax applies on the value of the gift or bequest that is in excess of the "annual exclusion" amount ($14,000 currently) and the applicable tax is reduced by any gift or estate tax paid to a foreign country with respect to that gift or bequest. Exceptions are also provided for taxable gifts by a covered expatriate and for taxable estates of a covered expatriate, i.e., property that is otherwise subject to U.S. gift or estate tax by the covered expatriate or his/her estate. Finally, an exception is also provided for property transferred to a spouse that qualifies for the marital deduction and for transfers to qualifying charities.
A "covered gift" is any gift acquired from an individual who is a "covered expatriate" and a "covered bequest" is any bequest acquired because of the death of a "covered expatriate."
A "covered expatriate" is an individual who is regarded as such under the mark-to-market exit tax regime under §877A(g)(1), i.e., a U.S. citizen who gives up U.S. citizenship, or a long-term resident (holder of a green card for eight out of the last 15 years) who ceases to be a lawful permanent resident, and whose average annual income tax liability for the past five years equals $160,000 (current inflation index) or whose net worth at the time of expatriation equals or exceeds $2,000,000, or who is not able to certify U.S. tax compliance for each of the past five years. (Exceptions exist for certain dual citizens at birth and certain minors.)
Special rules are provided for covered gifts and bequests to trusts. In the case of a covered gift or bequest to a U.S. trust, the U.S. trust is regarded as a U.S. citizen in which case the tax is borne by the U.S. trust. However, in the case of a covered gift or bequest to a foreign trust, the tax applies not at the trust level but, rather, on any distribution to a U.S. citizen or resident. Moreover, a deduction under §164 for the §2801 tax paid by reason of the distribution from the foreign trust is allowed. Solely for purposes of §2801, and provided various procedural rules are met, a foreign trust is able to elect to be treated as a U.S. trust so that the trust pays the tax on the covered gifts and bequests rather than the beneficiaries at the time of distribution.
The proposed regulations confirm many of the provisions of the statute but also provide significant clarifications. For example, the proposed regulations define "resident" of the United States as one who is "domiciled" in the United States. This is different from the expatriation statute itself, which is based on an income tax definition of a resident. This makes sense given that, in the gift and estate tax area, domicile is the controlling rule.
The date of receipt of a covered gift is the date the gift is given while the date of receipt of a covered bequest is the date the property is distributed from the estate. However, in the case of property that passes by operation of law to a beneficiary, the date of receipt is the date of death.
The §2801 tax applies regardless of whether the assets were acquired before or after the expatriation event. Qualified disclaimers of property made by a covered expatriate are excepted from the definition of a covered gift or covered bequest, although the exercise, release, or lapse of a covered expatriate's general power of appointment for the benefit of a U.S. citizen or resident is a covered gift or a covered bequest. In addition, a covered expatriate's grant of a general power of appointment over property not held in trust is a covered gift or bequest to the holder of the power as soon as both the power is exercisable and the transfer of the property subject to the power is irrevocable.
In the case of covered gifts or bequests to trusts, the proposed regulations confirm that a gift or bequest to a U.S. trust (or a foreign trust electing to be treated as a U.S. trust for §2801 purposes) is treated as a gift or bequest to a U.S. person (and taxable upon the trust's receipt of the gift or bequest) and that a gift to a foreign trust is not taxed to the trust itself but, rather, taxed to U.S. citizens or residents when they receive distributions from the trust, but only to the extent that the distribution is attributable to covered gifts or bequests to that trust. For this purpose, distributions include disbursements from a trust pursuant to the exercise, release, or lapse of a general power of appointment. The proposed regulations provide that, in determining the portion of a distribution that is attributable to a covered gift or bequest, a pro-rata rule is applied based on the percentage (at the time of the distribution) of the trust's assets received from the covered expatriate, redetermined after each contribution to the trust. Each distribution is made proportionately without any tracing rule.
A special rule is provided for certain foreign trusts that migrate and become U.S. trusts. In that case, the trust will be treated solely for §2801 purposes as a U.S. trust for the entire year during which the migration occurred. However, the trust must report and pay the §2801 tax on all covered gifts and bequests received at any time during that year as well as on the portion of the trust's value attributable to any covered gifts and bequests received by the trust prior to the year in which it became a U.S. trust.
The proposed regulations also clarify that the deduction under §164 for the §2801 tax paid on the distribution to the U.S. citizen or resident is limited to the extent that tax is paid on that part of the distribution that is included in the gross income of the U.S. citizen or resident.
Finally, the proposed regulations confirm that the IRS will issue Form 708 enabling U.S. citizens and residents to report and pay tax on their receipt of covered gifts and bequests as soon as the proposed regulations become final. The proposed regulations place the burden of knowing whether a gift or bequest is from a covered expatriate directly on the U.S. recipient but acknowledge that this may be a difficult challenge. In upcoming guidance, the IRS will publish the requirements and procedures for requesting relevant information and the circumstances under which the IRS will disclose such information. If a living expatriate does not authorize such disclosure, there is a rebuttable presumption that the donor is a covered expatriate and that each gift is a covered gift.
The proposed regulations do clarify many open points in the statute but, at the same time, provide an incentive for taxpayers and their advisers to work around the issue with proper tax planning.
This commentary also appears in the November 2015 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, 6080 T.M., Section 911 and Other International Tax Rules Relating to U.S. Citizens and Residents, and in Tax Practice Series, see ¶6310, The Nonresident Alien's Estate.
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