U.S. Gift, Estate, and Generation-Skipping Tax Planning for Cross-Border Couples

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Robert E. Ward,  Esq.

By Robert E. Ward, Esq. Ward Chisholm, P.C. Bethesda, Maryland

Borders are porous, especially when it comes to love. Nothing is simple, especially love. Among its many complexities are unintended tax consequences which arise when love leads to a cross-border marriage. That line “until death do us part” is really an omen about estate taxes and your beloved's loss of his or her expected inheritance. On this side of the border, the estate tax marital deduction disappears as quick as a lover's smile when the surviving spouse is not a U.S. citizen. This commentary considers the U.S. estate planning appropriate for cross-border couples (that is, U.S. citizens married to non-citizens) who live outside the United States. Such unions suffer from two disadvantages. First, any marriage (regardless of the couple's domicile) between a citizen of the United States and a citizen of another country is disadvantaged by the loss of the marital deduction. Unlike intra-spousal transfers between U.S. citizens, assets transferred from the U.S.-citizen spouse to the non-citizen spouse are fully subject to U.S. gift taxation if the transfer occurs while alive and U.S. estate taxation if the transfer occurs at death. If done carelessly, the same assets can be subject to both gift and estate taxation. When the marriage moves abroad, a second disadvantage arises.

While the U.S. revenue laws graciously allow U.S. citizens and domiciliaries a gift and estate tax exemption of $5 million (and further graciously index that amount to $5.45 million for gifts made and decedents dying in 2016), individuals who are not U.S. citizens or domiciled in the United States have a significantly more limited estate tax exemption of only $60,000 and no gift tax exemption. Neither of which matters, of course, if the non-citizen spouse has no U.S.-situs assets. In the case of someone who is not a U.S. citizen or domiciliary, only U.S.-situs assets are subject to U.S. gift and estate taxation.

The most common U.S.-situs assets for U.S. estate tax purposes are shares of corporations organized in the United States, non-portfolio debt obligations of U.S. persons, and tangible or personal property present in the United States. For example, the shares of Google, the loan to a child to buy a U.S. residence, the non-citizen's vacation home in Palm Desert, and the SUV in its driveway, as well as the art and furnishings inside, are all U.S.-situs property for purposes of computing the gross estate of a non-citizen domiciled in another country. All of these assets will be fully subject to U.S. estate tax (except for $60,000 of value) if owned by the non-citizen spouse at the time of death.

While cross-border couples lack two critical tax benefits available to couples who are both U.S. citizens, they have one significant advantage: the non-U.S.-situs assets owned by the non-citizen spouse are exempt from U.S. gift, estate, and generation-skipping transfer taxation. Use of the non-citizen spouse as a conduit through which non-U.S.-situs assets may be conveyed to trusts for the benefit of the U.S.-citizen spouse, children, and other family members allows those assets to be permanently removed from the U.S. gift and estate tax system. Understanding the advantageous and disadvantageous status of the non-citizen spouse drives the planning. In contrast, the assets (regardless of situs) owned by the U.S.-citizen spouse will either be subject to U.S. gift taxes if conveyed by the U.S.-citizen spouse before death or will be subject to U.S. estate taxes if transferred at death once the exclusions and exemptions available to the U.S.-citizen spouse are exhausted.

The lack of a marital deduction and a limited U.S. estate tax exemption require adjustments to the customary estate planning for married citizens or domiciliaries of the United States. It is helpful to consider these adjustments in alternative circumstances created by the order of death. In each circumstance, it is assumed that the couple's preference is to benefit the survivor when the first of them dies and to defer provision for other beneficiaries until the last of them dies (that is, the death of the survivor). However, regardless of the order of death, success in the testamentary planning requires the proper positioning of assets prior to death. Generally, U.S.-situs assets should be owned by the U.S.-citizen spouse. Non-U.S.-situs assets should be owned by the non-citizen spouse. This may require intra-spousal transfers prior to death. This shuffling requires sensitivity to U.S. gift tax consequences.

Just as the United States subjects worldwide income of its citizens to U.S. income taxation, worldwide assets of U.S. citizens are subject to U.S. gift and estate taxation. The $5 million U.S. gift and estate tax exemption may be used before death, and it is often advantageous to do so. U.S. gift taxes are based on the fair market value of the assets transferred on the date the gift occurs. In contrast, U.S. estate taxes are based on the fair market value of the assets transferred on the date the transferor's death occurs (increased by the fair market value of inter vivos taxable gifts). U.S. gift and estate taxes are imposed at a flat rate of 40% for transfers in excess of the gift and estate tax exemption. In the case of tangible property present in the United States, transfers before death avoid state estate taxes, and thereby create a further incentive for pre-mortem conveyances. However, the benefits of avoidance of state estate taxation and computation of the gift tax on a pre-appreciation value must be balanced against the loss of a basis adjustment for assets included in the gross estate of the U.S.-citizen spouse. The basis of assets transferred prior to death carries over from the transferor to the transferee, increased only by the amount of gift tax paid by the transferor. In contrast, the basis of assets transferred at death is adjusted to equal the date-of-death value. This basis adjustment applies for U.S. tax purposes to worldwide assets of the U.S.-citizen spouse.

Inter Vivos Transfers to the U.S.-Citizen Spouse. U.S.-situs assets should be owned exclusively by the U.S.-citizen spouse. Any U.S.-situs assets owned by the non-citizen spouse should be conveyed either to the U.S.-citizen spouse or to an irrevocable trust for the benefit of the U.S.-citizen spouse prior to the death of the non-citizen spouse. Because the transferee is a U.S. citizen, the conveyances will qualify for the marital deduction. However, asset transfers from the non-citizen spouse to the U.S.-citizen spouse increase the gross estate of the U.S.-citizen spouse and potentially result in a U.S. estate tax liability at the death of the U.S.-citizen spouse if the fair market value of the assets included in the U.S.-citizen spouse's gross estate exceeds the available gift and estate tax exemption in the year the U.S.-citizen spouse dies. In this regard, a planning opportunity is created by a difference in the definition of U.S.-situs property for gift and estate tax purposes. Section 2501(a)(2) exempts transfers of intangible assets. Consequently, shares of corporations organized in the United States and non-portfolio debt obligations of U.S. persons may be transferred to an irrevocable trust for the benefit of the U.S.-citizen spouse without relying on the marital deduction or triggering a U.S. gift tax liability. The trust is intended to provide the same result as a “bypass” or “credit shelter” trust in customary U.S. estate planning and designed with similar features. If properly drafted, the bypass/credit shelter trust will protect the assets it holds at the death of the U.S.-citizen spouse from inclusion in the U.S.-citizen spouse's gross estate.

Inter Vivos Transfers to the Non-Citizen Spouse. Inter vivos transfers from the U.S.-citizen spouse to the non-citizen spouse circumvent the U.S. gift and estate tax system entirely or take advantage of that system by diminishing the assets subject to inclusion in the gross estate of the U.S.-citizen spouse. Inter vivos transfers to a non-citizen spouse are not eligible for the marital deduction. However, those transfers will qualify for an increased annual exclusion of $100,000. The increased annual exclusion amount for inter vivos transfers to a non-citizen spouse is indexed for inflation to a $148,000 amount for gifts made in 2016. If amounts transferred in any year exceed the amount of the annual exclusion, the transferor's gift and estate tax exemption will be applied to offset any gift tax due. Once the annual exclusion and gift and estate tax exemption of the transferor are exhausted by prior gifts, the tax paid by the transferor reduces the assets otherwise includable in the transferor's gross estate and subject to U.S. estate tax at the transferor's death.

Death of the U.S.-Citizen Spouse Followed by Death of the Non-Citizen Spouse. At the death of the U.S.-citizen spouse, U.S.-situs assets must be conveyed to a bypass/credit shelter trust for the benefit of the non-citizen spouse in order to avoid U.S. estate taxation of those assets at the death of the non-citizen spouse. To the extent the gift and estate tax exemption of the U.S.-citizen spouse has not been exhausted by inter vivos gifts, the U.S.-situs assets which pass to the bypass/credit shelter trust will be exempt from U.S. estate tax. To the extent the gift and estate tax exemption of the U.S. citizen is insufficient to fully shelter the U.S.-situs assets from U.S. estate taxation at the death of the U.S.-citizen spouse, the bypass/credit shelter trust eliminates a second round of U.S. estate tax at the death of the non-citizen spouse. Thus, the couple's U.S.-situs assets will be subject to U.S. estate tax only at the death of the U.S.-citizen spouse before any post-death appreciation occurs. Because the bypass/credit shelter trust does not have to satisfy either marital deduction or qualified domestic trust (QDOT) requirements, it offers greater flexibility to accommodate contemporaneous co-beneficiaries with the non-citizen spouse and strive for treatment under the revenue laws of the country in which the couple resides which are consistent with the desired U.S. estate tax treatment.

In the event inter vivos gifts did not reduce the gross estate of the U.S.-citizen spouse to a level at which it is fully sheltered by any remaining U.S. gift and estate tax exemption, U.S. estate tax at the death of the U.S. citizen spouse can be deferred by use of a QDOT. The impact of the lack of a marital deduction for transfers to a non-citizen spouse is ameliorated by a QDOT but far from solved. The revenue laws of the United States allow the estate tax otherwise imposed on transfers to or in trust for the benefit of a surviving non-citizen spouse to be deferred if the transfer is made to an irrevocable trust satisfying the requirements of §2056A . The deferred tax is imposed either when principal is distributed from the QDOT or at the death of a non-citizen spouse for whose benefit the QDOT was established. However, unlike the deferral achieved by the marital deduction, the estate tax on distribution or death is calculated as if assets held by the QDOT were taxable in the estate of the U.S.-citizen spouse who settled the QDOT. The cost of deferral is that the estate tax is calculated at date of distribution or date of death values (that is, when the surviving non-citizen spouse dies). Consequently, the benefit of the non-citizen spouse's $60,000 estate tax exemption is not available to shelter even that small amount of assets held by the QDOT, nor do those assets get the benefit of the lower estate tax brackets available to the estate of the non-citizen spouse.

Death of the Non-Citizen Spouse Followed by Death of the U.S.-Citizen Spouse. At the death of the non-citizen spouse, all assets (without regard to situs) must be conveyed to a bypass/credit shelter trust for the benefit of the U.S.-citizen spouse in order to avoid U.S. estate taxation at the death of the U.S.-citizen spouse. Even if the increasing U.S. estate tax exemption of the U.S.-citizen spouse is sufficient to fully shelter assets from the U.S. estate tax at the death of the U.S.-citizen spouse, use of a properly designed trust protects the transferred wealth from spousal, property, litigation, and creditor claims. The trust will also insure the transferor that the assets which remain in the trust at the death of the U.S.-citizen spouse will benefit the couple's children.

Planning for Other Family Members. Regardless of the order of death, if the couple intends to benefit any citizen or domiciliary of the United States at the death of the survivor, the trusts each spouse establishes for the other should include generation-skipping provisions. A generation-skipping trust furthers asset protection objectives and controls beneficial enjoyment of the cross-border couple's wealth. If established by the non-citizen spouse and funded with non-U.S.-situs assets, a generation-skipping trust will also permanently exempt the assets it holds from U.S. estate taxation for as long as those assets remain in the trust, regardless of how many generations of U.S. beneficiaries enjoy those assets.

Although cross-border couples must grapple with the complexities and consequences of the unavailability of the marital deduction, a significantly diminished estate tax exemption, and a nonexistent gift tax exemption, the gift and estate tax and generation-skipping transfer tax status of the non-citizen spouse creates a huge window of opportunity. Using the non-citizen spouse as a conduit through which bypass/credit shelter and generation-skipping trusts are created offers the opportunity to permanently remove the family's wealth from the U.S. transfer tax system. In addition to the transfer tax objectives of such trusts, opportunities exist to consider the foreign or domestic situs of such trusts. These issues will be addressed by subsequent commentaries appearing in this space.