DWC congratulates 3 attorneys selected for inclusion in 2017 Southern California Super Lawyers!

• Scott Mendler
• Jonathan Reich – Litigation, Trust and Estate Administration/Litigation
• Mark Share – Business, Real Estate, Litigation

Super Lawyers is a rating service of outstanding lawyers from more than 70 practice areas who have attained a high-degree of peer recognition and professional achievement. Super Lawyers selects attorneys using a rigorous, multiphase rating process. Peer nominations and peer evaluations are combined with third party research. Each candidate is evaluated on 12 indicators of peer recognition and professional achievement. Selections are made on an annual, state-by-state basis.

James A. Elkins, Jr. left an estate including interests in 64 artworks acquired during his lifetime, from Cézanne to Picasso to Pollock. He owned a half interest in three of the works and a 73% interest in the other 61, with his children owning the remaining interests. He and his children had effected agreements voluntarily restricting their individual rights to possess, transfer or force partition of the artworks.

Mr. Elkins’ estate tax return set the value of his interests in the artworks at $12.1 million, determined by applying a 44.75% fractional interest discount for lack of control and marketability, as determined by the estate’s expert appraisers, to his share of the works’ fair market value. The IRS denied any discount and assessed a deficiency in excess of $9 million.

The Tax Court held in Estate of Elkins v. Comm’r., 140 T.C. 5 (2013) that IRC § 2703(a)(2), which provides that any restriction on the right to sell or use property must be ignored in determining its value for estate tax purposes, negated the restrictions in the cotenant and lease agreements. The court rejected the estate’s discounted values and applied a 10% discount from fair market value.

The Fifth Circuit held that “in the absence of any evidentiary basis whatsoever, there is no viable factual or legal support to the court’s own nominal 10 percent discount.” It found the estate’s evidence in support of its 44.75% discount to be “uncontradicted, unimpeached and eminently credible,” and ruled that the 44.75% discount would control, ordering the IRS to refund the estate $14.4 million for taxes overpaid.

The most important takeaway from this big win is that estates must have reputable and expertly performed professional appraisals to support significant fractional interest discounts on works of art. The second lesson is that properly drafted co-tenancy and lease agreements with meaningful restrictions on the partition, possession and transfer of artworks can produce deep discounts in the determination of estate tax.

Topics will include:

• Potential legal and tax pitfalls when planning for the disposition of a U.S. client’s financial and real property interests abroad and a non-U.S. client’s interests in the U.S.

• The impact of situs rules on gifts and bequests by non-U.S. citizens/non-U.S. residents, including the disposition of interests in real property, business entities and debt instruments and issues involved in converting assets to “intangible” interests.

• U.S. tax reporting and compliance issues relating to the disposition of interests in business entities, real property and financial accounts in the international context.

• Benefits and pitfalls of U.S. or foreign grantor or non-grantor trusts for cross-border estate planning, including potential uses of “dynasty” trusts.

Our panel will guide estate planning counsel and tax advisors with approaches and techniques for clients who are members of an international family. Our panel will discuss and offer solutions to the complexities involved with foreign or inbound-U.S. business, real estate and financial account interests.

After our presentations, we will engage in a live question and answer session with participants so we can answer your questions about these important issues directly.
I hope you’ll join us.

For more information or to register >
Or call 1-800-926-7926 ext. 10
Ask for Estate Planning for Multijurisdictional Families on 10/7/2014
Mention code: ZDFCT

This article provides an overview of corrective United States tax compliance measures for individuals and companies who have failed to file required U.S. tax returns or foreign bank account reports (“FBARs”) in prior years (“delinquent filers”) or whose prior filings have contained errors or omissions (“errant filers”).  Corrective compliance involves filing the late or amended return or participating in a special program for delinquent or errant filers before U.S. tax authorities become aware of the delinquency, error or omission.

The focus here is on taxpayers with dual citizenship or dual residency (“dual status” taxpayers) and non-residents of the U.S. who have U.S. filing obligations because of contacts with the U.S., such as, conduct of business in the U.S., ownership of interests in U.S. business entities, ownership of real property in the U.S., or wealth transfer planning for family in the U.S.

There is greater urgency than ever for corrective compliance with the impending enforcement of “FATCA”  (Foreign Account Tax Compliance Act) provisions that will cause foreign financial institutions and other foreign entities to identify “U.S. owners” of foreign financial accounts to the U.S. Internal Revenue Service (“IRS”).  The U.S. tax whistleblower reward program is another reason for some to be concerned about corrective compliance.  June 2014 changes to the IRS Offshore Voluntary Disclosure Program (“OVDP”) and the Streamlined Filing Compliance Procedures affect the analysis as to the appropriate course of action.

I.          Categories of Dual Status and Foreign Filers in the U.S.  These are common examples of dual status and non-U.S. taxpayers who have U.S. filing obligations:

A.        Dual Status U.S. Income Tax Resident:  A foreign citizen (i) is considered to be a U.S. federal income tax resident; (ii) has U.S. federal income tax and FBAR filing obligations; and (iii) is subject to U.S. federal income tax on worldwide income (after any available foreign tax credits or exemptions), if he/she:

(1)        has dual U.S. citizenship;

(2)        has U.S. permanent residence (a “green card”); or

(3)        is a U.S. income tax resident because deemed to have “substantial presence” in the U.S. under a rolling three-year “day-counting” test (i.e., if in any year his/her total days of presence in the U.S. (a) in that year + (b) 1/3 of days in the prior year + (c) 1/6 of days in the second prior year = 183 or more), unless an exception applies.[1]

B.        Non-U.S. Individual or Entity with U.S. Contacts:  A non-citizen, non-resident of the U.S. (“non-resident alien” or “NRA”) may have U.S. reporting and tax payment obligations in many circumstances, such as:

(1)        Statutory or Treaty Claim of U.S. Income Tax Non-Residency.  A non-U.S. national whose 3-year day-count exceeds 183 under the substantial presence test, but who can claim U.S. income tax non-residency (i) because the current year day-count is less than 183 and he/she maintains “closer connections” to a foreign country or (ii) qualifies for U.S. non-residency under an income tax treaty residency “tiebreaker” provision.  To claim an exemption, the taxpayer must file a U.S. tax return with the appropriate exemption form.

(2)        Non-Resident with U.S. Source Business Income.  A non-resident of the U.S. who conducts business (including rental business) or performs services in the U.S. or who has an interest in a U.S. “pass-through” entity (such as, a limited liability company (LLC) or partnership) that conducts business in the U.S. or who sells a U.S. real property interest and is subject to “FIRPTA” (Foreign Investment in Real Property Tax Act) obligations.

(3)        Foreign Owner of U.S. Corporate Subsidiary or Foreign Settlor of U.S. Trust.  The U.S. entity has U.S. tax obligations and the foreign ownership must be reported.

(4)        Gift/Estate Tax Resident makes any taxable gift or has U.S. taxable estate or Non-Resident who makes “U.S. situs” gifts or bequests.

A U.S. citizen or person deemed to be U.S. resident for estate and gift tax purposes, is subject to gift tax (after applicable exemptions and credits) on worldwide gifts and is subject to U.S. estate tax at death (after applicable exemptions and credits) on worldwide assets.  The estate of a non-citizen and non-resident of the U.S. is subject to U.S. estate tax (after applicable exemptions and credits) on the decedent’s U.S. situs assets, an a non-citizen/non-resident of the U.S. is subject to U.S. gift tax (subject to certain exceptions) on gifts of U.S. situs assets.

U.S. estate and gift tax residency is based on domicile, which is a facts and circumstances test of what constitutes the person’s permanent home.  There are not uncommon circumstances where a person may be deemed to be a U.S. income tax resident but not an estate or gift tax resident, such as, where the person has “substantial presence” in the U.S. but not a permanent home in the U.S.  The converse — domicile without U.S. income tax residency — may be true in other less common circumstances.  If an estate and gift treaty applies, this also affects the analysis.

A taxable gift by, or taxable estate of, a dual citizen or a non-citizen U.S. domiciliary gives rise to U.S. gift or estate tax filing requirements and may give rise to tax liability to the donor or decedent’s estate, after applicable exemptions and credits.  If the gift or bequest is from a non-resident/non-citizen this also gives rise to reporting obligations to a U.S. person who is a recipient of the gift or bequest.

II.        U.S. Federal Tax and Informational Reporting By Category:

A.        U.S. Citizens / U.S. Income Tax Residents:

If a person is a U.S. citizen or is deemed to be U.S. income tax resident, the full complement of U.S. filings is required, and filing is typically more complicated than for sole U.S. status filers because of cross-border transactional, foreign tax credit and reporting issues.  Examples of required filings include:

•           IRS Form 1040 (Individual U.S. Income Tax Return) and all required schedules.

•           FBAR (Foreign Bank Account Report).  This must be filed electronically on FinCen Form 114 (formerly filed on Treasury Form TD F 90-22.1) to report foreign bank and brokerage accounts held directly or through controlled entities.

•           IRS Form 8938 (Report of Specified Foreign Financial Interests).  Since 2011, this is filed in addition to the FBAR, as an attachment to Form 1040, if reporting thresholds are met.

•           IRS Form 3520 (Report of Foreign Trust Transactions and Foreign Gifts and Bequests).  This is filed by a U.S. recipient of a gift or bequest in excess of $100,000 from a non-U.S. donor or U.S. recipient of a distribution of any size from a foreign trust.  It is filed separately from IRS Form 1040.

•           IRS Form 3520-A (Report of Foreign Grantor Trust).  This may apply in the very common situation where there is a revocable “living trust” that is governed by foreign law.  This form is filed by the trustee of the trust.  The U.S. owner also files Form 3520 when this applies.

•           IRS Form 5471 (Report of U.S. Shareholder of Foreign Corporation).  This is filed as an attachment to the U.S. federal income tax return of the “CFC” U.S. shareholder (Form 1040, if an individual shareholder).  In general, there is a CFC if U.S. shareholders directly or indirectly own shares constituting more than 50% of the value or vote in a foreign corporation.

•           IRS Form 8621 (Report of U.S. Shareholder of Passive Foreign Investment Company).  This is filed as an attachment to the U.S. federal income tax return of the “PFIC” U.S. shareholder (Form 1040, if an individual shareholder).  In general, there is a PFIC if a U.S. shareholder owns a minority interest in a foreign corporation that is not predominantly engaged in active business (for example, foreign mutual fund, hedge fund and other investment fund interests, including non-actively managed real estate.).

•           IRS Form 8858 (Report of Controlled Foreign Partnership).  This is filed as an attachment to the U.S. federal income tax return of the U.S. partner of the “CFP”  (Form 1040, if an individual partner).  The foreign partnership does not necessarily have to be U.S.-controlled to give rise to CFP filing requirements.

B.        U.S. Non-Residents:

                        (1)        U.S. Non-Residency Exemption Claim:  If an individual is treated as a U.S. income tax resident, under U.S. Internal Revenue Code (the “Code”) and Treasury Regulations (the “Regs.”), such as, due to “substantial presence”, he/she may qualify for an exemption from U.S. income tax residency based on having closer connections to a foreign country.  The claim of exemption requires filing of U.S. tax returns.

•           IRS Form 1040NR (Individual U.S. Non-Resident Income Tax Return) is filed in this case.

•           IRS Form 8840 (Closer Connection Statement) is filed if the exemption from the substantial presence test is claimed under the Code and is based on less than 183 days of U.S. presence in the current year  and closer connections to a foreign country.

•           IRS Form 8833 (Claim of Treaty Benefits) is filed to claim benefits under a bilateral income tax treaty between another country and the United States, such as, a claim of a non-residence for U.S. income tax purposes under a treaty residency “tiebreaker” provision (if the closer connections exception under the Code does not apply or as a backstop to a closer connections claim).  This form is also used to claim reduced rates of withholding or exemption from U.S. tax on business profits if there is no U.S. “permanent establishment” or “fixed base”.

Note 1:  If exemption occurs under the Code, then the person is not a U.S. tax resident for all purposes, including FBAR and any other form requirements that may apply, such as those noted in Section II.A above.  However, if exemption is claimed under a treaty residency tiebreaker, the person files Form 1040NR and has U.S. tax computed as a non-resident (i.e., is subject to U.S. tax on U.S. source income only), but is treated as a U.S. tax resident (a “U.S. person”) for special reporting purposes including FBAR and special tax form requirements, such as, filing of Form 5471 with respect to any CFCs, etc.

Note 2:  U.S. income tax treaties have a “saving clause” that prevents U.S. citizens from claiming most treaty benefits against the U.S., including a claim of non-residency under treaty tiebreaker provisions.

(2)        Non-Resident with U.S. Source Business Income.  In this category, there is often withholding paid by the payor of the U.S. source business income or by the U.S. partnership.   If there is under-withholding (withholding of tax that is not sufficient to cover the taxpayer’s U.S. tax liability after any allocable deductions), tax is paid with the U.S. return; if there is over-withholding (withholding of tax that exceeds the taxpayer’s U.S. tax liability after any allocable deductions), U.S. filing is the means of obtaining a refund or carryover crediting of the excess. Examples of required filings include:

•           IRS Form 1040NR (Individual Non-Resident Income Tax Return) and all required schedules.

•           IRS Form 1120F (Foreign Corporation Income Tax Return).

(3)        Foreign Owner of U.S. Corporate Subsidiary or Foreign Settlor of U.S. Trust.  The U.S. entity has U.S. tax obligations and the foreign ownership must be reported.  For example:

•           IRS Form 1120 (Domestic Corporation Income Tax Return).

•           IRS Form 1041 (Domestic Trust Income Tax Return).

•           IRS Form 5472 (Report of Foreign 25% Ownership of U.S. Corporation).  This is filed as an attachment to IRS Form 1120.  Transactions with the foreign owner are reported on this form.

(4)        U.S. Estate/Gift Tax Resident who makes any gift or Non-Resident who makes “U.S. Situs” gifts or bequests.  Forms for this reporting are:

•           IRS Form 709 (Gift and Generation-Skipping Tax Return).

•           IRS Form 706 (Estate Tax Return).

In addition, the U.S. recipient of a gift with value in excess of $100,000  or any bequest from a foreign person must file IRS Form 3520 to report receipt.  This is filed whether the gift or bequest from the foreign donor was a U.S.

III.       Four Basic Options for U.S. Corrective Tax Compliance.   The delinquent or errant filer should consult with a knowledgeable U.S. tax advisor about possible means of corrective U.S. tax compliance, the costs, benefits and risks involved in each approach, and the suitability for the particular person’s circumstance.  These are several key options:

A.        Offshore Voluntary Disclosure Program (OVDP).

If a delinquent or errant filer is not currently under audit or investigation, he can participate in OVDP.  If OVDP is chosen as the corrective measure, it is imperative that “pre-clearance” be obtained from IRS criminal investigations to ensure that the taxpayer is not the subject of an investigation.  Absent pre-clearance, submissions made in an attempt to participate in OVDP can be used against the taxpayer in pursuing a criminal case.  Starting in July 2014,  the request for pre-clearance must include the name of any foreign financial institutions at which the taxpayer has an account and any foreign entities in which the taxpayer has an interest.

OVDP involves filing eight prior years of corrected (or newly filed) tax returns, FBARs, and all other applicable forms, such as those noted in Part II.A above.

The prime benefits of OVDP are (1) amnesty from criminal tax and FBAR prosecution, and (2) quantification of monetary penalties, thus eliminating possible exposure to multiple 75% civil tax fraud penalties, 50%-of-account-balance penalties applicable to willful failures to file FBARs, and other high penalties, such as possible 35% penalties for failure to report foreign trust distributions on IRS Form 3520.  OVDP does not provide amnesty from any non-tax criminal exposure (such as, any relating to the source of funds in foreign accounts).

OVDP involves a high price for these benefits:  (1) an “all-in-one” FBAR/failure to file penalty equal to 27.5% of the highest “foreign account balance” in the eight-year look-back period (including the value of interests any previously unreported foreign entities), (2) underpaid tax owed during the 8-year look-back period, (3) a civil tax penalty of 20% any underpaid tax, and (4) interest on the underpaid tax and 20% penalty.  Under newly revised OVDP “FAQs”, the FBAR penalty is raised to 50% for accounts at banks that have been publicly identified as the subject of an IRS investigation.  The 50% penalty is presumably intended as an incentive for those with unreported foreign bank income to come into OVDP right away, rather than taking a wait and see approach.

As an alternative to the quantified penalties above, a taxpayer who has been accepted into OVDP may “opt out” and have the eight years of past returns and FBARs subjected to IRS examination. Amnesty from criminal tax prosecution for these years is retained by those who opt out of the OVDP monetary penalty regime.  In many circumstances, the IRS position in such an opt-out examination may be that the taxpayer owes more than under OVDP’s quantified penalties.  As with any examination, the taxpayer would have an opportunity to present his/her case, including any arguments as to why penalties should be reduced or eliminated due to “reasonable cause” (such as, reliance on prior bad professional tax advice).  Negotiations are part of this process.

OVDP is the best approach for those who have committed egregious violations and for those who are otherwise averse to any risk of criminal prosecution or exposure to higher monetary penalties.  The OVDP opt-out option generally is best suited to those who have arguments as to reasonable cause for their filing errors.

B.        Streamlined Filing Procedures.

In June 2014, the IRS announced substantial changes to the so-called streamlined filing procedures that were first introduced by the IRS in 2012 (and which were anything but streamlined, in its original incarnation).  Originally, the streamlined program was available only to non-residents who had not filed U.S. tax returns (delinquent filers).  For those eligible, the original streamlined program involved a guessing game as to whether the returns would qualify as “low risk,” in which case they would be processed normally or “high risk,”  in which case they would be subjected to audit.  Previously, a delinquent non-resident could be deemed to be high risk from owing only $1,500 of U.S. tax, which could easily arise as a result of complications in the foreign tax credit rules.

Now, as revised, the streamlined program is available to both U.S. residents and non-residents, and is available to errant filers as well as delinquent filers with unreported foreign income.  Non-residents who qualify for the program are subject to no penalties.  U.S. residents who qualify for the program are subject to a 5% penalty, based on their highest aggregate foreign account balance for the last six years.   The key issue for participation in the streamlined program is whether the prior failure to file or failure to report non-U.S. income was “willful”.  A taxpayer who participates in the streamlined program must certify that the errors or delinquency were not willful and explain why they were not.

The streamlined program does not eliminate any exposure that may exist to criminal prosecution, so it is best suited to those who may owe little or no U.S. income tax after foreign tax credit and who have a solid basis for asserting non-willful failure to file or errors in previous filings (such as, faulty professional advice, or, perhaps, past ignorance or misunderstandings about U.S. filing obligations).  The IRS has warned that it will examine participants’ claims of non-willfulness.  If willfulness is found, the taxpayer may face civil penalties and perhaps could face criminal prosecution.  Therefore, the facts and circumstances of the past failure and whether it was willful or not should be addressed carefully in consultation with a tax advisor.

The streamlined program involves filing (1) three prior years of delinquent or amended returns and payment of any tax and interest due;  (2) six prior years of FBARs, with an explanatory statement as to reason for non-filing or past errors; and (3) completion and submission of a statement as to non-willfulness.  (This essentially replaces a questionnaire that had been required under the former version of the streamlined program).

Note:  For those taxpayers who have no unreported income but who merely failed to file FBARs or tax information forms (such as, Form 5471, relating to U.S. shareholders of foreign corporations or Form 8938, relating to foreign financial assets or Form 3520, as it relates to reports of foreign gifts), these errors can now be corrected by filing these forms in accordance with program guidelines.  Careful analysis should be conducted as to whether participation in the full-scale streamlined program is appropriate.

C.        “Quiet filing” of delinquent returns or amended returns to correct errors.

It has been IRS historic practice, as expressed in the Internal Revenue Manual, not to pursue criminal prosecution and not to seek tax or civil penalties for earlier years if six years of amended returns (and FBARs) are filed to correct prior errant filings or six years of delinquent returns (and FBARs) are filed to correct delinquent filings.  Such “voluntary disclosure” outside of OVDP may (but is not certain to) eliminate exposure to criminal tax prosecution, and does not quantify penalty risk (such as, possible assertion of multiple 50% FBAR willful failure penalties) if the returns are audited, nor does it necessarily eliminate exposure to civil penalties for years prior to the six years of returns for which the statute of limitations is open for tax and civil penalties.  (In general, the civil statute remains open indefinitely for years for which no return was filed or for which fraud was involved).  It is also possible that quiet corrective filing could result in a better monetary result than the 27.5% penalty regime under OVDP, such as, acceptance of the returns as “qualified amended returns” that do not give rise to underpayment penalties.  IRS has warned that it is on the lookout for quiet disclosure so that it can subject such returns to the audit process.  The streamlined program now offers taxpayers who had previously made quiet filings the opportunity to file again under the streamlined program.  In that case, as long as there are grounds for lack of willful error, penalty exposure would be removed for non-residents and would be quantified at 5% of the highest account balance for U.S. residents.

D.        “Going Forward” compliance.

Some taxpayers may choose to come into U.S. tax compliance on a going forward only basis (and not correct past year errant or delinquent filing).  This route involves full exposure to criminal penalties until applicable statutes of limitations burn off and full exposure for tax and civil penalties for all prior years.  The IRS has also warned that it is giving close scrutiny to first-time filers in this context.  In view of new FATCA requirements for foreign financial institutions to identify U.S. accountholders (and U.S. owners of entity accountholders) to the IRS, going forward compliance involves greater risk than ever with respect to past years of non-compliance.

IV.       “Coming in” to get out:  Exit tax / Coming in to stay: Green card renewal or citizenship application.

The United States now has an “exit tax” regime (a deemed sale or “mark to market” of worldwide assets) that is applicable to those who renounce U.S. citizenship and is also applicable to green card holders who relinquish their green cards after having had permanent residency status for eight years or more.

The exit tax only applies to “covered expatriates,” which generally means those with at least $2 million net worth at the time of expatriation or those who owed a high U.S. income tax liability in the prior five years.  However, the exit tax (and continuing U.S. estate and gift tax consequences and U.S. withholding tax obligations on distributions from foreign trusts) applies in all events if the expatriate cannot certify that he has been in compliance with all U.S. tax obligations for past 5 years.

Some dual status taxpayers who wish to give up their U.S. status may have to come into the U.S. tax system with corrective compliance for the prior five years in order to get out of the system without owing an exit tax.

Others may need corrective compliance in connection with green card renewal applications or conversion of permanent residency to citizenship, or simply to maintain the privilege of residing in the U.S.  A conviction for criminal tax evasion will subject a non-citizen to deportation, in addition to the criminal penalties.

            V.        Attorney-Client Privilege.

Any taxpayer facing corrective compliance issues should consult with an attorney about his/her options, preferably before discussing the matter with the taxpayer’s accountant or any other advisor.  The communications and development of the case prior to filing of returns should be subject to attorney-client privilege.

Every corrective compliance case has particular details that will affect the risks, costs and benefits involved in one alternative versus another, as does the client’s own tolerance for, or aversion to, risk.

DWC congratulates its 4 attorneys selected for inclusion in 2014 Southern California Super Lawyers!

Bruce Glickfeld – Tax and Business Transactions
Menasche Nass  – Tax, Business Transactions, and Estate Planning
Jonathan Reich – Litigation, Trust and Estate Administration/Litigation
Mark Share – Real Estate, Litigation

Super Lawyers is a rating service of outstanding lawyers from more than 70 practice areas who have attained a high-degree of peer recognition and professional achievement. Super Lawyers selects attorneys using a rigorous, multiphase rating process. Peer nominations and peer evaluations are combined with third party research. Each candidate is evaluated on 12 indicators of peer recognition and professional achievement. Selections are made on an annual, state-by-state basis.

One or more trade or business activities or rental activities may be grouped as a single activity if they constitute an appropriate economic unit for the measurement of gain or loss. Treas. Regs. § 1.469-4(c)(1). The taxpayer has wide latitude in grouping activities, with certain exceptions (such as that a rental activity generally may not be grouped with a trade or business activity because rental activities are considered passive per se). Note, importantly, that an activity is not necessarily congruent with a legal entity. A pass-through entity must make an initial grouping of its activities for purposes of section 469, but its members or partners may then group its activities with their own activities or activities conducted through other entities in which they hold interests. Treas. Regs. § 1.469-4(d)(5)(i). Having elected one grouping of activities, the taxpayer generally may not regroup them in subsequent taxable years. However, the Service recently proposed regulations that would give taxpayers subject to the Obamacare tax a one-time opportunity to regroup. Prop. Regs. § 1.469-11(b)(3)(iv). Clients also sometimes find that they have not made even an initial grouping and have the ability to do so now.

Once the taxpayer has grouped his or her activities, the activity giving rise to the investment income must be examined to determine whether the taxpayer materially participates in the activity. Material participation means involvement in the operations of an activity that is regular, continuous, and substantial. IRC § 469(h)(1). A taxpayer is treated as materially participating in an activity if he or she satisfies one of seven tests. Temp. Regs. § 1.469-5T(a)(1)-(7). Test 1: Did the individual have more than 500 hours of participation during the tax year? Test 2: Did the individual’s participation constitute substantially all participation in the activity by all individuals (including non-owners)? Test 3: Did the individual have at least 100 hours of participation with no other person (including non-owners) participating more than the individual? Test 4: Was the individual’s participation in a “significant participation activity” (100-500 hours) with the individual having more than 500 hours in all such significant participation activities? Test 5: Did the individual materially participate for any five of the prior ten taxable years? Test 6: If the activity is a personal service activity, did the individual materially participate in the activity for any three preceding taxable years? Test 7: Did the individual have at least 100 hours of participation and participate on a “regular, continuous, and substantial basis” during the tax year under the facts and circumstances? Individuals whose ownership of an activity is through a limited partnership or LLC may use only Test 1, Test 5, or Test 6 to qualify for material participation. If, under any of the foregoing tests, the taxpayer materially participates in the activity producing the investment income, it will not be subject to the Obamacare tax.

Cross-border tax issues add an extra layer of complexity to estate and wealth-transfer planning.  This article is the first in a series that addresses United States estate, gift and income tax planning for international families.

1.         Differences in Estate, Gift and GST Tax Rules Mean Different Planning for

            U.S. Citizens and U.S. Residents Than for U.S. Nonresidents

Introduction.  After applicable exemption amounts, the United States imposes the following wealth-transfer taxes:

(1) estate tax on the net value of a decedent’s estate;

(2) gift tax on gifts made during lifetime (including funding of irrevocable trusts); and

(3) generation skipping tax (“GST”) on gifts and trust transfers to grandchildren or others two or more generations below the donor.

The top tax rate on any of these taxable donative transfers is now 40% of the amount of cash or fair market value of the property transferred, regardless of whether the transferor is U.S. or non-U.S.  But there are two key differences between other U.S. estate, gift and GST tax rules applicable to U.S. citizens and U.S. residents, versus those applicable to U.S. nonresidents:

Worldwide assets vs. U.S.-situs assets.  U.S. citizens and U.S. residents are subject to U.S. estate, gift and GST tax on worldwide assets, but U.S. nonresidents are subject to these taxes only on U.S. situs assets.

Exemption Amount.   In 2013, U.S. citizens and U.S. residents have no liability for U.S. estate, gift and GST tax on estates and lifetime gifts totaling less than $5.25 million ($10.5 million for a U.S. married couple) under the “unified” transfer tax exemption.  (The $5.25 million is indexed for inflation from a base of $5 million).  But U.S. nonresidents have an estate and GST tax exemption of only $60,000  (on their U.S.-situs transfers) and zero “lifetime” exemption on U.S. situs gifts.

These two key differences (as well as other differences) make for different tax planning strategies for U.S. citizens and U.S. residents than for U.S. nonresidents.  This article addresses many of the basic rules that account for these different strategies. (Special rules apply to expatriates — former U.S. citizens and former U.S. long-term green card holders.  “Covered expatriate” provisions are not addressed in this article.)

U.S. Tax Residency.  U.S. income tax residency is based on days of presence in the U.S. each year and the two preceding years or whether a person has a U.S. permanent residence visa (a “green card”), but U.S. estate and gift tax residency is based on all of the facts and circumstances of whether a person is “domiciled” in the U.S.  That, in turn, looks to whether the person has made the U.S. his permanent home.  Possession of a U.S. green card would be a key factor for U.S. estate and gift tax residency.

If a person qualifies for benefits under an applicable income tax treaty or estate and gift tax treaty between the United States and another country, the treaty may override tax residency rules under U.S. domestic law and may provide additional benefits, such as, exemption of certain categories of income or assets from U.S. tax or larger exemption amounts than that provided under U.S. domestic law to non-residents.  Most U.S. tax treaties contain a “savings clause” that prohibits U.S. citizens from claiming non-U.S. residency or other benefits against the U.S. under the treaty.

Other Estate and Gift Tax Exemptions.  Besides the unified $5,250,000 unified exemption for U.S. citizens and U.S. residents and the zero or near-zero exemption for U.S. nonresidents, there are the following exemptions:

•           Small Annual Gifts.  U.S. citizens and U.S. residents and U.S. nonresidents are exempt from gift tax or GST on gifts of “present interests” of up to $14,000 per donee per year, and these small gifts are not counted against the applicable unified exemption amount.  Husbands and wives each can make tax-free $14,000 gifts to the same donee.

•           Direct Payment of Tuition and Medical Expenses of Others.  U.S. citizens and U.S. residents and U.S. nonresidents can make gift-tax-free direct payments of tuition and direct payments of medical expenses in an unlimited amount.

•           Gifts and Estate Transfers to Spouses.

U.S. citizens and U.S. residents can make unlimited  lifetime gifts and estate transfers to a spouse that is a U.S. citizen without triggering tax and without being charged against the unified exemption.

But gifts to a non-citizen spouse are exempt from U.S. tax only if less than an inflation-adjusted $100,000 in any year (currently $143,000).  Any excess is charged against the applicable unified exemption (currently $5.25 million for U.S. citizen or U.S. resident donors) and is taxable if in excess of that amount.

Special qualifying testamentary trusts called “QDOTs” (qualified domestic trusts) can obtain the unlimited “marital deduction” applicable to U.S. citizen spouses, but this results in a mere deferral of estate tax because the remaining QDOT assets are subject to U.S. estate tax upon the non-citizen spouse’s death.

Situs Rules.  Rules for U.S. situs and non-U.S. situs assets (which are critical for U.S. nonresidents) are not intuitive and are not consistent for estate and gift tax purposes.  To cite a few examples:

•           Stock in U.S. corporation.  Shares of a corporation organized in the U.S. are U.S. situs assets for estate tax purposes (regardless of what assets the corporation owns) but are non-U.S. situs for gift tax purposes because “intangibles” are treated as non-U.S. situs for gift tax purposes.

•           Stock in foreign corporation.  Shares of a foreign corporation are non-U.S. situs for estate and gift tax purposes even if the foreign corporation owns assets solely located in the U.S.   However, there may be U.S. estate tax issues if U.S.-situs assets that are owned directly are later transferred to the foreign corporation.

•           Debt instruments.  Debt instruments issued by U.S. borrowers (including U.S. corporations and U.S. citizens or residents) are U.S. situs assets for estate tax  purposes under the general rule, but are non-U.S. situs under certain special rules, such as, if the debt instrument provides “portfolio interest” (which is the case with practically all publicly traded bonds and debentures).  Debt instruments generally are non-U.S. situs intangibles for gift tax purposes.  It may be possible to structure personal promissory notes to provide for portfolio interest.

•           Partnership and LLC Interests.  There is no clear guidance from the U.S. Internal Revenue Service (“IRS”) on the situs of partnership or LLC interests.  Unlike shares of a foreign corporation, membership interests in a foreign LLC that owns U.S. real estate may be deemed by the IRS to be U.S. situs for estate tax purposes (under a “look-through” or aggregate ownership theory) whereas a U.S. or foreign LLC membership interest logically may be respected as a non-U.S. situs intangible for gift tax purposes even if the LLC owns U.S. real estate (just as with shares of a corporation).

•           Checks and Wire Transfers.  There is incomplete IRS guidance on the situs of transfers of checks and wire transfers from non-U.S. residents to U.S. residents.  Substantive analysis of what constitutes an “intangible” and informal IRS guidance supports the view that a check drawn by a non-U.S. resident from a foreign bank and paid to a U.S. donee is a non-U.S. situs transfer.  This view logically also would extend to a gift by wire transfer from a foreign bank to the account of a U.S. resident at a U.S. bank.  But this treatment is not certain.

Takeaways: 

•           U.S. citizens and U.S. residents should optimize use of $5.25 million per donor             unified exemption and other exemptions:

–           Since U.S. citizens and U.S. residents are subject to U.S. estate, gift and GST tax                          on worldwide assets, but U.S. citizens and U.S. residents qualify for a large                            exemption amount (currently $5.25 million), planning for U.S. citizens and U.S.                                   residents generally involves transferring as much value as possible within                                                 exemption amounts, such as, by:

•           Making lifetime gifts of property that is expected to appreciate in value                                          after the transfer, and

•           Using techniques to qualify for “discounted” valuations of property, such                                       as, family partnerships or partial undivided interests in property.

–           The current $5.25 million unified exemption and the low interest-rate                                              environment may provide an opportunity for large estates to “leverage” this tax-                             free amount with sales or other transactions with trusts or family members.

•           U.S. nonresidents should optimize use of non-U.S. situs assets and applicable   exclusions:

–           For U.S. nonresidents, the basic strategy is planning for non-U.S. situs                                            property, such as, by:

•           Holding U.S. real estate, U.S. stocks and U.S. business interests in                                                  foreign corporations as an estate tax “blocker” (so as to qualify as owning                                       only the shares of the    foreign corporation — a non-U.S. situs asset — and                                        not the corporation’s underlying U.S. situs assets), and

•           Making lifetime gifts (including funding of trusts) with intangibles and                                          other non-U.S. situs assets.

–           Other techniques involve use of “discounting” and perhaps further diminishing the                         net value of U.S. situs property by encumbering the U.S. property with debt                            and investing the proceeds of         that borrowing in non-U.S. situs assets.

–           With regard to trusts, it is possible for a U.S. nonresident to fund a “dynasty” trust                        for the benefit of multiple generations of U.S. descendants with non-U.S. situs                                    property and to escape GST (generation skipping tax) on distributions to                                          grandchildren and more remote U.S. descendants.

–           Revocable trusts or irrevocable trusts that qualify as disregarded entities for U.S.                           income tax purposes are other vehicles that may be used in connection with other                           non-U.S-situs holding structures.

(A later installment in this series will address some of the myriad issues relating                              trusts for international families.)

2.         U.S. Nonresident Estate, Gift and GST Tax Planning Needs to Be Coordinated with Income Tax Planning and with Any Applicable Foreign Taxes

Overview:

Often, there is a trade-off of higher income tax cost from use of entities that achieve gift or estate tax savings, but there can be means of mitigating these trade-offs. The U.S. and foreign income tax costs of an estate and gift tax structure need to be evaluated as part of the planning, as do any foreign tax issues.

For example:

•           Lifetime Gifts Take “Carryover” Income Tax Basis.  If a U.S. nonresident makes a lifetime gift (such as, of a non-U.S. situs “intangible” interest), the gifted property takes an income tax basis equal to the donor’s basis in the property (or a fair market value basis if the property has depreciated in value).  Property obtained upon death generally acquires a “stepped up” basis equal to fair market value.

•           Gifts of Encumbered Property May Trigger Income Tax.  If there is a gift of property subject to debt in excess of the donor’s basis in the property, this triggers a deemed sale for income tax purposes, which may be subject to U.S. income tax if the gain is deemed to be U.S. source income (such as with U.S. real estate or interests in partnerships that own U.S. real estate).

•           Foreign Corporation Loses Capital Gain Benefit and Provides No “Inside Basis” Step-Up at Death.  If U.S. real estate is held inside a foreign corporation (as an estate tax “blocker”), gain on the sale of the real estate is taxable at full U.S. corporate rates (currently, 35% maximum) and is not eligible for the 15% rate that currently applies to long-term capital gains of individuals. Furthermore, since the real estate is held inside a corporation, it would not qualify for a “step-up” in basis to fair market value at the time of the holder’s death (as occurs when property is held directly by a decedent).

Note:  Under so-called “FIRPTA” provisions, a withholding tax based on gross values is imposed when there is a disposition of U.S. real property that is owned by a non-U.S. entity or non-U.S. person.  If tax owned on net gain is less than the amount withheld, this excess is recovered by filing a U.S. tax return and claiming a refund of the excess.

•           Foreign Corporation With U.S. Business Subject to U.S. “Branch Profits” Tax.  If U.S. rental real estate or other U.S. business property is held directly by a foreign corporation (rather than by a U.S. corporate subsidiary of a foreign corporation), the foreign corporation can be subject to a second-level U.S. “branch profits” tax (a deemed dividend tax) on earnings accumulated inside the foreign corporation.

•           Foreign Corporation May Be Income-Tax-Efficient For Holding U.S. and Non-U.S. Portfolio Type Investments.  As with a nonresident individual, a foreign corporation generally is not subject to U.S. tax on capital gains on portfolio-type investments and is not subject to U.S. tax on “portfolio interest” from qualifying U.S. debt instruments, but is subject to a 30% withholding tax (perhaps reduced under a Treaty) on other investment income (so-called “FDAP” or fixed and determinable annual or periodic income), such as U.S. source dividends, rents and royalties.  A lower withholding rate may apply if the recipient of the U.S. source income qualifies for benefits under an income tax treaty between the U.S. and another country.  As with a nonresident individual, a foreign corporation is not subject to U.S. tax on non-U.S. source investment income.

•           U.S. Shareholders of CFCs and PFICs.  If a foreign corporation is used as a blocker to hold U.S. situs assets and the shares in the foreign corporation are inherited by U.S. descendants or inside a trust for the benefit of U.S. beneficiaries, then these “U.S. shareholders”  may find themselves subject to special U.S. income tax “anti-deferral” regimes applicable to “controlled foreign corporations” (CFCs) or “passive foreign investment companies” (PFICs).

A U.S. person’s ownership of shares in a CFC or PFIC that owns U.S. assets is a tax -inefficient structure (sometimes referred to as a “CFC sandwich”).  At minimum, the structure could have the detrimental effect of converting capital gain income into higher taxed ordinary income.  Potentially, the structure could involve an extra layer of U.S. withholding tax or income tax imposed on the foreign corporation and U.S. ordinary income tax on distributions or deemed distributions from the foreign corporation.  PFIC rules can cause a tax interest charge to be imposed on delayed distributions from the foreign corporation to a U.S. shareholder.

•           “FATCA” (Foreign Account Tax Compliance Act) Issues.

Starting with returns filed for the 2011 tax year, U.S. citizens and U.S. residents must report interests in foreign financial assets (including interests in foreign trusts and foreign estates that have a known value) if these assets exceed a threshold amount (at minimum, $50,000).  This report is filed on IRS Form 8938 with the U.S. person’s tax return.  These rules will extend in the future to certain domestic entities that own foreign financial assets.

Form 8938 supplements, and does not precisely correspond to, so-called “FBARs” (foreign bank account reports on Treasury Form TD F 90-22.1) that are required to be filed with the Treasury on June 30 of each year with respect to foreign financial accounts held during the preceding year.

Foreign financial institutions must now comply with new U.S. tax rules (enacted as part of the FATCA provisions that were enacted in 2010) that require identification of U.S. account holders and imposition of a 30% withholding tax on U.S. source income of accounts whose non-U.S. ownership cannot be ascertained.

Takeaways:

•           It is best to develop an integrated plan that considers all estate, gift, GST and                                income tax ramifications and the trade-offs among them, as well as U.S. tax-                            reporting issues.

•           There should be a plan in place for addressing CFC and PFIC issues at the time of                         death.  Some U.S. tax rules require action within 30 days of death in order to obtain          beneficial treatment.  There also needs to be a plan in place for succession to accounts           with foreign financial institutions.

•           With regard to U.S. real estate and other taxable U.S. situs property, a decision needs to   be made regarding the trade-off between U.S. income-tax-efficient structures and U.S.            estate and gift tax-efficient structures.  The time horizon for holding a particular U.S. real    estate or U.S. business is a key factor in this decision.  If a short time frame is expected,           perhaps estate tax risk could be addressed through the use of term life insurance.

•           All U.S. planning must be coordinated with foreign income, gift and estate tax issues.

IRS CIRCULAR 230: This article is intended for general informational purposes only and not as tax or legal advice.  It is not provided or intended by this firm to be used for (i) the purpose of avoiding federal tax penalties that may be imposed, or (ii) promoting, marketing or recommending any entity, investment, plan or arrangement to any person.