All U.S. situs assets held by a non-resident non-citizen (NRNC), both tangible and intangible, unless falling within a limited exemption, are subject to the U.S. estate tax. Those same assets held in a foreign corporation are excluded from estate tax.
The foreign corporation is used to break the estate and gift tax ownership connection to U.S. situs assets. The offshore entity separates the NRNC individual or foreign trust from direct ownership of U.S. assets, removing any tax arising upon the death of the NRNC shareholder. Shares in a foreign corporation held by an NRNC are considered situated outside the U.S. and subject to neither Gift nor estate tax.
Treasury Regulations place “situs” of a corporation at the place of organization. The regulations further state that this test applies “irrespective of the location of the (ownership) certificates.” Shares of stock owned by a decedent in a U.S. entity are thus subject to estate tax. Conversely, NRNC equity in a foreign entity taxed as a corporation is not subject to estate tax.
Foreign trusts formed by an NRNC should make U.S. investments through a foreign holding company. Using separate foreign companies to hold different trust assets both avoids exposure to the Estate Tax on trust assets and segregates corporate liabilities. The holding company must carefully comply with applicable corporate formalities and be treated (for legal, financial and operational purposes) as separate and distinct from its owner(s).
U.S. property transferred by an NRNC to a foreign trust during their life remains subject to estate tax if the grantor retains at their death the power “to alter, amend, revoke or terminate” the rights of a trust beneficiary. If the NRNC grantor may revoke or deplete a foreign trust, which owns U.S. situs property, the IRS will include in the NRNC's estate any trust assets in the U.S.
The NRNC grantor of a foreign revocable (ignored) trust with U.S. property must move trust assets into a foreign holding company (itself owned by the trust) before death. The foreign corporation will generally break the estate tax connection to the NRNC and the NRNC grantor may otherwise reduce the risk of incurring estate tax by relinquishing control of, and benefit from, the trust. However, if they die within three years after relinquishing such rights, the estate tax will not be avoided.
Foreign trust assets may subject an NRNC grantor to estate tax even if trust assets are foreign situs on the date of the grantor’s death. If U.S. property was initially in the trust, but was later sold and replaced with foreign assets, such assets may be deemed U.S. if the transfer occurred within three years of the NRNC’s death.
Clients should initially acquire U.S. property in the foreign entity. Transferring stock in an existing U.S. corporation to a foreign holding company may cause a foreign holding company to be treated as a U.S. corporation for tax purposes. Until 2017, the 35% U.S. corporate tax rate was one of the highest and applied to worldwide corporate income. Shifting ownership abroad though “inversion” typically reduced net income tax. The legislative intent of Code §7874(b) is to block the shift of ownership to a low-income tax jurisdiction.
Anti-inversion regulations provide that, if at least 80% ownership of the new foreign corporation is retained, the offshore entity will be deemed a U.S. corporation and receive no tax benefits from the reorganization. Furthermore, the anti-inversion regulations provide that if the U.S. shareholders retain less than 80% but at least 60% of the new corporation, then the new corporation is not deemed a U.S. corporation. In such case, the offshore corporation is prohibited from using U.S. tax credits or net operating losses to offset gains from asset transfers to the new corporation.
Deemed U.S. corporation status of a foreign holding company applies if: the U.S. corporation becomes a subsidiary of a foreign corporation or otherwise transfers substantially all its assets to a foreign corporation; the former shareholders of the U.S. corporation hold at least 80% of the foreign corporation's stock; and the foreign corporation does not have substantial business activities in the foreign country of incorporation.
Real property has tax situs in the jurisdiction in which it is located. Consequently, U.S. real estate (a tangible asset) is included in the taxable estate of an NRNC. If real estate is instead owned by a foreign corporation, which itself is owned by the NRNC, the property is excluded from gift tax and estate tax.
The NRNC acquiring U.S. real estate should do so through a foreign corporation. If U.S. real estate is initially purchased directly by the NRNC, the subsequent transfer of the property to an offshore corporation could have tax consequences or be treated as an inversion. Appreciated U.S. real estate held by an NRNC may trigger taxable gain upon transfer to a foreign corporation.
Unlike the rules regarding corporate stock, the tax situs of foreign entities taxed as partnerships is ambiguous. The limited case law suggests that a factual examination of the partnership’s assets and business activities is necessary to determine the situs. The IRS has not ruled on exactly how to determine the situs of foreign partnership interests in the hands of an NRNC. Situs may be based on such factors as where the partnership does business or holds assets or where the equity holder resides.
IRS rulings suggest that the taxable U.S. estate of an NRNC will include the NRNC’s pro-rata share of U.S. assets held by a foreign partnership if either the country of formation does not recognize the partnership as a legal entity or the partnership dissolves upon the death of a partner. In either case, the partnership entity is disregarded, and its U.S. assets are deemed owned by the partners, and situated in the U.S. A U.S. federal appeals court confirmed that dissolution of a foreign entity upon the death of one of its owners causes its U.S. assets to be included in the NRNC owner’s estate.
If the country where the partnership was organized recognizes the partnership as a legal entity, which survives the death of a partner, then equity in the partnership will likely be recognized by the IRS. Situs of equity in the partnership must then be determined. One court ruled that, if equity in a foreign partnership is intangible property, situs is the domicile of the decedent. Treaties (if applicable) typically follow the same logic. One IRS position is that equity has situs at the business location of the partnership. In any case, the situs of an IRS recognized partnership seems unrelated to the location of partnership property.
If the entity is recognized by the IRS, avoidance of U.S. situs can therefore be accomplished by, for example, either, avoiding U.S. operations or holding partnership equity in a foreign corporation. Foreign situs will keep the value of partnership equity outside the taxable U.S. estate of the NRNC partner.
The Limited Liability Company
The clarity of U.S. law establishing the country of organization as the situs of “corporate” stock, makes foreign limited liability companies (LLCs) an attractive option. The LLC is generally more protective of owner equity than the corporation. Although LLC membership interests are not identical to corporate stock, Treasury Regulations treat foreign LLCs as corporations for tax purposes, unless the LLC elects otherwise, if all members have limited liability. If any of the members do not have limited liability, the LLC is treated as a tax partnership. Establishing limited liability in a foreign LLC is typically not difficult.
If a foreign LLC is treated as a corporation for tax purposes, ownership interests in the LLC are not U.S. situs property and may be transferred tax-free by NRNCs (during life or at death). One planning technique is to own U.S. real estate, or a U.S. real estate holding company, through a foreign LLC, itself owned by the NRNC or a foreign entity. The structure moves situs offshore to the LLC, which is typically taxed as a corporation, thus avoiding estate tax. In the case of appreciated real estate subject to U.S. tax on gains from sale, no tax is payable on appreciation until the property itself is sold, irrespective of any transfer of the foreign entity owner.
Massachusetts also imposes estate tax on non-residents. The tax is levied on tangible property located in MA, to the extent of value exceeding $1,000,000 upon the death of the non-resident owner. Fortunately, MA allows for the avoidance of the estate tax on tangible property in the state if held in an entity. The entity is considered intangible property held by an out of state owner. This removes MA situs and eliminates the MA estate tax payable upon the death of the owner/LLC member.
NRNCs and foreign trusts incur U.S. estate tax on bequests of U.S. situs assets. If such U.S. assets are held in a foreign corporation, they are excluded from U.S. estate tax. The foreign corporation, or LLC taxed as a corporation, is used to break the U.S. estate and gift tax connection to U.S. situs assets. Equity in the foreign holding corporation is not U.S. situs property and may be transferred tax-free by NRNCs during life or at death. NRNCs should own U.S. situs assets outside the U.S. estate tax net through a foreign corporation.
The same strategy applies to avoid MA estate tax on tangible property in MA. To avoid MA estate tax, non-residents should hold tangible property located in Massachusetts in an LLC.
Gary Forster, J.D., LL.M, is managing partner at ForsterBoughman. Contact him at firstname.lastname@example.org.