Estate, gift and trust tax considerations for US domiciliaries and non-residents

Federal income versus transfer tax

The US taxes its citizens and residents on their worldwide income but also levies a gift, estate and generation-skipping transfer tax (GSTT) on worldwide assets of both citizens and individuals domiciled in the US. A non-citizen is subject to US income tax when they become a resident. Transfer tax applies when the foreign person becomes domiciled in the US.

‘Residence’ and ‘domicile’ are often used interchangeably. However, they have different meanings and implications for tax purposes.

Residence versus domicile

A non-US citizen is a resident of the US for income tax purposes when they obtain a green card or are present in the US for at least 183 days in a year. The presence test also includes a formula that considers an individual’s presence over three years. US residence, even as a green card holder not living in the US, presents US tax filing obligations in respect of worldwide income, although foreign tax credits may cover some or all of any US tax on that income.

However, a person can be a US resident but not domiciled in the US. A person is considered domiciled in the US when they live in the country and intent to remain indefinitely.

The intent of the taxpayer is a determining factor. When establishing intent, relevant factors include declarations of intent in visa applications or testaments; duration of residence in the US; commercial and family interest links with other countries; place of religious practice; country of registration as a voter and driver’s licence.

A US domiciliary is subject to transfer tax on worldwide assets. A person not domiciled in the US – a nonresident alien (NRA) – is only subject to US transfer tax on assets located in the US. The transfer tax rate caps at 40%.

Exemptions from transfer tax

A $12,060,000 exemption applies to lifetime gifts made by US citizens and domiciliaries as well as on their estates. An annual gift tax exemption applies to gifts to individuals of up to $16,000 per beneficiary, and such gifts do not reduce the lifetime exemption.

A GSTT exemption of $12,060,000 applies to transfers to family members who are two generations below the transferor. Or if the beneficiary is not part of the family, to individuals 37 and ½ years younger than the transferor.

No tax is applied on transfers between US spouses, regardless of the value. This is called an unlimited marital deduction. However, if only one of the spouses is a US citizen, transfers from the US citizen spouse to the non-US citizen spouse only benefit from the less favourable gift tax exclusion of $164,000 per annum.

The current exemption regime will sunset on 31 December 2025, reverting to a less favourable regime.

The estate tax exemption for an NRA is only $60,000. If the surviving spouse receiving assets from the NRA is a US person, that spouse must file Form 3520 if the assets received exceed $100,000.

Trusts created by a foreign individual

Trusts are an excellent planning tool for high net-worth-individuals (HNWIs). They can be used to accomplish many objectives, including income and estate tax minimisation, pre-immigration planning, and asset protection planning.

A trust is a domestic trust if a court in the US can exercise primary oversight over the administration of a trust and a US person has control over substantive decisions regarding the trust. All other trusts are foreign.

Foreign trust with a US beneficiary

Taxation of a foreign trust’s income depends on the qualification of the trust as a non-grantor or grantor. For a non-grantor trust, the trust itself or the beneficiary is subject to income tax. Conversely, the settlor is taxed on the income of a foreign grantor trust.

If a US settlor creates a foreign trust with a US beneficiary, the settlor is treated as the owner of the trust’s assets and is taxed on its income, regardless of whether he maintains any kind of interest in the trust.

A trust has a US beneficiary unless no portion of the income or capital can be paid or withheld for the benefit of a US person, and no portion of the income or capital is transferred to a US person if the trust ends.

If a foreign trust is created by an NRA and has a US beneficiary, the latter is generally liable for income tax in the US on any distribution from the trust. If the trustee does not provide adequate information about the trust’s income, distributions are treated as accumulated distributions subject to an anti-deferral regime known as the ‘throwback.’ Accumulated distributions are taxed as ordinary income and compound interest for each year of accumulation.

In addition, a foreign trust created by an NRA settlor is subject to the five-year lookback rule. Under the lookback rule, if the settlor moves to the US within five years from the asset transfer, he may be subject to stringent compliance requirements concerning the original transfer to the trust and may be considered the owner of the assets in trust if there is a US beneficiary.

Domestic trust created by an NRA

Most domestic trusts created by NRAs are classified as non-grantor trusts. As such, the trust’s income is taxed in the US, eliminating any income tax advantage.

However, if the NRA does not move to the US, there may still be an estate tax advantage because the assets in trust could be considered as outside the estate and not subject to estate tax upon death.

Compliance and sanctions

A US person who receives assets as gifts or mortis causa from a foreigner may need to submit a Form 3520 information return.

The Internal Revenue Service (IRS) may issue steep sanctions to the recipient of undisclosed gifts. The monthly penalty is 5% of the total value received, up to a maximum of 25%.

A US person who receives distributions from a foreign trust and knows or has reason to know that such distributions come from a foreign trust is required to file Form 3520. Failure to report a distribution is subject to a penalty of up to 35% of the gross amount of the distribution.

Form 3520 is also required if a US person creates a foreign trust or makes a transfer to a foreign trust. Form 3250-A must be filed if a foreign trust has a US owner.

Due to the complexity of the US tax landscape, US citizens, residents and NRAs need to carefully consider their US estate tax exposure, together with any potential foreign estate tax implications.