By CREATIVE PLANNING
March 03, 2022
Cross-Border Issues that Amplify the Complexity of Estate Tax Planning
U.S. Estate Tax Basics
U.S. taxation – “exceptional” in reach and scope: America is “special” in many ways, but few aspects of American “exceptionalism” are as tangible as the way the U.S. Treasury levies taxes on its citizens who leave its borders to live and work abroad. While the global income taxation of U.S. citizens gets far greater attention, U.S. transfer taxes apply no matter where a U.S. citizen lives, gifts property, or dies. While expat Americans do enjoy income tax relief in the form of the foreign earned income exclusion, there is no transfer tax corollary for expats. Accordingly, the expat should expect the U.S. Treasury to impose estate tax at their death upon all worldwide assets, including proceeds of life insurance policies, retirement assets, personal property (including investments), real estate, and other assets. Additionally, estate tax may be owed on certain assets transferred to others within a specified period before death, or where the decedent retained an interest in the property.
Currently, the vast majority of Americans, at home or abroad, have little concern for U.S. federal estate taxes. Recent estate tax law changes have significantly increased the federal estate and gift tax lifetime exclusion amount to very high thresholds:
- $12.06 million personal lifetime exemption (2022).
- Interspousal transfers: gifts and bequests (during your lifetime or upon death) between spouses are unlimited (to citizen spouse).
- Portability of unused exemption to surviving spouse: Beyond that, if the first-to-die spouse’s exemption amount is not fully utilized, an election on that estate tax return will preserve the remaining unused exemption amount for the second-to-die spouse.
With a $24.12 million-per-couple exemption, most Americans feel that the estate tax is something that can be ignored. That said, the U.S. federal estate tax regime may be described as in a state of flux, with some policymakers calling for its complete abolition, and others seeking to return the exemptions to much lower levels. At present, the recently doubled exemptions are slated to sunset in 2025, returning to pre-2017 tax law levels. Moreover, a laissez-faire attitude to estate planning is far less justified if the U.S. citizen client is married to a non-U.S. citizen. If the non-U.S. citizen is the surviving spouse, the unlimited marital deduction will not be available and the likelihood of estate taxation upon the death of the first spouse increases. Transfers during lifetime to the non-U.S. citizen spouse can reduce the U.S. citizen spouse’s estate, but the annual marital gift tax exclusion is reduced from unlimited to $164,000 (2022). In short, since no one can confidently predict where the estate tax exclusion, marital deduction and tax rate levels will be in the future, ignoring estate planning based on current tax thresholds may be a costly mistake.
Estate planning challenges for the expat and/or multinational family: Multi-jurisdictional estate planning issues are nothing new for Americans and their financial advisors: A typical affluent American family may have brokerage accounts, savings accounts, and a security deposit box with valuables in New York, a primary residence in Connecticut, a second home in Florida, and possibly even a trust established in Delaware or Nevada. Accordingly, in addition to the federal estate, gift, and generation-skipping transfer (GST) tax regimes, the transfer tax regimes of multiple states may also factor in the distribution of wealth (during lifetime and after death) to the surviving spouse, the children, and future generations. This is already a complex situation, requiring the assistance of legal and financial professionals.
Now imagine that typical affluent American family in a modern, global setting: A United States citizen living in Germany, married to a citizen of France (a “non-U.S. person”), with two children from a prior marriage living in the United States and one from the present marriage living with their parents in Germany. There may be real property in various jurisdictions, separately or jointly titled, personal property also spanning the globe, limited partnership interests (e.g., hedge fund, private equity, or structured products), joint brokerage accounts, individual brokerage accounts, pension funds, defined contribution plans, IRAs, Roth IRAs, and college savings or UTMA/UGMA accounts for the children. There are many factors that will make the transfer tax planning puzzle exponentially more complex for this model global family than for the multistate family.
A Brief Overview of Contrasting International Transfer Tax Regimes
Common law vs. civil law foundations: While the estate tax laws of different U.S. states may have critical differences (e.g., the recognition and/or treatment of community property), these differences are subtle in comparison to the international landscape. This is partially because all (save Louisiana) states share the same legal foundation: English common law. On the other hand, most European, Latin American, and African nations have civil law systems. Broadly speaking, civil law systems are based on Roman law, and statutes tend to be longer, more detailed, and leave far less discretion or interpretative influence to the courts. In contrast, common law systems tend to have more concise constitutions and statutes and afford more discretion and interpretive power to the courts when applying the laws to particular facts and circumstances.
Substantial planning flexibility in common law regimes: In the estate planning context, common law jurisdictions typically afford much more discretion to the individual (the decedent) to design a scheme of distribution to those people or institutions (heirs) to whom the individual desires to pass on their wealth before or after death. Wills are the common method of establishing a blueprint of specific instructions for passing (bequeathing) wealth to others (spouses, descendants, friends, charities, etc.) through the probate system. Trusts are a primary method of implementing a scheme of distribution that may allow some or all of the decedent’s assets to bypass probate, and (sometimes) to defer or avoid estate taxation. In common law jurisdictions, it is usually the estate of the decedent that is taxed prior to distribution of wealth to chosen heirs. If the decedent fails to construct a legally valid will (a situation known as intestacy), trust or other will-substitute scheme (e.g., joint titling all property), the state intestacy laws will direct the distribution of the decedent’s property.
Succession and forced heirship dominate civil law and other regimes: Civil law countries tend to follow a succession regime, developed under the Napoleonic code, also known as hereditary reserve (or forced heirship). This is analogous to the intestate succession rules followed in common law when the decedent has otherwise failed to direct the distribution of wealth upon death through a will. These regimes are quite different, a decedent in a civil law country may have little or no say in the distribution of all (or most) of the wealth accumulated (or previously inherited), during their lifetime. Moreover, civil law succession regimes tend to prefer to impose tax upon inheritance (i.e., upon the heirs) at the time of distribution of the decedent’s estate rather than impose tax upon the estate of the decedent prior to the distribution of the decedent’s estate. Finally, the concept of a trust is likely to be of little or no legal validity in a civil law context.
Given the critical fundamental legal differences in the distribution and taxation regimes around the world, it should come as little surprise that a family’s existing estate plan (designed for one legal system) may quickly become outmoded, ineffective, and even counter-productive once the family relocates overseas (and becomes subject to a completely different legal system).
Concepts of Citizenship, Residency, and Domicile
Concepts of citizenship, residency, and domicile have crucial significance in determining the exposure of a person to the transfer tax regime of any particular country. An expat should understand the definitions and requirements under the laws of the country(ies) in which they live, work, or own property. Naturally, the likelihood that the effectiveness of an American’s existing estate plan will deteriorate will depend not only on to where the family relocates, but also on how much the family integrates its wealth/assets/investments into the new country of residence, and for how long the expat family remains (or plans to remain) in the new country of residency. For example, the U.K. has three residence statuses that impose different rules based on length of residency or election of status: resident, domiciliary, or deemed domiciliary. The status of the taxpayer will have significant income and transfer tax consequences, and of course, the distinctions vary by country.
In the United States, there is an objective test for determining whether a non-U.S. person is a U.S. resident for income tax purposes (the “substantial presence” test) that measures the days of the tax year that the taxpayer was physically within the United States. A U.S. citizen is always considered resident in the U.S. for U.S. income tax purposes. A U.S. Lawful Permanent Resident (a green card holder) is considered resident in the U.S. for income tax purposes unless they make a treaty valid election to be considered non-resident.
Transfer taxes are more closely tied to the concept of domicile rather than residency. Domicile is acquired by living in a jurisdiction without the present intention of leaving at some later time. Residency, without the requisite intention to remain, will not create domicile, but domicile, once created, will likely require an actual move outside the country (with intention to remain outside) to sever it. Accordingly, for an immigrant to attain estate tax residency in the U.S., the person must move to the United States with no objective intention of later leaving. Permanent resident (green card) status would in most (but not necessarily all) cases establish domicile. In practice, there is no bright line test for noncitizens to establish domicile. U.S. Courts have looked at a number of factors in determining the domicile of a decedent.
