By CREATIVE PLANNING
March 03, 2022
Estate Planning Strategies: Cross-Border Pitfalls and Considerations
Traditional Estate Planning Tools
The solutions or tools of estate planning and wealth management that could be utilized in any given situation may include (but by no means are limited to):
- Wills (either a U.S. will, or a U.S. will coupled with a will where the expat has accumulated property (“situs will”);
- Trusts (living or testamentary, grantor or non-grantor, revocable or irrevocable, QDOT);
- Life Insurance (Whole, Universal, Second-to-die, ILIT – irrevocable life insurance trust; for business planning, retirement, estate preservation);
- Gifting Strategies (charitable, inter-spousal and trans-generational gifting);
- College Savings Plans (529s can be an extremely effective estate tax planning tool, particularly for grandparents and great-grandparents);
- Personal Investment Companies (PICs); and
- Cross-portfolio investment optimization (the right investment in the right type of account and in the right owner’s account).
Most of these tools are very familiar and frequently utilized by domestic financial planners and estate planning attorneys to assist single and multistate U.S. families. The utilization of offshore PICs should no longer utilized for U.S. clients or Controlled Foreign Corporation (CFC), or Passive foreign Investment Company (PFIC) rules will create income tax problems that would vastly outweigh any estate planning benefits.
However, PICs may be instrumental in the financial plan of a non-U.S. person investing into the United States.
Examples of Estate Planning Tools that May Not Travel Well
Perhaps one of the more dangerous routes that an expat family could take would be to rely upon the estate planning that was done before leaving the United States. It is generally advisable to review an existing estate plan (and the broader financial plan) when major events (divorce, remarriage, etc.) have resulted in changed circumstances, but the importance increases with a relocation overseas, or a move from one foreign country to another. U.S. expats need to be aware that standard U.S. estate planning techniques will likely fail to protect wealth in cross-border situations and may even produce unintended, counter-productive results.
These are issues that extend beyond the scope of this guide, but certain issues can be discussed to illustrate the nuances involved in cross-border estate planning. As the fact patterns (citizenship, domicile, residency, marital history, assets, etc.) of the global family change, so will the tax implications and the available solutions.
Utilizing wills in international estate planning:
A will is one of the more common and widely utilized estate planning tools in the United States. A traditional will provides written directions on how the individual (the “testator” of the will) wishes to distribute their assets upon their death. While different states have specific legal requirements for executing a will with legal effect, generally the requirements are straightforward:
- That the testator be legally competent and not under undue influence;
- That the will describe the property to be distributed; and
- That the will be witnessed by the requisite number of witnesses.
In addition to testamentary wills, living wills and powers of attorney are also utilized to direct who can make decisions for the individual in the event of physical or mental incapacity. The complexity and sophistication of traditional and living wills varies greatly, and any individuals with estates that may approach the levels that trigger any transfer taxes (which may be substantially lower in many foreign countries), or anyone who wants to make sure that their wishes are given legal effect, would be well advised to seek legal counsel regarding the drafting and execution of their will.
Within the cross-border context, individuals would be wise to seek legal counsel with a specialized focus on estate planning in the relevant jurisdictions. Some international estate planning experts suggest multiple “situs” wills, with each will governing the distribution of property in the country for which the will is executed. There seems to be some risk in a strategy of multiple wills, as the traditional rule holds that the legal execution of a will extinguishes the validity of any prior will. Coordination of multiple wills would be critical in such circumstances.
Other experts suggest one “geographic will,” which would incorporate the laws of the relevant jurisdictions involved in the distribution of the testator’s assets. The propriety or effectiveness of the geographic will is likely to depend on the laws of the relevant jurisdictions and the expertise of the legal advisers involved in the design and execution of the will.
Caution when moving overseas with trust structures:
If your estate plan includes trusts, it is particularly dangerous to move overseas with your old domestic estate plan in tow as it may not travel well at all. For example, consider a U.S. citizen who established a revocable grantor trust in favor of their children and grandchildren, but who thereafter moves to live and work overseas. There may be extremely negative consequences (e.g., the trust may be separately taxed upon the grantor obtaining residency in the new country), and those consequences will vary depending on where the expat relocates and how long the expat and their family remain in their new country of residence.
In civil law/forced heirship regimes, a fundamental problem exists when examining distributions to heirs through such a trust: the beneficiary is receiving the property from the trust, rather than a lineal relative (parent, grandparent, etc.).
For example, if the expat grantor moves to Germany with their family, the children-beneficiaries will be German residents and the intended consequences of the grantor trust will conflict with German gift and inheritance tax laws. This exposes distributions from the trust to potentially higher German transfer taxes. The magnitude of unintended tax consequences might intensify over time. If the grantor and beneficiaries remain in Germany over ten years, the tax relief offered by the U.S.-Germany Estate and Gift Tax Treaty phases out and distributions from the trust could be exposed to the highest German transfer tax rate of fifty percent.
Similar results may occur in France, which has a complex reporting and tax regime applicable to any trust with French situs assets or a French domiciled settlor or beneficiary. There have been recent reforms in several civil law jurisdictions designed to better accommodate immigrants’ trusts, but uncertainties and complications remain.
The dangers are not limited to the expat who relocates to a civil law jurisdiction. If a U.S. citizen arrives in the U.K. (a common law jurisdiction) with an existing U.S. trust, the U.K. authorities may not recognize this trust structure, or, worse, consider the trust a U.K. resident and subject the trust assets to immediate income taxation on the gains within the trust. If the trust provides for a successor U.S. trustee, then a settlement (triggering U.K. inheritance gains taxes) could also be declared on the death of the U.K. resident trustee (the grantor).
In Canada, which shares the British common law heritage, a special capital gains tax will be periodically assessed on trusts holding Canadian real property.
Gifting strategies (e.g. 529s) to reduce your taxable estate:
Lifetime gifting strategies are a common method for reducing a taxable estate in the United States. Section 529 college savings plans have grown substantially in popularity over recent years, as parents begin to realize the tremendous long-term advantages to saving larger amounts for college in earlier years for their children, and 529 accounts allow substantial deposits (as much as $160,000 in a one-time gift from joint filers covering a five year period) and provide Roth IRA style tax-free growth of the investment account, provided that the 529 plan assets are withdrawn for qualified educational expenses. Moreover, grandparents and great-grandparents can employ a 529-plan gifting strategy to shrink the taxable estate and to pass on wealth to grandchildren and great grandchildren (otherwise “skip classes” that would trigger generation skipping transfer (GST) taxes in addition to estate or gift taxes). In short, Section 529 college savings accounts provide tremendous income and transfer tax-advantaged gifting opportunities to accomplish multigenerational wealth transfer. They also provide the donor with control over the use of the gifted proceeds and flexibility regarding the designation of account beneficiaries.
However, while U.S. expats are free to open and fund 529 college savings accounts, they must be aware of the local country rules in their country of residence regarding the gains that will eventually accumulate within these accounts. From an income tax perspective, it is worth mentioning here that there are no treaties between the United States and any foreign jurisdiction that recognizes the tax-free growth of investments in 529 accounts (or Coverdell ESAs – another type of U.S. savings vehicle for education expenses allowing much smaller annual contributions). Therefore, it is quite possible that the expat individual will find that gifting through a 529 plan could create detrimental tax consequences, as the donor may potentially incur tax liability on any investment gains in the portfolio going forward (recognized or unrecognized gains, depending on the local tax rules). Alternative college savings or generational gifting strategies (including having U.S. based relatives open the 529 account) may work better for expats.
Estate Planning for Families That Include a Non-U.S. Citizen Spouse
Americans living abroad may accumulate more than income and assets while living and working abroad, they may also find love! Unfortunately, the tax complications and challenges facing American expats also extend to the circumstance of marrying a foreigner. Even if an expat’s spouse obtains U.S. permanent resident (“green card”) status, gifts and bequests to the noncitizen spouse are not eligible for the unlimited marital deduction. On the other hand, the $12.06 million (2022) lifetime exclusion applies to bequests left to anyone, including a noncitizen spouse.
For estates larger than the lifetime exclusion limit, alternative estate planning strategies may be required, two of which are discussed below.
Lifetime gifting to the noncitizen spouse: First, although a citizen can give unlimited assets to a fellow citizen spouse during their lifetime, there is a special limit allowed for tax-free gifts to noncitizen spouses of $164,000 annually (2022). Accordingly, a gifting strategy can be implemented to shift non-U.S. situs assets from the citizen spouse to the noncitizen spouse over time, thereby shrinking the taxable estate of the citizen spouse. The nature, timing, and documentation of the gifts should be done with the assistance of a knowledgeable tax and/or legal professional.
Qualified domestic trust (QDOT) – an important tool for marriages between a U.S. citizen and a noncitizen spouse: A QDOT is a type of trust designed to afford the surviving spouse the ability to claim use of and income from the decedent spouse’s estate during the lifetime of the surviving spouse, but then the QDOT assets will pass to the original decedent’s heirs upon the death of the surviving spouse. With a QDOT, only distributions from principal during the surviving spouse’s life and at the surviving spouse’s death are subject to estate tax (insofar as they exceed the original decedent spouse’s exclusion). Accordingly, the QDOT can be a critical wealth planning tool for deferring the estate tax until distribution to eventual U.S. citizen heirs when the surviving spouse is a non-U.S. citizen.
The QDOT can be created by the will of the decedent or the QDOT can be elected within 27 months after the decedent’s death by either the surviving spouse or the executor of the decedent’s estate. If the QDOT is created after decedent’s death, the surviving spouse is treated as the grantor for income and transfer tax purposes. Certain transfer tax treaties provide spousal relief that may lessen the need for a QDOT, and, if the treaty benefit is claimed, the QDOT may no longer be utilized.
It should also be noted that, while the QDOT trust can certainly be a useful tool for arranging for the eventual transition of the U.S. estate to U.S. citizen heirs while providing maintenance for the surviving noncitizen spouse, the tax and maintenance consequences may pose considerable negatives that outweigh the benefits of setting up the trust arrangement. The cross-border family may have alternative solutions for providing for the heirs and for the maintenance of the noncitizen spouse that are more practical or even more tax efficient (such as a lifetime gifting strategy, discussed above). The personal and financial merits of the QDOT and alternative planning tools must be analyzed on a case-by-case basis.
Gifts/Inheritances from Foreigners
In contrast with many succession/heirship-based transfer tax systems abroad, gifts and inheritances in the United States are not taxed to the beneficiary of the gift or bequest, because we have a transfer tax system that taxes these transfers at the source of transfer (i.e., the donor, grantor, or the estate). For transfers on death, in addition to receiving the distribution tax free, the beneficiary of a bequest will receive what is known as a “step-up in basis” to the fair market value of the asset on the date of death (or the alternative valuation date, 6 months after the date of death).
For gifts, the recipient takes the donor’s original cost basis.
For the American taxpayer (citizen or resident) inheriting or receiving a gift from a foreign person, the general rule still applies: no income or transfer tax will be due at the time of receiving the gift or inheritance, and the beneficiary receives the donor’s basis in a gift or receives a full step-up in basis in a bequest. However, the American taxpayer needs to be mindful that special disclosure rules apply to gifts or bequests received from foreign persons (or entities). If the American taxpayer receives annual aggregate (can be from multiple donors/grantors/testators) gifts above $17,339 (2022) from a foreign corporation or partnership, or aggregate gifts or bequests from a nonresident alien or foreign estate exceeding $100,000, the taxpayer must report the amounts and sources of these foreign gifts and bequests on IRS Form 3520, which must be filed at the time that the income tax is due, including extensions. Not unlike the FBAR, this disclosure requirement is designed to help the IRS flag substantial income that may have been mischaracterized by the taxpayer so that the IRS may further investigate and verify the nature and character of the transactions.
Non-U.S. Persons Investing in the United States
Even modest foreign investments in the U.S. may raise transfer tax issues: When non-U.S. persons own U.S. situs assets, including real estate, U.S. corporation stocks, and tangible personal property (e.g., collectibles) that remain in the United States, they are generating a U.S. estate – one with a considerably smaller exemption of only $60,000. If the investor resides in one of the sixteen estate tax treaty countries, there may be significant treaty-based relief available.
Non-Americans are more likely to trigger federal transfer tax liability than a similarly situated U.S. citizen. While the foreign investor in the U.S. may become very aware of the federal (and possibly state) income tax regime, they might be well served by learning the particulars of the federal (and possibly state) estate and inheritance tax regimes that could impact the distribution of those investments to their heirs. More sophisticated estate planning tools become necessary at more modest estate levels whenever the assets of a non-U.S. person are concerned.
Nonresident foreign (NRA) investors in U.S. real estate:
The United States can provide a very attractive market for investing in marketable securities. For example, the situs rules discussed earlier illustrate that investments in U.S. publicly traded fixed income (bonds) will not subject the foreign investor to estate taxes (nor income taxes). However, the United States has not extended the investor-friendly income and estate tax rules to foreign investment in U.S. real estate. As mentioned previously, foreign direct ownership of U.S. real estate will subject the nonresident’s estate to U.S. estate tax. Frequently, it will make sense to own U.S. Real Estate through an offshore corporate or trust structure (for a foreign, nonresident investor only, as U.S. persons should avoid offshore corporate or trust structures) to avoid U.S. estate tax, and possibly reduce U.S. income tax as well.
From an income tax perspective, direct ownership of investment real estate will subject the foreign, nonresident investor to preparing the annual federal income tax (U.S. 1040-NR) and state income tax return. More concerning, it will also subject the foreign, nonresident to a more complicated tax regime – the Foreign Investment in Real Property Tax Act (FIRPTA) – which creates a myriad of tax headaches that are well beyond the scope of this article. This example merely highlights that certain investments may be subject to more draconian reporting and taxation rules than other investments. Ultimately, competent financial planning and investment management must recognize and design an investment plan that takes full consideration of the cross-border tax issues.
Cross-Portfolio Investment Optimization
While non-U.S. investors and noncitizen spouses present obstacles for certain common traditional estate planning tools (e.g., joint ownership), knowledge of U.S. situs rules can be utilized to construct family portfolios that are particularly U.S. income tax and U.S. estate tax efficient. Despite its importance, cross-portfolio investment optimization is something that is seldom discussed in a meaningful way, much less implemented effectively.
In addition to optimizing after-tax returns, a holistic approach involving all of the various accounts available to cross-border investors (brokerage, IRA, etc.) can also help with transfer taxes. For example, to return to the global family from earlier (U.S. citizen, French spouse, and child living in Germany, with two U.S. children from the U.S. citizen’s prior marriage living in the U.S.), the tax-conscious financial plan can go beyond the routine suggestion of a QDOT, and design investment portfolios that will minimize potential income and transfer taxes in a comprehensive wealth management strategy. The U.S. citizen’s portfolios might be over-weighted in certain asset classes including U.S. stocks or ETFs, while their spouse’s portfolio might be overweight bonds, international equities, or non-U.S. ETFs).
This approach can allow for superior after-tax returns to help achieve important lifetime goals and greater wealth transfer to heirs. Solutions can even be modified with sophisticated ownership structuring (e.g., the noncitizen spouse might own securities through a trust or offshore company), all designed with the assistance of legal and tax advice from competent consultants in the relevant jurisdictions. Indirect ownership can be a particularly effective means for non-U.S. persons to own U.S. real property, too.
Cross-border families and multinational asset portfolios add substantial complexity to the financial planning needs of global families. Citizenship/domicile/residency, location, and character of investments (situs of assets), applicable tax treaties and/or the availability of foreign tax credits, and the existing or proposed estate plan are some of the critical variables that must be factored into a financial plan and in the design of a comprehensive portfolio that is optimized for income as well as transfer tax efficiency. The savvy expat or multinational family needs to understand that the standard U.S. estate plan may not protect wealth as intended. A team of expert trusted advisors is required. This team of expert trusted advisors should possess a combination of cross-border legal, tax, and financial planning expertise to tailor a comprehensive financial plan including an estate plan and an investment strategy that is suitable for the multijurisdictional taxation regimes to which the expat or multinational family’s wealth is subject.