US Non-Resident Alien Estate Tax Trap by Chinese Owners of US Situs Assets: also significant for other foreign buyers
The United States still remains the emigration destination of choice among Chinese HNWI
On July 15th, 2017 Hurun Research Institute in association with Visas Consulting Group released the “Immigration and the Chinese HNWI 2017”. By surveying early this year hundreds of Chinese HNWI with wealth of between CNY 10 million and 200 million (USD 1.5 million to USD 30 million), and UHNWIs with over USD 30 million who have already emigrated, are applying to emigrate or who plan to do so in future, the report reveals that in terms of property purchasing and emigration, the United States still remains the emigration destination of choice among HNWI. The top destinations for emigration and property purchase are Los Angeles, Seattle, San Francisco, New York and Boston in the United States.
The National Association of Realtors (NAR) data show that in 2016 Chinese dominated the US home sales to foreign buyers: Chinese citizens purchased 29,195 US homes; this results in 11,386 US homes sold to Chinese citizens for investment or occasional use. Chinese buyers were the largest by dollar volume, investing an estimated USD 27 billion into US real estate.
Within China, a case has come to light in which a Chinese entrepreneur in the years since 2009 bought under his own name 20 properties in the United States: 10 in California, 6 in Hawaii, 2 in New York and 2 in Massachusetts. From 2012 his business went downward and all his assets in China gradually were taken over to pay off debts. He died recently and his son went to the United States to inherit the properties, hoping to cash out. To his great astonishment he found out that the properties in New York and Massachusetts had long been confiscated due to unpaid property taxes, and for the other 16 properties he would first need to pay a 40% estate tax to the US in order to inherit from his late father.
Because he is a non-resident alien in the US, he can only get USD 60,000 exemption for the estate. That has sent a shockwave to the HNWIs in China attempting to buy or for those who have already acquired property in the US. In addition to the income tax and various taxes on federal, state, city or even town/village level, estate tax, or elsewhere called inheritance tax, is the type of tax to be paid at death.
In China, culturally, “death” is not really a pleasant or comfortable topic for people to openly talk about, not to mention when coupled with tax. Moreover, thanks to China’s “development” stage, China currently does not have estate tax. For the first decades after the revolution in China, people were generally poor so there was really nothing to pass on or inherit; later after the country’s economy took off in 1990’s, the new wealth was mostly first generation wealth. This generation still wants to grow and exponentially expand their wealth. They also believe they are invincible and will live forever. Certainly the government of China helps reinforce that mentality. The estate tax law has been in the discussion stage since it was first drafted in 2010. Tax and death have therefore been absent from people’s mind.
However, those who have bought properties in the US suddenly find themselves facing US estate tax, and their surviving families are surprised to find out that the US estate tax could take an almost 40% giant bite off the fair market value of the estate of their deceased family member. It makes people regret buying property when compared with the favorable income tax treatment, or at least the equal “national treatment”, enjoyed when they were “enticed and lured” into buying the US properties or stocks.
Since estate tax is a usually an afterlife issue, it only gets people’s attention when they find out that they have to pay the government a big chunk of the estate before they can inherit from their family. US citizens are of course subject to US estate taxation with respect to their worldwide assets, but the US estate tax often catches a non-resident aliens (NRA) family by surprise.
Specifically, for those NRAs investing in the US properties, the estate tax levied under US tax law on the estates of NRAs holding US situs assets including real estate, stock and other valuables after the owner’s death is very unfavorable compared with that on citizens or residents, up to 40% tax for anything beyond the small exemption of USD 60,000. However, though American citizens are subject to US estate taxation with respect to their worldwide assets, the current (for taxable year 2017) estate tax exemption is USD 5,490,000.
Is the deceased a US resident or non-resident alien under the US estate tax rules?
This is a multi-million-dollar question! It is worth especially emphasizing that even to a lot of Green Card holders’ surprise, though automatically “residents” for US tax purposes, they are not necessarily “residents” from US estate tax perspective.
For US income tax purposes the mechanism of determining the “residency” of a foreign national is based on how much time they are physically present in the US or simply holding a Greed Card or not, but the rules on residency for estate tax is not the same. Instead, the “domicile” concept is applied for estate tax in part to find the intention of having made the US her / his permanent home, which should be supported by evidence of the individual’s particular circumstances.
Having determined the estate tax status of the deceased, executors for nonresidents are required to file Form 706NA, United States Estate (and Generation-Skipping) Tax Return, Estate of a nonresident not a citizen of the United States, if the fair market value at death of the decedent's US-situated assets is over USD 60,000. We have uncovered situations where families shockingly got the news that they would be able to inherit from a wealthy relative who had recently passed away, but then equally or even more shockingly found out they were unable to inherit because they did not have the cash to first pay off the estate taxes, accumulated interests and penalties.
Despite the surge in foreign ownership of US assets the IRS is not likely to see an influx of 706-NA forms anytime soon, since the IRS does not learn about the death of the NRA owners of US assets. Though ordinarily the NRA will be asked by the withholding agent to provide W-8BEN to certify his/her non-US status and applicable double-tax treaty benefits, if the surviving family does not come forward voluntarily, and there also does not appear to be any enforcement mechanism for the IRS to reach into foreign countries to collect the tax it says it is owed, especially if the assets are US equities instead of real estate properties, thus this rule is widely ignored worldwide.
However, with the US and counterparty countries implementing the IGA (intergovernmental agreement) under the FATCA (Foreign Account Tax Compliance Act) enacted in 2010, information concerning the NRA’s investment in the US may be disclosed and exchanged to the countries of his or her tax residence. On February 22nd, 2017 the IRS posted on its website “Some Nonresidents with U.S. Assets Must File Estate Tax Returns”. Basically the IRS is reminding the nonresidents (who were not American citizens) that they are subject to US estate taxation with respect to their U.S. situs assets.
The IRS may collect any unpaid estate tax from any person receiving a distribution of the decedent’s property under transferee liability provisions of the tax code. Large penalties apply for non-compliance and estate executor or the transferee may personally become liable for the taxes if not properly paid. In extreme case, the property of the estate can be seized without obtaining a court order to pay off the outstanding estate taxes.
How to plan on estate tax
The most straightforward way is to take advantage of the annual gift exclusion during NRA’s life time. The current annual exclusion amount of gift transfer of US real or tangible property by an NRA is USD 14,000.
As almost always, there are exceptions that may be applicable: Assets that are exempt from US estate tax include securities that generate portfolio interest, bank accounts not used in connection with a trade or business in the US, and insurance proceeds.
Certainly estate tax treaties between the US and other countries often provide more favorable tax treatments to nonresidents by limiting the type of asset considered situated in the US and subject to US estate taxation. Currently there are 15 countries which have such estate tax treaties with the US: these are countries (Australia, Austria, Canada, Denmark, Finland, France, Germany, Ireland, Italy, Japan, Netherlands, Norway, South Africa, Sweden, Switzerland and the United Kingdom.
A non-resident alien may find discover they are domiciliary of one of the treaty nations and can enjoy great benefits through such treaties. Executors for nonresident estates should consult such treaties to determine breaks in tax rates, domicile definitions, and additional deductions applicable. Currently there is no estate and gift tax treaty between China and the US.
Practical methods that Amicorp can assist with include:
- Life Insurance (together with Trust): The insurance trust owns the insurance policies for the NRA. Since after setting up the trust the NRA individual doesn’t personally own the insurance or have any incidents of ownership, it will not be included in the NRA’s estate – thus there is no estate taxes. If the NRA’s estate still has to pay estate taxes after transferring insurance policies to a trust, having the trust buy additional life insurance can surely reduce estate taxes.
- QDOT: When the US situs assets are transferred to a NRA surviving spouse, the unlimited marital deduction is available only if the property is transferred into a “Qualified Domestic Trust” (QDOT) for the benefit of the NRA. If QDOT is correctly structured with all the requirements met, it will allow the family to defer estate tax until the surviving spouse’s death. The NRA decedent’s estate should be entitled to the marital deduction and estate tax deferral, just as a US citizen, if the NRA surviving spouse can become the US citizen before her/his own death, provided that before getting the citizenship he/she has been a US resident at the decedent’s death.
- Non-US corporations: Planning opportunities involving the formation of non-US corporations holding US situs assets through domestic LLCs might help mitigate or avoid exposure to US estate taxes. When the UBO dies, the non-US corporation does not “die”. Therefore, there is no estate tax triggered upon the UBO’s death. Proactive estate tax planning can completely eliminate this unexpected NRA US estate tax. However, the transfer of US real estate to the non-US entity offers no protection from income taxes on US source income, and the income is still taxable. Moreover, the transfer of US-situs real properties directly owned by foreign persons, including shares of foreign corporation holding US real estate, may trigger FIRPTA (Foreign Investment in Real Property Tax Act) and will be subject to 15% capital gains withholding tax on the proceeds. With all of these significant and confusing tax consequences, unless taking thoughtful pre-immigration and/or pre-acquisition tax planning steps, non-US persons may create for themselves and their families an unnecessary US tax problem after investing in US-situs properties.
- Proper tax planning can shield the non-US person from the US estate tax with respect to US assets. Specific plans depend on the particular circumstances of each individual and we encourage that professional advice should always be sought beforehand in order to determine the best structure for the particular client case presented.