Select U.S. cross-border planning pitfalls: a deeper dive

Abstract

This article focuses on the use of pre-immigration “drop-off” trusts and “pre-expatriation” trusts. The author explores whether the “drop-off” trust should be a U.S. or foreign trust and some of the pitfalls of utilizing a foreign trust. The balance of the article is focused on how to draft a “pre-expatriation” trust and discusses some of the legal and tax considerations the draftsperson must discuss with the client. Finally, there is commentary around the use of “indirect” gifts under the U.S. inheritance tax laws.

“DROP-OFF” TRUSTS

Example #1

A wealthy non-U.S. citizen, non-U.S. domiciliary (NCND) is moving to the USA and owns a significant foreign business interest controlled by his or her family members residing in a foreign country and/or foreign portfolio assets consisting of single stock positions (not foreign mutual funds). The NCND is primarily concerned that should he or she die while temporarily living in the USA, he or she would incur very significant U.S. estate tax liability on such non-U.S. situs assets. The client is less concerned with income tax implications realizing that as a U.S. “substantial presence” taxpayer or as a “green card” holder, he or she will likely incur U.S. income tax on worldwide income. Assume that the client has already been advised about the potential CFC and PFIC implications on moving to the USA, including the possibility of making a “check-the-box” election with respect to the foreign family business in which he or she is a shareholder.

Overview

For U.S. federal income tax purposes, an individual is classified as a “resident alien” or a “non-resident alien” in accordance with the rules of IRC Section 7701(b) and the detailed Regulations thereunder, based largely on the number of days the individual is present in the USA in the current and preceding 2 years or if the individual holds a green card. For U.S. transfer tax purposes, on the other hand, whether an individual is a resident or nonresident alien is based on whether the individual is domiciled in the USA. Therefore, in order to distinguish between the terms “resident alien” and “non-resident alien” for U.S. income tax purposes, on the one hand, and the terms “resident” and “non-resident” for U.S. transfer tax purposes, this article uses the terms “resident alien” and “non-resident alien” for U.S. income tax purposes but uses the terms U.S. domiciliary and NCND for U.S. transfer tax purposes.

The advantage to an individual of being classified as an NCND for U.S. transfer tax purposes is that U.S. transfer taxes are imposed only on assets that have a “situs” in the USA, and not on assets that have a situs outside of the USA. In contrast, an individual who is a U.S. citizen or a U.S. domiciliary for U.S. transfer tax purposes is subject to U.S. transfer tax on worldwide assets. Similarly, an individual who is a non-resident alien for U.S. income tax purposes is generally subject to U.S. income tax only on U.S.-source income, whereas a U.S. citizen or resident alien is generally subject to income tax on worldwide income.

The NCND individual moving to the USA should first consider the extent to which an estate tax treaty might provide protection from estate tax during his or her temporary residence in the USA. Under the six post-1971 estate tax treaties, a non-U.S. citizen may be protected from estate tax on all U.S. situs assets other than U.S. real estate and assets of a U.S. branch of an unincorporated business. These treaties may also have the effect of reclassifying a non-U.S. citizen who becomes a domiciliary under the U.S. tax code as a non-domiciled alien for a certain period of years, provided certain tests are met.

Special U.S.–U.K. considerations in these uncharted times

For example, under Article 4(2)(b) of the U.S.–U.K. estate and gift tax treaty, a U.K. national who is not a U.S. citizen and who moves to the USA but remains domiciled in the UK for treaty purposes, may remain classified as a non-domiciled alien for U.S. transfer tax purposes until the individual has completed six years of U.S. residence for income tax purpose. Thus, even if a U.K. national acquires a green card and becomes a U.S. income tax resident, the treaty would protect the individual from domiciled alien status in the USA until the beginning of the seventh year of resident alien status in the USA. Importantly, the U.K. national retains his or her U.K. passport in this situation.

As of the date of this article, the Labour government in the UK is proposing sweeping changes that would eviscerate the current “non-dom” tax regime and completely change the ground rules for IHT purposes. A key change would be to switch the UK to a residency-based tax system in place of the current domiciliary-based tax system. In particular, the Labour party is proposing that they would not grandfather existing IHT rules for trusts created before 6 April 2025. “Labour will include all foreign assets held in a trust as within UK inheritance tax, whenever they were settled so that nobody living here permanently can avoid paying UK inheritance tax on their worldwide assets.” Accordingly, the future IHT treatment of trusts settled by foreign domiciliaries is now quite uncertain, making it very hard for advisors to advise, and for individuals to plan.

It is unclear how the current rules will apply to “formerly domiciled residents” who are now subject to a harsher tax regime than other foreign domiciliaries by virtue of having been born in the UK with a U.K. domicile of origin. Will the worldwide assets of individuals born in the UK automatically be within the scope of IHT, even after 10 years of non-U.K. residence?

Should a U.K. national renounce U.K. citizenship and move to the USA? Such individual might then invoke the U.S.–U.K. estate tax treaty, which currently provides that where a U.S. person who is not a U.K. national is “treaty domiciled” in the USA for estate tax purposes, the USA has exclusive taxing rights over their worldwide assets, other than U.K. real estate or a U.K. permanent establishment. This ability to give the USA the sole estate taxing jurisdiction over most assets is only available to non-U.K. nationals (ie, individuals who have renounced their U.K. citizenship). The UK does not impose an exit tax on individuals who renounce their U.K. citizenship.

General comments about “drop-off” trusts

High-net-worth NCNDs considering a temporary or permanent move to the USA are often advised to establish a “drop-off” trust. The expectation is that if the former NCND dies while domiciled in the USA, the trust assets will not be included in their U.S. gross estate of the former NCND. The key to success requires that the NCND still be domiciled outside the USA on the date the assets are transferred to the “drop-off” trust.

The rationale is that if the NCND is still considered domiciled outside the USA on the date the assets are transferred into the trust, the transfer is likely to be exempt from U.S. gift tax (except to the extent of U.S. situs tangible property). See IRC Section 2511(a). If the NCND can avoid retaining so-called “string powers” of IRC Sections 2035–2038 between the date of gift in trust and the date of death, and the trust is administered properly by an independent trustee, U.S. transfer tax will be avoided in full on the value of the “drop-off” trust assets upon the death of the settlor. If the “drop-off” trust can be maintained as a so-called “dynasty trust,” it may also be possible to keep the trust in effect for successive generations while still avoiding U.S. transfer tax on the value of the trust assets for each successive generation.

Before exploring the U.S. tax implications and how best to fund the “drop-off” trust, it is vitally important to consult with counsel in the donor’s current country of residence. As noted, if the donor is a U.K. domiciliary, the current highly fluid situation with the UK. IHT rules may suggest either accelerating or waiting before undertaking a “drop-off” trust in the USA. Obtaining proper advice from U.K. counsel is a pre-requisite. If the donor is a Canadian resident and establishes a U.S. “drop-off” trust within 60 months of relocating to the USA and a beneficiary is a Canadian resident, such trust will be treated as a Canadian “deemed resident trust” (DRT) subject to the Canadian tax net.

Aside from properly drafting the “drop-off” trust, such trust must also be administered in a cautionary way. “Drop-off” trusts should not be funded with all of the settlor’s assets. In general, no more than 80% of the settlor’s assets should be transferred to the “drop-off” trust. Following this rule of thumb should avoid an inference drawn by the IRS that the former NCND had an understanding or an arrangement with the trustee, and expected the trustee to provide regular access to the trust assets, either directly or indirectly, after the settlor moves to the U.S. IRC Section 2036. It is recommended that no assets subject to U.S. transfer taxes should be subsequently contributed to the trust, to avoid tainting an otherwise exempt trust. Distributions to the trust’s settlor should be kept to a minimum, or better yet avoided altogether. Multiple distributions to the settlor or distributions that follow a pattern could be taken by the IRS as evidence that the settlor retained an impermissible interest in the trust. Estate of Nicol v Commissioner, 56 T. C. 179 (1971). If the trust is overfunded, the grantor may be left with insufficient personal means to support his or her family’s lifestyle while living in the USA.

Ensuring the settlor is a non-U.S.-domiciled alien on the date of contribution to “drop-off” trust

It is important that the settlor of the “drop-off” trust be an NCND on any date on which he or she makes contributions to the trust. Assuming the settlor is in fact an NCND on the date on which he or she makes contributions of foreign situs property and of U.S. situs intangible property to the “drop-off” trust, those contributions will be exempt from U.S. gift tax even if the settlor might subsequently become a domiciled alien for U.S. gift and estate tax purposes.

Upon moving to the USA, the NCND settlor of the “drop-off” trust may not necessarily intend to become a U.S. domiciliary for U.S. transfer tax purposes. A U.S. domiciliary for U.S. transfer tax purposes is an individual who is physically present in the USA with no current intent to depart. By maintaining a permanent home and other ties to the current country of domicile, an individual whose current intent is to return to their permanent home outside the USA should be able to avoid being classified as a U.S. domiciliary. Treas. Reg. Sections 20.0-1(b) (estate tax) and 25.2501-1(b)(gift tax).

It is vitally important, and relatively easy, for the settlor of a “drop-off” trust to ensure that he or she is classified as an NCND on the dates the trust is created and funded. Even though the alien might not create the “drop-off” trust until after having moved to the USA and, therefore, after having become a resident alien for U.S. income tax purposes, such settlor is likely not yet an NCND of the USA for transfer tax purposes. The fact that the NCND will hold a non-immigrant visa (eg, L-1 or O visa) on the date of contribution to the “drop-off” trust (which visa by its terms has a “limited duration”) and, additional evidence that the NCND does not have a present intent to obtain a permanent residence immigration visa (eg, green card), taken together would be strong evidence of NCND status on the dates the “drop-off” trust is created and funded. However, it may also be advisable for the NCND to take additional steps to maintain as many personal and economic contacts in their home country.

“Drop-off” trust: foreign or domestic?

A critical issue often overlooked by practitioners is whether the “drop-off” trust should be structured as a foreign or domestic trust for U.S. tax purposes.

Income taxation of the trust during the settlor’s lifetime

If the non-domiciled alien settlor and spouse each will be a beneficiary of the “drop-off” trust, the trust will be classified as a grantor trust for U.S. income tax purposes during the settlor’s life, whether the trust is domestic or foreign. As a result, the “drop-off” trust will be subject to current worldwide income tax by the USA for so long as the settlor resides in the USA.

Even if the settlor is not a beneficiary of the trust and the trust is foreign, it is likely that the trust will still be classified as a U.S. grantor trust under IRC Section 679(a)(4) as to the settlor if such trust was funded within 5 years of the settlor’s U.S. residency start date. As a resident alien of the USA, the settlor will be treated as the “owner” of the trust income and gain under IRC Section 679, even if the settlor is not a permissible trust beneficiary and has transferred all control over trust distributions to a foreign trustee. This raises a potential liquidity issue for the settlor if he or she is considered the U.S. tax “owner” of the income and gain of the foreign trust but he or she is not a permissible beneficiary and there is an independent trustee and, therefore, the settlor has no direct access to the trust assets from which to pay the U.S. tax liability during the period it is a U.S. grantor trust.

It is assumed that the settlor, along with his or her immediate family members, is moving temporarily or permanently to the USA. It is highly likely that the trust will benefit family members who are either already U.S. persons or who will move to the USA and become resident aliens around the same time as the settlor. While income and gain of such foreign trust will be taxed directly to the settlor as the deemed U.S. owner of such income and gain during the period of U.S. residency and/or U.S. citizenship, to the extent trust distributions are made to U.S. beneficiaries they should have no U.S. income tax liability on receiving such foreign trust distributions.

IRS reporting during the settlor’s life

The IRS reporting rules are definitely more burdensome and expensive to comply with if the “drop-off” trust is foreign rather than domestic during those years during which the settlor is a resident alien of the USA. In the case of a foreign trust that is treated as a U.S. grantor trust under IRC Section 679, either the trustee or the settlor must file Form 3520-A annually. Distributions from the foreign trust made to the settlor and/or other beneficiaries who are U.S. persons must be reported on Form 3520. Form 8938 may have to be filed by the settlor and/or by the U.S. beneficiaries. In many cases, FBARs would have to be filed by the settlor and/or trustee to the extent of any foreign accounts.

In contrast, if a trust is domestic and owns no foreign situs assets, none of the foregoing U.S. tax returns and forms must be filed by the settlor, the trustee or the beneficiaries.

Income taxation of the trust if the settlor leaves the USA

What happens if after having lived in the USA for a period of time, the settlor and his family members decide to permanently move out of the USA and resume non-resident status for U.S. income tax purposes? If the settlor established a foreign “drop-off” trust within 5 years of his residency start date in the USA, such trust became a U.S. grantor trust when the settlor became a resident alien of the USA. Thereafter, if the settlor decides to leave the USA and the trust reverts to being classified as a foreign non-grantor trust (FNGT), the special exit tax applicable to outbound trusts under IRC Section 684 will apply and will result in an income tax on the trust’s appreciated assets when the settlor leaves the USA. This outcome occurs because when the settlor resumes non-resident alien status as to the USA, this will likely have the effect of converting the foreign trust from a U.S. grantor trust status under IRC Section 679 into an FNGT under IRC Section 672(f)(2). See, Treas. Reg. Section 1.684-1(e)(1).

However, the special exit tax rules under IRC Section 684 applicable to converting outbound trusts will not apply if the “drop-off” trust is and remains a U.S. domestic trust. IRC Section 684 only applies if assets are deemed transferred to a foreign trust or if a domestic grantor trust converts and becomes a FNGT, either when the settlor leaves the USA or when the settlor dies.

Possible taxation of unrealized gains of a foreign trust when the settlor dies

Upon the settlor’s death, a significant disadvantage of foreign trust status for a “drop-off” trust is that IRC Section 684 will usually impose an exit tax on the trust’s unrealized appreciation in its assets. The reason is that the trust will cease to be a grantor trust as a result of the death of the settlor and become an FNGT. See Treas. Reg. Section 1.684-1(e)(2), Ex. 2.

If the “drop-off” trust is always domestic, no U.S. income tax can be imposed on the unrealized appreciation in assets held by such trust at the date of the settlor’s death under IRC Section 684. Nevertheless, the trust assets will not be stepped up to their fair market value at the settlor’s death under IRC Section 1014, assuming no federal estate tax is imposed on the trust’s assets at the death of the settlor.

Income taxation of the domestic “drop-off” trust after the settlor’s death

Since the “drop-off” trust will no longer be a grantor trust after the settlor dies, if the trust is a domestic trust, it will potentially be subject to U.S. tax on its worldwide income each year without any opportunity to defer the tax due. At best, the U.S. income tax burden can be shifted by the trustee to the trust beneficiaries to the extent the trustee distributes income to them on a current basis.

To the extent the trustee makes distributions of current year trust income to U.S. beneficiaries, the distributed income will be taxed to them at the U.S. tax rates applicable to individual taxpayers.

To the extent distributions are made to non-U.S. beneficiaries out of current trust income, as a general rule only certain U.S. source income will be taxed to them. In general, the non-U.S. trust beneficiaries’ U.S. income tax will be limited to U.S. source dividends, since most U.S. source interest will be “portfolio interest” exempt from U.S. tax and most capital gains from sales of U.S. securities will also be exempt from U.S. tax under IRC Section 871(a)(2).

Income taxation of a foreign “Drop-Off” trust after settlor’s death: FNGT distributions to U.S. beneficiaries

If the trust has always been a foreign trust, following the settlor’s death the trust and its non-resident alien beneficiaries will generally be taxed the same as a non-resident alien taxpayer, discussed immediately above.

However, following the settlor’s death, the foreign trust is likely to be categorized as an FNGT. This means that the U.S. beneficiaries of an FNGT could be subject to the punitive throwback tax and deferred interest charge if they receive distributions of accumulated income or gain earned by the foreign trust during a prior year. In addition to the deferred interest charge, any capital gain not distributed currently and accumulated, will be converted to ordinary income when distributed to U.S. beneficiaries.

If the FNGT is domesticated to the USA through a change of situs and/or change of trustee, for U.S. tax purposes such a migration to the USA is generally considered a continuation of the prior foreign trust. Such a migration (domestication) to the USA does not trigger acceleration of gain on the entire “undistributed net income” (UNI) account, but rather such UNI account is “frozen” as of the date of migration (domestication) and is retained during the period the trust is a domestic non-grantor trust. The trustee must then monitor distributions in excess of current year income, and try to limit so-called “accumulated distributions” of prior year income and gain subject to throwback tax, deferred interest charges and recharacterization of capital gains as ordinary income when distributed to U.S. persons.

Moreover, California and New York resident beneficiaries may also be subject to state throwback taxes applicable in those states on receipt of “accumulated distributions.”

“PRE-EXPATRIATION” TRUSTS

Example # 2

A grad student who is a “long-term” permanent resident in the USA has $2.5M in cash as his or her only asset. The grad student expatriates. No exit tax is due. (Cash is not an appreciated asset subject to exit tax). However, since the grad student had more than $2M in personal net worth on abandoning his or her green card, the grad student is classified as a Covered Expatriate for life. Subsequently, the Covered Expatriate marries a U.S. citizen while living abroad. The couple has two children both of whom are U.S. citizens; however, they never live in the USA. The Covered Expatriate inherits $100M from his or her parents or self-creates $100M in business/investment assets decades after leaving the USA. The Covered Expatriate faces the prospect that unless his or her spouse and children expatriate, they will be subject to a 40% tax on virtually all assets they inherit from the Covered Expatriate. Once final regulations are issued, the U.S. recipients will be required to report their “covered” gifts and bequest on Form 708 and pay whatever inheritance tax is due.

Example #3

A “long-term” green card holder is a medical entrepreneur from Singapore. The client’s spouse is also a “long-term” green card holder who owns U.S. residences. The client indicates that he or she owns roughly $15M in appreciated worldwide assets, consisting primarily of founders’ common stock in several non-traded private companies including some U.S. companies. Since COVID the client has not made any trips to the USA. The couple have each decided to voluntarily abandon U.S. green card status (by filing form I-407 with the U.S. CIS) in a calendar year following the year of completion of their pre-expatriation planning.

General comments

Most high-net-worth U.S. citizens and “long-term” residents (green card holders of more than 7 years) are likely ineligible for either exception to Covered Expatriate status, and, therefore, classification as a Covered Expatriate on the day before expatriation is inevitable. It is assumed that for most of these expatriates unable to bring their personal net worth below $2M as of their date of expatriation, they still wish to engage in some pre-expatriation planning to mitigate their upcoming exit tax liability.

Before expatriation, the expatriate might consider engaging in restructuring their personal assets to predominantly cash (not subject to exit tax) and/or possibly selling a principal residence eligible for gain exclusion on sale. In some situations, it may be possible to retain only enough worldwide appreciated assets so as to fall below the special one-time exemption from the “mark-to-market” (MTM) exit tax regime ($866,000 in 2024, subject to an annual inflation adjustment). However, for the vast majority of expatriating clients, their worldwide assets will far exceed the $2M threshold as of the day before their expatriation.

It is assumed in this article that the reader is familiar with the three tests that must be met before an expatriate is classified as a Covered Expatriate. Special tax considerations arise when the expatriate either has transferred assets to a trust or is the beneficiary of a trust. IRS Notice 2009-85 is the controlling guidance (including how to determine net worth) with reference back to its predecessor, IRS Notice 97-19.

Background involving the “net worth” test

Determining net worth involving trusts

Where an expatriate has made completed gifts to an irrevocable trust for U.S. gift tax purposes, those assets will not be included in the expatriate’s net worth according to Notice 97-19. The logic is that assets previously transferred away as completed gifts would not be eligible for transfer immediately prior to expatriation.

The instructions to Form 8854, Part II, Section B Balance Sheet, Line 9 provide as follows:

For purposes of determining your net worth, you are considered to own assets held in trusts that would be subject to U.S. gift tax if you had transferred your interests in the trusts by gift immediately before your expatriation date, but without regard to sections 2503(b) through (g), 2513, 2522, 2523 and 2524.

This is the same language found in Notice 97-19.

Determining net worth if the expatriate is a beneficiary of a trust?

Even though property held in trust is not legally the property owned by the expatriate, the IRS attempts to value a beneficiary’s interest in the trust as property for net worth purposes.

First, according to Notice 97-19, the IRS looks to the terms of the trust to determine the beneficiary’s interest. Absent an ascertainable beneficial interest in the trust, Notice 97-19 allows the IRS to examine the pattern of trust distributions to the expatriate beneficiary. A beneficial interest in a fully discretionary trust with virtually no distributions to beneficiaries presents a significant challenge to value.

Second, if the first step does not indicate how the trust property is to be allocated among its beneficiaries, the IRS will apply the Uniform Probate Code rules on intestacy to value an expatriate beneficiary’s interest in the trust for net worth purposes.

Many practitioners believe the IRS’ approach to valuing beneficial interests in fully discretionary trusts is arbitrary and, if litigated, the Service’s position is unlikely to be upheld by the Tax Court. As most practitioners contend, a beneficiary of a fully discretionary trust holds a mere expectancy because under U.S. state property law his or her interest is neither a present nor a future interest.

The author recommends avoiding this morass if possible by simply not naming the settlor as a permissible beneficiary of an “pre-expatriation” trust.

In addition, the advisor must examine whether a beneficiary of an existing trust can disclaim his or her beneficial interest in such trust. However, disclaiming a beneficial interest in a trust is itself likely a gift under IRC Section 2518 and would use up some amount of the disclaiming beneficiary’s lifetime gift/estate tax exclusion amount. Moreover, what if the disclaiming beneficiary lives in a country with an inheritance tax regime that includes a gift tax? Accordingly, it may not be possible for the expatriate beneficiary of a trust to disclaim his or her interest in such trust.

For those interested in reading further on this topic see M. Stegman and J. Campbell, “Confronting the New Expatriation Tax: Advice for U.S. Green Card Holder,” 35 ACTEC Journal No. 3 (Winter 2009).

Background involving the MTM exit tax and trusts

Determining assets includible in the “mark-to-market” exit tax regime

Apart from the foregoing question of whether assets are included in an expatriate’s net worth base for purposes of classifying an individual as a Covered Expatriate, there is the separate issue of whether trust assets are included in a Covered Expatriate’s tax base under the MTM exit tax under IRC Section 877A?

Covered expatriate as settlor

If the Covered Expatriate has settled a trust (eg, a “pre-expatriation” trust), IR Notice 2009-85 provides that the assets of the trust will be includible in the [AQ]“mark-to-market” tax base if the assets would otherwise be includible in the expatriate’s gross estate for federal estate tax purposes. Notice 2009-85, Section 3A, confirms that to the extent the expatriate made a completed gift to a “pre-expatriation” trust in a calendar year before the calendar year of expatriation and retained no powers over the trust, the trust assets should not be subject to the exit tax liability of a Covered Expatriate.

Covered expatriate as a beneficiary of a Non-Grantor trust

There is a special exit tax regime applicable to Covered Expatriates who have an interest in a “non-grantor trust.” This special exit tax regime applies a 30% withholding tax obligation on the trustee in respect to the U.S. taxable portion of the trust as if the Covered Expatriate had remained a U.S. person for income tax purposes.

A Covered Expatriate who is a beneficiary of a non-grantor trust must elect either to be treated as receiving the entire value of his or her interest in the trust on the day before the expatriation date, which requires first obtaining a private letter ruling from the IRS stating the value of his or her interest in the trust as of that date (based on information required to be provided by the trustees), or incur a 30% U.S. withholding tax on taxable trust distributions and the deemed waiver of all rights to reduction on distributions under any treaty.

The tax practitioner must understand the distinction between the withholding obligation of a trustee on distributions of U.S.-source income made from a non-grantor trust to a Covered Expatriate, and the Covered Expatriate’s actual U.S. tax liability as to those trust distributions received. Even if a distribution of current-year income from a non-grantor trust to a Covered Expatriate subjects the trustee to a 30% withholding requirement, the Covered Expatriate’s actual U.S. tax liability may be significantly lower than the withheld amount because he or she is no longer a U.S. person for income tax purposes. This would permit the Covered Expatriate to file a claim for a refund.

A distribution of current-year U.S.-source income from a non-grantor trust would carry out distributable net income (DNI) but would retain the character of the income items in the hands of the trust beneficiaries. A non-resident alien usually is not subject to U.S. federal income taxation on portfolio interest, non-FIRPTA capital gain and foreign-source income. Assuming the substantive U.S. tax liability of a Covered Expatriate after the expatriation date is determined under the same rules otherwise applicable to a non-resident alien of the USA, the Covered Expatriate should likewise not have to pay U.S. federal income tax on non-ECI, non-FDAP income. See, C. McCaffrey and E. Harrison, INTERNATIONAL ESTATE PLANNING, Chapter Four, Section 4.02[2][iii] Rules Applicable to Distributions from Non-Grantor Trusts.

The author is aware of Covered Expatriates who are beneficiaries of non-grantor trusts where the trustee satisfied the 30% withholding requirement on the taxable portion of the trust, and thereafter the Covered Expatriate successfully obtained a refund from the IRS based on his or her status as a non-resident alien of the USA.

Implementing the “pre-expatriation” trust to reduce the expatriate’s “net worth”

There are several considerations to explore in structuring a “pre-expatriation” trust. As an alternative to outright gifts of assets, for a variety of reasons it is assumed that the expatriate would prefer to fund an irrevocable, U.S. domestic, non-grantor trust in a U.S. state that has enacted asset protection legislation, commonly known as a “pre-expatriation” trust. As discussed elsewhere in this article, it is the author’s view that excluding the settlor as a permissible or discretionary beneficiary of the “pre-expatriaiton” trust is preferable.

*Spouse: It may be possible for the spouse to be included in the class of permissible beneficiaries depending on whether the spouse also plans to expatriate and whether such spouse will be classified as a Covered Expatriate.

*Self-Settled Trust in U.S. Asset Protection State: If the expatriating settlor insists upon being named a permissible beneficiary of a self-settled discretionary asset protection trust, the “pre-expatriation” trust must be settled under the laws of a state that has adopted specific asset protection legislation. If this is not done, the IRS would take the position that all trust assets held in a self-settled trust organized in a non-asset protection jurisdiction (ie, in any of the 36 U.S. states that have not yet adopted state asset protection legislation) are countable under the expatriate’s net worth test. Even if the settlor is not designated a permissible or discretionary beneficiary of a “pre-expatriation” trust, the author routinely advises clients to settle “pre-expatriation” trusts in an asset protection state because the trust assets would not be includible in the estate of the settlor for U.S. estate tax purposes, and should be excluded from the net worth base of the expatriate. Rev. Rul. 77-378, 1977-2 C.B. 347; IRS PLR 200944002 (October 30, 2009).

*Valuation Issues for Trust Beneficiaries Who Expatriate: Regardless of whether the “pre-expatriation” trust is organized in an asset protection jurisdiction, the IRS might be expected to value and attempt to include the settlor’s retained beneficial interest in the “pre-expatriation” trust in his or her net worth in determining Covered Expatriate status. In valuing the expatriate’s beneficial interest in the “pre-expatriation” trust for purposes of the “net worth” test for Covered Expatriate status, the IRS employs a frankly untested opaque facts and circumstances test. According to the IRS, they can consider not only the terms of the trust instrument, but also any letters of wishes, historical patterns of trust distributions, and the powers of any trust protector or advisor. IR Notice 97-19. (Although this IR Notice 97-18 was issued under the old alternative exit tax regime, the current regime enacted in 2008 relies on the same “net worth” test as found in prior law under IRC Section 877(a)(2). IR Notice 2009-85, issued under the current exit tax regime, incorporates the guidance issued in Notice 97-19 for purposes of the “net worth” test.)

To the extent the settlor is named as a beneficiary of a “pre-expatriation” trust, the longer the existence of such trust with little or no distributions to the settlor the more difficult it will be for the IRS to contend that a portion of the value of the trust should be included in the expatriate’s net worth for classifying him or her as a Covered Expatriate.

As with all non-grantor trusts potentially benefiting a settlor or spouse, the drafting of the “pre-expatriation” trust should require another beneficiary of the “pre-expatriation” trust (such as an adult child who is known as an “adverse party” to the settlor and spouse) to consent in writing to any trust distributions to be made by the trustee to the settlor or spouse. This mechanism should prevent grantor trust status while the settlor is alive. Further, adding such an “adverse party” consent mechanism should also weaken any IRS argument for including the settlor’s beneficial interest in the trust in his or her personal net worth.

*Preclude “Grantor Trust” Status: The draftsperson of the “pre-expatriation” trust will want to preclude the “pre-expatriation” trust from falling within the definition of a “grantor trust” under IRC Sections 671 through 679.

Originally, the IRS took the view that the entire value of a grantor trust was includible in the “net worth” base of the expatriate, even if the expatriate was not a permissible beneficiary. (In the USA, many practitioners have routinely established so-called irrevocable “intentionally defective grantor trusts” (IDGTs) in which the trust assets are excluded from the settlor’s U.S. gross estate, while the trust income and gain is reported and tax paid by the settlor of such trust).

An earlier version of Form 8854, Balance Sheet, Line 9 and the instructions required the expatriate to include as part of his or her net worth all assets held in trusts that he or she was treated as owning under IRC Section 671 through 679 (a “grantor trust”). In its letter of July 9, 2014, to the IRS, ACTEC pointed out that this requirement is inconsistent with the guidance contained in IR Notice 97-19. ACTEC noted that Notice 97-19 does not require inclusion in an expatriate’s net worth of assets held in his or her grantor trusts. Under the 1997 Notice, trust assets are includible in an expatriate’s net worth only if they would have been subject to gift tax if the expatriate had transferred his or her interest by gift immediately before expatriation. Subsequently, IRS revised the Form 8854, Line 9 and related instructions to provide that assets held in trusts would be subject to U.S. gift tax if the expatriate had transferred his or her interest by gift immediately before their expatriation.

As mentioned, in order to prevent grantor trust status during the settlor’s lifetime, the “pre-expatriation” trust must provide that no income or principal can be distributable to the settlor without the consent of an “adverse party.” IRC Sections 674, 677. For these purposes, the settlor’s spouse is not adverse to the settlor, and consent would have to be provided by other beneficiaries who are “adverse parties” such as adult children named as trust beneficiaries. If a beneficiary is a minor, consent would have to be provided by the beneficiary’s natural or legal guardian.

*Preclude Foreign Trust Status: Moreover, to insure that the “pre-expatriation” trust is not a U.S. grantor trust under IRC Section 679, the trust must not be classified as a foreign trust for U.S. income tax purposes. IRC Section 679(a)(1). A foreign trust is considered a grantor trust under IRC Section 679(a)(1) if such foreign trust is established by a U.S. person and a U.S. person is one or more of the current or future beneficiaries. This would occur if an expatriating settlor, a U.S. person, designates him or herself as a permissible or discretionary beneficiary of such trust.

In general, a foreign trust is any trust over which a U.S. court is unable to exercise primary supervisory jurisdiction or does not have a U.S. person making all substantial trust decisions whether as trustee, trust protector or advisor. IRC Section 7701(a)(31)((B).

The draftsperson should take particular care to ensure that the trustee, along with the trust protector and other advisors, will be U.S. persons at all times. Care must also be taken to make sure that any “adverse parties” with consent power over distributions to the settlor and spouse, are also always U.S. persons.

*Avoiding U.S. Gift Tax on Structuring or Funding the “Pre-expatriation” Trust: To the extent the expatriate has remaining U.S. lifetime gift/estate tax exemption available (currently $13.61M in 2024), a completed gift to a “pre-expatriation” trust made in the calendar year before the calendar year of expatriation, should reduce the individual’s net worth without the exposing the expatriate transferor to U.S. gift tax liability on the transfer in trust.

Using the “pre-expatriation” trust to prevent assets from being subject to the MTM exit tax regime

For many clients, avoiding classification as a Covered Expatriation is impossible to achieve. Their net worth far exceeds the relatively low $2M personal net worth amount (not adjusted for inflation). If this is the case, the expatriate can keep certain assets outside of the reach of the MTM exit tax regime and more importantly out of reach of the new draconian U.S. inheritance tax system.

The keys to successfully avoiding the inclusion of assets owned by a “pre-expatriation” trust from being subject to the IRC Section 877A exit tax have already been discussed. They include the following: (1) establishing a fully discretionary, irrevocable, non-grantor, domestic trust in a state that has enacted asset protection legislation for self-settled discretionary trusts; (2) avoid having the settlor retain trustee-type removal and/or hiring of trustee powers or other trustee-type powers that would run afoul of the U.S. estate tax inclusion rules or if held by a foreign person would cause the trust to be classified as a foreign trust under the “control” test; (3) draft the trust as a U.S. domestic trust for income tax purposes and require that at all times U.S. persons will make all substantial trust decisions; (4) structure the trust from the outset as a non-grantor trust; (5) avoid naming the settlor as a permissible beneficiary of the trust due to the drawback of having to deal with the separate exit tax regime applicable to interests of Covered Expatriates in non-grantor trusts.

Pre-expatriation planning: using a “Pre-expatriation” trust to avoid U.S. inheritance tax: considerations for the covered expatriate and U.S. beneficiaries

Where the planning objective is to minimize the future impact of the U.S. inheritance tax, the most effective pre-expatriation estate planning action that a person can take is to fund a “pre-expatriation” trust using as much of the person’s $13.61M gift tax exemption as possible. This is important to do before expatriation because once an expatriate loses U.S. domicile, his or her estate and gift exemption equivalent amount will drop from $13.61M (in 2024) to a $60,000 exemption equivalent amount (not adjusted for inflation). It is therefore important to use the larger exemption while it is available. Furthermore, when deciding which assets to transfer to the trust, it may be most advisable to use assets like U.S. real estate that are impossible to move outside of the USA and which would be difficult to restructure into non-U.S.-situated assets for U.S. estate tax purposes. In general, it is often advisable to transfer illiquid, hard-to-value appreciating assets to the “pre-expatriation” trust.

Funding a “pre-expatriation” trust prior to expatriation is an especially important step to take if the person intending to expatriate anticipates that he or she will want to make future gifts or bequests to U.S. persons (citizens or residents) after his or her expatriation date. The IRC Section 2801 inheritance tax is imposed on U.S. recipients who receive “covered gifts” and “covered bequests” from Covered Expatriates and from foreign trusts that have been funded with covered gifts or bequests. In contrast, the IRC Section 2801 inheritance tax is not imposed on distributions from domestic trusts that were funded by an expatriate prior to expatriation.

If the expatriate is classified as a Covered Expatriate as of the day before expatriation, such classification applies for life and his or her U.S. heirs would remain forever subject to the IRC Section 2801 inheritance tax regime. Post-expatriation gifts and bequests to U.S. persons beyond an annual exclusion amount ($18,000 in 2024) are subject to the U.S. inheritance tax, which would be imposed on the U.S. recipients of such gratuitous transfers received from or through a Covered Expatriate.

The bottom line is that if the expatriate settles the “pre-expatriation” trust before expatriation and before his or her classification as a Covered Expatriate, subsequent distributions made by the trustee from such trust to the Covered Expatriate’s U.S. children or grandchildren will not be subject to U.S. inheritance tax. The inheritance tax is only applicable to a transfer from a person who is a Covered Expatriate at the time of the transfer to the trust. IRC Section 2801(e)(1).

Pre-expatriation planning: using a “pre-expatriation” trust to avoid a deemed sale of expatriate’s worldwide assets held at expatriation (avoiding the liquidity issue)

In addition, funding of a “pre-expatriation” trust should also have the effect of eliminating the settlor’s expatriation as an event that has tax consequences for the trust. Furthermore, the assets held by the trust are not subject to a hypothetical deemed sale of the expatriate’s worldwide appreciated assets under the MTM exit tax regime held on the day before the date of expatriation. Instead, there should be U.S. tax on the trust assets when the trustee decides to sell the trust assets. This avoids a liquidity problem for the expatriate.

Post-expatriation planning considerations: sale for note and PIE exemption

Following expatriation, Covered Expatriates may avoid the Section 2801 inheritance tax liability by selling non-U.S. situs assets to U.S. heirs in exchange for the heirs’ promissory notes bearing interest at the applicable federal rate (AFR). For example, as an NCND and non-resident alien of the USA, the Covered Expatriate might sell to U.S. heirs securities that are treated as intangible property for U.S. gift tax purposes. No trust would be involved, which should eliminate the argument that the loan is really a disguised trust distribution. Further, a sale for adequate consideration should not be deemed to be equivalent to a gift or bequest.

Any post-sale appreciation on the transferred assets, to the extent it exceeds the interest due on the notes, will benefit the U.S. purchasers, and will not be gifts and, therefore, will avoid Section 2801 inheritance tax. If the sale is made shortly after expatriation, due to the MTM exit tax rule allowing a basis adjustment, there may be no further gain to recognize on the sale.

IRC Section 871(h) provides that a Covered Expatriate who sells assets to U.S. persons in exchange for promissory notes with a couple of additional benefits not available in the domestic context. First, if the interest payments required by the promissory notes qualify as “portfolio interest” (including the requirement that a special legend be placed on the note), then the Covered Expatriate could at least avoid liability for income taxes on the interest that the Covered Expatriate receives under the PIE exemption of IRC Section 871(h)(5). Second, debt obligations that are PIE exempt for income tax purposes are generally foreign situs, even if issued by a U.S. person, and, therefore, are treated as situated outside the USA for U.S. estate tax purposes. IRC Sections 2105(b)(3) and 871(h)(3). See also IRS PLR 200752016 (IRC Section 2105(b)(3) exempts from U.S. estate tax portfolio debt obligations an NCND taxpayer owned as a noteholder at death).

INDIRECT TRANSFERS TO AVOID INHERITANCE TAX

Example # 4: Facts are the same as in Example # 2, except that shortly after marrying the Covered Expatriate (CE), the spouse renounces U.S. citizenship and subsequently files Form 8854. No exit tax is due by the spouse and such spouse is classified as a “non-CE” as of his or her expatriation date. Shortly before the spouse renounces U.S. citizenship, the Covered Expatriate allocates his or her very significant assets to separate LLCs, one for the U.S. situs assets and the other for the non-U.S. situs assets but the CE retains complete ownership of the LLCs. A couple of years after the spouse renounces U.S. citizenship, the Covered Expatriate transfers his or her LLC interests (intangible property not subject to U.S. gift tax) to the non-U.S. citizen, non-CE spouse. As the owner of the LLCs, the non-CE spouse makes all investment and business decisions without consulting with the Covered Expatriate. Another three years elapse and the couple come to you concerning the U.S. inheritance tax implications if the non-CE spouse transfers the LLC interests owned by such spouse to a new foreign trust for the couple’s U.S. citizen children.

IRC Section 2801 applies to gifts and bequests acquired “indirectly” as well as directly from a Covered Expatriate. Proposed Treas. Reg. Section 28.2801-2(i) provides four examples of an indirect acquisition. After providing these examples, the proposed Regulations provide a “catch-all” category that has been heavily criticized by ACTEC and others. This “catch-all” category includes property acquired by an individual “in other transfers not made directly by the Covered Expatriate to the U.S. citizen or resident.” Proposed Treas. Reg. Section 28.2801-2(i)(5).

In their 10 March 2016, letter to the Office of Chief Counsel, ACTEC submitted substantive comments to the IRS about this issue and other provisions of the proposed IRC Section 2801 Regulations.

In its 2016 letter, ACTEC pointed out that because transfers not made directly by a CE include transfers by all persons who are not CEs, a literal application of the “catch-all” provision would result in all transfers received by a U.S. individual being treated as covered gifts or bequests. Presumably, the “catch-all” category is intended to include transfers made to U.S. individuals by persons who are not CEs of property given to them by CEs, with the expectation that they would give the property to U.S. individuals.

In its 2016 letter, ACTEC recommended that rules similar to those in Treas. Reg. Section 1.643(b)-1 and 1.679-3(c) apply. ACTEC noted that all of these statutes—IRC Sections 643, 679 and 2801—deal with a common problem, the use of “intermediaries” to avoid tax. Sections 643 and 679 address when distributions from or contributions to foreign trusts will be treated as made through intermediaries to avoid income tax. Under Treas. Reg. Sections 1.643(h)-1 and 1.679-3(c), a transfer is not deemed made through an intermediary if there is no tax avoidance purpose or if the purported intermediary has a relationship with a recipient that establishes a reasonable basis for the purported intermediary making a transfer and the purported intermediary acted independently. In the case of Treas. Reg. Section 1.643(h)-1, which deals with distributions from foreign trusts to U.S. persons, there is a presumption of tax avoidance if the purported intermediary received funds within 24 months before or 24 months after the transfer to the recipient. The presumption is rebuttable.

ACTEC pointed out to the IRS that it will often be the case that a gift or bequest to a family member of a CE, who is neither a U.S. person nor a CE, will be followed by a gift or bequest from that family member to a U.S. person. This is not necessarily abusive. As long as the purported donor has dominion and control over the asset received originally from the CE and acts independently of the CE during such ownership period, the structure of the transaction should be respected. See, eg, Estate of Bies v Commissioner, 80 T.C.M. 628 (2000)(concluding that the transfers at issue were transfers to intermediaries and that the donor intended to make transfers to the ultimate recipients, thus disallowing annual gift tax exclusions for amounts transferred to the intermediaries, but acknowledging that, “as a general rule” the form of a transaction will be respected and that the substance over form principle will not apply unless the circumstances warrant).

ACTEC suggested, for example, a gift by a CE to her non-CE spouse followed by a gift from the non-CE spouse to the couple’s U.S. children. Unless the non-CE spouse was acting as an agent of the CE spouse and not independently, ACTEC commented that there is “no reason for the gift by the non-CE spouse to the children to be treated as an indirect gift from the CE, since both spouses have a reasonable basis for making gifts to their children.” Moreover, if the spouse is a U.S. person when the spouse receives the gift from the CE, there would be potential for a double IRC Section 2801 inheritance tax, first when the non-CE U.S. spouse receives the gift from the CE and later when the U.S. citizen children receive the gifts from the non-CE spouse.

Author Biography

Melvin A. Warshaw, Esq. is a Massachusetts admitted international tax and cross-border private client lawyer currently in sole practice. He has 45 years of experience including at a major international law firm. He began his career at the IRS National Office in Washington. He is also an ACTEC Fellow.