International clients face U.S. tax rules that differ significantly from those applying to U.S. citizens and domiciliaries. Nonresident aliens are taxed only on U.S. situs property, but with a much smaller exemption. Noncitizen spouses do not qualify for the unlimited marital deduction without special planning. The Foreign Investment in Real Property Tax Act imposes withholding requirements on dispositions of U.S. real estate by foreign persons. Understanding these rules is essential for estate planning for the international client with U.S. assets or U.S. family members.
Determining Tax Status
The U.S. uses different definitions of residency for different taxes, which creates complexity for international clients.
For income tax purposes, a person is a resident alien if they hold a green card or meet the substantial presence test based on days physically present in the United States. For estate and gift tax purposes, however, the test is domicile. Under Treasury Regulation Section 20.0-1(b)(1), a person is domiciled in the United States if they entered with no present intention of later leaving. This is a subjective, fact-based inquiry that considers visa status, length of stay, location of family, business ties, where personal effects are kept, and statements of intent.
A person can be a resident for income tax purposes but a nonresident for estate tax purposes, or vice versa. The practical consequence is significant. U.S. citizens and domiciliaries are taxed on their worldwide assets but receive the full estate tax exemption of $15 million. Nonresident aliens are taxed only on U.S. situs assets but receive only a $60,000 exemption.
Estate Tax Rules for Nonresident Aliens
Under Internal Revenue Code Sections 2101 and 2103, nonresident aliens are subject to U.S. estate tax only on property situated in the United States.
U.S. situs property includes real property physically located in the United States, tangible personal property physically located in the United States, and stock of U.S. corporations including shares in U.S. mutual funds organized as corporations. Debt obligations of U.S. persons are generally U.S. situs property with certain exceptions.
Certain property is specifically excluded from U.S. situs. Bank deposits with U.S. banks that are not connected to a U.S. trade or business are not U.S. situs property. Life insurance proceeds on the life of a nonresident alien are not U.S. situs. Debt obligations that qualify for the portfolio debt exception are also excluded.
The limited exemption creates significant exposure. A nonresident alien receives only a $60,000 estate tax exemption under IRC Section 2102(b)(1), compared to $15 million for U.S. citizens and domiciliaries. The 40% estate tax rate applies to amounts over the exemption. A nonresident alien who dies owning $1 million in U.S. corporate stock faces potential estate tax of approximately $345,800 after the $60,000 exemption.
Gift Tax Rules for Nonresident Aliens
Gift tax rules for nonresident aliens differ from estate tax rules in an important way that creates planning opportunities.
Under IRC Section 2501(a)(2), nonresident aliens are subject to U.S. gift tax only on transfers of real property and tangible personal property situated in the United States. Gifts of intangible property, including stock in U.S. corporations, are not subject to U.S. gift tax when made by a nonresident alien.
This means a nonresident alien can gift U.S. corporate stock to family members during lifetime without incurring U.S. gift tax. The transfer removes the stock from the donor’s U.S. taxable estate. The gift must be a completed transfer with no retained control, and it must occur while the donor is still a nonresident alien. Nonresident aliens do not have a lifetime gift tax exemption, but the annual exclusion of $18,000 per recipient in 2024 is available.
U.S. persons who receive gifts exceeding $100,000 from a foreign person must report the gift on Form 3520. The recipient is not taxed on the gift, but the reporting requirement applies.
Planning for Noncitizen Spouses
The unlimited marital deduction that allows U.S. citizens to transfer any amount to a surviving spouse free of estate tax does not apply when the surviving spouse is not a U.S. citizen. IRC Section 2056(d)(1) denies the marital deduction for transfers to noncitizen spouses based on concern that a noncitizen spouse could leave the United States with the assets, avoiding eventual U.S. estate tax.
The solution is the Qualified Domestic Trust, or QDOT, authorized by IRC Section 2056A. Property passing to a QDOT for the benefit of a noncitizen surviving spouse qualifies for the marital deduction, deferring estate tax.
A QDOT must meet specific requirements. At least one trustee must be a U.S. citizen or a U.S. corporation. If the trust assets exceed $2 million, the trust must have a U.S. bank as trustee, or the trustee must furnish a bond or irrevocable letter of credit equal to 65% of the fair market value of trust assets. The trust instrument must provide that the trustee has the right to withhold estate tax from any distribution. The executor must make an irrevocable QDOT election on the estate tax return.
The QDOT defers rather than eliminates estate tax. Income distributions to the surviving spouse are not subject to estate tax but are subject to income tax. Distributions of principal trigger estate tax at the rates that would have applied to the first spouse’s estate. A hardship exception allows distributions for immediate and substantial financial needs without triggering tax. When the surviving spouse dies, the remaining trust assets are subject to estate tax.
If the noncitizen spouse becomes a U.S. citizen before the estate tax return filing deadline, the marital deduction is available without a QDOT. If the spouse becomes a citizen after the QDOT is established and meets certain requirements, the QDOT can be terminated without additional tax.
FIRPTA Withholding on Real Property
The Foreign Investment in Real Property Tax Act, codified at IRC Section 1445, requires withholding when a foreign person disposes of a U.S. real property interest.
The buyer of U.S. real property from a foreign person must withhold 15% of the sales price and remit it to the IRS. A reduced rate of 10% applies if the property is acquired for use as a residence and the sales price is $1 million or less. No withholding is required if the property is acquired for use as a residence and the sales price is $300,000 or less.
U.S. real property interests include direct ownership of U.S. real estate, interests in U.S. corporations that are U.S. real property holding corporations, and partnership interests to the extent attributable to U.S. real property.
The withholding is not the final tax. The foreign person files a U.S. income tax return reporting the actual gain on the disposition. If the actual tax liability is less than the amount withheld, a refund is available. If the actual tax exceeds the withholding, additional tax is owed. A foreign person expecting reduced tax liability can apply for a withholding certificate on Form 8288-B before closing to reduce the withholding amount.
Common Planning Strategies
Several strategies can minimize U.S. transfer tax exposure for nonresident aliens holding U.S. assets.
A foreign corporation can serve as a blocker between the nonresident alien and U.S. assets. The nonresident alien forms a foreign corporation that holds the U.S. assets. Because stock in a foreign corporation is not U.S. situs property, no U.S. estate tax applies when the nonresident alien dies. The tradeoff is that the corporation may pay U.S. corporate income tax on earnings from the U.S. assets, and FIRPTA still applies to dispositions of U.S. real property by the foreign corporation.
Lifetime gifting of U.S. stock takes advantage of the rule that gifts of intangibles by nonresident aliens are not subject to U.S. gift tax. Transferring U.S. stock to family members during lifetime removes the assets from the U.S. taxable estate without gift tax.
Life insurance provides liquidity because proceeds on the life of a nonresident alien are not U.S. situs property. A policy owned by a foreign person on the life of a nonresident alien can provide funds to pay any U.S. estate tax due on other assets.
Estate and gift tax treaties between the United States and certain countries may provide benefits. Treaties with countries including Germany, the United Kingdom, and Canada may provide an increased exemption prorated based on the ratio of U.S. assets to worldwide assets. Treaties may also provide relief from double taxation. The specific treaty provisions must be analyzed for each situation.
U.S. Trusts for International Clients
Nonresident aliens can create U.S. trusts, including Wyoming asset protection trusts and dynasty trusts. These structures can provide asset protection features and multi-generational planning for U.S.-based beneficiaries.
Complex rules apply to trusts with foreign grantors or beneficiaries. Foreign grantor trust rules differ from domestic grantor trust rules. Distributions to U.S. beneficiaries may have special tax consequences. The income tax treatment of a foreign grantor trust with U.S. beneficiaries can be favorable because the trust is treated as transparent for income tax purposes with respect to the foreign grantor. Proper planning requires coordination of U.S. and foreign tax advice.
Conclusion
Estate planning for the international client requires careful attention to U.S. situs rules, the limited exemption available to nonresident aliens, QDOT requirements for noncitizen spouses, and FIRPTA withholding on real property transactions. Proper structure can minimize or defer U.S. transfer taxes. Treaty benefits should be analyzed where available.
For guidance on how Wyoming trusts can serve international planning goals, consider consulting Mark Pierce and Matt Meuli at Wyoming Trust Attorney.