U.S. Tax Strategies For Cross-border Families
f you are an American citizen of means, you probably consider taxes to be one of your primary financial concerns and put considerable effort into making sure you are not paying more than you have to. So the following statement might shock you: The United States is a tax haven.
The surprising truth is if you are wealthy and worldly, and you are neither a U.S. citizen nor a resident, it could be true for you.
According to Wikipedia, a tax haven is “…a state, country or territory where, on a national level, certain taxes are levied at a very low rate or not at all.” As it turns out, if you are not a U.S. citizen, and do not live or spend much time in this country, you may be able to set up trusts here with investment assets that are not subject to any U.S. gift, estate or Generation-Skipping Transfer (GST) taxation. The income tax can be minimized as well.
Moreover, you have the benefits of a stable political environment, the rule of law and a non-blacklisted country. Then for good measure, you get asset protection, estate planning opportunities and, importantly, a surprising degree of opacity.
HOW IT WORKS
It begins with a person being characterized as a non-resident alien (NRA), or a “non-U.S. person,” and the test will vary, depending on the tax.
For income tax purposes, an NRA is a person who is not a U.S. citizen and who neither has a green card nor is “substantially present” in the country (essentially 183 days in a given year). A person is automatically considered an NRA if they do not meet this test.
For estate and gift tax purposes, the test is whether or not an individual is domiciled in the U.S., which is more subjective. All of this is important because if one is a U.S. domiciliary or citizen, they are subject to full U.S. taxation on all asset transfers — globally! However, if a person is an NRA or living – but not domiciled – in the U.S., it is a vastly different situation. Let’s take it a step at a time.
Gift & estate taxes
Because there is no U.S. connection, an NRA is not subject to the U.S. transfer tax regime, except on “U.S. situs assets.” Recall, the top federal estate & gift tax rate here is 40%. The power of this is that NRA’s can make unlimited gifts to U.S. residents (or trusts for their benefit) with no gift tax being assessed, no estate tax ever payable, and not subject to the Generation-Skipping Transfer tax (GST) (when assets are in trust). That U.S. resident can be anyone- a spouse, child, parent – even their favorite estate attorney.
By comparison, a U.S. taxpayer would be limited to transferring the current applicable exclusion amount of $11.18 million, beyond which gift tax is payable. The same is true in regard to the GST.
This would mean, for example, that a dynasty trust of unlimited size could be set up in a state with favorable trust laws (a dynasty trust lasts over many generations for the benefit of the heirs of the person setting it up) and there would be no gift tax payable when it is established, and no estate or GST tax due at any point during the term of the trust.
This creates the ability to grow assets that are never subject to any form of transfer tax, and the economics on it are profound. For example, a dynasty trust funded with only $1million and enjoying 4% after-tax growth over four generations would be valued at over $230 million, versus under $50 million when the trust is subject to federal estate or GST tax, which would reduce the assets by 40% at each generational transfer point.
Having said all of that, it’s important to know that U.S. situs assets are subject to U.S. transfer taxes. These include U.S. real estate, personal property, U.S. equities (although idiosyncratically not for gift tax purposes), and shares of U.S.-based mutual funds, including money market accounts.
As importantly, assets that are not considered U.S. situs include shares of non-U.S. corporations; most publicly traded bonds; and bank accounts with U.S. banks including checking, savings, and CDs.
With that knowledge, an NRA can make a gift to a U.S. person or trust that is 100% non-taxable. This, again, makes possible a “super funded” trust that is forever exempt from American transfer taxes.
To make it even better, many foreign persons also make use of foreign corporations. They would, for example, form an offshore corporation — also known as a personal investment corporation (PIC) and fund it with the assets they plan to gift.
The PIC, or “blocker” company, would then invest those funds in a typical securities portfolio and the shares of the PIC would be gifted to the trust. The trust now owns shares of a foreign corporation and the fact that some of the assets of that corporation would otherwise be considered U.S. situs assets is now irrelevant for transfer tax purposes.1
Income Taxation
As mentioned above, for income tax purposes there is a “bright line” test to determine whether or not a person is subject to aforementioned U.S. tax on all global income. That test is objective, including citizenship, green card and an objective definition of “substantial presence” in the U.S.
If one stays on the right side of this line and remains an NRA, then taxation occurs only on “U.S. source” income, meaning income deemed to be “effectively connected” with a U.S. trade or business – essentially, income derived from the U.S. business of an NRA. Then it is taxed at U.S. progressive ordinary income rates.
NRA’s also pay income tax on income from U.S. situs investments at a flat 30%, generally collected at the source via withholding. (Note: this rate could be lower or eliminated if the NRA lives in one of the approximately 70 countries with which the U.S. has a tax treaty.)
Importantly, U.S. situs investment income does not include interest received from U.S. government bonds, corporate bonds, U.S. bank deposits and dividends from non-U.S. corporations. It also, most notably, does not include capital gain from the sale of U.S. securities.
Additionally, it is important to know that while placing U.S. situs investments in a PIC may avoid estate tax, the technique does not avoid income tax. Notwithstanding, it is easy to see that if an NRA has a diversified, U.S.- source/tax-sensitive portfolio, U.S. income taxation can be meaningfully minimized.
A U.S. “FOREIGN” TRUST COMPANY
Although it may seem odd at first, when it comes to avoiding U.S. income tax a trust located and administered in the U.S. can be a “foreign” trust, just as if it were a Cayman or Cook Islands trust.
Any trust becomes “foreign” if it is either governed by a non-U.S. legal jurisdiction, or if a non-U.S. person has a degree of control over any substantial decision of it. When that is the case, as mentioned above, the trust will experience income taxation only on U.S. situs assets. The same is true, for the U.S. gift, estate and GST taxes, though with some positive variation (U.S. situs securities held within a PIC are not subject to transfer taxation).
From the standpoint of an NRA, there are many advantages to having a U.S. situs trust. They include: the strength of the “rule of law” in the U.S., the stable U.S. political environment (the most recent election cycle notwithstanding!) the fact that the U.S. is a non-blacklisted jurisdiction, and the non-exposure to U.S. taxation.
Another factor driving the increased interest in U.S. foreign trusts is the privacy of reporting. Ironically, when U.S. citizens and entities hold assets at foreign institutions, the U.S. requires those institutions to report back on those holdings.2 But for now, it’s a one-way street. The U.S. has not signed on to the agreement (known as the Common Reporting Standard or CRS) that would require its own institutions to report the holdings of foreign citizens and entities back to their respective countries. Talk about “Switzerland West”!
PUTTING IT ALL TOGETHER
So, let’s imagine a wealthy Central American family that has a range of concerns about retaining all of its accumulated wealth in the country it lives in. The older family members are citizens and residents of their home country, and while they enjoy visits to New York and other U.S. cities a few times a year, they spend much less than 183 days here and are not considered to have domicile. As such they are not subject to U.S. taxation on worldwide assets and income, and very much want to remain so. There are, however, a number of younger family members who are U.S. persons for U.S. tax purposes, (and a number of others that would like to come “on-shore” at some point in the future).
All of this being the case, they want to move substantial assets off-shore to a country that has a strong legal system, political stability, and to do so in a way that helps build and preserve wealth for future generations of the family.
In consultation with their professional advisors, they decide to establish a trust in Delaware, a state with trust-friendly laws including the ability to create a trust that lasts in perpetuity. At the same time, they will form a PIC in an appropriate off-shore jurisdiction with low or no applicable taxation. The trust will be designed to distribute income and principal to the family in the trustee’s discretion (although the income, on U.S. situs assets, will be taxable to the non-U.S. citizen creator of the trust, who will also retain the right to revoke it during his life) and will continue as long as there are direct lineal descendants of the parents. It will also contain language protecting the beneficiaries from the claims of creditors. Finally, there will be at least one non-U.S. person who has the discretion to change the trustee.
Once the corporation is formed it will be capitalized with the assets that the family wants to move offshore, and the corporation will hire a U.S. investment advisor to invest those monies in a well-diversified portfolio of securities. Let’s say that amount is $50 million and note that amount is far in excess of the U.S. gift tax exemption amounts. The shares of the corporation will be gifted to the trust.
With this structure in place, the family will have moved significant assets offshore to the United States at zero gift tax cost, and be exempt from U.S. estate and GST tax as long as the trust is in existence. This is true even for assets in the corporation that would otherwise be taxable as U.S. situs assets (like the public shares of U.S. corporations) because, for this purpose, the trust is deemed to hold onlyshares of the off-shore corporation. Moreover, because the trust will be considered a foreign trust, income tax can be minimized if the investment advisor invests mindful of what is and is not taxable as “U.S. situs” assets. Even then, the tax is generally at the 30% withholding rate. Moreover, all of this will have been done with no obligation to comply with CRS reporting, from a U.S. perspective3.
CONCLUSION
With the major caveat that this is a complex area of tax law and that unique facts and circumstances will affect each situation and solution (including tax treaties and home country laws), it is nonetheless true that for nonresidents, the U.S. is an attractive offshore tax haven- just like, maybe better than, the Cook Islands, Caymans, or BVI.
If properly structured, trusts set up in this country are not subject to U.S. gift, estate or GST taxes. Income taxation can be minimized as well. Beyond this, you have the benefits of a stable political environment and the rule of law. Of perhaps equal importance, from the U.S. perspective, there is no need to comply with CRS reporting requirements. Then for good measure, there is asset protection and the ability to create an uber legacy or dynasty trust, and life gets pretty good … la vida es buena, жизнь хороша, 生活很好!
1Note Well: The method of structuring these blocker corporations has changed significantly in response to changes in the 2017 ATCJA tax reform laws.
2FATCA, the Foreign Account Tax Compliance Act
3CRS may be an issue for assets situated in an offshore jurisdiction.
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