Entries Tagged 'Trusts, estates, gifts' ↓

A reader of my November, 2008 article in California CPA Magazine (hi, David) called me and asked a question about the article. He wanted to clarify a generation-skipping transfer tax question.

I didn’t have the space in the article to cover all of the nooks and crannies on the subject of estate taxation for cross-border families. And if there’s anything that has nooks and crannies, it’s the Internal Revenue Code. And one of the cranniest nooks is the generation-skipping transfer tax.

The question, simply put, is how you can make a foreign trust that later becomes a U.S. trust into a generation-skipping transfer tax exempt trust if you don’t allocate generation-skipping transfer tax exemption to it. [Ha! You call that a simple question? On what planet? ed.]

(Warning. Highly technical stuff follows. Causes brain damage.  You can read this charming little essay or you can skip this and go visit Internal Revenue Code Section 2663 and its progeny in the Treasury Regulations.)

U.S. citizens funding dynasty trusts–estate or gift tax

Start with normal U.S. estate tax planning for U.S. citizens. We’ll work around to noncitizens and foreign trusts. Trust me.

Let’s say your goal is to set up a dynasty trust–a trust that will hold assets for multiple generations. You don’t want an estate tax haircut as wealth passes from grandfather to child to grandchild to great-grandchild. As long as the assets stay inside the trust, that result is generally achievable.

The problem is getting the assets into that trust in the first place. Once the assets are inside the trust, we’re home free–that piece of real estate can stay in the family for generations without any estate tax.

There are only two ways for a U.S. citizen to get assets into such a trust:

• by dying (which means that first you pay the estate tax and whatever is left over goes into that trust), or

• by making a lifetime gift (which means you have to pay gift tax).

Plainly put–no matter which way you go, the IRS makes you pay a tax (estate tax or gift tax) in order to fund a dynasty trust.

U.S. citizens–generation-skipping transfer tax

The U.S. tax system is built on the idea that a tax should be paid on the transfer of wealth from one generation to the next.

If grandfather died and left money to his child, then the child died and left the money to the grandchild, there would be a tax when the grandfather died and when the child died.  The IRS takes two bites out of the family fortune.

Compare that to the simple scenario of the grandfather dying and leaving money to his grandchild.  There is estate tax on the grandfather.  The IRS gets one bite.

“Two taxes are better than one” is defined as “good” for purposes of the U.S. government. Reasonable people (i.e., all random semi-sentient multi-function humanoids who love their children more than they love supporting the Federal government’s profligacy) might define this result differently.

The generation-skipping transfer tax is set up so that if grandfather dies and leaves money to the grandchild, there will be a tax in about the same amount as if the grandfather had left the money to his child, then the child died leaving the money to the grandchild. Approximately, if not worse.

That’s the idea behind the generation-skipping transfer tax–make the grandchild’s after-tax inheritance the same, whether the money passes from grandfather to father to grandchild (two estate taxes) or from grandfather to grandchild (estate tax plus generation-skipping transfer tax).  So far, not too much brain damage.

Exemptions

Yeah, there are little fiddly exemptions for some things you do. Make the right elections and the generation-skipping transfer tax doesn’t apply. Congress has to give you that in order not to look too harsh. “The first million is on the house, buddy! Whee!”

Let’s ignore the exemptions temporarily. Where we’re going, we won’t need them.

Intruder alert! Intruder alert!

OK. I warned you. Now I really mean it. Your head is going to hurt in a second, so save yourself and get out while you can.

Why a nonresident noncitizen can avoid generation-skipping transfer tax

Up to now we’ve been talking about generic tax planning for U.S. citizens. Now let’s turn to what our law firm does, day in and day out — when the U.S. tax code reaches out to touch non-U.S. people.

Let’s say a nonresident noncitizen grandfather makes a simple gift to his U.S.-citizen grandchild. Grandfather wires $10,000,000 from his London bank account to the grandchild’s U.S. bank account. Done.

This looks suspiciously like a generation-skipping transfer, doesn’t it? It’s a great big gift that skips over a generation.

But there is no generation-skipping transfer tax.  Why?

No “transferor” = no generation-skipping transfer tax

In order to have a generation-skipping transfer tax, you have to have a “transferor” as defined in the rules. That’s at Section 2652(a) for you Internal Revenue Code buffs, which says that you have a transferor if the property transferred by that person would be subject to U.S. estate tax or subject to U.S. gift tax.

In my example, the gift by grandfather to U.S.-citizen grandchild would not be subject to U.S. gift tax. Therefore, grandfather is not a “transferor” as defined in Section 2652(a)(1)(B).

Here are the implications of having no “transferor.”

The gift I have described looks like a “direct skip”:

The term “direct skip” means a transfer subject to a tax imposed by chapter 11 or 12 of an interest in property to a skip person. Section 2612(c)(1).

The generation-skipping transfer tax will apply when money goes to a “skip person.” This is:

a natural person assigned to a generation which is 2 or more generations below the generation assignment of the transferor. Section 2613(a)(1).

Grandchild is a “natural person.”  Grandchild is 2 or more generations younger than the grandfather.  But the grandfather is not a “transferor.”  And if the grandfather isn’t a “transferor” then the whole definition falls apart because there is no starting point to define the number of generations.  So Grandchild can’t be a “skip person.”

Therefore, because grandfather is not a “transferor”, the grandchild can’t be a “skip person”.

Since the gift is made to someone who is not a “skip person”, the transfer can’t be a generation-skipping transfer. And the generation-skipping transfer tax can’t apply.

An even easier answer

Let’s look at the definition of a “direct skip” again. It’s a transfer that is subject to a tax imposed by chapter 11 (estate tax) or chapter 12 (gift tax) AND that transfer is made to a skip person.

When a nonresident makes a gift of cash from a foreign country to a U.S. citizen, that transfer is not subject to gift tax.

So even if the grandchild was a “skip person” the transfer would not be a “direct skip.” Which means that the transfer would not be subject to the generation-skipping transfer tax, because the transfer wasn’t subject to the gift tax.

Now let’s add trusts into the mix

So far I’ve been talking about the grandfather making a direct gift of cash to the grandchild.

What if the grandfather instead set up an irrevocable trust for the benefit of the grandchild? The same result would exist:  no generation-skipping transfer tax.

Because the post is so long already I won’t go into the “kneebone connected to the thigh bone, the thigh bone connected to the hip bone” explanation.

In brief, though, the distribution from the trust would either be a “taxable distribution” or a “taxable termination”.  But since these definitions require that the recipient be a “skip person”, we’re safe–the grandfather isn’t a transferor, so the grandchild isn’t a “skip person.”

Internal Revenue Code Section 2663

OK.  So you want the easy way out.  You don’t want my explanation, eh?

Go to Section 2663.  That’s where the application of the generation-skipping transfer tax to nonresidents is dealt with.

And go straight to Treasury Regulations 26.2663-2(b) which says that the generation-skipping transfer tax only applies if the original transfer (a straight gift or a transfer to a trust) was originally subject to U.S. estate or gift tax.

Moral of the story

A nonresident noncitizen may fund an irrevocable trust with non-U.S. assets without fear of the generation-skipping transfer tax.

In the classic and time-honored game of “Big guy beats up little guy” the United States looks likely to start squeezing small tax haven countries next year.  President-elect Obama is promising blacklists and other devices against countries that we use to set up foreign trusts and corporations.

The Guardian reports that a new bill will be introduced within weeks of Mr. Obama taking office.

Key measures are likely to include: revealing the beneficial owners of secretive trusts; prohibiting accountants from charging fees on specific tax services; and identifying ‘offshore secrecy jurisdictions’ that ‘unreasonably restrict US tax authorities from obtaining needed information’. The measures could end years of financial secrecy that have protected the super-rich and international businesses as they move money from one jurisdiction to another.

If you do your tax planning with an eye on transparency, you’ll be fine.  Everything we set up is something you could plop down in front of a grumpy career governmento.  Secrecy simply doesn’t work.  Confidentiality is fine, but be prepared to reveal and report as appropriate.

The small countries are notably (and correctly) worried about the economic impact.  Isle of Man.  Cayman Islands.  Bermuda.  I’m sure there are more I could find.   But you get the drift.

I’m troubled by this trend.  I am seeing a consistent pattern of big countries abusing smaller countries (see Germany and Liechtenstein as a particularly egregious recent example).  This has happened since national borders were invented, and is just playground bully behavior on a grand scale.  It’s not going to change.  Ever.  Tax policies.  Tariffs.  Soldiers.  U.S. history is full of this behavior.  Let’s just stipulate to the sad fact that this will continue long after you and I die.

What’s troubling is the trend of persistent invasive governmental behavior.  I fear over the long run this will mean collateral damage to other individual liberties.

Memo to all personnel:  re-acquaint yourselves with the Law of Unintended Consequences.

Here’s the Intended Consequence stuff that’s easy to see:  for those of you with complex financial situations, expect more tax forms to file, more revelations to give to the U.S. government, more expense for lawyers and accountants, and more tax to support the U.S. government.  Expect more prosecutions, Government Careers Advanced, etc.

For all of the people who were in my “Foreign Investment in U.S. Real Estate” class yesterday in San Francisco (I taught a 1-day course sponsored by the California Society of CPAs Education Foundation), here is one of the things I promised to deliver.

Tax Court Opinion

The Estate of Fung attached (warning: PDF) are from the United States Tax Court, and the affirming opinion from the Ninth Circuit Court of Appeals.

The problem, with easy math

The idea here is to describe the pickle facing heirs of a nonresident alien who has the bad judgment to die while owning U.S. real estate.

Let’s say the nonresident owns real estate and there’s a mortgage on the property.  Let’s make up some numbers.  The property is worth $5,000,000, and the mortgage is $4,000,000.  The nonresident dies.  What’s the estate tax?

Example 1:  nonrecourse debt

If the mortgage is truly nonrecourse (meaning the lender can ONLY go after the property in the event of a default, and can never go after the borrower personally), then the estate tax is calculated on the nonresident’s equity in the property, $1,000,000.

For the sake of our example, let’s say the applicable estate tax rate is 40%.  The heirs sell the property, pay off the mortgage, give Uncle Sam $400,000 ($1,000,000 equity times 40% tax rate = $400,000 estate tax), and go home with $600,000.

Example 2:  recourse debt

If the mortgage is recourse (meaning the lender has the option of going after the borrower for personal liability on the debt in the event of a default), then the estate tax is calculated on $5,000,000 — the gross value of the real estate, without deducting the mortgage.

The heir sell the property.  Pay off the mortgage ($4,000,000).  They have $1,000,000 of cash left over.  Now they tote up the estate tax on a $5,000,000 asset at 40% = $2,000,000.  Note the conundrum:  the mortgage plus the estate tax liability adds up to a bigger number than the cash on hand.  The heirs get nothing.

My God!  Is there no mercy?

Seems insane, doesn’t it?  Well, in fact there is a way to get that mortgage to help reduce the estate tax.

On the nonresident dead guy’s estate tax return (Form 706NA) (warning:  PDF) the executor will report the nonresident dead guy’s worldwide balance sheet.  (!)  Then there is some higher math involved.  The details of the higher math are unimportant for our purposes–we’re just talking concepts here.  But if you’re looking for specifics, look at the instructions for Schedule B of Form 706NA.

The idea is that since the nonresident dead guy only has U.S. estate tax on his U.S. assets, you have to do a pro-rata allocation of debt based on a fraction that looks like U.S. assets (numerator) divided by worldwide assets (denominator).

The answer is usually pretty grim.  Usually your nonresident dead guy has LOTS of assets outside the United States, and only a little bit in the United States.  This means that when you pro-rate that $4,000,000 mortgage, it’s not going to end up being all that big of a deduction from the gross estate in order to arrive at the taxable estate.

Which means that the tax savings for going through this exercise are likely to be relatively small.

And the heirs aren’t going to want to tell the U.S. government all about nonresident dead guy’s worldwide assets.  Maybe they don’t want to spend the money for accounting and legal fees to do this.  Maybe they’re just not interested in doing all of the necessary work.  But more likely it is because of a healthy desire for privacy.

Action plan

If you have a situation like this (nonresident owner of U.S. real estate, and mortgage on the real estate) first look at the loan documents very carefully, and come to a professional conclusion as to whether it is a recourse mortgage or a nonrecourse mortgage.

If you have a recourse mortgage, do a quickie spreadsheet to calculate out the value of reporting worldwide income in order to use the mortgage to reduce the size of the taxable estate.  Tell your (alive) nonresident alien investor or the (dead) nonresident alien investor’s heirs that number.  Let them tell you whether they’re willing to report worldwide assets on Form 706NA.

I’m guessing the answer is “Not!”

Thanks

Thanks to all of you who came to the course.  Please keep in touch.  Subscribe to the RSS feed here so you’ll get updates of stuff we talked about.

I am working on a trust document at this very moment.  It is sufficiently painful that I decided to stop somewhere on page 30-oblivion and blog about it.

Someone else wrote this trust document.  It is a template from a gigantic trust company and it is <bad words> horrible.  It is horrible because a lazy lawyer wrote it.  Someone who didn’t want to take the time to do it right.

The time he/she saved in writing will permanently cause the world to lose 100x that amount of time trying to figure out WTF the document means.  And no, I’m not going to fix it for them.

Evil incarnate:  “notwithstanding” is an evil word and finding it in a document is the sign of an inferior talent.

Let’s say you want to tell the reader “First you do this, then you do that, and when you’re finished do a third thing.”  DON’T then add a provision 12 pages later that says “Notwithstanding anything else you might find in this document, here is something that might overrule everything else I’ve written.”

Interpreted into English, that lawyer has just told you:  “This is really, really important, so watch out.  I’m not telling you where it might apply, I’m not telling you how it might work. kthxbai!  And good luck.”

Second translation:   “This is really important but I’m too lazy or stupid to figure out how to tell you about it, so you figure it all out.”  (Insert a lot of swear words from Phil right here).

Now I have to go through the entire document and think to myself, “Hmmm.  That thing the <blasphemy> lawyer stuck in the Second Schedule.  Does that apply to this clause?  What about this one?  What about this one?”   And once I find a potential candidate where that “Notwithstanding” trump card might apply, I have to figure out how it applies.  In other words I have to be a mindreader.

In addition to making the reader do the work that the author should have done, there is a deeper problem.  Writing a document like this makes for potential ambiguities and conflicts in interpreting the document.  On another trust document our office is working on right now, both we and the trustee (Gigantic TrustCo #2) agree that we have no <swearing> clue what a particular provision means.  And it is a “make or break” point.

Memo to all personnel:   if you’re writing a trust document (or any kind of document), it is the job of the author to understand the situation and tell the reader clearly and simply what’s going on.  Readers aren’t supposed to guess.

</rant>

The fallout starts. Apparently 195 Germans confessed to tax evasion. There are 20 uncomfortable Australians. The United States is getting into the act and has a list of 100 American taxpayers they are looking at.

To summarize the business plan:

1. Some people figured that they could hide money, lie about it, and not pay tax.
2. They stuck the money in Lichtenstein banks.
3. Real, grown-up countries (Germany, U. K., and who knows who else in in on this), by apparent bribery, bought the services of someone who was willing to break the laws of Lichtenstein and steal bank data that revealed everything about.
4. ???
5. Profit! (For the tax collectors in Germany, the United Kingdom, the U. S., and elsewhere).

Unlike the underpants gnomes‘ business plan, THIS business plan worked.

Possible countermeasures for people like this, who are yet undiscovered:

• Jump up and down and say “It’s not right! The government can’t do illegal stuff like that!” (Response: So what? Cat. Bag. Out.)
• Sit tight and do nothing. (Response: Inevitable merely postponed. Pain handed to your kids because you won’t deal with it.)
• Run away to Panama. (Saw that happen last week for a U. S. citizen I know. He is a fugitive for the rest of his life.)
• Be a grown up and clean up your mess. (Why make a money problem into a jail problem?)

The Tigerhawk blog has a tax reform proposal that has a high Sanity Quotient but unfortunately a zero probability of enactment.

I’m one of the tax lawyers in the tax/estate planning industry who would be wiped out if Tigerhawk’s estate tax proposal (item 1 on the list) ever comes about. I still think his idea is good, against my own self-interest.

The estate tax is — to a large extent — a voluntary tax paid by the heirs of dim bulbs and procrastinators. I am repeatedly astonished I can sit with a prospective client and show them I will eliminate $40 of estate tax for every $1 they spend on my fees, and they have to think about it. Then I never hear from them again.