Nonresident Individual Income and Transfer Taxation in the United States

I. Introduction

The goal of this article is to provide an introduction and overview of United States federal tax rules for the estate, gift, and generation-skipping transfer taxation in the context of nonresident alien individuals. There will also be some discussion of the federal income taxation of nonresident alien individuals to highlight a major divergence between the regimes. It is important to understand that the income tax and estate, gift, and generation-skipping tax (“transfer tax”) are two separate and distinct taxing regimes that have their own rules, definitions, and applicability.

It is important to note that this article does not contain an analysis of state taxation on these issues but readers should keep in mind that the United States consists of fifty sovereign states. Each state has its own tax code, which may differ from the federal tax regime. It is possible that an individual may be obligated to pay taxes both to the United States federal government and also to an individual state(s) or even to a city.

The United States differs somewhat from most other major countries in the world by subjecting all of a citizen’s worldwide assets to transfer taxation, regardless of where that citizen is resident. It is much more common to see a country only subject the assets located in the jurisdiction to transfer tax, with the individual’s worldwide assets only being subject to transfer tax if the individual is resident in the jurisdiction. This can potentially result in double taxation (for some or all assets, depending on the mix of assets) for United States citizens domiciled in a foreign jurisdiction at their death. With the exception of the worldwide taxation of citizens on transfers, the United States is quite similar to others in the imposition of a transfer tax on the worldwide basis for residents and on a situs basis for nonresident aliens. Similarly, on the income tax side, the United States taxes citizens and residents on worldwide income while nonresident aliens are taxed only on U.S.-source income. It is important to note also that residence for gift and estate tax purposes differs from residence for income tax purposes, this will be discussed below.

II. Who Pays Tax

A. Citizens

The question of who is a “citizen” of the United States is (for the most part) easy to answer. Aside from a few special rules such as in the case of expatriation or citizens of the United States solely because they are a citizen of a possession of the United States,[1] all persons born or naturalized in the United States and subject to its jurisdiction are citizens.[2] Recognize this would mean a child born in the United States to parents who are diplomats of a foreign country, and not subject to the jurisdiction of the United States, would not be a citizen. The following rules provide guidance on who may receive U.S. citizenship at birth:

1. Persons born outside the United States to parents, who are both citizens of the United States and at least one of whom has had a residence in the United States or one of its possessions prior to the birth of such person;

2. persons born outside the United States to parents, one of whom is a citizen of the United States who has been physically present in the United States or its possessions for a continuous period of one year prior to the birth of such persons, with the other parent being a national but not a citizen of the United States; and

3. persons born outside the United States to parents, one of whom is an alien, and the other parent who is a citizen of the United States, and prior to the birth of such person(s), was physically present in the United States or its possessions for a period or periods totaling not less than five years, with at least two of these years being after the parent attained fourteen years of age.[3]

There are a couple of other provisions of narrower application as well provided in the statute 8 U.S.C. § 1401. Additionally, one may gain citizenship to the United States through the naturalization process, which typically requires lawful permanent resident status to be maintained for five years.[4]

It is not uncommon for persons to hold dual citizenship in the United States and another country. For taxation purposes in the United States, a dual citizen is treated the same as another citizen. Dual citizens should be aware though that it is possible to lose U.S. citizenship by taking an oath of allegiance to another country or taking actions regarding citizenship in another country, which by their nature preclude dual nationality.[5]

B. United States Residence (Income Tax)

For more than 30 years the rules for determining residence in the United States for income tax purposes have been laid out by statute and are quite straightforward. There are two major tests for residence for income tax purposes: (1) the lawful permanent resident test or (2) the substantial presence test.[6] A lawful permanent resident may also elect resident status for the first year of residence from the first day of actual presence in the United States. This is an “election” so it would be at the choice of the individual.[7] A lawful permanent resident is an individual holding a “green card” or a visa entitling the individual to permanent residence, and the ability to work, in the United States.[8] Lawful permanent residents of the United States are subject to income tax on their worldwide income just as a U.S. citizen. This is the case as long as the individual holds their green card whether or not the individual resides in the United States during the period that the green card is valid.[9] Also, note the special rules that govern the first and last years of United States residency.[10]

Abandoning permanent resident status, for tax purposes, requires more than simply relinquishing the holder’s green card. Additionally, while it is beyond the scope of this article, it is important to note that depending on the length of time a green card has been held, surrender of the green card may have other tax consequences.[11]

The substantial presence test has a couple of interesting quirks that are important to note. However, for the most part, the substantial presence test is quite formulaic and requires a bit of simple math and careful record-keeping to make an appropriate analysis.[12] The substantial presence test looks simply at the number of days an individual has spent in the United States in the present year and in the two preceding calendar years. This determination is made on an annual basis. An individual is a nonresident if the weighted number of days spent in the United States in the current and preceding years is less than 183 or if the individual has spent fewer than 31 days in the United States in the current year.[13] The calculation for the weighted number of days in the United States takes the number of days the individual was present in the current year, one-third of the days the individual was present in the preceding year, and one-sixth of the days the individual was present in the second preceding year.[14] This test may also be referred to as the “120-day test,” because if an individual never spends more than 120 days in the United States in one calendar year, the individual will never meet the substantial presence test and will not be subject to taxation on worldwide income.[15]

As mentioned above, an individual must meet both the 183-day test and the 31 days in the current year test to be deemed a resident of the United States for income tax purposes. This means, even if an individual’s weighted aggregate for three years exceeds 183 days, the individual could still be a nonresident in the current year if the individual is present in the United States fewer than 31 days in the current year.[16] This is important to note if an individual is looking time the realization of income in a year when the individual is not a resident of the United States and subject to taxation on their worldwide income. The individual would simply need to stay below the 31-day threshold in the current year.

It is also worthwhile to quickly note a few important exceptions to the substantial presence test for determining whether an individual is resident in the United States for income tax purposes. Most of these exceptions apply to how one counts days “present” in the United States. One exception even allows nonresident alien individuals to spend more days in the United States:

1. Foreign government-related individuals, teachers, teacher trainees, students, and professional athletes in the U.S. temporarily to compete in charitable sports events, so long as they are in the United States legally and acting within the scope of their visa are not deemed “present” here at all and thus need not concern themselves with the substantial presence test. However, there may be certain tax filings for an individual claiming such status who otherwise would have met the substantial presence test.[17]

2. Commuters from Canada or Mexico are not “present” in the United States on days they commute here.[18]

3. A day spent in transit through the United States (such as a layover in the United States while traveling from one country to another) does not count if it is only transitory and the individual does not have any meetings or visit any friends during the transit day.[19] The individual also cannot be present in the United States for more than twenty-four hours to benefit from this transit exception.[20]

4. An individual forced to prolong a stay due to an unforeseen medical condition that arose while in the United States and prevents departure is not “present” for the days after the medical condition arose so long as the individual did intend to leave.[21] This claim should be documented by the individual through filing a Form 8843 and attaching a doctor’s certificate.

Separate and apart from the above “exempt” days is the statutory “closer connection” test, which grants individuals the ability to spend even more days in the United States each year. As covered above, the substantial presence test is based on a weighted, three-year total of more than 182 days. Under the statutory closer connection test, an individual can spend a total of up to 182 days in the United States each year if the individual demonstrates to the Internal Revenue Service that the individual has a tax home in another country (as understood in I.R.C. § 162(a)(2)), and based upon the facts and circumstances, the individual maintains a closer connection to the other country than to the United States.[22] It is not necessary for the individual to spend more days in the home country than in the United States, simply that the total connections must be closer. It is important though to file a Form 8840 (outlining the facts of how the connections are determined and the number of days in the United States and the home country) currently, because this form cannot be filed later and applied retroactively in the event of an audit.[23]

C. United States Resident (Transfer Tax)

The Internal Revenue Code (I.R.C. or the Code) promulgates an estate tax on “… the transfer of the taxable estate of every decedent who is a citizen or resident of the United States.”[24] However, “residence” in the United States is not defined in the Code for transfer tax purposes.[25] Instead, for estate tax purposes it is necessary to look to the regulations to find that

[a] “resident” decedent is a decedent who, at the time of his death, had his domicile in the United States. The term United States, as used in the Estate Tax Regulations, includes only the States and the District of Columbia [and not the territories or possessions of the United States]. A person acquires a domicile in a place by living there, for even a brief period of time, with no definite present intention of later removing therefrom. Residence without the requisite intention to remain indefinitely will not suffice to constitute domicile, nor will intention to change domicile effect such a change unless accompanied by actual removal.[26]

The test is clearly a subjective one based on an individual’s intent. Ultimately, the determination of domicile will be made based upon all the facts.

A few examples of how domicile has been determined may be instructive:

1. In Estate of Nienhuys v. Commissioner, the Tax Court held that a Dutch citizen who had come to the United States on a business trip in 1940 and then was unable to return home because of the German invasion and ultimately died in the United States in 1946, was not domiciled in the United States. The facts revealed that technically the individual could have returned home, but at the end of the war his health was poor, there were food shortages, and the individual did not want to return during the winter. Based on these facts, the court determined that the individual did not have the requisite intent to remain in the United States on a permanent basis.[27]

2. Courts have also recognized that an individual may spend a portion of every year in the United States without becoming domiciled in the United States. This is important for many Canadians who may spend six months each year in Canada with the other six spent in the United States. Indeed, this was the case for a Canadian citizen who died in Florida in 1975, and the Tax Court determined the individual never intended to change his domicile to Florida.[28]

3. The question of whether an individual is in the United States legally or illegally does not provide a “bright line” determination of intended domicile. The IRS determined that an illegal alien was domiciled in the United States because he died while residing in the United States, he had lived in the United States for nineteen years, had owned a home in the United States for fourteen years, and was active in community affairs. The IRS issued a ruling that the individual had established the requisite intent to be domiciled in the United States and thus was subject to U.S. estate tax on his worldwide assets.[29]

If an individual is “resident” in the United States based on the above definition at the time of death the individual is subject to estate tax on their entire worldwide estate.[30]

The gift tax code operates in a different manner, though the end result is generally favorable with appropriate planning. Gift tax is imposed upon all individuals, resident or nonresident.[31],[32] Notwithstanding, the Code quickly excludes from taxation all transfers of intangible property by nonresident aliens.[33] The definition of “residence” for gift tax purposes is the same as for estate tax purposes.[34] Thus, while it may initially sound as though the gift tax is more inclusive than the estate tax, in fact, it is far less inclusive. This means, for nonresidents who can afford to do so, they should gift stocks, bonds, or other intangibles to their beneficiaries during their lifetime. It is also worthwhile to note that the United States does not have an inheritance tax; thus the recipient of a gift or inheritance is not taxed on that “income.”[35]

Finally, a generation-skipping transfer tax is imposed on “every generation-skipping transfer.”[36] The statute fails to distinguish between U.S. persons and nonresident aliens. However, the Code requires the Treasury to adopt regulations to provide for the application of the chapter in the case of transferors who are nonresidents not citizens of the United States.[37] Regulations were adopted establishing that the generation-skipping transfer tax applies to the extent the gift or estate tax would apply to the transfer.[38] Be careful of circumstances that could result in double taxation, particularly if one or both taxes could be avoided, such as in the event a nonresident alien makes a testamentary gift of stock in an American corporation to a grandchild, this bequest would be subject to both estate tax and generation-skipping transfer tax.[39]

D. Special Rules for Citizens of United States Possessions

Special rules apply to the estate taxation of citizens of the United States who are citizen and resident of possessions of the United States.[40] A decedent who is a United States “citizen” solely by reason of being a citizen of a U.S. possession or through birth or residence in the possession is deemed a nonresident alien of the United States.[41] It is important to note that one cannot benefit from this unless they are a U.S. citizen solely by reason of being a citizen of the U.S. possession or birth or residence within the possession.[42]

This provision has been applied through regulations and rulings and even seemingly expanded. Importantly, the Service has ruled that a U.S. citizen who passed away resident in a U.S. possession was not a citizen for estate tax purposes at death, even though the U.S. possession the individual was resident of at death was different from the U.S. possession in which the individual was born and gained citizenship.[43] Treasury has also provided regulations establishing that a U.S. citizen who became a citizen through naturalization after moving to a U.S. possession is not a U.S. citizen for estate tax purposes.[44]

III. U.S. Income Taxation (Nonresident Aliens)

Generally, nonresident aliens and foreign corporations only pay United States income taxes on income paid from sources within the United States (“U.S. source income”). The rules are set out in subchapter N of chapter 1 of the Internal Revenue Code.[45] Additionally, there are other special rules addressing certain direct or indirect dispositions of interests held by nonresident aliens in United States real property.[46]

Nonresident aliens with income from the conduct of a trade or business within the United States or from the performance of personal services within the United States is taxed at ordinary graduated tax rates.[47] Income from fixed or determinable sources within the United States (dividends, interest, or royalties) is taxed at a flat 30 percent (unless an income tax treaty applies) by withholding at the source upon the income payment.[48] Income from the sale or exchange of capital assets (other than real property) located in the United States is only subject to the 30 percent tax if the owner was present in the United States for more than 182 days both in the year the gain was effected and in the year the income was collected (if collected in a future year).[49] Again, it is important to note that these are general rules and there may be income tax treaties that provide a better result. Income tax treaties can only help; they cannot cause an individual to pay more tax.

A. Trade or Business Income

Typically, income from a U.S. trade or business is one of three kinds:

1. Personal Services

Income generated from personal services performed in the United States is likely to be deemed income from a U.S. trade or business. A small exception exists if the services are performed for a foreign employer, the aggregate compensation does not exceed $3,000, and the nonresident employee is present in the United States for no more than 90 days.[50] As an example of one place treaties can make a difference, most income tax treaties allow an individual to spend up to 182 days a year in the United States and to earn an unlimited amount without U.S. income tax if the individual’s employer is based in the individual’s country of residence.[51]

2. Securities or Commodities Trading

A foreign person who trades in stocks, securities, or commodities in the United States is not treated as conducting a U.S. trade or business, as long as the individual does not have an office in the United States through which the securities transactions are effected.[52] Additionally, even if there is a United States office for a foreign individual, corporation, or trust, if the transactions are for the individual’s own account there are safe harbor provisions to prevent the treatment of the trading as a U.S. trade or business.[53]

3. Facts and Circumstances

If an individual is engaged in activities other than performing personal services or trading in securities and commodities, then the question of whether there is a trade or business is determined based on the facts and circumstances of each case. The IRS will not issue advance rulings or determination letters on an individual taxpayer’s status in the conduct of a U.S. trade or business. A U.S. trade or business does not include isolated or nonrecurring transactions. The individual must have been, during a substantial portion of the tax year, regularly and continuously transacting business in the United States. The facts and circumstances test takes into account the nature and extent of the economic activities and contacts within the United States.

B. Other Income Not Connected to U.S. Trade or Business

Nonresident taxpayers pay flat rate U.S. withholding taxes on U.S. source income not connected with the conduct of a trade or business.[54] U.S. source income means income paid by United States payors. However, the Code provides exceptions to the taxation of certain types of U.S. source income to encourage investment.[55] Taxable passive U.S. source income includes interest, dividends, rent, royalties, original issue discount, and other more specialized categories of income. While some of these categories are pretty straightforward, it is instructive to look more closely at others.

1. Original Issue Discount

Original issue discount (OID) is the difference between the issue price and the stated redemption price at maturity of a bond or other instrument of indebtedness purchased by an investor. OID is subject to U.S. income tax in the hands of a nonresident individual unless it is paid on a short-term obligation payable within 183 days of its original issue or paid on a tax-exempt instrument.[56]

2. Portfolio Debt

All interest paid to a nonresident individual, whether “coupon” or other interest payments actually made or deemed paid as original issue discount, is exempt from tax if it is portfolio interest income. Portfolio interest income is interest paid on fixed income securities purchased by a nonresident to be held in the individual’s investment portfolio. Portfolio interest is not subject to withholding, and is defined as any interest, including original issue discount that would be subject to tax under I.R.C. § 871(a) but for I.R.C. § 871(h) and is either: (1) interest on nonregistered obligations of the type described in I.R.C. § 163(f)(2)(B); or (2) interest on a registered obligation with respect to which the withholding agent has received a statement that the beneficial owner is not a U.S. person.[57] Note that bearer bonds issued after March 18, 2012, are not considered portfolio debt, and thus the interest on such bonds is not exempt from tax.[58]

Most long-term U.S. Treasury and corporate obligations are issued in registered form, and thus are exempt from tax for nonresidents upon presentation of the appropriate paperwork. Additionally, interest paid by United States individuals on borrowings from nonresident individuals can also be made exempt from tax if the note is drafted in conformity with the portfolio debt rules.

3. Bank Deposit Interest

Interest on deposits with U.S. based banks, savings and loan associations, and insurance companies by nonresident individuals are typically exempt from income taxation.[59]

4. Sales of Capital Assets

Sales or exchanges of capital assets that produce U.S. source gain is subject to 30 percent tax on the net gain (unless altered by an income tax treaty) if the gain is not otherwise taken into account as effectively connected to a U.S. trade or business. However, in most cases as long as the nonresident is not physically present in the United States for 183 days or more during the year of the sale, and the year the gain is received, the gain will be exempt from tax.[60]

IV. Transfer Taxation of Nonresidents

The rules for transfer taxation of nonresidents are similar to those for income taxation. The major difference is that property must have a situs in the United States for transfer tax purposes as opposed to the income being sourced to the United States.

A. Estate Tax

The estate taxation of nonresident individuals is covered by subchapter B of chapter 11 of the I.R.C. (§§ 2101-2108). The rules are as follows:

1. Situs of Various Assets

Tangible Property – all tangible property, both real and personal located in the United States includable in the estate of a citizen or resident is also includable in the estate of a nonresident.[61] There is an exception for works of art that are imported into the United States solely for exhibition at a public gallery or museum or are en route to or from an exhibition at the time of the nonresident’s death.[62] Similarly, personal property that a nonresident has with them while temporarily visiting the United States would not be included if the nonresident passes while present in the United States.[63]

Real property – real property’s situs is the place where it is located. Issues with real property arise in determining what constitutes real property. The estate tax determines what constitutes real property under United States law rather than the law of the place where the interest is located.[64] Real property includes land, buildings, improvements, and fixtures. It also includes crops, timber cutting rights, and mineral rights (but not certain extracted commodities and minerals). Typically, a condominium apartment is deemed to be real estate in the United States. On the other hand, a cooperative apartment is treated as intangible personal property and not subject to tax in the United States. However, stock in a cooperative apartment corporation is subject to estate tax as stock of a U.S. corporation if directly owned by a resident of a non-treaty country.

Corporate Stock – Whether an intangible personal property is situated within the United States and subject to estate tax for a nonresident individual depends less on the location of the paper evidencing title to the property than on the nature of the property interest owned. Shares of stock issued by a domestic corporation are property within the United States; shares of stock issued by a foreign corporation are not.[65] If a nonresident individual forms a foreign corporation to hold U.S. situs property, it is imperative that the individual ensure corporate formalities are followed and the foreign corporation is clearly listed as the owner of the property.

Life Insurance Proceeds – Proceeds of insurance on the life of a nonresident decedent are not property within the United States regardless of whether the company issuing the life insurance policy is a domestic or foreign company.[66] However, this is only the case if the life insurance policy is on the life of the decedent. If a nonresident individual owns an interest in a life insurance policy on the life of another that is issued by a United States company, it is U.S. situs property includable in the gross estate at its present value.[67]

Debt Obligations – As a general rule, the debt obligations of U.S. persons or of the United States are property within the United States subject to estate tax. However, there is a major exception to this rule. Debt obligations are not “located in the United States” if, the interest thereon would be treated as portfolio interest exempt from U.S. income tax if the decedent had received the interest before death.[68] Similarly, interest on bank deposits not subject to income tax is not subject to estate tax by the United States.[69] A good rule of thumb here is—if the interest is not subject to income tax, the principal is not subject to estate tax.

Copyrights, Patents, and Trademarks – Treasury regulations do not provide concise guidance on copyrights, patents, and trademarks due to the law and international conventions governing intellectual property rights. However, the best place to begin an analysis is to determine the country that issued the intellectual property right. Thus, if the United States issued the primary patent, copyright, or trademark, it is likely subject to estate tax in the United States, but results tend to be fact-specific. Estate tax treaties often resolve the ambiguities, but there are very few countries with estate tax treaties with the United States.

Partnership Interests – A threshold issue with partnership interests is, of course, entity classification. The “check the box” rules are certainly useful in determining whether a particular entity is a corporation or a partnership.[70] The long-standing position of the United States government is that partnerships are deemed “sited” in or out of the United States based on where the partnership primarily conducts business. However, this is not the only option for determining the situs of the partnership and the situs of such an interest can be difficult to determine with certainty.[71] Typically partnerships are reviewed at an “entity” level and not at the “asset” level.

Trust and Estate Interests – In contrast to the above, interests in trusts are determined according to the situs of the assets as opposed to the situs of the trust. If a nonresident individual is a beneficiary of a trust that has United States situs property, the nonresident individual’s interest in the U.S. assets is included in their estate, even if the trust is a foreign trust. However, foreign assets in the trust would not be included, except in certain instances.[72] U.S. trusts investing in U.S.-based common trust funds are deemed situated in the United States regardless of where the assets owned by the common trust fund are located, the important consideration is that the fund is located in the United States.[73] Mutual funds can be tricky because they can be organized as corporations, partnerships, or trusts. If the fund is organized as a U.S. corporation, then the fund interest in the fund is deemed a U.S. interest. On the other hand, if the fund is a partnership or trust, then the fund is looked through and only assets actually located in the United States are deemed located in the United States for estate tax purposes.[74]

Other Intangible Personal Property – All intangible personal property, the written evidence of which is not treated as the property itself, is located within the United States if it is issued by, or enforceable against, a resident of the United States or a domestic corporation or governmental unit.

2. Tax Rates

Nonresident individuals used to have a different rate of estate tax than U.S. citizens, with a maximum rate of 30 percent.[75] Since the change in November 1988, everyone subject to the United States estate tax is subject to the same rates (up to a maximum of 40%), although for nonresident individuals the tax only applies to assets located in the United States.

3. Deductions

Nonresident individuals are only entitled to limited deductions for estate tax purposes. These include general expenses of administration, debts, taxes, funeral expenses, and losses. These expenses are deductible in the ratio the U.S. estate bears to the total worldwide estate, regardless of where the expenses were incurred or paid, as long as there is full disclosure of the worldwide estate and worldwide expenses.[76]

Charitable Deductions – A nonresident individual is entitled to an unlimited charitable deduction just as a U.S. Citizen would be with respect to the portion of the estate located in the United States, provided: (1) in the case of a charitable contribution to a corporation, the deduction is only available for gifts or bequests to U.S. corporations; and (2) in the case of a charitable contribution to a trust or foundation, the deduction is applicable only to the extent the gift or bequest requires the charity to spend the money within the United States. A charitable deduction is not allowed for foreign situs property, even if given to a U.S. charity. The gift must be of property that was included in the gross estate.[77] Similar to the deduction for administration expenses, the executor must disclose the entire worldwide estate to benefit from the charitable deduction.

Marital Deduction – An estate of a nonresident may claim a marital deduction, without limit, under the same rules that apply to citizens and residents, but only for bequests of property that was subject to tax in the United States. Bequests to U.S. citizen spouses are eligible for the marital deduction if paid directly or in an otherwise deductible fashion under I.R.C. § 2056. However, a bequest to a noncitizen spouse is only deductible if paid to a qualified domestic trust (QDOT).[78] Some estate tax treaties expand the application of the marital deduction.[79]

4. Estate Tax Credits

Nonresident estates are entitled to a unified credit equal to the amount of tax due on a $60,000 estate, or about $13,000.[80] Contrast this with the exemption of $11.18M available to individuals citizen or resident (domiciled) in the United States.

B. Gift Tax

As previously mentioned, chapter 12 of the I.R.C. (Gift Tax) differs from chapter 11 (estate tax) because, on its face, it is more generally applicable. The terms of chapter 12 state that it applies to nonresidents with respect to all gifts of property, but in fact, it only applies to gifts of property with a U.S. situs. The application of the gift tax is further limited in the Code when it provides that the gift tax shall not apply to gifts of intangible property by nonresident donors, except those who have expatriated from the United States.[81] The practical effect of this provision is that all intangible property is deemed to have a foreign situs for gift tax purposes (if the gift is by a nonresident individual). While the Code does not speak to the situs of property for gift tax purposes, Treasury Regulations expressly state the gift tax only applies to nonresident individuals on gifts of real estate or tangible personal property located in the United States.[82]

Citizenship or residence of the one receiving the gift is of no consequence for estate or gift tax purposes. Nonresident individuals making gifts of property to U.S. resident or citizen children need not pay tax upon or even declare his gifts. Changes were made to the Internal Revenue Code in 1996,[83] to require a U.S. resident or citizen to declare receipt of gifts.[84] The purpose of this reporting is for the I.R.S. to have a record of gifts made. However, the gifts are not subject to tax, merely the reporting requirement. Be aware that the gift can be recharacterized as income in the hands of the recipient if it is found that the source of the gift was in fact a foreign nongrantor trust (or trusts) rather than an individual.[85]

1. Annual Exclusion

The annual exclusion for the first $10,000 (adjusted for inflation, the amount is $15,000 in 2018) of gifts or present interests in property to each done is available to every donor, whether or not they are a U.S. citizen or resident.[86] The exclusion applies specifically to gifts that would otherwise be taxable. Thus a nonresident individual could gift a full $15,000 (in 2018) of otherwise taxable property along with an unlimited amount of intangible property not otherwise subject to U.S. gift tax.

2. Tax Rate

The gift tax rate has been the same for citizens, residents, and nonresident since 1988. It follows a graduated schedule with a maximum 40% tax.[87]

3. Unified Gift Tax Credit

There is no gift tax credit for gifts by nonresident individuals. A nonresident must begin paying tax as soon as his or her gifts of U.S. situs property exceed the $15,000 (in 2018) annual exclusion.

4. Charitable Deduction

There is a distinction in the Code between charitable gift deductions for gift tax purposes for gifts from citizens or residents and for gifts by nonresident individuals.[88] Nonresident individuals’ gifts must meet a couple of criteria: (1) if the gift is to a corporation, it must be a U.S. corporation; or (2) if the gift is to a trust or foundation, the trust or foundation must spend the gift within the United States. It is worth noting that these are the same as the rules for the charitable deduction under the estate tax.

5. Marital Deduction

The unlimited marital deduction is not available to nonresident individuals unless the gift is made to a United States citizen.[89] If the spouse receiving the gift is not a U.S. citizen, there is an increased annual exclusion ($152,000 in 2018, as opposed to $15,000), but note this is far less than unlimited. This is available to U.S. persons and nonresidents but remember with nonresidents this exclusion amount would only be applied toward gifts of U.S. situs property.

6. Gift Splitting for Third Party Gifts

While availability of the marital deduction for gifts to a spouse depends upon the citizenship status of the receiving spouse, gift splitting by spouses for gifts to third parties depends upon citizenship or residence of both spouses. The regulations are clear that the issue is the residence or citizenship of both spouses at the time of the gift.[90] Nonresident individuals are not entitled to split gifts.

C. Generation-Skipping Transfers

The generation-skipping transfer tax is an extra, prohibitive tax at a flat 40 percent rate imposed upon transfers made to grandchildren or further descendants. It will also apply to recipients of gifts whose “generation assignment” is to a generation twice removed from the donor’s, generations are set by statute at 25 years.[91]

There was initially considerable debate about whether the generation-skipping transfer tax would apply to nonresidents, and if so, how would it apply. Ultimately, the Treasury Department enacted final regulations as required by I.R.C. § 2663 imposing a generation-skipping transfer tax upon nonresidents based solely upon the situs of the property transferred as determined under estate and gift tax rules.[92] This creates an interesting situation where a transfer during life by a nonresident individual of stock in a U.S. corporation to a grandchild would not be subject to any tax; however, the same transfer of stock after the death of the nonresident individual would be subject to the estate tax and generation-skipping tax.[93] This is an outcome that is obviously best avoided.

Transfers otherwise subject to the generation-skipping transfer tax are exempt from the tax, up to a cumulative $11.18M per donor in 2018, at the election of the donor.[94] This exemption is available (for purposes of the generation-skipping transfer tax) to nonresident individuals to use against otherwise taxable gifts.[95]

V. U.S. Income Taxation of U.S.-Situs Real Property Dispositions by Nonresidents

The Foreign Investment in Real Property Act (FIRPTA)[96] was enacted by Congress in 1980.[97] Before the enactment of this statute, gains on the sale of U.S. situs real property by nonresidents had been taxed the same as gains upon the sale of any other U.S. situs capital asset. That is to say, they were only subject to U.S. income tax if the nonresident owner was present in the United States for more than 182 days in the year of sale and (if different) the year of collection of the sales proceeds.[98]

FIRPTA was enacted because of increasing foreign investment in U.S. real estate, particularly farmland, by nonresident investors in the 1970s. Congress determined, unlike other investments that receive preferential tax treatment, this type of foreign investment actually harmed U.S. individuals because it increased the prices of a scarce resource, land. Thus, Congress found it appropriate to impose an income tax on disposition regardless of the nonresident’s presence in the United States.

FIRPTA subjects gain or loss upon disposition of “a United States real property interest” to income tax as if the gain or loss were effectively connected with the conduct of a trade or business in the United States.[99] The tax imposed is pursuant to I.R.C. § 871(b)(1). “United States Real Property Interests” include both directly held interests in land, buildings, mines, farms, and other “real estate” and interests in certain corporations, 50 percent or more of whose assets consist of United States real property interests (unless the corporation is publicly traded).

Minimum tax rules found in I.R.C. § 55 apply to the calculation of the FIRPTA tax, and U.S. purchasers of FIRPTA interests are typically required to withhold 10 percent of the gross purchase price of the asset from a foreign purchase and remit to the I.R.S. with a FIRPTA information return.[100] It is possible for the seller to avoid the withholding through the delivery of a withholding certificate that reduces or eliminates the withholding requirement.[101] Nonresident sellers of United States real property interests are required to file a United States income tax return Form 1040NR, even if the 10 percent withholding equals or exceeds the tax due.[102]

In 1980, Congress gave Treasury statutory authority to require annual information returns by all nonresident individuals owning United States real property interests.[103] Luckily for nonresidents, Treasury has yet to adopt any regulations requiring such reporting.

VI. Treaty Impact

The United States has bilateral income tax treaties with all its major trading partners and an increasing number of third world nations. The purpose of such treaties is to reduce double taxation, to allocate primary taxing authority, and to facilitate cooperation of tax administration by the two nations. Most treaties reduce from 30 percent to 15 percent or less the flat withholding rate of tax on most classes of passive income, and many also allow nonresidents to spend more time in the United States before being taxed as a resident.

The United States also has estate (and sometimes gift) tax treaties with fewer countries. Additionally, many of these, such as the dual estate tax treaty with Japan, are outmoded. As in the case of bilateral tax treaties, the purpose of dual estate tax treaties is to reduce double taxation, allocate primary taxing authority, and facilitate cooper

[1] Possessions include Puerto Rico, the Virgin Islands, Guam, American Samoa, the Northern Marianas, Okinawa, and the Marshall Islands.

[2] 8 U.S.C. § 1401.

[3] Id.

[4] 8 U.S.C. § 1427.

[5] 8 U.S.C. § 1481.

[6] IRC § 7701(b)(1)(A)(i)-(ii)

[7] IRC §7701(b)(1)(A)(iii)

[8] 8 USC § 1101(a)(20)

[9] IRC § 7701(b)(1)(A)(i).

[10] IRC § 7701(b)(2). Residency status for the green card test generally begins on the first day of the year that the alien is physically present in the United States with a lawful permanent resident visa and ends on the last day on which the alien holds a lawful permanent resident visa (subject to certain exceptions for dual-residents under the treaty “tie-breaker” rules, and certain “long-term” residents under the expatriation rules). In the case of the substantial presence test, by its terms, the test refers to the first day of physical presence for the initial year. If an alien either satisfies the substantial presence test in a given year or makes a “first-year” election under I.R.C. § 7701(b)(4) to be treated as a U.S. resident starting from their date of entry into the U.S. in a year in which they would not generally be considered a resident under the substantial presence test, their date of entry into the U.S. will be their residency start date. Thereafter, the alien will be deemed a U.S. resident for the entire year that they meet the substantial presence test, and a nonresident alien for the entire year that they do not meet the test (subject to exceptions under the “closer connection” rule).

[11] IRC §877A

[12] U.S. Tax Guide for Aliens, I.R.S Pub. No. 519, Cat. No. 15023T (Feb 28, 2018), https://www.irs.gov/pub/irs-pdf/p519.pdf

[13] IRC §7701(b)(3)(A)

[14] IRC § 7701(b)(3)(A); Treas. Reg. § 301.7701(b)-1(c).

[15] U.S. Tax Guide for Aliens, I.R.S Pub. No. 519, Cat. No. 15023T (Feb 28, 2018), https://www.irs.gov/pub/irs-pdf/p519.pdf

[16] Treas. Reg. § 301.7701(b)-1(c)(4).

[17] IRC § 7701(b)(5). Treas. Reg. § 301.7701(b)-8(a).

[18] IRC § 7701(b)(7)(B).

[19] IRC § 7701(b)(7)(C); Treas. Reg. § 301.7701(b)-3(d).

[20] Treas. Reg. § 301.7701(b)-3(d).

[21] IRC § 7701(b)(3)(D); Treas. Reg. § 301.7701(b)-3(c).

[22] IRC § 7701(b)(3)(B); Treas. Reg. § 301.7701(b)-2.

[23] Treas. Reg. § 301.7701(b)-8(d)(1).

[24] IRC § 2001(a).

[25] The Income Tax is Subtitle A of the Code, while Estate and Gift Tax is addressed under Subtitle B.

[26] Treas. Reg. § 20.0-1(b)(1). Similar domicile rules apply to the imposition of the gift tax. Treas. Reg. § 25.2501-1(b).

[27] Estate of Nienhuys v. Comm’r, 17 T.C. 1149 (1952).

[28] Estate of Paquette v. Comm’r, T.C.M. (P-H) 1983-571 (1983).

[29] Rev. Rul. 80-209, 1980-2 C.B. 248.

[30] IRC § 2031(a).

[31] For those unfamiliar with the United States gift tax, it is important to remember that the Treasury Regulations provide: “Donative intent on the part of the transferor is not an essential element in the application of the gift tax to the transfer.” Treas. Reg. § 25.2511-1(g)(1). The issue thus becomes one of whether the transfer was for less than full and fair consideration and, if so, whether, based on the relationships of the parties and all of the facts and circumstances, the transfer was a gift and not just a bad bargain.

[32] IRC § 2501(a)(1).

[33] IRC § 2501(a)(2).

[34] Treas. Reg. § 25.2501-1(b).

[35] IRC § 102.

[36] IRC § 2601.

[37] IRC § 2663(2).

[38] Treas. Reg. § 26.2663-2.

[39] Treas. Reg. § 26.2663-2(d), Example 2. Gifts of real estate will be subject to the generation-skipping transfer tax whether made inter vivos or upon death.

[40] See IRC §§ 2208-2209.

[41] IRC § 2209.

[42] IRC § 2208.

[43] Rev. Rule. 74-25, 1974-1 C.B. 284.

[44] Treas. Reg. § 20.2209-1. Example 5.

[45] See IRC §§ 861-884.

[46] IRC § 897.

[47] IRC § 871(b)

[48] IRC §§ 871(a), 1441.

[49] Treas. Reg. § 1.871-7(d)(2).

[50] IRC § 864(b)(1).

[51] See, e.g., Convention Between the Government of the United States of America and the Government of the United Kingdom of Great Britain and Northern Ireland for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion with Respect to Taxes on Income and on Capital Gains, art. 14.

[52] IRC § 864(b)(2).

[53] IRC §§ 864(b)(2)(A)(ii) and 864(b)(2)(B)(ii).

[54] This was not always the law, but under current law, a nonresident alien pays U.S. income tax on U.S. source income not connected with the conduct of a U.S. trade or business at a flat 30 percent rate whether or not the alien is conducting a U.S. trade or business. If the alien is conducting a U.S. trade or business, the individual must keep records of which classes of U.S. income are connected with the U.S. trade or business and which are not, and each is taxed at the appropriate rates, with their own deductions. Treas. Reg. § 1.871-8(a).

[55] See IRC § 871(h)-(k).

[56] IRC § 871(g)(1)(B).

[57] IRC § 871(h).

[58] H.R. 2847, the Hiring Incentives to Restore Employment (HIRE) Act, § 502.

[59] IRC § 871(i).

[60] Treas. Reg. § 1.871-7(d)(2).

[61] Treas. Reg. § 20.2104-1(a).

[62] IRC § 2105(c).

[63] See, e.g., Delaney v. Murchie, 177 F.2d 444 (1st Cir. 1944).

[64] Estate of de Perigny v. Comm’r, 9 T.C. 782 (1947) (holding 99-year lease to real estate to be “real property” for federal estate tax purposes).

[65] IRC § 2104(a).

[66] IRC § 2105(a).

[67] Treas. Reg. § 20.2104-1(a)(7). See also, Rev. Rul. 2009-13 and 2009-14 for additional clarity and guidance.

[68] IRC § 2105(b)(3).

[69] IRC § 2105(b)(1).

[70] Treas. Reg. §§ 301.7701-1 to 301.7701-3 (effective Jan. 1, 1997).

[71] Rev. Rul. 55-701, 1955-2 C.B. 836.

[72] IRC § 2104(b); see also Comm’r v. Nevius, 76 F.2d 109 (2d Cir. 1935).

[73] Rev. Rul. 55-163, 1995-1 C.B. 674.

[74] PLR 9748004 (Aug. 19, 1997).

[75] Prior IRC § 2101(d), repealed effective for estate of decedents dying after November 10, 1988, by Pub. L. No. 100-647, 102 Stat. 3342, § 5032(c) (1988).

[76] IRC § 2106(a)(1); Treas. Reg. § 20.2106-2.

[77] IRC § 2106 (a)(2); Treas. Reg. § 20.2106-1(a)(2); I.R.S. TAM 9040003 (June 27, 1990).

[78] IRC § 2106(a)(3); Treas. Reg. § 20.2106-1(a)(3).

[79] See Convention Between the Government of the United States and the Government of the French Republic for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion with Respect to Taxes on Estates, Inheritances, and Gifts signed at Washington on November 24, 1978, amended by the Protocol signed at Washington on December 8, 2004.

[80] IRC § 2102(b)(1).

[81] IRC §2501(a)(2).

[82] Treas. Reg. §§ 25.2511-1(b), 25.2511-3.

[83] IRC § 6039F, enacted effective for gifts received after August 20,1996, by Pub. L. No. 104-188, § 1905(a) (1996).

[84] IRC § 6039F. Gifts exceeding $100,000 from a nonresident individual or $10,000 from a foreign person other than an individual must be reported on Form 3520.

[85] IRC § 643(h).

[86] IRC § 2503(b); Treas. Reg. § 25.2503-2(a).

[87] IRC §§ 2502 (Imposition of Gift Tax), 2001 (Imposition and Rate of Tax).

[88] IRC § 2522.

[89] IRC § 2523(i).

[90] IRC § 2513(a)(1); Treas. Reg. § 25.2513-1(b)(2).

[91] IRC § 2651(d).

[92] Treas. Reg. § 26.2663-2.

[93] Treas. Reg. § 26.2663-2(d), Example 2.

[94] IRC § 2631.

[95] Treas. Reg. § 26.2663-2(a).

[96] IRC § 897.

[97] Pub. L. No. 96-499, 94 Stat. 2682, § 1122(a) (1980).

[98] See discussion supra text accompanying note 42.

[99] IRC § 897.

[100] IRC § 1445. The transferee files Form 8288, disclosing the transaction, with the 10 percent withheld tax and two copies of Form 8288-A, one of which is stamped for use by the seller as a receipt for use with his tax return. Treas. Reg. § 1445-1(f)(2).

[101] Treas. Reg. § 1.1445-3.

[102] Treas. Reg. § 1.6012-1(b)(2).

[103] IRC § 6039C, enacted effective June 19, 1980, by Pub. L. No. 96-499, 94 Stat. 2687, § 1123(a).

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