U.S. Estate Tax Planning for Multinational Family Business
U.S. Estate Tax Planning for Multinational Family Business
By Rafael Carsalade
Do you have any foreign family member, friend or investor participating in your U.S. business through either equity or debt? If you have not considered U.S. estate tax planning for that person, you may be putting your business at risk. U.S. assets directly owned by nonresident aliens (NRAs), including interest in a U.S. partnership and loans to a U.S. business, can be subject to estate taxes of 50 percent at the time such property is transferred to the heirs at death. These potentially high estate taxes could require the estate of the foreign partner or investor to generate cash to settle the taxes. The U.S. business may be negatively affected if the estate chooses to generate the necessary cash by requiring cash distribution from the business, selling the interest in the business or calling in a loan made to the business by the decedent.
Simple estate tax planning will avoid most of the risks associated with estate taxation on a NRA involved in the U.S. business. Using foreign corporations and favorable loan structures are the primary planning tools for estate taxes because they provide an effective and reliable planning option for NRAs and are easily implemented in most cases.
General Rules of NRA Estate Taxation
The method to compute estate taxes on the gross estate of an NRA is basically the same as the one used for a U.S. citizen or resident, except for two important differences. First, the NRA’s estate is only taxed to the extent of its U.S. situs property holdings, and second, it has a much smaller unified tax credit against estate taxes. The discrepancy between U.S. citizens/residents and NRAs in the amount of unified tax credit allowed is significant. While U.S. residents are automatically allowed a credit of $1 million against estate taxes computed on their estate, NRAs only are allowed an automatic credit of $13,000 against the estate taxes. This relatively small credit allowed for NRAs makes estate tax planning particularly important for most involved in a U.S. business.
Only U.S. situs property is included in an NRA’s U.S. estate, and is subject to estate taxes. Generally, situs of the property held by the estate is where that property was located at the time of death of the NRA. For example, a house in the United States owned by the NRA would be included in the U.S. estate of that individual, while a house in England would not. One important exception, especially for planning purposes, is stock of a corporation. The situs of corporate stock is the place of incorporation of the entity. Stock in a U.S. corporation owned by a NRA is deemed to be situated in the United States and subject to estate taxes – even if physical presence of the actual shares is abroad. On the other hand, stock in a Mexican S.A., for example, would not be deemed a U.S. asset subject to U.S. estate taxes, even if the company owned U.S. assets.
When it comes to estate tax planning for NRAs, the rule of thumb is fairly simple: hold your U.S. property in a foreign corporation. Since Treasury regulations clearly defined stock in foreign corporations as non-U.S. situs property, the use of foreign corporations by NRAs to hold U.S. assets is, in the majority of cases, a no-brainer. The certainty associated with this structure, along with the generally low cost of setting it up, makes it an important planning tool.
Configuring this foreign corporation structure is fairly simple. The NRA acquires the stock in a foreign company; the foreign company, in turn, acquires U.S real property, stocks and any other U.S. situs property. At the time of the NRA’s death, the estate is comprised solely of the stock in the foreign corporation. The stock of the foreign corporation is then transferred to the descendents free of U.S. estate tax. Had the NRA acquired the U.S. property directly, such property would have been subject to U.S. estate taxes at the time of death.
Foreign partnerships, on the other hand, do not provide the same planning certainty because the Internal Revenue Code and the IRS do not provide definite guidance on the situs determination of partnership interest. It is possible that interest in a foreign partnership holding U.S. assets will be considered U.S. situs property and included in the U.S. estate of an NRA. In addition, the IRS will generally not issue determinations on issues dealing with the imposition of estate tax on the estate of a living person. This uncertainty regarding partnerships effectiveness has discouraged their use for estate planning by NRAs. Although foreign partnerships may still be used for estate planning purposes and their risk can be mitigated, they do not provide the level of planning certainty afforded by foreign corporations.
Estate Tax vs. Income Tax
Using foreign corporations to hold U.S. assets is a simple estate tax planning tool, but it comes at the expense of potential income tax disadvantages due to inability of corporations to take advantage of reduced capital gains rates available to individuals. Should NRAs sell a U.S. asset they own as individuals, the gain on the sale of the asset would be taxed at capital gains rates that range from 5 to 15 percent for sales after May 5, 2003. However, these capital gains rates are not available to corporations. Should NRAs sell a U.S. capital asset they own through a foreign corporation, the gain on the sale of the asset would be taxed at the regular corporate tax rates that currently range from 15 to 39 percent. When doing estate tax planning, it is important to consider the income tax effects of a potential sale of U.S. capital assets from the estate.
What is not obvious to most people is that loans, for estate tax purposes, will be considered U.S. property subject to estate taxes if the recipient is a U.S. citizen or resident. A business loan from a relative in Mexico, or an investor friend in England to help start-up or boost a U.S. business, will be subject to U.S. estate taxes on the principal balance outstanding should the lender pass away.
One method to avoid or reduce this potential problem is to make the loan through a foreign corporation. This method requires the NRA to lend the money to a foreign corporation, and the corporation, in turn, lends the money to the U.S. business. As explained earlier, should the individual lender die, estate taxes should not apply to the balance of the loan because it would be owned by the foreign corporation. In some cases, holding a loan through a foreign corporation is not in the best interest of the parties involved, and alternative structures should be considered.
Estate tax laws allow a deduction for unpaid non-recourse mortgages or indebtedness taken exclusively against property that is fully includible in the gross estate. With that in mind, a properly structured loan agreement or mortgage could allow the liability to be offset against the value of the U.S. property included in the estate of the NRA.
Furthermore, using loan structures as estate tax planning tools require a significant amount of diligence when drafting loan agreements to ensure that the liability will be able to reduce the value of the includible property in the estate. Among the specific criteria that such agreements must meet, the most important one is that each agreement supports a bona fide loan that is allowable under state law and enforceable only against the property used as security.
Exceptions For Certain U.S. Assets Included in Estate of NRA
Although U.S. estate tax rules may seem aggressive with respect to taxation of assets owned by NRAs, they do exclude certain U.S. assets from estate taxation. U.S. bank deposits by NRAs are not subject to U.S. estate taxation if the income from such deposits is exempt from federal income tax. This exception applies to most regular bank deposits with U.S. banks, and also includes deposits made with U.S. banks abroad. However, deposits with brokerage firms not in the banking business, cash held in a bank’s safe deposit box, and funds held in a fiduciary capacity are not considered U.S. bank deposits; they are subject to estate taxes on the death of the NRA.
In a similar manner, debts are not considered U.S. assets subject to estate taxes if the interest on the debt would be treated as portfolio interest exempt from income taxes, even when the recipient of the loan is a U.S. person. To meet the requirements for exemption from estate taxes, among other things, the debt cannot be issued by an entity in which the decedent has an interest of 10 percent or more directly, indirectly or constructively.
The exclusion of the above assets and others from U.S. estate taxation, which would normally be considered U.S. situs property, is generally aimed at increasing the use of U.S. financial institutions by NRAs.
Avoid the Surprises
As we have seen, simple planning steps should be taken to avoid unpleasant surprises associated with estate taxation of NRA investor in U.S. businesses. Unpleasant surprises to these relatively small foreign investors would certainly lead to fairly significant difficulties for them and the U.S. business as well. Through the use of foreign corporation to hold U.S. assets, including equity in and loans to U.S. business, foreign investors can protect themselves from heavy U.S. estate taxation, and would therefore be able to increase their investment.
For those foreign investors looking to lend capital, loans can be properly structured so as to eliminate the estate tax exposure for them without significantly affecting the U.S. business or its owners. Family owned and small businesses are increasingly exploring the use of foreign capital to start or grow, both in the form of equity and debt. The ability to reduce or eliminate a significant impediment on the flow of foreign capital is vital to ensure some family and small businesses are able to grow and prosper.
Rafael Carsalade is a Tax manager with PKF Texas.