The Expatriate's Estate

An Evolving Context For Expatriation

ax rules affecting expatriation were somewhat toughened in recent years while United States income tax and estate tax rates have been reduced. If the repeal of the estate tax is made permanent, will there be any decrease in the number of wealthy Americans who decide to leave the United States and take up permanent residence elsewhere?

It is a plausible inquiry but there are too many factors involved to reach one hard and fast conclusion. According to the Internal Revenue Service, "tax-motivated expatriation" drains at least $70 billion a year from the United States Treasury.¹ But exact numbers on expatriation by individuals motivated by estate tax savings are subject to interpretation.²

Expatriation By Right

At common law, allegiance to one's nation was immutable. But in 1868, the United States Congress declared in a statutory preamble that "the right of expatriation is a natural and inherent right of all people, indispensable to the enjoyment of the rights of life, liberty, and the pursuit of happiness."

Section 877 was added to the Internal Revenue Code by the Foreign Investors Tax Act of 1966 (P.L. 89-809). Expatriates are subject to income, gift, and estate tax for 10 years following the termination of citizenship or residency. Income tax applies to U.S.-sourced income. Gift tax applies to inter vivos transfers of intangible property made during the 10-year period. Estate tax applies if such individuals die within the ten-year period.

Cases were rare but tax avoidance motivation was demonstrated where a taxpayer left the country two days before receiving a large corporate distribution.³

Under the old law, an expatriating taxpayer could avoid §877 by transferring appreciated U.S. assets to a foreign corporation under IRC Sec. 351 (tax free incorporation). The foreign corporation would then sell the assets without a capital gain (foreign taxpayers are generally not subject to taxes on long-term capital gains).

New Rules, New Presumptions

The topic of expatriation was placed on the legislative front burner on February 6, 1995, when President Clinton gave his budget message for 1996.⁴

The new expatriation provisions were signed into law by the President on August 21, 1996. Under the Health Insurance Portability and Accountability Act of 1996 (HIPAA), broad new rules were established to remove the tax incentives for expatriation. Note that new legislation distinguishing foreign and domestic trusts also arrived in 1996.⁵

Individuals giving up U.S. citizenship or a permanent U.S. residency after February 5, 1995, were presumed to have a tax avoidance motive if they had an average annual net income tax liability of $100,000 for the five years ending in termination of citizenship, or a net worth of $500,000.

Cost-of-living adjustments, rounded to the nearest $1,000, apply to these amounts after 1996. Thus, these thresholds have increased. Tax avoidance is currently presumed for expatriates with average annual net income tax liability for the five-year period before the loss of citizenship of $122,000 in 2003 (up from $120,000 in 2002); or net worth exceeded $608,000 (up from $599,000 in 2002).

The gross estate of a decedent dying within 10 years of terminating citizenship must include the stock of a foreign corporation if the decedent owned more than 50% of the corporation (i.e., 50% of value or voting rights) at the time of death. Where assets are subject to foreign estate or death taxes and are taxable only because of the expatriation rules, a gift and estate tax credit applies to prevent double taxation.

Evolving Rules: Note that additional rules governing expatriates are extensive. Capital gains were addressed in great detail by the Taxpayer Relief Act of 1997. Regarding ownership of foreign corporations, the IRS also provided guidance on the tax liability test, net worth test and other aspects of expatriation.⁶ Rules for rebutting presumptions of tax motivation for expatriation were established in 1998.⁷

International Variations

Estate and/or inheritance taxation approaches vary greatly from one nation to the next. The determination of tax on a particular estate must weigh the location of assets, transferors, beneficiaries, and applicable tax treaties.

Approximately 71% of nations have a death tax of some kind and it averages a tax rate of 21.6%.⁸ A nation without a national estate tax may have a variety of locally imposed death taxes as well as capital gains on appreciated property at the time of death. That approach was adopted in Canada simultaneously with the elimination of the estate tax. Some nations eliminated death taxes many years ago. Pakistan repealed its estate tax in 1979 and India did the same in 1985.

Note that many Civil Law nations in Europe have inheritance taxes rather than estate tax. While the United States and the United Kingdom impose tax on bequests, nations such as Japan, France and Germany impose tax on legatees. Japan and Spain are unusual in that the tax is based on the domicile of the recipient rather than the transferor.⁹

Naturally, top rates do not tell the entire story. Every nation has exemptions and variations. France, for example, has a top death tax rate of 40% but that top rate only applies to estates exceeding a threshold of nearly $1.9 million. Japan's top rate of 70% applies to the portions of estates exceeding $15.3 million.

Strategies and Alternatives

As opposed to a top income tax rate of 39.6%, a flat rate of income tax on the passive U.S. income of a non-resident alien is 30%. As opposed to a top rate of 49% for estate tax for decedent dying during 2003, many nations have lower transfer tax burdens.

Obviously, there are more than a dozen nations with no estate tax and they include our neighbors, Canada and Mexico, as well as English-speaking nations. While the United States is poised to repeal its estate tax, the American tax code is ever restless and unpredictable. And world economics and other factors will always shape the discussion of expatriation in the future.

But having reviewed the subject, one may wonder whether expatriation may be largely unnecessary when assets can flow across national borders so easily. There are many international opportunities for investment and wealth management. For example, it has been suggested that despite the complexities involved, offshore private placement life insurance (OPPLI) may be very useful in accumulating assets with tax-deferred growth of cash value, tax-free access to cash value, and tax-free death benefits.¹⁰ And with death taxes being eliminated in so many nations, the focus of future planning may well focus on capital gains and income taxation.

In Summation

It's a small world, after all. In a global community with mobile individuals and assets, there will be a continual ebb and flow of laws and economic conditions that make new strategies advantageous. Few individuals will avail themselves of expatriation to save taxes, but many will ask the question-how much tax can I avoid? People will always want to know whether the grass is greener on the other side of the fence…even if they don't actually want to move there.

Recent Decisions

The family limited partnership remains a useful tool of estate planning but recent cases continue to scrutinize FLPs and establish standards they must meet.

No Discount For Valid FLP

Two years before his death, Decedent formed family limited partnerships (FLPs) with his two children and contributed $1.4 million of assets to each. The FLPs then paid $100,000 to Decedent over the next two years. Decedent's estate included $1.7 million of the FLP assets on its estate tax return, claiming a 40% discount for a minority interest and lack of marketability. The IRS valued the FLPs at $3.1 million and assessed a $707,054 estate tax deficiency.

The Tax Court found the FLPs to have sufficient substance for tax purposes. The FLPs were validly created under State law (Florida) and the Court reasoned that potential purchasers of the decedent's assets would have to respect that.

However, the circumstances of the transfer led the Court to conclude that there was an implied agreement that the decedent would retain the enjoyment and economic benefit of the contributed property during his lifetime. The assets transferred would have been required for the Decedent's support, said the Tax Court, so "there had to be an implied understanding that his children would agree to his requests for money from the assets that he contributed."

According to the Court, the FLPs were simply an alternative vehicle for implementing the Decedent's estate plan. This was not a bona fide sale for consideration nor were the transfers motivated by business concerns. Therefore, the FLP assets had to be included in the decedent's gross estate under §2036(a)(1) based on their fair market value as of the date of death. Estate of Thompson v. Comm'r., TC Memo. 2002-246, 84 TCM 374 (Sept., 2002).

Court Unimpressed by FLP Arrangement

Similar facts, similar result. Two months before her death, R, a 96-year-old woman created a partnership, but the decedent's age or health were not determining factors. R's revocable living trust held a 99% limited partnership interest and an LLC held the other 1% as general partner. R and her son each owned 50% of the LLC.

Upon the woman's death, her son valued her estate at $1,257,000. The IRS valued the estate at $2,463,000. Under Section 2036(b), the retention of the right to vote share of stock is considered a retention of the enjoyment of transferred property, in which case the higher valuation would apply for estate tax purposes. R had the power to remove the LLC as general partner, which was one indication that she had retained interests in the property.

There are instances where it can be argued that the general partner is obligated not to act arbitrarily by fiduciary duty. This is an argument based on, Byrum v. United States, 408 U.S. 125 (1972). But that argument was rejected here. Not only does section 2036(b) contradict that argument, but the partnership agreement in question actually that the general partner owed no fiduciary duty to the partnership or to any other partner. Nor was there any evidence that the formation of the partnership was the product of an arm's length transaction or negotiation

The District Court found no exception to Section 2036 applicable and granted a partial summary judgment to the government. This probably means that no discount will apply to the FLP assets. However, this case is appealable to the Fifth Circuit Court of Appeals which may be more sympathetic to the taxpayer. Kimbell v. United States, 2003 U.S. Dist. LEXIS 523 (N.D. Tex. Jan. 15, 2003).

FLP Battles To Follow

As this issue was being prepared, the latest round of, Strangi v. U.S., was gearing up. Here too, an elderly person transferred assets to a partnership two months prior to death and received a 99% limited partnership interest. The assets transferred were valued at about $10 million, but the partnership interest received in return was valued at $6.5 million. In that case, the government had lost on the issues before the Tax Court.

But last June, the Fifth Circuit Court of Appeals found that the Tax Court has abused its discretion in not permitting the government to amend its pleading to include another legal argument based on section 2036. The Tax Court's conclusions about the FLP's valid business purpose were affirmed. But upon remand to address whether the assets were includible in the decedent's estate under Section 2036, the discounted value of those assets will be reconsidered.

If those discounts are reduced or disallowed, it will eliminate the value of FLPs by any means, but it will direct impact how FLPs must be drafted and strategies for all FLP litigation. Gulig v. Comm'r., 293 F. 3d 279 (5th Cir., 2002).

TECHNICAL REFERENCES

¹ There are few reliable statistics in this area. Many estimates combine corporate and individual expatriation. There have been assertions that only one in ten emigrations is actually reported. Not all expatriation is tax motivated. And transfers of assets rather than people totally confound the issue.

² There are estimates that America had 900,000 immigrants last year as compared to approximately 300,000 Americans moving overseas. Most émigrés are former immigrants returning to their nations of origin. That may narrow the number of Americans leaving for other reasons to less than 100,000 and those leaving specifically because of tax consequences could be a very small number. Many departures reflect the economic globalization: "the land of opportunity has lost its borders." http://www.cyberhaven.com/offshorelibrary/expatriation.html.

³ Kronenberg v. Comm'r., 64 T.C. 428 (1975).

⁴ The President's budget address was later deemed the significant date of public notice so changes were made effective retroactively to that date. In June, 1995, House Ways and Means Chairman Dan Archer proposed a number of changes while retaining the basic existing provisions on expatriation: IRC Sections 877, 2107, 2501(a)(3).

⁵ HIPPA, P.L. 104-191. The Small Business Job Protection Act of 1996 (SBJPA), P.L. 104-188, addressed foreign trusts. It became law on August 20, 1996. For an excellent outline of rules, see, Pfiefer, The New foreign trust and expatriation rules, ALI-ABA Estate Planning Course Materials Journal (February 1999); and Pfiefer and Henderson, Expatriation: The ultimate estate planning tool? ALI-ABA Estate Planning Course Materials Journal (February and April, 2002). See also, Share, Planning impact of new expatriation and foreign trust tax rules, 24 EP 2, p. 51 (Feb., 1997); and The Estate Analyst, International issues of estate planning (June, 1998).

⁶ Notice 97-19, 40 I.R.B. 1997-10 (1997). During 1997, fifteen private letter rulings were issued under Notice 97-19. All of them were favorable to the taxpayer.

⁷ Cumulative Bulletin Notice 98-34, I.R.B. 1998-27, 30, I.R.B. 1998-34 (July 6, 1998), modified certain portions of Notice 97-19 by providing that certain individuals, in order to rebut the presumption of tax motivation under sections 877(a)(2), 2107(a)(2)(A), and 2501(a)(3)(B), would no longer be required to obtain a substantive ruling; they may rebut the presumption of tax avoidance by submitting a complete ruling request in good faith.

⁸ The averages were based on a limited number of well known nations and were not comprehensive for all nations on earth. For comparison of selected international death tax rates, see http://www.accf.org/deathtax699.htm.

⁹ Hauser, Estate planning in and for civil law countries, 138 T&E 13, p.45 (Dec., 1999) and 139 T&E 1, p. 62 (Jan., 2000).

¹⁰ Solomon and Saret, Reaping the benefits of offshore private placement life insurance, 29 EP 9 (Sept., 2002).

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