The U.S. capital market is attractive to nonresident aliens seeking to invest, because rates of return on investments historically have been higher and more reliable than in other countries.1 By the end of 2002, foreign investments in U.S. corporate stocks were valued at $1,170.8 billion, despite substantial declines in the U.S. stock market. Foreign investment in U.S. corporate and agency bonds reached an all-time high of $1,690.3 billion.2

The U.S. economy benefits from foreign investment, because the availability of foreign capital reduces the cost of capital to U.S. corporations, helps finance new businesses and expansions, helps keep interest rates low, and reduces the impact of our trade balance deficits. Congress recognized these advantages in 1984 when it eliminated the 30 percent income tax on interest paid to nonresident alien holders of most U.S. corporate bonds, and eliminated the U.S. estate tax on these bonds upon the deaths of their foreign owners.3

Unfortunately, no similar tax relief was provided to the nonresident alien investor in the U.S. stock market. A foreigner's U.S. stocks are subject to U.S. estate tax at death; the dividends received during life are subject to U.S. income tax at a rate of 30 percent.

Despite the high level of foreign investment in the U.S. stock market and corresponding tax burdens, few foreigners file U.S. estate tax returns. In 2000, the last year for which these figures are available, only 438 estate tax returns were filed for nonresident aliens. Of these, only 113 — about one in four — were complete and filed by estates of decedents who had been domiciled in countries with which the U.S. had no estate tax treaties and who had more than $60,000 of assets. Less than half of that portion — 55 — reported ownership of stock in U.S. corporations. The total value of this stock was $57.8 million.4

One explanation for this phenomenon might be that a substantial portion of the foreign investment in the U.S. stock market is made by foreign institutions rather than individuals.

But there is also another plausible explanation: There are ways nonresidents can avoid U.S. estate taxes on their U.S. stock market investments. Some of the techniques they employ to achieve this goal are fairly simple, such as investing assets through a foreign corporation; others are more sophisticated. One of the most complex, yet useful approaches involves creating three foreign corporations to own the nonresident's assets in a two-tiered structure. Foreigners also have several good options for avoiding income tax on their gains from U.S. stocks.


The exclusion of shares of stock of a foreign corporation from a nonresident alien's U.S. gross estate makes it possible for nonresident aliens to avoid U.S. estate taxation on assets situated in the United States by investing in these assets through foreign corporations. But this strategy won't work if the Internal Rev-enue Service finds that the corporation is a mere nominee.5 To avoid the nominee classification, the nonresident alien should consistently treat the corporation as a separate entity, complete with corporate meetings and elected officers and directors. Most importantly, the shareholder should not deal with the corporation's assets as if she owned them directly.

Even when all of the normal formalities are observed, the IRS might argue that the assets still must be included in an estate if the transfer to a corporation falls under either Internal Revenue Code Sections 2036 or 2038. Section 2036 requires the inclusion in the gross estate of a decedent of property she has transferred during her life if she has retained the right to the income from the property for a period that does not end before her death. Section 2038 requires the inclusion in a decedent's gross estate of property she has transferred during her life if at the time of her death she has the right to change the enjoyment of the property.

Property transferred by an individual to a wholly owned corporation is arguably subject to Sec-tions 2036 and 2038, because the transferor has retained the right to all of the income from the corporation, and has retained the effective right to amend the transfer by taking the property out of the trust. The counter argument is that the transfer to the corporation is a bona fide sale for adequate and full consideration in money or money's worth. Such sales are excluded from Sec-tions 2036 and 2038.6

The Service's recent success at including the assets transferred by decedents to family limited partnerships in their gross estates under Section 20367 could encourage it to take the same position with respect to assets transferred to foreign corporations by nonresident aliens.

Because of the interaction between Sections 2036 and 2038 and IRC Section 2104(b), nonresident aliens who wish to use foreign corporations to shield U.S. investments should use non-U.S.-situs assets to fund their corporations. The corporation then could use these assets to make U.S. investments. Section 2104(b) provides that property transferred by trust or otherwise within the meaning of Sections 2036 and 2038 is deemed situated in the United States if it was situated here either at the time of transfer or at the time of the decedent's death. As a result, if Sections 2036 and 2038 are applicable to transfers to foreign corporations, the value of the corporation's assets would be included in a nonresident alien's estate — if the corporation was initially funded by her with U.S. assets, even if no such assets were held in the corporation on the date of her death.

Nonresident aliens also could consider using debt to protect their U.S. investments from U.S. estate tax. Section 2106(a)(1) permits the estate of a nonresident alien to deduct a portion of the debts that the estate of a citizen or resident would be entitled to under Section 2053. The deductible portion is a fraction of the debt, the numerator of which is the value of her estate situated in the United States and the denominator of which is her gross estate determined as if she was a U.S. citizen or resident. Section 2106(b) provides that no such deduction under Section 2053 will be permitted — unless the nonresident alien's executor files a U.S. estate tax return that reports all of her gross estate situated outside of the United States.

The limitation on debt deduction can be avoided by using nonrecourse debt. If a nonresident alien's U.S. assets are subject to debt when she dies, and she has no personal liability for the debt, the full value of the debt will be deductible.8

Here's how this technique could work: Assume a nonresident, “Jennifer Anderson,” owns all of the stock of a foreign corporation, and that this corporation owns $1 million of U.S. stocks. Anderson can create an irrevocable foreign trust, for her benefit and the benefit of her issue, and fund it with foreign assets worth $1 million. The foreign corporation then can borrow, say, $900,000 from the trust, securing the debt with its U.S. stocks.

The next step is for the corporation to distribute the $900,000 to Anderson, leaving the corporation with a net value of $100,000. Even if the IRS successfully argues that the corporation's assets should be included in Anderson's gross estate under Section 2036 or 2038, the net inclusion only would be $100,000.


The gross income of a nonresident alien investor in U.S. stock includes dividends paid on the stock.9 The tax rate on dividends is 30 percent — more than twice the rate currently applicable to U.S. investors.

The highest tax rate on dividends paid on U.S. stock to U.S. trusts is 15 percent, regardless of the nationality of the trusts' beneficiaries.10 Therefore, nonresident aliens whose tax rate on U.S. dividends is higher than 15 percent may want to arrange for their U.S. stock to be held by a U.S. trust — but not a grantor trust. (Grantor trust status will be avoided provided the trust is irrevocable and trust property may be distributed during the grantor's life to any person other than her spouse.)11,12

To qualify as a U.S. trust, courts within the United States must be able to exercise primary supervision over administration of the trust, and one or more U.S. citizens must have the authority to control all substantial decisions of the trust.13

In order to use the trust to minimize U.S. income tax, the trustee must have the power to accumulate the dividend income it receives. If the trustee had to distribute its dividend income annually to the nonresident alien, the trust would pay no tax on its dividend income but would be required to withhold U.S. taxes at the 30 percent rate applicable to nonresident aliens.

Here's how this strategy might look. Suppose the foreign corporation owned by Anderson transferred its $1 million worth of U.S. stock to a New York corporate trustee on Jan. 1, 2004, to hold in trust for the foreign corporation's benefit and for the benefit of the Anderson heirs. The trust is a U.S trust because it's governed by New York law and subject to the primary jurisdiction of the New York courts. The terms of the trust give the corporate trustee the power to accumulate income or to distribute it to the corporation or Anderson's heirs. At the end of a fixed number of years, say five, or on Anderson's death, whichever comes first, the trust will terminate and all of its property will be paid to the corporation.

Suppose the trust collected and accumulated $60,000 worth of dividends each year for five years. It then terminated and paid the trust property back to the corporation. During the first five years of the trust, 2004 through 2008, because no income was distributed to the corporation, all of its dividend income was taxed to the trust at the 15 percent rate. Suppose it distributed all of its assets to the corporation on Jan. 1, 2009. All of its accumulated income would be paid to the corporation free of any U.S. income tax.

If the trust earned interest income or recognized gain on the sale of assets during its five-year term, the U.S. income tax it would be required to pay because of its U.S. status could effectively cancel out the benefit of the trust technique. It would be required to pay tax at a maximum rate of 35 percent on interest income and short-term capital gains as well as 15 percent on long-term capital gains. In contrast, if the corporation had held the investments directly, it likely would pay no tax on interest (because of the so-called portfolio debt exception14) and no tax on capital gains (other than gains from the sale of interests in U.S. real property or real property holding corporations). In order to avoid U.S. income tax on interest income and capital gain income, the trust terms could require that all interest income and capital gain income be distributed annually. The trust would receive a distribution deduction for the distributions under IRC Section 661, and would not be required to withhold any U.S. income taxes from its distribution.

If the corporation or its shareholder, Anderson, is reluctant to give a U.S. trustee so much control over their U.S. stock investments, they could use two trusts: a U.S. and a foreign trust. The corporation would transfer a small amount of cash to the U.S. trust and create a foreign trust. The corporation then would transfer all of its U.S. stock to the foreign trust, which would require that its trustee distribute all of its dividend income derived from U.S. stock to the U.S. trust. Those U.S. corporations that paid dividend income to the foreign trust would be required to withhold U.S. taxes at the 30 percent rate. The U.S. trust, however, would credit the withheld tax against its 15 percent income tax liability on its U.S. income tax return and would claim a refund for the extra 15 percent.


Using a corporation to shield U.S. assets from U.S. estate tax can cause difficult income tax issues for the U.S. beneficiaries of a nonresident alien's estate. After the death of the nonresident alien, the foreign corporation used to hold the U.S. assets likely will be a controlled foreign corporation (CFC) or a foreign personal holding company (FPHC). A foreign company is a CFC if at least 50 percent of its stock is owned by “United States shareholders.”15 The corporation is an FPHC if the following two criteria are met: at least 60 percent of its gross income for the taxable year is foreign personal holding company income (FPHCI); and, at any time during the taxable year, more than 50 percent of its stock is owned by five or fewer individuals who are citizens or residents of the United States.16

If U.S. beneficiaries receive shares of FPHCs and CFCs, their retention of the shares will subject them to current income tax on their share of corporate income — whether or not the income is distributed to them. Liquidating the corporation would result in their being taxed on their share of the unrealized appreciation in the corporation's assets. If their share of the value of the assets received on liquidation exceeds their basis in the stock of the corporation, they might be taxed on that gain as well.

One way to limit tax exposure after inheriting CFCs is to liquidate within 30 days. Assume that Anderson dies and leaves her entire estate to her two U.S. children. The corporation becomes a CFC — unless the children arrange for its liquidation within 30 days of their mother's death. If they liquidate, the gain the corporation would recognize under Section 336 as a result of its distribution of appreciated property to the children will not be taxed to them. Moreover, because their shares of the corporation will receive a basis equal to the shares' value on the date of Anderson's death, they will be subject to U.S. income tax on liquidation only to the extent that the value of the property distributed in liquidation exceeds the value of the corporation's shares on the date of the nonresident's death.17

For FPHCs, the situation is more complicated, because the FPHC rules don't provide for a 30-day grace period in which to liquidate. For example, if Anderson dies and bequeaths her entire estate to her U.S. children, the corporation immediately becomes an FPHC, because there is no grace period. Even if the children promptly liquidate, a literal application of the FPHC rules would subject them to tax on all of the FPHCI earned by the corporation in the year of Anderson's death as well as on the gain the corporation would be treated as recognizing under Section 336 as a result of its distribution of appreciated property to the children.

So far, case law seems to compel a different result. The U.S. Court of Appeals for the Fourth Circuit in Marsman v. Commissioner18 and the Tax Court in Gutierrez v. Commis-sioner19 refused to apply IRC Section 551(b) literally in the case of a nonresident alien who became a U.S. person during the taxable year. The Fourth Circuit observed that a literal reading of the predecessor of Section 551(b) would require a nonresident alien who became a U.S. resident on Dec. 31 of a year to include in her gross income her share of the company's earnings for the full year. It concluded that Congress could not have intended such an extraordinary result and that that result was inconsistent with the purposes of the FPHC rules. The court's rationale would apply with equal force to the U.S. person who acquires an interest in a corporation on any day other than the first day of the corporation's year, if the corporation becomes an FPHC when she acquires her interest.

If Marsman and Gutierrez apply to limit the tax exposure of the nonresident's U.S. children, the amount of tax they pay depends on the timing of Anderson's death and the speed with which they are able to liquidate the corporation. Suppose, for example, that the nonresident dies on May 31, 2004, and that the corporation had collected $900,000 worth of dividends and interest before that date. Suppose too that the children liquidated the corporation on June 30, after it had collected an additional $100,000 of income. The corporation's gain on the liquidation of its assets was $1 million. The children would be required to include one-sixth of this income or $333,333. Suppose, on the other hand, that the nonresident died on Jan. 1, 2004. A speedy liquidation would not protect the children from tax on any part of the $1 million liquidation gain.


The liquidation tax can be minimized by using a combination of three foreign corporations arranged in a two-tiered structure. The nonresident would own all of the shares of two upper-tier foreign corporations, which, in turn, would each own 50 percent of the shares of the third, lower-tier foreign corporation. The third foreign corporation would own the nonresident's U.S. assets. Each of the three foreign corporations must be one of the types of corporations that would be classified as a partnership for U.S. income tax purposes, if an appropriate election is made,20 and none of them should have any presence or business activities within the United States.

Within 75 days after the death of the nonresident, the lower-tier foreign corporation would file an election to be classified as a partnership for U.S. income tax purposes effective 75 days before the date of election. The effect of the election would be to treat the lower-tier corporation as having distributed all of its assets and liabilities to its two shareholders in complete liquidation of the corporation on the day before the effective date of the election.21 The lower-tier corporation would be treated as recognizing gain to the extent the fair market value of its assets exceeds its basis in those assets,22 but would not pay U.S. income tax on this gain, because it is not subject to U.S. income tax. The basis of the lower-tier corporation's assets in the hands of its corporate shareholders would be the fair market value of the assets on the day before the effective date of the election.23 The deemed receipt by the upper-tier corporations of the lower-tier corporation's assets would be treated as amounts received in exchange for their stock in the lower-tier corporation.24 Any gain recognized, however, would not be subject to U.S. income tax, as the corporations are not U.S. persons for U.S. income tax purposes.

After the lower-tier corporation has made its election to be treated as a corporation, the two upper-tier corporations would make the same election. To avoid partnership treatment on the date of the nonresident's death and the uncertain U.S. estate tax consequences of that status, the effective date of the upper-tier corporations' elections would be the day after the nonresident alien's death. The effect of the upper-tier corporations' elections would be to treat them as having liquidated and distributed all of their assets to their shareholders, the nonresident alien's estate or her U.S. beneficiaries. Because the upper-tier corporations' assets received a basis adjustment earlier as a result of the deemed liquidation of the lower-tier corporation, the deemed liquidation of the upper-tier corporations should produce minimal gain recognition. The shareholders of the upper-tier corporations would be treated as having received the corporations' assets in exchange for their stock. If the nonresident alien's U.S. beneficiaries own the stock, their gain on their deemed receipt of the corporations' assets should be minimal, because their basis in the stock of the corporations will be the value as of the date of the nonresident alien's death.25


Here's how the triple-entity structure might work for Anderson and her two American children. Suppose, at the time of her death, Anderson owned all of the stock of two foreign corporations, the upper-tier corporations, and that each of them, in turn, owned 50 percent of the stock of a third lower-tier foreign corporation that owned $5 million worth of U.S. stocks, with a basis of $1 million. Assume Anderson dies on July 1, 2004. On July 15, Anderson's personal representative, “Kate Parker,” elects to treat the corporation as a partnership effective June 30, the day before Anderson's death. On July 16, Parker elects to treat the two upper-tier foreign corporations as partnerships effective July 2. The third lower-tier corporation will be treated as an FPHC in 2004, and its income will flow through to the two upper-tier corporations in 2004. Assume all three corporations had no income other than the $4 million deemed gain on the liquidation. A portion of the two upper-tier corporations' combined income of $4 million will be taxed to Anderson's two children. The portion will be that portion of the year that the first two corporations were FPHCs. The year starts on Jan. 1, 2004 and ends with the liquidation of the first two corporations on July 2, which comes to a total of 183 days. The portion of the year that the first two corporations were FPHCs is one day or 1/183. As a result, 1/183 of the $4 million gain, or about $22,000, will be taxed to the two children.26 This result also could be achieved with the use of a single corporation that is deemed liquidated the day after Anderson's death.

The triple-corporation structure can work to save significant taxes when the decedent dies within the first 75 days of the taxable year. The earlier in the year that the decedent's death occurs, the larger the portion of the liquidation gains that will be FPHC income to the U.S. beneficiaries. But, if death occurs within the first 75 days of the taxable year, an election to treat the corporation as a partnership retroactive to the prior year can protect the U.S. beneficiaries from income tax on all of the liquidation gains.

Suppose, for example, that Anderson dies on Jan. 31, 2004. On Feb. 15, Parker elects to treat the corporation as a partnership effective Dec. 31, 2003. On Feb. 16, Parker elects to treat the other two corporations (the owners of the first corporation) as partnerships. Because the original corporation was deemed liquidated in 2003, the deemed income from its liquidation would be treated as income of the other two in 2003 when neither of them were FPHCs. As a result, the children will not be taxed on any portion of the gain from the lower-tier corporation's deemed liquidation. Without the triple-entity structure, the children would have been taxed on the entire $4 million gain from the liquidation because the corporation would have been an FPHC for all of 2004 prior to its liquidation. If Anderson had directly owned the corporation, an election to treat the corporation as a partnership retroactive to 2003 might have subjected all of the U.S. assets owned by the corporation to U.S. estate tax because it would be treated as a partnership on the date of Anderson's death.27


Combining the techniques protecting a nonresident alien from U.S. estate tax on her investment in U.S. equity securities and from U.S. income tax on the dividend income earned on those securities, and for minimizing the income tax exposure of her U.S. beneficiaries when they inherit these assets from her, produces the following relatively complex set of arrangements:

Anderson would own all of the stock of two foreign corporations. Each of those corporations would in turn own 50 percent of a third foreign corporation that owned the U.S. equities in which Anderson wanted to invest. The foreign corporation would borrow the funds to make these investments from an irrevocable foreign trust for the benefit of Anderson and her children. From time to time, if the value of the U.S. investments grew substantially, the trust would lend the corporation additional funds, which would be distributed as dividend income to the two upper-tier corporations, and perhaps by them to Anderson. The object of these loans and subsequent dividends is to keep the net value of the potential inclusion in Anderson's U.S. gross estate at a minimum.

The lower-tier corporation would transfer its U.S. equities to a foreign irrevocable trust for the benefit of itself, Anderson's children and another U.S. irrevocable trust. The latter irrevocable trust, also created by the lower-tier corporation, would be held for the benefit of itself, the nonresident and the children. The first trust would be required to distribute all of its dividend income from U.S. securities to the second. The object of these distributions is to entitle the dividends earned on the U.S. securities to the 15 percent U.S. tax rate on dividend income.

These arrangements are quite complicated. The fact that our tax laws encourage such structures to enable nonresident aliens to invest in our equity markets in a tax-efficient manner presents a challenge to tax professionals, but may have the unfortunate effect of discouraging foreign individuals from investing in our equity markets.


  1. Richard N. Cooper, Testimony before the United States Trade Deficit Review Commission, Dec. 10, 1999.
  2. Elena Nguyen, “The International Investment Position of the United States at Yearend 2002,” 83 Survey of Current Business No.7, 12 (July 2003).
  3. General Explanation of H.R. 4170, Staff of Joint Committee on Taxation, 98th Cong., 2d Sess. 391 (1984).
  4. Darien Jacobson, “Federal Estate Tax Returns Filed for Nonresident Aliens, 1999 and 2000,” Statistics of Income Bulletin 66 (Summer 2002).
  5. Fillman v. United States, 355 F.2d 144 (2d Cir. 1957).
  6. The legislative history to Section 2107 suggests that Sections 2036 and 2038 should not apply. S. Rep. No. 1707, 89th Cong. 2d Sess. 54 (1966). See D. Chase Troxell, “Aliens — Estate, Gift and Generation-Skipping Taxation,” 837 T.M. at p. A-11, and Robert C. Lawrence III, “U.S. Estate and Gift Taxation of the Nonresident Alien with Property in the U.S.,” 1990 Philip E. Heckerling Institute on Estate Planning, pp. 10-12, footnote 61.
  7. See, for example, Kimbell v. United States, 91 AFTR 2d 585 (N.D. Tex 2003); Estate of Strangi, 85 T.C.M. 1331 (2003).
  8. Estate of Johnstone v. Commissioner, 19 T.C. 44 (1952), acq. 1953-1 C.B. 5, holds that, “If a particular debt can be collected only from property mortgaged to secure the debt and not from the estate generally, the full amount of the debt should be excluded even in the case of a nonresident alien, but if it can be collected from the estate generally, and a part of that estate is not being taxed in the United States, then it is appropriate to allow only a proportionate part of the debt to be deducted.”
  9. Section 861(a)(2).
  10. 1(h)(11). The 15 percent rate applies for all taxable years beginning after Dec. 31, 2002 and beginning before Jan. 1, 2009.
  11. Section 672(f).
  12. This technique is discussed more fully in Fred Feingold, “The Complex Domestic Trust, a Potential Vehicle for Reducing the Tax on U.S. Source Non-Effectively Connected Dividend Income of Non-U.S. Persons and Capital Gains of Certain Corporations?” (Sept. 10, 2003) (presented to The Tax Club of New York).
  13. IRC Section 7701(a)(30).
  14. IRC Section 871(h).
  15. IRC Section 957(a).
  16. IRC Section 552(a). The minimum FPHCI is 50 percent of gross income after the first taxable year for which the corporation is an FPHC.
  17. IRC Section 1014(a). No basis adjustment would be allowed, however, if Anderson was married to a U.S. person. Her marriage to a U.S. person would result in the corporation's being treated as a foreign personal holding company. IRC Section 552(a). Section 1014 does not permit basis adjustment at death for shares of FPHCs. Section 1014(b)(5).
  18. 205 F.2d 335(4th Cir. 1953).
  19. 53 T.C. 394 (1969).
  20. Treas. Reg. Section 301.7701-2 classifies, for U.S. income tax purposes, a foreign business entity — other than an entity that is automatically classified as a corporation under Treas. Reg. Section 301.7701-2(b) — as a partnership if it has more than one member, at least one of which does not have limited liability. The foreign corporation qualifies as an association taxable as a corporation if all of its members have limited liability. If the entity has only one member and that member does not have limited liability, the entity is disregarded as an entity separate from its owner. A business entity is, generally, any entity other than an entity properly classified as a trust. Foreign entities that are automatically classified as corporations include: the Societe Anonyme in Belgium, France, and Switzerland; the Aktiengellschaft in Austria, Germany and Switzerland; the Sociedad Anonima in Mexico and Spain; and the Public Limited Company in the United Kingdom. If a foreign entity is not automatically classified as a corporation, but is classified as an association taxable as a corporation because all of its members have limited liability, it may elect to be classified as a partnership by filing Form 8832 with the appropriate IRS service center. The election made on Form 8832 will be effective on the date specified on the form, provided that the effective date may not be more than 75 days prior to, or more than 12 months after, the form is filed.
  21. Treas. Reg. 301.7701-3(g)(1)(iii).
  22. IRC Section 311(b). U.S. income tax could be imposed, however, if the lower tier corporation owns U.S. real estate.
  23. IRC Section 334(a).
  24. IRC Section 331(a).
  25. IRC Section 1014(a). Unless the nonresident alien was married to a U.S. person. See footnote 17.
  26. This result depends on the application of the Marsman and Gutierrez cases.
  27. The treatment of partnership interests for U.S. estate tax purposes is unclear. Under one theory, the aggregate theory, a nonresident alien's interest in a partnership would not be subject to U.S. estate tax. Instead, the assets owned by the partnership would be included in her gross estate to the extent they had a U.S. situs.