Non-resident aliens (NRAs)1 seeking to avoid U.S. estate tax on foreign trusts may find Internal Revenue Code Section 2104(b)2 to be particularly confounding and nettlesome. Under IRC Section 2104(b), some transfers of property, by trust or otherwise, made within three years of death or over which an NRA decedent retained certain types of interests or powers may be treated as part of that decedent’s U.S. gross estate; therefore, they’re subject to U.S. estate tax. The tax is triggered if the transferred property had a U.S. situs either at the date of the transfer or at the date of the NRA’s death.3 It’s precisely this reach that most often catches NRA grantors and their non-U.S. counsel, advisors and trustees off guard, often causing considerable dismay over the U.S. estate tax due after the grantor’s death.
A recent episode concerning a client is illustrative. A few days after an NRA grantor funded a foreign grantor trust with U.S. situs and foreign assets, the foreign corporate trustee conveyed all trust assets into a foreign corporation newly formed by the trustee. Following the NRA’s death years later, the foreign legal advisor and trustee were confident that this conveyance resolved any possible U.S. estate tax issues with respect to the trust. However, when the foreign trustee and trust beneficiaries sought our advice following the grantor’s death, we pointed out the applicability of Section 2104(b) back to the date of the trust’s funding with U.S. situs assets and the unwelcome consequence of the U.S. estate tax reporting requirement. A challenge that practitioners face is advising NRA clients seeking to avoid U.S. estate tax how to steer clear of Section 2104(b) when funding a foreign trust, or if too late to avoid the tax because of the NRA grantor’s death, how to calculate the U.S. estate tax due in view of limited Internal Revenue Service guidance.
Section 2104(b) states:
For purposes of this subchapter, any property of which the decedent has made a transfer, by trust or otherwise, within the meaning of Sections 2035 to 2038 inclusive, shall be deemed to be situated in the United States, if so situated at the time of the transfer or at the time of the decedent’s death.
A first notable aspect of the statute is that applicability is predicated on IRC Section 2035, which includes certain gratuitous transfers made within three years of death, or IRC Sections 2036 through 2038, which include transfers characterized by so-called retained strings. Specifically, the retained string provisions relate to any transfers of property, by trust or otherwise, over which a decedent retained certain interests or powers during his lifetime, including transfers in which:
• the decedent retained for life the right to income or use and enjoyment of the transferred property or the power to determine beneficial enjoyment of the transferred property (Section 2036);
• the beneficiaries can obtain possession or enjoyment of the property only by surviving the decedent and/or the decedent retained a reversionary interest greater than 5 percent of the value of the transferred property (Section 2037);
• the decedent made a revocable transfer or had a power at death to determine beneficial enjoyment through altering, amending or terminating the trust (Section 2038).4
A second remarkable aspect of the statute is that transferred property is deemed to be a U.S. situs asset if such property was situated in the United States at the time of transfer or at the grantor’s death. Thus, under Section 2104(b), if an NRA transferred property within the meaning of Sections 2035 and 2038, and that property was a U.S. situs asset either on the date of the transfer or the date of the NRA’s death, then that status triggers the U.S. estate tax reporting requirement.5 “Finding the Situs,” p. 73, lists certain types of property and their statuses as U.S. situs assets for U.S. estate tax purposes,6 but not U.S. gift tax purposes.7 Thus, under Section 2104(b), if property was transferred by an NRA, within the meaning of Sections 2035 through 2038, and that property was a U.S. situs asset either on the date of the transfer or the date of the NRA’s death, then that status triggers the U.S. estate tax reporting requirement.
Technical Advice Memorandum 9507044 exemplifies the applicability of Section 2104(b).8 Under the facts of TAM 9507044, a U.S. citizen in 1923 transferred U.S. stocks, debt instruments of U.S. corporations and U.S. real estate to a lifetime trust in which she retained the right to income for life and a testamentary power of appointment (POA). In 1974, the grantor renounced her U.S. citizenship and became an NRA. In 1984, she exercised her testamentary POA by her will. The power to determine who would enjoy the property on her death constituted a power to alter, amend, revoke or terminate the trust within the meaning of Section 2038. At the time of the transfer to the trust in 1923, the property was situated in the United States, but at the time of the decedent’s death in 1991, the trust property consisted entirely of portfolio debt obligations, which aren’t considered U.S. situs assets for estate tax purposes under Section 2105(b). The decedent’s estate maintained that Section 2105(b) pre-empted the application of Section 2104(b), and none of the trust property should be subject to U.S. estate tax. The IRS rejected this argument and required inclusion of the entire trust property at its date-of-death value under Section 2104(b) because it was originally situated in the United States at the time of transfer. In reaching this determination, the IRS noted that it was immaterial:
[w]hether the situs of the property changed because it was physically removed from the United States, or because it was reinvested in non United States situs assets, or because, the rules for determining the situs of property changed.
The Office of Chief Counsel furnishes TAMs as guidance on request by an IRS director in view of technical or procedural questions that develop during a proceeding. Although TAMs represent the considered position of the IRS with respect to a particular issue and taxpayer, they’re not necessarily binding on other, similarly situated, taxpayers. With respect to TAM 9507044, some practitioners might attempt to argue a contrary position based on fairness. For example, had the NRA decedent owned the U.S. situs property individually, rather than through a trust includible in the decedent’s estate under Sections 2035 through 2038, and had she either sold it or transferred it to a foreign corporation immediately before her death, then it wouldn’t have been included in the decedent’s U.S. gross estate and subject to U.S. estate tax under Section 2104(b). According to this argument, simple fairness seems to dictate that the result should be no different if that same property is held through a trust that’s transparent as to the NRA decedent for U.S. estate and gift tax purposes. Notwithstanding, practitioners must be mindful that, on its face, the statutory language of Section 2104(b) is unambiguous in its application to such a transfer in trust.9
The only surefire way to avoid the application of Section 2104(b) to a foreign trust is to make sure that the property doesn’t have a U.S. situs when the NRA grantor transfers the property to the trust and/or at the time of his death or to structure the trust such that the grantor never possesses dominion and control over the transferred property (or irrevocably parts with all dominion and control and survives for at least three more years). Typically, however, grantors don’t wish to part with all dominion and control over transferred property for personal reasons. Moreover, a foreign grantor trust is usually the preferred estate-planning vehicle to pass property to U.S. beneficiaries on the grantor’s death, and it’s not possible to structure a foreign grantor trust without the grantor retaining some dominion and control.10 It’s, thus, especially important to ensure that any property to be transferred to a foreign trust doesn’t have a U.S. situs before making the transfer and at the time of the grantor’s death.
Accordingly, to avoid the issue of U.S. situs under Section 2104(b), I recommend adopting one of the following funding techniques:
• Transfer to the trust cash only from accounts located outside the United States or other assets that don’t have U.S. situs for U.S. estate-tax purposes, and have the trust fund a non-U.S. corporation with that cash or those other assets. Raising that cash may involve selling U.S. situs assets and depositing the resulting cash in an account located outside the United States. Note that the corporation shouldn’t immediately repurchase the U.S. assets that the grantor sold to avoid recharacterization of the
transactions under the step transaction doctrine.11
• Capitalize a non-U.S. corporation with U.S. situs assets held individually by the grantor in exchange for capital stock of equal value, and then transfer said stock to the trust. The non-U.S. corporation must be treated as a corporation for U.S. tax purposes. If the grantor transfers to the trust less than all of the grantor’s interest in the corporation, the grantor should engage in arm’s length dealings with the corporation to avoid an argument of “implied retention.”12 The grantor should observe corporate formalities to avoid any grounds for piercing the corporate veil and the resultant characterization of the corporation as a “nominee” of the grantor.13
However, if the trust in question was already funded with U.S. situs assets and the grantor is alive, then the grantor should revoke the trust, transfer assets to the grantor’s own name and then resettle trust assets, making sure to adopt one of the above-mentioned funding techniques. If, during the grantor’s life, revocation isn’t possible, the trustee can amend or decant14 the trust to another trust, in each instance making sure to eliminate the grantor’s powers or interests that resulted in the inclusion of the trust in the grantor’s estate under Sections 2036 through 2038. The grantor may be deemed to have made a gift and may need to survive three years for this latter technique to be effective, given the provisions of Section 2035.15
Calculating Estate Tax Owed
If the NRA grantor dies before the trust can be restructured to avoid Section 2104(b), then the question becomes how to calculate the U.S. estate tax owed. Under the facts of TAM 9507044, the entire trust corpus was subject to the estate tax because the trust was funded entirely with U.S. situs assets. In most cases, however, trusts are only partially funded with U.S. situs assets. The difficulty in such cases is to make a proper estate tax calculation in light of limited IRS guidance on the subject.
One possible, simplified estate tax calculation would be to take the ratio of U.S. situs assets to total assets valued on the date the trust was funded, then multiply the total trust assets valued as of the decedent’s death by that ratio. If the trust has been in existence for a long time and some account statements are missing, this may be the only feasible way to calculate the tax.
A second possible calculation is more complicated, but likely yields more accurate results. It involves undertaking a detailed review of trust account statements to trace any U.S. situs assets used to fund the trust from the date of funding through the date of death. The objective is to determine the identity of U.S. situs assets that funded the trust and the extent to which they still remained on hand at the grantor’s death. When the trust holds the same U.S. situs assets on the grantor’s death as had funded the trust, then those assets should be included in the decedent’s U.S. gross estate at their date-of-death value.
Suppose a trust was funded with 1,000 shares of Apple Inc. stock and other, non-U.S. situs assets, and on the date of death, the trust holds 1,000 shares of Apple stock and non-U.S. situs assets. You would include the value as of the date of death of those 1,000 shares in the grantor’s U.S. gross estate. If the trust holds only 700 shares of Apple stock on the date of death and the trustee sold 300 shares prior to the date of death and reinvested proceeds in non-U.S. situs assets, you would include in the gross estate the value of those 700 shares as of the date of death. The question becomes how to value, for purposes of inclusion in the gross estate, the 300 shares that were sold prior to death.
Below is a four-step formula that can be used to calculate the value of U.S. situs assets that fund a trust, but are sold prior to the grantor’s death:
Step 1. Compute a fraction with a numerator that’s the value at the time of contribution of the U.S. situs assets no longer on hand and a denominator that’s the value at the time of contribution of all assets transferred to the trust.
Step 2. Determine the value of the trust as of the decedent’s death (or the alternate value date, as the case may be).
Step 3. Reduce the value of the trust determined in Step 2 by the value of the U.S. situs assets still on hand as of the decedent’s death (or the alternate value date) because that value is separately reported.
Step 4. Multiply the value obtained in Step 3 by the fraction computed in Step 1.
Now let’s assume the value of the 700 shares of Apple stock that remained at the date of death was $350,000; at the date of contribution, the value of the 300 shares that were later sold was $120,000 (the sales price is irrelevant for purposes of these computations); the value of all assets (U.S. situs and foreign) at the time of contribution to the trust was $3 million, and the value of the trust at the date of death was $7 million. Applying the formula above, here’s how to calculate the value of the U.S. assets:
Step 1: The fraction is $120,000/$3 million or 0.04;
Step 2: The value is $7 million;
Step 3: Subtract $350,000 (the value of the Apple stock remaining on hand at the date of death) from $7 million (the value of the trust at the date of death), resulting in $6.65 million;
Step 4: Multiply $6.65 million by 0.04, resulting in $266,000. The total amount includible in the U.S. gross estate is, therefore, $616,000 (adding the $266,000 from Step 4 to $350,000, which is the value of the Apple stock remaining on hand at the date of death).
Always include in the U.S. gross estate the value of any additional U.S. situs assets that are held at the decedent’s death, but that weren’t used to fund the trust.
1. For U.S. estate, gift and generation-skipping transfer (GST) tax purposes, a non-resident alien (NRA) is a non-U.S. citizen who isn’t U.S. domiciled. An individual is domiciled if he’s physically present in the United States with an intention to remain indefinitely, as shown by the surrounding facts and circumstances. See Treasury Regulations Sections 20.0-1(b) and 25.2501-1(b).
2. All section references herein are to the Internal Revenue Code of 1986, as amended, and Treasury Regulations promulgated thereunder.
3. IRC Section 2104(b).
4. However, all these retained string provisions carve out an exception for “bona fide sales for full and adequate consideration in money or money’s worth.” See IRC Sections 2036(a), 2037(a) and 2038(a).
5. An NRA decedent’s estate has a U.S. estate tax filing obligation if the U.S. gross estate exceeds $60,000. See IRC Section 2102(b).
6. IRC Sections 2104(c) and 2105(b). Bilateral treaties between the United States and other individual countries should be reviewed to see if they alter the rules on situs of assets for U.S. estate, GST and gift tax purposes. To avoid double taxation, the United States typically enters into tax treaties with other countries that impose significant taxes of their own on individuals deemed domiciled in those countries, while the United States taxes its citizens regardless of their domicile.
7. For U.S. federal gift tax purposes, only U.S. real property and tangible personal property physically located in the United States (including cash in a U.S. bank account) are considered U.S. situs assets. See IRC Section 2501(a)(2) and GCM 36860 (Sept. 24, 1976).
8. Technical Advice Memorandum 9507044 (May 31, 1994).
9. See Richard B. Stephens, Stephen A. Lind, Guy B. Maxfield and Dennis Calfee, Federal Estate and Gift Taxation, par. 6.04, “Property Subject to Lifetime Transfer.”
10. To qualify the trust as a foreign grantor trust, the grantor must retain strings over the trust by providing either that the grantor has the power to revoke the trust or the grantor and/or the grantor’s spouse are sole beneficiaries of the trust during the grantor’s life (Section 672(f)(2)(A)). Then, the trust is treated for tax purposes as owned by the grantor so that all items of income, deduction and credit of the trust are treated as if the grantor received them directly (IRC Section 671). If the trust invests in assets that don’t produce U.S. source income, and the trust isn’t engaged in a U.S. trade or business, neither the trust nor the grantor is subject to U.S. income tax (Section 672(f)). A distribution to a U.S. beneficiary of income from a foreign grantor trust isn’t taxed to the U.S. beneficiary (Revenue Ruling 69-70, 1969-1 C.B. 182).
11. Under the step transaction doctrine, all steps taken to achieve an intended result are viewed as a single transaction and evaluated as one transaction for tax purposes. See Commissioner v. Clark, 489 U.S. 726, 738 (1989).
12. See Strangi v. Comm’r, 417 F.3d 468 (5th Cir. 2005), aff’g T.C. Memo. 2003-145.
13. See Fillman v. U.S., 355 F.2d 632 (Ct. Cl. 1966). Examples of corporate formalities that should be observed include: treating the corporation as the legal and beneficial owner of the assets; electing directors and officers who maintain proper books and records for the corporation and execute all necessary forms on its behalf; and opening a separate bank account in corporate name.
14. Decanting of trust assets may be treated as a conveyance to a new trust. Income tax consequences of the proposed decanting should be analyzed.
15. The U.S. gift, estate and GST tax implications for the grantor resulting from the trustee’s amendment or decanting of the trust are beyond the scope of this article, but should be thoroughly explored by the trustee.