There are various theories proposed for determining situs of partnership interests for U.S. federal estate tax purposes when those interests are held by a non-resident alien (NRA)1 and the partnership is a domestic (U.S.) partnership or holds U.S.-situs assets or conducts business in the United States.2 When no applicable bilateral estate tax treaty speaks to the issue,3 there's a good deal of uncertainty about situs due to a lack of guidance in the Internal Revenue Code and Treasury regulations. The Internal Revenue Service's position, in an old revenue ruling, is that a partnership interest is a U.S.-situs asset if the partnership is engaged in business in the United States.4 But the ruling is based on scant reasoning and the IRS has refused to provide more meaningful guidance.5

Congress or the Treasury department should provide greater certainty in this area so NRAs are encouraged to make investments in the United States through the partnership vehicle.

Situs Rules

The gross estate of an NRA consists only of property that has, or is deemed to have a U.S. situs at the time of his death or at the time of certain lifetime transfers.6 Unless modified by a bilateral estate tax treaty, the determination is made in the same manner as the gross estate of a U.S. resident or citizen, except that property outside the United States is excluded and special rules apply to joint property when the surviving spouse is not a U.S. citizen. Also, the deductions and credits available to an NRA's gross estate are limited.7 The situs rules are found in IRC Sections 2104 and 2105, as amplified by the Treasury regulations.

Unless modified by a bilateral estate tax treaty, these types of property have, or are deemed to have a U.S. situs for purposes of the estate tax:

  • Tangible personal property and real property — Subject to certain exceptions for works of art on loan and personal property accompanying an NRA who dies while visiting the United States, an NRA's tangible personal property that is physically located in the United States has a U.S. situs.8 Real property located in the United States has a U.S. situs;9 real property subject to a non-recourse mortgage is included at its net equity value, while real property subject to a recourse mortgage is included at its full value against a pro-rated deduction.10
  • Intangible personal property — Intangible personal property, the written evidence of which is not treated as the property itself, is deemed to have a U.S. situs if it's issued by, or enforceable against, a U.S. resident.11 With exceptions for portfolio debt, certain short-term original issue discount obligations and bank deposits, this includes debt obligations of a U.S. person or a U.S. governmental entity, the written evidence of which is not treated as the property itself.12 There is a specific situs rule for stock of a U.S. corporation, which is deemed to have a U.S. situs regardless of where the share certificates are physically located.13 The converse is also true; stock of a foreign corporation is deemed to have a situs outside of the United States.

Notably, there is no mention in the Code or Treasury regulations of partnership interests nor is there any case law applying the relevant provisions to partnership interests.

Two Theories

There are two prevailing theories regarding the situs of a partnership interest. The “aggregate theory,” which indicates that a partnership should be viewed as an aggregate of the partners' assets and businesses14 and the “entity theory,” which indicates that a partnership should be viewed as a distinct entity separate from its owners.

  • Aggregate theory — If a partnership is deemed to be an aggregate of the partners' various interests, then the aggregate theory regards “the property interests of a deceased partner for federal estate tax purposes [to be] his share of assets in the partnership.”15 This approach requires situs rules to be applied to each asset individually.

    In 1934, the U.S. Court of Appeals for the Second Circuit in Sanchez v. Bowers held that the situs of a decedent's interest in an entity, which terminated at the partner's death, was determined by the location of the partnership assets.16 Commentators argue that Sanchez supports the aggregate theory because that court made its holding in accordance with the termination of a partnership interest upon the decedent's death based on the location of the assets.17 But the Sanchez court did not necessarily adopt the aggregate theory because the case involved a partnership that terminated upon the decedent's death. Its holding could also have been supported by another theory, that is to say that a foreign entity could be subject to a U.S. tax as a result of business activities in the United States.18 This alternate theory laid the groundwork for the IRS position expressed in Revenue Ruling 55-701.

  • Entity theory — Under the entity theory, a partnership is considered a separate and distinct entity from its partners.19

    There are several approaches under the entity theory to determine partnership situs. A partnership could be deemed located in the place where: it's doing business,20 it's legally organized,21 or the decedent was domiciled.22

    1. Where the partnership is doing business — Rev. Rul. 55-701 concerned the application of the U.S./U.K. estate tax treaty to a British decedent, domiciled in England, with an interest in a partnership organized and operating in New York. In arriving at its holding — that the situs of the partnership is where the business is conducted — the IRS rejected classifying the partnership interest as a debt23 and rejected applying the aggregate theory due to the lack of authority on this subject at the federal level. Interestingly, the IRS did not address the other theory, that the partnership interest is intangible personal property of the NRA decedent. The ruling was based on an interpretation of an estate and gift tax treaty, not on an interpretation of any particular U.S. law, and therefore, commentators have rightly criticized it as not being broad enough to provide the necessary guidance.24

      In 2003, the Taxation Section of the California state bar proposed that a situs rule similar to that for U.S. stock be adopted; that is, a partnership interest should be a U.S.-situs asset if issued by a U.S. resident partnership, regardless of the location of the partnership agreement or membership interests or certificates.25 At that time, Treas. Regs. Section 301.7701-5 provided a special test for a “U.S. resident partnership” that looked to whether the partnership was engaged in a U.S. trade or business and provided specifically that whether a partnership was regarded as resident or nonresident was not determined by the nationality or residence of its members or by the place in which it was created or organized.

      But since then, this Treasury regulation was amended to delete the reference to “U.S. resident partnerships.” Indeed, it now provides that the determination of whether an entity is domestic or foreign is made independent from the determination of its corporate or non-corporate classification, and a business entity created or organized in the United States is a domestic entity.26

      Still, back in 2003, the Taxation Section of the California state bar proposal would have been consistent with the IRS position in Rev. Rul. 55-701, with the emphasis on place of business. Although it could be argued that this is a sensible approach, it does not provide a uniform rule for purposes of the estate tax, because the determination of whether a partnership is engaged in a U.S. trade or business is highly fact-dependent.27 It also can have the unintended consequence of bringing into the “estate tax net” interests of partnerships engaged in worldwide operations with marginal U.S. trade or businesses.28

    2. Where the partnership is legally organized — Even though there is no statutory authority or case law specifically supporting this particular view, a partnership interest may be deemed to be situated according to the place where the partnership is legally organized.29 When dealing with a corporation, shares of the corporation's stock are deemed situated in the United States when issued by a corporation “created or organized in the U.S. or under the law of the U.S. or of any state.”30 Similarly, if a partnership is created or organized according to the law of the United States or of any state, the partnership interest may be found to be situated under in the United States.31

      Although arguably contrary to Rev. Rul. 55-701, this approach would yield a bright-line test for purposes of uniform application of the estate tax. Nevertheless, some have suggested that if IRC Section 7701(a)(4) were sufficient by itself to be determinative for estate tax purposes, there would be no need for IRC Section 2104(a), which explicitly situates shares based on whether the issuer is a domestic corporation.32 This suggestion is supported by the Taxation Section of the California state bar proposal to amend IRC Section 2104(a) to explicitly address partnerships, rather than reading in a reference to IRC Section 7701(a)(4) when one does not exist.

    3. Where the domicile of the decedent is located — Based on the common law maxim of mobilia sequuntur personam, an interest in a partnership can be considered an NRA decedent's personal property.33Blodgett v. Silberman and Estate of Vandenhoeck are generally cited in support of the proposition that a decedent's domicile determines the situs of a partnership interest.34

      In Blodgett, the U.S. Supreme Court found that a partnership interest was an ownership interest in an entity, not the underlying assets. The court also found that intangible property can be taxed where the owner is domiciled.35 While Blodgett's holding may suggest the proposition that a partnership is located where the decedent's domicile is located, the actual holding in the case concerned the constitutionality of a Connecticut law permitting taxation of all of a domiciliary's personal property, regardless of where it was situated. For this reason, commentators do not believe it is indicative of a particular situs rule.36

      In Estate of Vandenhoeck, a case involving an NRA decedent's ownership in a marital community of U.S. assets in the form of stock in a U.S. corporation, the shares of stock were clearly U.S. property under the IRC; the issue was whether 50 percent could be excluded as community property.37 Commentators argue that neither Blodgett nor Estate of Vandenhoeck cites to the doctrine of mobilia sequuntur personam to support its holding.38 Consequently, applicability of these cases to support the theory that domicile determines situs may be debatable.

Encourage U.S. Investments

Case law and commentary support entity theory more so than aggregate theory. When applying the entity theory, there are two possible outcomes for determining situs: (1) that situs is determined based on the location where the partnership conducts its business,39 or (2) that situs is determined based on the residency of the partnership for income tax purposes (that is to say, its place of organization).40

Although the second of these outcomes would obviously be easier to administer, provide certainty and likely encourage capital investment in the United States by NRAs, only the first outcome is supported by official guidance from the IRS.

As a result, care should be taken when advising an NRA who intends to invest in a partnership with U.S. connections that could potentially be considered a U.S.- situs asset.41 He should consider refraining from investing directly in (1) a partnership formed under the laws of the United States or a political subdivision thereof, or (2) a partnership that is doing business in the United States or owns U.S. assets.

Instead, he would be well-advised to consider making these investments through “blocker” foreign corporations to achieve greater certainty with respect to the U.S. estate tax ramifications. Unfortunately, using blockers results in a lower investment yield to NRA investors. Investing through a foreign corporation generally increases the effective U.S. tax rate. Whereas an NRA who invests directly or through a pass-through entity, such as a partnership, is subject to only one level of taxes in the United States and can qualify for certain preferential tax rates, a corporation pays two levels of taxes and generally cannot qualify for preferential tax rates. A foreign corporation pays income tax to the extent of its income that is effectively connected with the conduct of a U.S. trade or business and generally pays a branch profits tax to the United States.42 In some cases, the NRA will choose to avoid a foreign blocker corporation because the income tax savings may outweigh the risk of premature death.

In many instances, the business plans of the underlying partnership and the profile of the NRA will guide a sensible result. But of course, that result remains subject to some uncertainty until Congress or the Treasury department acts to clarify the law in this area.

Clarification would be a welcome change — especially for NRAs who are interested in putting their money to work in a safe investment environment. By providing certainty, the government would be encouraging NRAs to invest in the United States — an objective that our government clearly wants to achieve to encourage economic growth at home. If the government acts, the best approach is to make the estate tax situs rules consistent with the income tax residency rules. These rules are clear and easy to administer. Also, by unifying these rules, there would be a consistent regime for NRAs investing in the United States.

The author thanks Daniel L. Gottfried, an attorney at Day Pitney LLP in New York, for his able assistance with parts of this article.

Endnotes

  1. For U.S. federal estate tax purposes, a non-resident alien (NRA) is someone who's not domiciled in the United States. A person acquires a domicile by establishing residency, even for a brief period of time, with no definite present intention of leaving as shown by external facts and circumstances. Treasury Regulations Section 20.0-1(b).

  2. It is generally accepted that an interest in a partnership that is organized outside of the United States, which holds no U.S. assets and conducts its business outside of the United States, is not a U.S.-situs asset.
  3. The United States has 16 estate tax treaties with foreign countries, but few address situs of a partnership interest. www.irs.gov/businesses/small/article/0,,id=186064,00.html/.
  4. Revenue Ruling 55-701, 1955-2 C.B. 836.
  5. The Internal Revenue Service has consistently refused to rule on whether a partnership interest is intangible property for purposes of Internal Revenue Code Section 2501(a)(2) (dealing with transfers of intangible property by an NRA for purposes of the U.S. federal gift tax). Section 4.01(27) of Revenue Procedure 2009-7, 2009-1 C.B. 226.
  6. IRC Sections 2101-2104. Under Section 2104(b), any property subject to the so-called “string provisions” of IRC Sections 2036 through 2038 is included, if it had or was deemed to have a U.S. situs at the time of the transfer or death. This includes property transferred within three years of the NRA's death, transfers with a retained life estate, transfers taking effect at death and revocable transfers.
  7. See Jane Tse and Dina Kapur Sanna, “Nonresident Aliens,” Trusts & Estates, December 2005.
  8. Treas. Regs. Section 20.2104-1(a)(2).
  9. Treas. Regs. Section 20.2104-1(a)(1).
  10. Treas. Regs. Section 20.2053-7.
  11. Treas. Regs. Section 20.2104-1(a)(4).
  12. IRC Section 2104(c), Treas. Regs. Section 20.2104-1(a)(7).
  13. IRC Section 2104(a), Treas. Regs. Section 20.2104-1(a)(5).
  14. M. Annette Glod, “United States Estate and Gift Taxation of Nonresident Aliens,” 51 Tax Law 109, 1997.
  15. Ibid.
  16. Sanchez v. Bowers, 70 F.2d 715 (2d Cir. 1934).
  17. Glod, supra note 14; Richard A. Cassell, Michael J. A. Karlin, Carlyn S. McCaffrey and William P. Streng, “U.S. Estate Planning for Nonresident Aliens Who Own Partnership Interests,” 99 Tax Notes 1683 (2003) and 31 Tax Notes Int'l 563 (2003).
  18. Ibid.
  19. Since the time that Sanchez and Rev. Rul. 55-701 were issued, the Revised Uniform Partnership Act (adopted in 1997), various limited liability company acts and other similar laws have essentially codified the entity theory for substantive state law purposes. See, for example, Revised Uniform Partnership Act (1997), Section 201(a) (stating that a partnership is an entity distinct from its partners).
  20. Rev. Rul. 55-701, supra note 4.
  21. Sanchez, supra note 16.
  22. Blodgett v. Silberman, 277 U.S. 1 (1928).
  23. An alternate theory is that a partnership interest, being an intangible, should be subject to the debt situs rules, with the partnership or surviving partners being the issuer or obligor against whom the claim is enforceable. However, although a partner may have claims against the partnership or partners, the nature of being a partner is that there is a joint undertaking which is inconsistent with the debt analysis. Also, the claim arises after death and is not in existence at death, which is when the determination of the gross estate is made under IRC Sections 2033 and 2103.
  24. Cassell et. al., supra note 17.
  25. Patrick W. Martin, “Why Section 2104 Must Address When Partnership Interests Owned by Foreign Investors are (and are not) subject to United States Estate Tax,” State Bar of California, Taxation Section, International Committee.
  26. See Treas. Regs. Section 301.7701-5(a) as amended by T.D. 9153 (8-11-2004).
  27. The question of whether an entity is engaged in a U.S. trade or business turns on the nature, extent and continuity of U.S. activities, as well as other facts and circumstances.
  28. Cassell et.al., supra note 17. Some estate tax treaties that do address partnerships restrict inclusion in the gross estate of an NRA to the pro rata portion of the partnership related to the U.S. business. See, for example, Article 8 of Estate and Gift Tax Treaty, Dec. 3, 1980, United States — Germany.
  29. Glod, supra note 14.
  30. IRC Section 2104(a). IRC Section 7701(a)(4) defines “domestic” with respect to a corporation or partnership as one that is “created or organized in the United States or under the law of the United States or of any State unless, in the case of a partnership, the Secretary provides otherwise by regulations.” A foreign partnership is one that is not domestic.
  31. Glod, supra note 14.
  32. Jeffrey Schoenblum, Multistate and Multinational Estate Planning, Section 20.05[i] Vol. 1, 2008 Edition.
  33. Glod, supra note 14.
  34. Furthermore, the notion that a partnership interest is the personal property of the partner is well-accepted for substantive state law purposes. For example, Revised Uniform Partnership Act (1997), Section 502. The official commentary under this section states clearly that “[t]he partner's transferable interest is deemed to be personal property, regardless of the nature of the underlying partnership assets.” See also Connecticut Limited Liability Company Act, C.G.S. Section 34-169 (“A limited liability company membership interest is personal property”).
  35. Blodgett, supra note 22 at p. 10.
  36. Glod, supra note 14; Cassell et. al., supra note 17.
  37. Estate of Vandenhoek v. Commissioner, 4 T.C. 125 (1944).
  38. Glod, supra note 14.
  39. See, for example, Rev. Rul. 55-701, supra note 4.
  40. For example, Treas. Regs. Section 301.7701-5, which is consistent with the rules applied to corporations under IRC Section 2104(a) and Treas. Regs. Section 20.2104-1(a)(5).
  41. This assumes that no bilateral tax treaty overrides the result under general U.S. tax law.
  42. The branch profits tax is an additional U.S. tax imposed on foreign corporations conducting business directly in the United States or through a pass-through entity like a partnership, and which tax is based on the so-called “dividend equivalent amount.” IRC Section 884. Sometimes a foreign corporation will consider investing through a U.S. subsidiary to avoid the branch profits tax, and instead pay a tax at the time dividends are paid at the statutory 30 percent withholding rate on dividends or lower treaty rate.

Dina Kapur Sanna is an attorney with Day Pitney LLP in New York