Over my many years of international tax practice, I regularly come across the loving foreign parent (or relative) with a child (or other relation) residing in the United States. The individual may be studying there or living there and pursuing the American dream – starting a business or perhaps buying a home. He or she has likely attained US status with a green card or citizenship. The foreign relative wants to generously assist the individual in pursuit of the dream. For the sake of simplicity, my post will often refer to the parent-child, but it can be any family or other close relation involving a foreign donor and US recipient.
In order to help the dream come true, the donor is ready to furnish some financial support to assist the US person’s goals, be they educational, home or business ownership etc. Cash gifts or loans, while not the only options, are most frequently used. Other options are also possible. For example, a parent could consider some form of co-ownership of the home or business his child wishes to obtain. Determining the best option for the family situation will depend on various factors, predominantly the degree of financial help the relative is willing and able to provide, as well as the level of control and involvement they wish to maintain.
Today’s post will focus on some of the pitfalls to be considered when it comes to making cash gifts or loans in such international family circumstances.
Outright Gifting of Cash
Making a cash gift is often chosen since this is the simplest way to provide financial assistance. The foreign person must be very careful when using this option. Simply put, this simple gifting transaction could result in the foreign individual being subject to US gift tax.
In a nutshell, a foreign national who is not a US “resident” is subject to US gift tax only if two requirements are met: The transfer must be one of tangible property (gifts of intangible property are exempt), and, the transfer must occur within the US. There is no exemption amount under the so-called lifetime exclusion or unified credit rule for such nonresidents who make gifts having a US situs. This exclusion is available only to US citizens or foreign persons treated as “domiciled” within the US and is currently at USD12.06 million. For the nonresident, only a US$16,000 per donee, per calendar year exemption will apply to gift transfers of “tangible” property made within the US. As mentioned, transfers of “intangibles” (e.g., stock whether in a US or non-US company) are exempt from the gift tax when transferred by nonresident donors.
Cash, Checks, Wire Transfers
The Internal Revenue Service (IRS) has taken the view that cash is a tangible asset and checks and wire transfers are embodiments of cash. Whether the transfer is treated as occurring within the US gets tricky when it comes to checks and wire transfers. If the transfer is deemed to occur within the US, the gift tax can apply. Accordingly, when a nonresident transfers funds to a donee-recipient who is in the US, he could inadvertently be subject to US gift tax. The more cautious approach would be to avoid using checks drawn on US banks and wire transfers into the United States. If the US recipient of the gift does not have an account outside the US, he should consider setting one up so that the funds can be transferred from the nonresident donor’s foreign account to the recipient’s foreign account. The gift transfer will then take place wholly offshore the US and avoid possible US gift tax. After the donee receives the gift, he or she can transfer the funds to his or her US account. By transferring gifted funds strictly between foreign financial accounts, the US situs rules for purposes of the gift tax are not triggered.
“Qualified Transfers” are Exempt
If the gift is for tuition payments or healthcare the donor can make use of special rules for so-called “qualified transfers” as defined in IRC Section 2503(e) and relevant Treasury Regulations. Regardless of the amount of the gift and regardless if the funds are transferred into the US, no gift tax is imposed if the donor pays another individual’s medical care or educational tuition meeting the qualified transfer rules. Since these rules permit tax-free gifts without regard to the annual $16,000 exemption, they can be very helpful in the international family context.
With regard to educational tuition, the payment must be made directly to the school. Colleges as well as nursery schools, private grade schools, or private high schools are covered under the rule. The payment must be only for tuition and cannot cover room/ board or books. Tuition pre-payments can often be made as soon as the individual is admitted to the school.
With regard to medical expenses, the payment must be made directly to the health care provider or to the insurance company providing medical insurance. Payments can be made for diagnosis, cure, mitigation, treatment or prevention of disease. Transportation and certain limited lodging expenses for the person seeking medical care can also come within the exemption. If the person is reimbursed by medical insurance for the care, the payment is not exempt from the annual gifting limit.
Reporting Duties
While such qualified transfers are exempt from gift tax, it does not mean that the US recipient will not have a filing duty to report the foreign gift. The US recipient may be required to disclose the foreign gift on IRS Form 3520. Details at my blog post here. In other cases when gifts are paid to a foreign financial account, if required, the US recipient should report the foreign financial account on Form 114, (the famous “FBAR”) and on IRS Form 8938. Full details about FBAR at my blog posts here and everything you need to know about Form 8938 here.
If the gift is from a former American or long term resident, special rules under the “expatriation” regime may apply to tax the US recipient of the gift. My earlier blog post provides all of the details on this “ouch” rule.
Foreign Person Loans
An alternative to an outright gift, is making a loan of funds to the US recipient for the home purchase, business acquisition or other purpose. Depending on the facts, the loan can be secured or not, but the parties must take care that the loan will be respected by the IRS as a “loan” and not recharacterized as a “disguised gift”. Various factors are examined to determine whether an intra-family loan will be respected as a bona fide debt, including whether the loan is documented, whether interest was charged at a reasonable rate, whether the parties established a fixed repayment schedule, whether the lender had a reasonable expectation of repayment according to the terms of the note, whether payments were in fact made in a timely manner, whether collateral was given to secure payment and generally, how the parties acted with regard to the transaction.
Intra-family debt is closely scrutinized by the IRS. A US tax advisor should be consulted to make sure the parties do not to run afoul of the principles mentioned above.
Withholding Duties
It is also critical that the US debtor understand the US tax obligations concerning interest income. When income is paid from “US sources” to a foreign payee, it is taxable by the United States and the US-payor will have to withhold US tax at a 30% rate on the payment. Interest income paid by a US resident-debtor to a foreign person is treated as from US sources. The litmus test is the residence of the debtor, not his or her citizenship.
The withholding tax can possibly be eliminated due to a certain exception in the tax law or it can be reduced due to a favorable income tax treaty negotiated between the United States and the lender’s foreign country. However, taking advantage of the exception or treaty reductions is not automatic and proper paperwork has to be in place. If withholding is required, a failure to do so can result in personal liability for the tax that should have been withheld as well as significant penalties. These issues become complicated, including provision of proper tax forms such as a W8-BEN (details on this form and when it is used are at my blog post here). With proper planning, it may be possible to structure the loan to prevent taxation of the interest income or to lessen the tax bite with application of a relevant treaty.
Takeaway
If you are a foreigner, don’t just make gifts or loans to someone in the USA, no matter how much you love them! Doing things wrong can cost you. If making gifts, I can guide you through the tax maze. If making loans, I can help you structure the loan in the most tax efficient manner and to ensure it will be respected as debt, backed up by proper documentation.
Posted July 28, 2022
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