With more and more Americans living and working abroad, the reality is that US persons will also pass away while residing in a foreign country. Did you know that a US citizen residing abroad at death may have a “foreign estate” for US income tax purposes? What does that mean for the estate? What does it mean for US beneficiaries of the foreign estate? Having some familiarity with the US tax issues raised when an American abroad passes away is critical in today’s highly mobile society.
Today’s post will focus on the factors that determine whether an estate is a US “domestic” estate or a “foreign” estate for US income tax purposes. This determination will govern the income tax treatment of the estate and the income tax treatment of both its US and foreign beneficiaries. These are important points and will be discussed in greater detail in a future blog post.
Remember, the income tax treatment of the estate and its beneficiaries is completely distinct from the estate tax issues. The estate tax is a tax based on the fair market value of the assets comprising the estate of the decedent. In the case of an American decedent, worldwide assets are counted. Details about the US estate tax can be found at my blog posts here and here.
Here are a few examples of the importance of the income tax consequences that arise when an estate is treated as “domestic” or “foreign”:
A “domestic” estate is taxed on its worldwide income regardless of source, whereas a “foreign” estate is taxed only on US-source income and income treated as “effectively connected” with a US trade or business. For US beneficiaries of a “foreign” estate, if the foreign estate has only foreign source income, it will have not have any so-called Distributable Net Income (DNI). This means that a distribution of income to the US beneficiary from the foreign estate will not be taxable.
First Things First – Domestic or Foreign Estate?
The Internal Revenue Code (IRC) essentially provides no guidance how to make the determination if an estate is domestic or foreign. Per IRC §7701(a)(31)(A) “… “foreign estate”. . .means an estate. . .the income of which, from sources without the United States which is not effectively connected with the conduct of a trade or business within the United States, is not included in gross income under Subtitle A.” Some guidance is provided by the Internal Revenue Service in Rev. Rul. 81-112, 1981-1 CB 598. In that Ruling when determining the status of the estate, the IRS phrased the issue: “the question is whether the estate is comparable to a nonresident alien individual. ….the standards that have been developed for making these determinations in the case of trusts are equally applicable to estates.”
Thus, two requirements must be established. The estate must be “alien” and it must be “nonresident”. A range of factors are to be considered in making this determination. Unfortunately, the relevant authority does not articulate a clear method of weighing the various factors.
Relevant Factors
Location of Estate Assets. When more than half of the value of the estate is located abroad, the estate is more likely to be characterized as “foreign”. See Revenue Ruling 69–108, 1969–1 C. B. 192.
Location of Estate’s Establishment and Administration. When the estate has been established pursuant to a will executed under the laws in a foreign country and is administered pursuant to such laws, the estate is more likely to be characterized as “foreign.“ See Revenue Ruling 69–108, above.
Alienage and Residence of Estate Fiduciary/Executor. When the estate is administered by foreign persons it is more likely to be characterized as “foreign”. It should be noted, however, that the appointment of an ancillary administrator in the United States will not necessarily cause the estate to be treated as domestic. The extent and duration of the activities of the ancillary administrator must be examined along with all other relevant factors. See Revenue Ruling 62–154, 1962–2 C. B. 148.
Alienage and Residence of Beneficiaries and Decedent. When the primary beneficiaries are non-US persons the estate is more likely to be treated as foreign. The presence of US residuary beneficiaries however is not in itself sufficient to cause the estate to be classified as domestic. When the decedent is a US citizen but a long-term resident of a foreign country the estate can be characterized as foreign if the other factors outlined above are present. The IRS has stated in a private letter ruling (PLR8527065) that in determining the residence of an estate one of the most significant factors to be weighed is the residence of the decedent.
Undeclared Foreign Assets/Accounts
Sometimes, upon the passing of an American abroad, the estate fiduciary will discover foreign accounts or assets that have not been reported to the IRS (e.g., income tax not paid; foreign accounts /assets not reported on FBAR or Form 8938). What should the estate executor do in that situation? It’s a difficult problem, but one that simply must be addressed. Check my blog posts here and here. I can help you navigate this problem.
Remember, the Federal Claims Priority Act (FCPA) establishes the personal liability of the executor of an estate, to pay any claim owed to the government, such as unpaid taxes of a decedent. Broadly speaking, the FCPA provides the United States with a direct cause of action against the estate executor if he or she makes payments to other creditors or beneficiaries of an insolvent estate over the tax owed to the US government. Personal liability attaches even in the absence of any bad intent on the part of the executor. Personal liability can result even if the executor is merely making a distribution from the estate of a bequest or a portion of the residuary estate to beneficiaries who have been named in the decedent’s will, or to those who are inheriting under intestacy laws. Various tax law provisions (see e.g., IRC sections 2203, 6324 and 6325), back up the FCPA’s bite.
US Recipients of Bequests from Foreign Estates
Finally, US recipients of bequests from foreign estates may have special reporting duties.
Posted December 29, 2022
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