The European Lawyer

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9 Jan 2010

Private Client Tax - USA

Editors: Andrew Weinstein & Kevin E. Packman Holland and Knight

United States

Holland and Knight Andrew Weinstein & Kevin E. Packman

1. NON-TAX ISSUES

1.1 Domestic law

While the United States’ federal government may impose numerous laws, including those dealing with taxation, there is no federal succession law. Succession laws are dependent upon state statutory schemes, and more than one state law may apply to a fact pattern. Even though there is no forced heirship in the United States, some states provide a mandatory share for a spouse. Notwithstanding, the mandatory share may be limited by agreement.

1.2 Private international law

States create a body of laws to control the probate process and standards for administering trusts. The local courts within each state have authority to resolve disputes including those pertaining to the proper jurisdiction for an international dispute. Parties may resolve issues under principles of international arbitration and courts may impose mediation. Federal courts generally do not entertain jurisdiction over wills and trusts.

2. TAXATION

2.1 US Federal income taxation of individuals

As a general rule, US citizens and US residents are subject to US federal income tax (income tax) on their worldwide income regardless of its source or character. An individual who is neither a US citizen nor a US tax resident is subject to US federal income tax only with respect to certain types of US-source ‘FDAP’ income (fixed or determinable annual or periodical income) and income that is ‘effectively connected’ with the conduct of a trade or business within the United States (ECI). See sections 871, 872, 881, 882.

Foreign individuals are generally subject to US income tax on ECI at graduated income tax rates. Foreign persons are taxed on their US-source FDAP income (eg, certain interest, dividends, rents, salaries, wages, annuities, etc.) at a flat rate of 30 per cent of the gross amount (or at a reduced flat rate whenever the provisions of an income tax treaty apply), and such tax is collected through a withholding mechanism. See sections 871, 872, 881, 882.

US Income Tax Residency: An individual who is not a US citizen is treated as a US tax resident during a particular calendar year, and is therefore subject to income tax on a worldwide basis (unless an applicable treaty provides otherwise), if the individual either (i) is a ‘lawful permanent resident’ of the United States at any time during such calendar year (ie, holds a valid US green card), (ii) satisfies the ‘substantial presence test’ explained below, or, where applicable, (iii) makes an election to be treated as a US tax resident. See section 7701(b)(1)(A).

Under the substantial presence test, an individual who is not a US citizen or green card holder (ie, a ‘non-resident alien’ or NRA) will be treated as a US tax resident during a particular calendar year, and thus will be subject to income tax on a worldwide basis, if he satisfies the ‘substantial presence test’ by being physically present in the United States for at least 31 days during that calendar year and satisfying the three-year look-back rule discussed below. See section 7701(b)(3)(A).

A non-resident alien will satisfy the three-year look-back rule if the sum of (i) the number of days of his physical presence in the United States in the current calendar year, (ii) one-third the number of days of his physical presence in the United States in the first preceding calendar year, and (iii) one-sixth the number of days of his physical presence in the United States in the second preceding calendar year equals or exceeds 183 days. See section 7701(b)(3)(A)(ii). Under this test, a person will generally not be classified as an income tax resident unless he spends on average more than 121 days per calendar year within the United States.

Certain narrow exceptions from US residency are provided for exempt individuals (exempt because they are present in the US under certain special visa classes and because of medical conditions). A foreign individual does not meet the substantial presence test with respect to a particular taxable year if such individual (i) is present in the United States on fewer than 183 days during such year, and (ii) establishes that, for such year, he has a ‘tax home’ in a foreign country and has a closer connection to such foreign country than to the United States.

A foreign individual who qualifies both as a US resident under the above rules and, pursuant to the internal tax law of a foreign jurisdiction with which the United States has an income tax treaty, as a resident of that foreign jurisdiction, may be able to claim treaty benefits to avoid Income Tax. Once the country of residence is determined for purposes of the treaty, the country of residence generally has taxing priority over items other than real property located in the other country and business profits attributable to a business carried on through a permanent establishment in the other country.

Source Rules: Sections 861 through 865 classify income by source, which determines whether the US may tax such income. Interest income is from US sources if the debtor is a domestic corporation or noncorporate resident and is from foreign sources if the debtor is a non-resident or foreign corporation. Sections 861(a)(1), 862(a)(1). Dividends from domestic corporations are from domestic sources, while dividends from foreign corporations are usually from foreign sources. Sections 861(a)(2), 862(a)(2). Income from the performance of personal services is sourced where the services are performed. Sections 861(a)(2), 862(a)(2). Rents and royalties are sourced within the country in which the property that is the subject of the lease or license is used. Sections 861(a)(4), 862(a)(4). Gain on a disposition of a US real property interest is always from US sources; Similarly, gain on a sale or exchange of real property located outside of the United States is from foreign sources. Sections 861(a)(5), 862(a)(5). Gains on sales of personal property not held for sale in the ordinary course of business are usually from sources in the taxpayer’s country of residence. Section 865(a). Sales of stock held for investment by a non-resident alien are from foreign sources and not taxable in the US even if the stock sold is shares in a US company and even if the sale occurs within the United States. Conversely, sales of stock held for investment by a US resident produce US source gain or loss.

2.2 Transfer taxes

US federal estate, gift, and generation skipping taxes (transfer taxes) apply to US citizens and US residents on a worldwide basis. Non-residents who are not US citizens are subject to transfer taxes on a much more limited basis. See sections 2101(a) and 2103 (estate tax); sections 2501(a) and 2511(a) (gift tax). For US transfer tax purposes (as distinguished from US income tax purposes), a ‘resident’ is an individual who is domiciled in the United States. Conversely, a ‘non-resident’ is an individual who is not a US citizen and who is not domiciled in the United States. A person acquires a domicile in a place by living there, even for a brief period of time, with no definite present intention of later removing himself from that place. Residence without the requisite intention to remain indefinitely will not suffice to constitute domicile, nor will an intention to change domicile effect such a change, unless accompanied by actual removal. See Treas. Reg. section 20.0-1(b)(1). It is important to understand while the transfer taxes are imposed by the federal government, each state may also impose its own estate tax.

It is possible for an individual to be a ‘resident alien’ of the United States for income tax purposes by reason of holding a green card or meeting the substantial presence test, and yet remain a non-resident/nondomiciliary of the United States for purposes of the transfer taxes. It is also possible for an individual to be a non-resident of the United States for income tax purposes and a resident of the United States for transfer tax purposes.

Notably, the United States has entered into tax treaties that govern transfer taxes with a number of foreign countries that limit the ability of the United States to impose such taxes. Thus, the existence and potential applicability of any such treaty should also be considered. A tax treaty impacts the federal Transfer Tax, not a state estate tax.

2.2.1 US gift tax

Non-resident aliens generally are subject to gift tax (gift tax) only on completed gifts of real or tangible personal property that is situated or deemed situated in the US See sections 2501, 2511 and Treas. Reg. sections 25.2501-1, 25.2511-3. For purposes of the gift tax, the situs of real and tangible personal property is determined based upon the physical location of such property.

Non-resident aliens are not subject to gift tax on transfers of intangible property. The situs of the intangibles is irrelevant. Whether a non-resident alien makes a completed gift of stock in a US or a foreign corporation, gift tax is not applicable to the transfer. See sections 2501(a)(2) and 2511(a). If a non-resident alien makes a completed gift of an interest in a foreign entity that is treated as a partnership for US tax purposes, the analysis is more complicated. In such cases, there is a risk that the foreign entity may be disregarded and the transaction viewed as though the non-resident made a transfer of a proportionate amount of the assets underlying the partnership.

A non-resident alien who makes a gift of US-situs property that is subject to gift tax is entitled to a $13,000 annual exclusion, other annual gift tax exclusions (section 2503) and to a limited charitable gift tax deduction (section 2522(b)), but not to the unified credit (section 2505) or to the splitting of gifts with a spouse (section 2513). Gift tax is imposed on US gifts at the usual gift tax rates.

There is no marital deduction available for gifts made to a spouse who is not a US citizen. Section 2523(i). However, every donor spouse, US or foreign, is entitled to give up to $100,000 each year to a non-US citizen spouse free of gift tax (this amount is indexed for inflation and is $133,000 for the year 2009). See Rev. Proc. 2008-66, 2008-45 I.R.B. 1107. Any such gifts must qualify as annual exclusion gifts under section 2503(b); that is, the donee spouse must receive a ‘present interest’ in the gifted property.

2.2.2 US estate tax

Estate tax applies to all property transferred at death, regardless of the property’s situs, if the donor or decedent is ‘a citizen or resident of the United States’ at the time of the gift or at death (estate tax). Section 2001(a). In contrast, non-resident aliens are usually subject to estate tax only with respect to US situs assets. See section 2101(a).

While transfers made to a US citizen spouse are typically fully deductible from the deceased spouse’s estate for US purposes (see section 2056), there is no marital deduction permitted for transfers made at death to a surviving spouse who is not a US citizen, except to the extent the property is timely transferred to a Qualified Domestic Trust, or QDOT. See section 2056(d).

A QDOT is a security device for ensuring that, either upon the distribution of principal from the trust during the spouse’s lifetime, or at the spouse’s death, the trust principal will be subject to estate tax as if it were included in the estate of the transferor spouse.

2.2.3 US GST tax

The US Generation Skipping Transfer Tax (GST tax) is generally applicable when a transfer is made to someone who is considered to be more than one generation beneath the transferor. With respect to liability for GST tax, federal tax rules do not explicitly distinguish between resident and non-resident transferors. The GST tax is, however, a tax in addition to the gift and estate taxes, so it only applies to transfers that are or were previously subject to gift or estate tax under the rules described above. See Treas. Reg. section 26.2652-1(a)(1).

2.2.4 Issues with respect to joint spousal ownership

Entering into joint tenancies where at least one spouse is not a US citizen can present special concerns for estate tax and gift tax purposes. Consequently, caution is warranted with respect to the creation of a joint tenancy in property between such spouses, and should only be entered into following discussions with a qualified US advisor.

2.3 Enforcement/collection of taxes

2.3.1 Assessment in general

The code is the primary body of statutory tax law. Section 6201 provides the Secretary of the Treasury with the authority to assess taxes of all kinds, including those shown on a tax return. Section 6203 provides that the assessment is made by recording the liability with the IRS. To the extent that additional taxes may be due over and above those that are reported, the IRS may determine a deficiency and procedures then exist for the determination of a deficiency. Sections 6211 through 6215. Communications between taxpayers and their tax advisors are treated as privileged communications. Section 7525.

2.3.2 Tax liens

The assessment of tax results in a statutory lien on all property and rights to property belonging to the taxpayer. Section 6321. IRS has the authority to also record the tax lien in the public records. The tax lien has priority over other certain liens, but there are exceptions thereto, commonly known as super priorities. Section 6323. There are also special liens for estate tax and gift tax, with the estate tax lien running for 10 years after death with respect to assets that are included in the gross estate. Section 6324; Section 2035 et seq. [with respect to certain gifts made within three years of death]. IRS will not, as a matter of policy, pursue the collection of gift tax from a transferee unless collection from the donor is not possible. See, CCA 200018013.

2.3.3 Levy and distraint

In addition to the tax lien, IRS has the authority to collect taxes by levy and distraint. Section 6331(a). This includes the right to seize property, and to sell it to satisfy unpaid tax assessments. Section 6331(b). A levy is considered to be made when the notice of seizure is given. Sections 6502(b); 6335(a). Taxpayers are, however, entitled to notice and opportunity for a hearing before levy and seizure. Sections 6330, 6335. If a levy is properly served on a third party, such as a financial institution, the party upon whom the levy is served must turn over property belonging to the taxpayer and is protected from liability for complying with the levy. Section 6332(a). There are severe penalties for failure to comply with a levy and personal liability as well. Section 6332(d). Of significant importance is that the code prohibits suits to restrain assessment or collection of tax. Section 7421.

2.3.4 Statutes of limitation

There are several statutes of limitation that apply to the assessment and collection of tax. Taxes are required to be assessed within three years after the return is filed. Section 6501(a). Timely filed returns are deemed to be filed on the last day prescribed for filing. Sections 6501(b); 6513(a) [applicable to credits and refunds]. Special rules exist with respect to when taxes are deemed to be paid. Section 6513(b). The normal three year statute of limitations on assessment may be extended indefinitely if no return is filed or there is fraud [Section 6501(c)(2) and (3)] and it may be extended up to six years attributable to substantial omissions [Section 6501(e)(2); 6501(c)(9)]. There are extensive special reporting rules for foreign transfers under Section 6038 et seq. and the failure to comply will extend the statute of limitations on assessment to three years after the required information is furnished to IRS. There is a six year statute of limitations for prosecution of criminal tax violations, with extension provisions applicable when the offence is continuing. See, US Department of Justice Criminal Tax Manual (2008), Section 7.00 et seq.

2.3.5 Collection from taxpayers

The authority to collect taxes is in Section 6301 and is effected by notice and demand within 60 days next following assessment. Section 6303. Collection follows after assessment and IRS has 10 years to collect assessed taxes. Section 6502(a)(1). If the taxes are not paid within 10 years, IRS may institute a court proceeding to collect the taxes due within the 10-year period, with the result that the collection statute is extended until the tax is paid. Section 6502(a).

2.3.6 Collection from transferees

If a taxpayer has transferred assets without equivalent value given in exchange, unpaid taxes may be collected from the transferee of the assets. Section 6901(a)(1)(A). The period of limitations is extended to allow for collection against a transferee. Section 6901(c)(1) and (2). Fiduciaries in receipt of a taxpayer’s property are also liable, with similar extensions of time to collect. Sections 6901(a)(1)(B); 6901(c)(3). Evidentiary rules involving the liability of transferees and fiduciaries are in Section 6902. There are extensive regulations that set out the procedures in the case of transferred assets [Reg. Section 301.6901-1 and the Internal Revenue Manual further sets out the procedures for the handling of transferee liability cases. See, IRM Section 4.11.52. The case law is split as to whether a transferee of property from an estate is liable for interest on unpaid estate tax and there is no definitive law on liability for penalties.

2.3.7 Fiduciary liability

Tax claims are entitled to priority. When a fiduciary fails to respect that priority and instead pays assets to another, the fiduciary is exposed to personal liability. 31 USC Section 3713(b). Fiduciaries are required to provide notice of their status to IRS and the termination thereof. Section 6903(a); 6903(b) [Form 56]; Reg. Section 301.6903. A fiduciary is not considered to be a transferee because the fiduciary has no beneficial interest in the transferred property, other than in a fiduciary capacity. The liability is therefore limited to the trust assets that remain in the fiduciary’s hands when transferee liability is asserted. The liability of a fiduciary to beneficiaries is generally broader than under tax law.

2.3.8 Liability of foreign fiduciaries

Transferee liability applies in general when a taxpayer transfers assets without satisfying his tax liabilities and is rendered insolvent. In estate tax situations, the special 10-year lien for estate taxes and the collection mechanisms that exist with respect thereto often negate the need for IRS to pursue collection under the transferee and fiduciary liability laws. When IRS does proceed against a fiduciary and that fiduciary has no US presence, jurisdictional issues arise, such as to how the IRS will acquire jurisdiction over the assets and of the fiduciary. Conflicts of law principles may apply, as well as issues relating to piercing of the corporate veil between parent and subsidiary entities, in personam jurisdiction over the fiduciary and in rem jurisdiction over the assets. The law is unclear as to how the US may acquire jurisdiction over a parent entity because of the US presence of a subsidiary, and as to how IRS may in turn collect on a US tax obligation from a non-US fiduciary holding non-US situs assets. Also unclear is the extent to which any liability would be limited to the assets held by the fiduciary, versus its own assets.

2.3.9 Assessment and collection from non-US taxpayers

There is a complex body of less than clear law applicable to the assessment and collection of taxes from non-US taxpayers. Issues arise with respect to taxes withheld on US source income, the right to levy on foreign situs assets, when the statue of limitations runs against the taxpayer versus against an agent, what constitutes a return, what acts will extend the statute of limitations on assessment, how foreign partners in US partnerships are affected and whether taxes can be collected once assessed. As to collection, the general rule is that courts will not collect the taxes due to foreign states and that rule generally applies pari passu when it is the US seeking to collect. Special rules exist when there is a tax treaty, but the issue then is whether the treaty contains the narrower purpose or broader purpose collection assistance provisions. It is only the latter that obligate a foreign state to lend collection assistance and support. As to income taxes, those treaties are limited to Denmark, France, Canada, the Netherlands and Sweden. As to estate and gift taxes, they are limited to Finland, France, Greece, Italy and South Africa. See, J.L. Rubinger and A.H. Weinstein, Assessment and Collection of US Taxes from Non-US Taxpayers, Tax Notes, June 6, 2005, p. 1262 et seq.

2.3.10 Penalties

The code imposes a panoply of penalties for non-compliance, from civil to criminal. Some penalties may be contested prior to payment, but many are ‘assessable’ and must be paid before there are effective remedies to contest penalties. The amounts can be confiscatory and discretion to abate penalties is often limited by law. In some situations, reasonable cause and good faith may be a defence, but the determination thereof is often discretionary on the part of the IRS. Criminal penalties are imposed incident to prosecution and can run from large dollar amounts to incarceration. In general, non-payment of penalties will not result in incarceration (there is no ‘debtor’s prison’), but non-payment in a criminal prosecution can derail a plea agreement. US tax authorities have repeatedly offered opportunities for amnesty in the form of voluntary compliance initiatives, but those opportunities are becoming more limited as efforts to enforce compliance are ratcheted higher. There are treaties allowing for extradition for certain criminal offences, but to date those treaties are not generally applicable to tax offences. This landscape should be expected to change, especially when tax offences are coupled with other violations of criminal laws, which is an evolving situation when the circumstances so merit. The US is continuously expanding its Tax Information Exchange Agreements (TIEA) and expects that TIEAs will be a continuing source of compliance information. Taxpayers should not take comfort in any prior weaknesses in those programs and, when their affairs are coupled with complex avoidance structures, should anticipate even greater aggressive enforcement efforts.

2.3.11 Forfeiture

In general, tax offences, by themselves, do not give rise to forfeiture of the assets involved. There is a broad body of tax and non-tax law, both civil and criminal that may nevertheless give rise to asset forfeiture. The Code allows the IRS to seize property that was removed or was used in fraud or violation of Internal Revenue laws. Sections 7301, 7302. Property that is subject to forfeiture under the Code may be seized. Section 7321. Civil forfeiture of assets, through seizure proceedings, is allowed with a limited burden of proof (preponderance of the evidence) when related to money laundering. 18 USC Section 981(a)(1)(A). Criminal forfeiture is also available when there are offences of the Money Laundering Control Act and the underlying specified unlawful activity involves wire or mail fraud. 18 USC Section 982(a)(1)(A). Although current Justice Department policies do not provide for the charging of mail or wire fraud, or money laundering, for tax offences, absent Tax Division (Washington) approval, in appropriate circumstances, this is allowed. US Department of Justice Criminal Tax Manual, Section 25.01. Recently proposed legislation to allow tax offences to be treated as predicate offences for money laundering failed enactment, but there are presently several efforts underway to enact similar legislation. This can have a direct effect upon international tax and trust planning because the movement of funds is often directly related to that planning. As of the date of this writing, the issue remains unclear because of the need for related wire or mail fraud to be charged as predicate offences for money laundering. The penalties for such offences are draconian.

3. EXEMPTIONS AND/OR EXIT TAXES FOR NEW IMMIGRANTS

The Heroes Earnings Assistance and Relief Tax Act of 2008 created a new income tax provision, Section 877A, which subjects certain expatriates to a ‘mark-to-market’ exit tax, and a new transfer tax provision, Section 2801, pursuant to which the US recipients of gifts and bequests from certain expatriates could be subjected to gift or estate tax. The law applies to all persons who are classified as ‘covered expatriates’ and who expatriate on or after 17 June, 2008. The term ‘covered expatriate’ includes individuals who renounce or relinquish US nationality or terminate their status as long-term lawful permanent residents (ie, green card holders for at least eight of the 15 taxable years preceding expatriation) and (i) whose average net income tax liability for the five years preceding expatriation exceeds $145,000 (indexed for inflation post-2009), (ii) whose net worth at the date of expatriation is at least $2 million (not indexed for inflation), or (iii) who fail to file IRS Form 8854 certifying under penalties of perjury that they have complied with all US federal tax obligations for the preceding five years.

The exit tax imposes a mark-to-market tax on net gain in excess of $626,000 (indexed for inflation post-2009) from a deemed sale of all of the covered expatriate’s worldwide assets. Section 877A(a)(3). There is a method by which the expatriate can defer the payment of tax. There are significant exceptions to the mark-to-market tax, for the following items: (i) deferred compensation items; (ii) specified tax deferred accounts; and (iii) interests in nongrantor trusts. On these items, the covered expatriate is instead taxed when he or she receives either an actual or a deemed distribution. Section 877A(c).

Section 2801 applies to a ‘covered gift’ defined as any property acquired by gift directly or indirectly from an individual who is a covered expatriate at the time the gift is received. Section 2801(e)(1)(A). It also applies to a ‘covered bequest’ defined as any property acquired directly or indirectly by reason of death from an individual who was a covered expatriate immediately before death. Section 2801(e)(1)(B) The US recipient of either a gift or bequest from a covered expatriate is subject to transfer tax on the value of the covered gift or covered bequest at the highest applicable gift or estate tax rate then in effect. Section 2801(e)(1)(B) The tax may be reduced by any foreign gift or estate tax paid on the same items.

This succession tax does not apply to gifts that are covered by the general annual donee exclusion ($13,000 per donee, annually, using 2009 figures), nor does the succession tax apply to gifts or bequests that are otherwise entitled to a marital or charitable deduction for US purposes. The succession tax also will not apply to a taxable gift shown on a timely filed US gift tax return or to property included in the estate of a covered expatriate and shown on a timely filed US estate tax return. Special rules apply to covered gifts and bequests made to trusts.

4. USE OF ASSET HOLDING VEHICLES

Advisors have a variety of entities available through which to conduct business in the United States. State law will determine the permissible entities that may be used and the conditions for formation, operation and termination. The following discussion assumes that the entity will not be publicly traded. State law also provides for the formation of private corporations, non-profit corporations, general partnerships, limited partnerships and limited liability companies. State law may also impose taxes on income in addition to federal income taxes.

4.1 Corporations

Corporations are formed by filing articles of incorporation typically with the Secretary of State in the state of incorporation. The selection of which state should be chosen for incorporation will be dictated by a number of factors, including place of business and operation, residence of the investors and preferred state law. The benefits of incorporation are: (1) avoidance of personal liability for the owners; (2) provision for central management in the form of the board of directors; and (3) continued or perpetual life of the entity provided the requisite fees and formalities are paid and met. The biggest disadvantage to using a corporation is that the corporation pays an entity-level tax on its income, then the shareholder pays a personal income tax when a dividend is received. Many owners would prefer to avoid the double taxation. Both corporate and individual rates currently start at 15 per cent and have a marginal or top rate at 35 per cent. However, a regular corporation can pay the top marginal rate on its income and then the shareholder, upon the distribution of dividends from the corporation, pays income tax on that distribution. The favourable taxation of corporate dividends at 15 per cent is set to expire 31 December, 2010 and Congress must affirmatively extend the favourable treatment of dividends or the tax on dividends will return to ordinary rates. Withholding taxes may be imposed on dividends.

4.2 General partnerships

The partners in a general partnership are entitled to participate in management of the business. They also are liable for the obligations of the partnership to the extent they have not limited those obligations, such as by non-recourse borrowing by the partnership. There is no entity-level taxation of a general partnership, and each partner pays that partner’s share of taxes on the profits allocated to that partner, whether distributed or not. Usually the allocation is based on a percentage of invested capital. Withholding taxes may be imposed on partnership distributions.

4.3 Limited partnerships

Unlike general partners, limited partners do not incur liability for the liabilities and obligations of the partnership. A limited partnership must have a general partner, who is personally liable for the partnership’s debts and is the manager of the partnership business. Limited partners, on the other hand, are not allowed to participate in the management of the partnership and, to the extent that they become involved in management of the partnership, they may become liable personally for partnership liabilities. For that reason, limited partners are typically passive investors.

4.4 Limited liability companies

Limited liability companies are a hybrid of a corporation and a general partnership. The limited liability company has combined partnership and corporate characteristics and is generally preferred as an entity over a corporation, general or limited partnership, or an S-corporation. Like a corporation, the members of the limited liability company have no personal liability for the limited liability companies’ obligations. The limited liability company statutes generally provide for a manager-managed limited liability company, in which a designated manager (who can be a member, but does not have to be) manages the limited liability company’s business, or member-managed limited liability company. In a member-managed limited liability company, the members collectively operate the business. Like a partnership, there is no federal income tax and usually no state income tax levied on the limited liability company’s income. Each member in this pass-through entity includes that member’s proportionate share of income or loss in the member’s individual income for a given year. The operation of the limited liability company provides for a pass-through of income and thus avoids a double layer of taxation. Another advantage to a limited liability company is the ability, within certain limitations, to allocate profit and loss on a basis other than pro rata in accordance with the members’ invested capital.

4.5 S-corporations

An S-corporation is a tax designation granted to corporations that apply and qualify for S-corporation status under provisions of the Internal Revenue Code. The benefit to a qualifying S-corporation is that it does not pay a corporate level income tax. The S-corporation’s shareholders report their allocated portion of corporate income on their personal returns. Federal law significantly restricts who may be an S-corporation shareholder. Corporations, partnerships, most trusts and non-US residents may not own shares in an S-corporation. If such ownership exists, it will result immediately in termination of the S-corporation status. The corporation cannot reapply for S-status for five years following the termination, even if it has corrected the defect causing the termination.

4.6 Life insurance

The use of life insurance in business and estate planning is an important economic consideration and should be evaluated carefully. In closely held entities, insurance proceeds can provide a source of funds to redeem the ownership interest of a deceased shareholder, partner or limited liability company member. Insurance can also be used to finance retirement benefits for key executives or business owners. Life insurance enjoys favourable tax treatment in the United States. Earnings that accrete in permanent policies (non-term) are not taxed while they remain in the policy. That cash value may be typically withdrawn as loans against the policies without resulting in tax recognition to the policy owner. On the death of the insured, the policy beneficiary generally receives the proceeds without taxation. The development of the life settlement market, in which a policy owner can sell the policy to a third party, is a relatively recent development and offers a market for the sale of a policy while the insured is still living, as an alternative to the surrender of the policy to the insurer.

4.7 US asset protection trusts

A recent development in a number of US jurisdictions has been the passage of legislation that allows for self-settled trusts to hold assets that the grantor’s creditors may not access. Traditionally, under the law of US states, a creditor could attach to the assets of a trust under which the grantor was also a beneficiary. In the states that have passed this asset protection legislation, that is no longer the case. Now a grantor may establish a trust, retain a limited beneficial interest in that trust, and still protect those assets from creditors. Each state’s legislation is slightly different and must be reviewed in each case, but the use of these asset protection trusts within the United States is rapidly growing in popularity and potentially has many benefits. In certain instances, not only are the assets protected from creditors, but state income tax may be avoided upon the sale of assets by the asset protection trusts, rather than by the grantor personally.

5. PHILANTHROPIC/CHARITABLE OPTIONS

The United States tax laws encourage philanthropy by providing donors with tax deductions for qualifying gifts. In order to be a qualifying gift, the recipient organisation must be recognised by the IRS as a charitable organisation. While there are a number of philanthropic options available to donors, we briefly review several alternatives that are most likely to be of interest:

• Donors are entitled to deductions for outright gifts to an organised charity, either during lifetime or at death. Income tax deductions are available only if the recipient organisation was created under US law and has been determined by the IRS to be tax-exempt under Code section 501(c)(3) (except for a church which does not require an IRS determination). For persons immigrating to the US, it may be of particular importance to know that income tax deductions are not available for gifts to a foreign charity. This limitation does not apply to deductions for purposes of the gift tax and the estate tax. Even though the law permits income tax deductions for charitable contributions, some donors may be unable to receive the expected tax saving for a variety of reasons. For example, they may not itemise their deductions, their income may be high enough to trigger a ‘phase-out’ of itemised deductions, or they may be subject to the alternative minimum tax.
• In order to receive an income tax deduction for a donation to a foreign charity, the donor can contribute funds to a US ‘friends of…’ organisation. There is a distinction between a US charity that conducts its activities in a foreign country (income tax deductions are permitted) and one that is obligated to use its funds to support a named foreign organisation (income tax deductions are prohibited).

6. REGULATORY ENVIRONMENT

The US remains a favourable regulatory and tax climate for investment funds and other vehicles, albeit with increased regulatory oversight and the rate of income tax is under review. The US is an active participant in the Financial Action Task Force and its anti-money laundering and know-your-customer laws, regulations and rules require ongoing oversight and strong compliance programs. TIEAs are in place with a number of countries, as are MLATs and treaty based exchanges. The list is ever expanding. Foreign investors are cautioned that financial privacy is subject to full compliance with applicable federal, state and local laws on an initial and ongoing basis.

7. KEY PLANNING POINTS FOR LONG TERM RESIDENT FAMILIES

There are several strategies that may be employed to help a non-resident alien who is considering a move to the US save tax. If the non-resident alien intends to become a permanent resident the strategies focus on transfering assets to avoid gift tax and reduce the value of assets held and subject to estate tax. For example, by transfering assets to a trust before relocating to the US, the non-resident alien could avoid transfer taxes. The various strategies are outlined, below.

• Liquidate any holding companies to obtain a stepped-up basis in the underlying assets. Related to this, an individual should sell marketable securities with unrealised gain before moving to the US, and then repurchase the securities, or similar securities with a new cost basis. The benefit of this transaction is the individual avoids paying tax in the US, on appreciation that took place when not a US resident.
• Sell assets to a spouse.
• Create a foreign trust for the benefit of a spouse and children. Special rules exist for (i) foreign trusts with US beneficiaries, and (ii) a foreign trust settled by an individual who becomes a US resident within five years of settling the trust.
• Gift assets.
• Accelerate income recognition before coming to the US.
• Defer income recognition if staying in the US for a short period of time.
• Purchase life insurance and annuities.

8. KEY POINTS FOR MIGRATING/TEMPORARILY RESIDENT FAMILIES

A foreign person who plans to reside in the United States only temporarily should seek early advice from US tax counsel to obtain a complete understanding of the Income and Transfer Tax consequences associated with US residency. It is important to have a comprehensive understanding of an individual’s tax status, income sources and situs of assets to effectively plan ahead for US tax compliance and avoidance of multiple taxation where possible. There are several strategies that may be employed to help a non-resident alien who is considering a move to the US save tax. If the non-resident alien intends to become a resident for a short period of time, but then return to the foreign jurisdiction, the techniques focus on the timing of income. It would be preferable to accelerate gain during periods of non-residence, and defer the recognition of certain income to periods of non-residence. For example, the non-resident alien could (i) exercise stock options prior to becoming a US resident, (ii) accelerate taxable distributions from a deferred compensation plan, or (iii) accelerate gains on any notes held from installment sales.

Considerations which should be reviewed prior to arriving in the US include the following:

• Determine the duration and start date of an employment assignment and document the agreement;
• Evaluate holdings in foreign trusts, corporations and other entities for potential US tax implications;
• Evaluate timing for payments of deferred compensation and investment income items to ascertain US tax implications; and
• Consider whether an election to be treated as a US resident in the year of arrival may be more beneficial than non-resident status.

Other issues should be viewed once the foreign person is in the US. These include the following:

• Keep diary of days of presence, including dates of arrival and departure and dates of performing services;
• File and pay taxes timely to avoid interest and penalties; includes reporting obligations for ownership of foreign bank accounts and certain corporations and trusts;
• Consider shifting the situs of property owned within the United States to eliminate potential estate taxation; and
• Plan ahead for departure from the United States.

9. FORTHCOMING LEGISLATION/OTHER CHANGES

Providing an overview of pending legislation is quite difficult as laws are often proposed in Congress and never become law. Thus, we have focused on one area in which there will be a substantive change. Under current law, there is no United States Estate Tax in 2010. This is a result of 2001 legislation, which reduced the maximum estate tax rates (from a high of 55 per cent in 2001 to a high of 45 per cent in 2009) and raised the exemption amount (from $675,000 in 2001 to $3.5 million in 2009) for US decedents. The exemption for a foreign domiciliary (someone who died with US assets) was limited to $60,000. The legislation had a sunset provision, which became effective as of 1 January, 2010, providing for suspension of the estate tax in 2010, and reinstatement at 2001 levels in 2011. As a result, all domiciliaries, whether US or foreign, are exempt from estate tax during 2010. Unfortunately, to benefit from the sunset provision and avoid estate tax, one has to die. While there is no estate tax in 2010, heirs will no longer be able to inherit assets and receive a full basis step-up to fair market value. Rather, they will inherit assets and have a carryover basis. The consensus of informed opinion is that transfer taxes will be enacted into law by no later than 2011.

10. USEFUL REFERENCES

Internal Revenue Service – www.irs.gov/
Internal Revenue Manual – www.irs.gov/irm/index.html
United States Department of Justice Tax Division – www.justice.gov/tax/
Holland & Knight LLP www.hklaw.com
Holland & Knight Private Wealth Services – www.hklaw.com/id16048/mpgid4745/
Holland & Knight Private Wealth & International Capabilities – www.hklaw.com/id16048/mpgid4766/ 

Portions of this Chapter were prepared by Leigh Basha, Kathy Davidson, Josh Husbands, Alan Jensen, Summer LePree, Jeff Rubinger and Richard Sills.

1All references to a section are to the US Internal Revenue Code of 1986, as amended (the ‘Code’), and the Treasury regulations promulgated thereunder.