How U.S. Tax Rules Apply to Inheritances and Gifts from Abroad

Many people are becoming globally mobile through vacations, extended stays, or relocation. As such, clients are asking estate planning attorneys questions relating to this global mobility.

One of the most frequently asked questions about inheritances from abroad is, "Will I be subject to tax on an inheritance or gift from abroad if I bring the asset into the United States?"

The short answer is as follows. The United States Internal Revenue Service does not impose inheritance taxes on bequests. Transfers by gift of property not situated in the United States from foreign nationals not domiciled in the United States are also not subject to U.S. gift taxes. Such gifts are exempt from the federal gift tax.

Tax advisors and CPAs must know other U.S. tax rules for such a gift or inheritance. For example, at the state level, some states impose a "death tax." Whether it is a state inheritance or estate tax, it varies by state. States imposing a tax on transfers related to death include:

• Iowa
• Kentucky
• Maryland
• Nebraska
• New Jersey
• NewYork
• Pennsylvania

Beneficiary Designations for Tax Planning

Beneficiary designations can minimize or eliminate probate. By operation of law, the assets with beneficiary designations are not considered owned by the estate. You can use beneficiary designations to pass assets to loved ones outside probate.

For example, so long as the assets are subject to beneficiary designations and not owned by the estate, they are not included in your gross estate. Beneficiary designations are popular for assets such as:

• Retirement accounts
• IRAs
• Annuities
• Life insurance
• Bank accounts

Having updated beneficiary designations on assets that allow for such transfers efficiently minimizes tax consequences for certain assets.

This article describes the U.S. tax rules that apply to transfers by gift or inheritance of property from abroad to U.S. citizens, U.S. lawful permanent residents ("green card" holders), or foreign nationals residing in the United States.

U.S. Estate Taxes

The estate is responsible for any estate tax owed on inherited assets given to beneficiaries out of the gross estate.

Marital Transfers

For married couples that include two U.S. citizens, neither lifetime gifts nor bequests in a will are subject to estate taxes when assets are transferred to a surviving spouse.

The marital deduction is an unlimited estate (and gift tax) deduction for transfers made during life or at the date of death to a spouse. Thus, if an individual died and conveyed an entire estate to a surviving spouse, the decedent's estate would have no tax liability. The exception is if a spouse is a noncitizen.

The marital transfer estate tax exemption does not eliminate estate taxes. It simply defers the tax bill. When the second spouse dies, estate taxes will be owed on the entire taxable estate, including the assets transferred upon the first spouse's death.

Structure for Transfers by Bequest

The estate and gift tax rules of the Internal Revenue Code include two basic structures for transfers by bequest. One structure covers death transfers by U.S. citizens regardless of where they are domiciled at death.

When the taxable estate of a deceased person exceeds the estate tax exemption amount for the federal estate tax, the decedent's estate is subject to an estate tax. The estate is liable for estate taxes at the applicable estate tax rate. The estate must file a federal estate tax return.

The federal government imposes this tax structure through its tax laws. There are some exceptions for transfers to noncitizen spouses. The tax laws apply to estates of foreign nationals domiciled in the United States.

The law considers foreign nationals who are green card holders to be domiciled in the United States. This is true for both U.S. estate and gift tax purposes.

In some instances, foreign nationals who reside in the United States without green cards may be considered domiciled in the United States for purposes of tax rules. A different estate tax structure imposes taxes on transfers of particular property in the United States for transfers by foreign nationals not domiciled in the United States.

An estate or gift tax treaty may control taxpayers' obligations under the Internal Revenue Code. The United States has estate tax treaties with the following countries:

• Australia
• Austria
• Canada
• Denmark
• Finland
• France
• Germany
• Greece
• Ireland
• Italy
• Japan
• The Netherlands
• Norway
• Switzerland
• South Africa
• United Kingdom

The Income tax treaty with Canada also includes articles that minimize the double tax previously caused when assets were subject to Canada's deemed disposition at death tax. The Canadian tax is a capital gains tax, not a death tax.

As long as the decedent who transfers the asset by bequest is neither a U.S. citizen nor a foreign national domiciled in the United States, U.S. estate tax law does not impose a tax on the transfer.

The United States does not impose inheritance taxes on the beneficiary's receipt of a bequest. Therefore, there is no U.S. tax resulting from the death transfer. Also, the United States does not impose an income tax on inheritances brought into the United States. However, other U.S. reporting and tax rules may apply to the asset.

U.S. Gift Taxes

The U.S. gift tax rules apply to gratuitous transfers by U.S. citizens and foreign nationals domiciled in the United States, regardless of the location of the asset transferred. Certain exemptions apply to gifts regardless of the donor's domicile or the asset's location.

As with the gift tax rules for U.S. citizens, there is an annual exclusion for gifts with a fair market value of up to $17,000 (for 2023) for each donee gift. Gift splitting is unavailable to foreign nationals not domiciled in the United States. Gifts to U.S. citizen spouses are free of gift tax. Gifts of up to $175,000 per year (for 2023) to a noncitizen spouse can be transferred free of tax.

Gifts by foreign nationals not domiciled in the United States are subject to U.S. gift tax rules only if the asset transferred is in the United States (referred to as "U.S. situs" property). Whether a property is U.S. situs for purposes of these rules is defined by arcane rules found in sections 2104 and 2105 of the Internal Revenue Code.

U.S. real estate and tangible personal property in the United States is U.S. situs property. Intangibles, on the other hand, are not. (However, intangibles such as stock in U.S. companies or debt instruments of U.S. entities or governments are situated in the United States for U.S. estate tax purposes.) Special rules apply to treat U.S. bank accounts located outside the United States.

The United States has gift tax treaties, either separate or in combination with estate tax treaties, with the following countries:

• Australia
• Austria
• Denmark
• France
• Germany
• Japan
• United Kingdom

These treaties may eliminate the U.S. gift tax on certain transfers otherwise subject to U.S. gift taxes under the Internal Revenue Code. An exemption from gift tax under a treaty is made on a gift tax return. The applicable treaty must be analyzed for application to the transfer.

U.S. Income Taxes

U.S. persons are subject to U.S. income taxes on worldwide income. Therefore, U.S. persons who own income-producing property abroad are subject to U.S. income taxes. U.S. persons for purposes of U.S. income tax rules include U.S. citizens and U.S. lawful permanent residents, regardless of where they reside.

The definition of U.S. persons also includes foreign nationals who are resident aliens for U.S. tax purposes. Resident aliens are foreign nationals who meet either the "green card" test or the 183-day substantial presence test of section 7701(b) of the Internal Revenue Code. The application of U.S. income taxes to property transferred or held in trust depends on the status of the grantor or beneficiary, whether U.S. or foreign, under these income tax rules.

Translation Into U.S. Dollars

To determine taxable income for U.S. tax purposes, when the income-producing asset is denominated in a foreign currency, the income and expenses related to the asset must be translated into U.S. dollars. The appropriate exchange rate must be used to make the conversion.

If payments are periodic, such as monthly interest, the amount is translated into U.S. dollars using the average exchange rate for the year. Nonperiodic transactions are translated using the spot rate for the day. Exchange rates are available from the Federal Reserve Board.

Foreign Taxes

Income from property located abroad may be subject to foreign income taxes and U.S. taxes.

Periodic income, such as interest, is usually subject to a withholding tax. Suppose the income is from a country with which the United States has an income tax treaty. In that case, this withholding tax can be reduced or eliminated by submitting the appropriate withholding certificates to the income payor.

Otherwise, the beneficiary can compute a foreign tax credit on Form 1116 of Form 1040. Foreign tax credits offset U.S. taxes attributable to foreign income in the individual's tax return. If there is no positive income, as in the case of a rental loss, the foreign taxes may be taken as an itemized deduction.

Foreign Trusts

A transfer by death or gift into a foreign trust for the benefit of a U.S. person will impose substantial reporting requirements upon the foreign trustee and U.S. beneficiary and subject income distributed to the beneficiary to U.S. income taxes.

If a U.S. person transfers the bequest or gift into a foreign trust, the U.S. income and reporting rules will apply to income to the trust under the foreign grantor trust rules whether or not the income is distributed to a U.S. person.

A foreign trust, for purposes of these rules, is a trust that is not a domestic trust. A domestic trust is a trust that meets two criteria: 1) A court within the U.S. can exercise primary jurisdiction over the administration of the trust, and 2) One or more U.S. fiduciaries have the authority to control all substantial decisions of the trust.

Stock Ownership in a Foreign Corporation

If an estate transfers stock in a foreign corporation by gift or bequest to a U.S. person, the ownership of that stock may trigger several U.S. anti-tax avoidance rules. Generally, these rules prevent income from certain passive assets from accumulating offshore free from U.S. taxation. Three primary rules comprise this anti-deferral regime:

• The controlled foreign corporation rules
• The foreign personal holding company rules
• The passive foreign investment company rules

These rules, designed for major multinational companies, apply equally to small, closely held foreign companies.

Controlled Foreign Corporations

A controlled foreign corporation (CFC) is a foreign corporation in which U.S. persons, each of whom is at least a 10% shareholder, own more than 50% of the vote or value as a group.

Under the stock attribution rules for determining whether a foreign corporation is a CFC, stock ownership is attributed to an individual's spouse, children, grandchildren, and parents who are also shareholders. If a nonresident shareholder is a spouse, child, grandchild, or grandparent of the U.S. person, that person's stock is not attributed to the U.S. person to determine CFC status.

Foreign Personal Holding Company

A foreign personal holding company (FPHC) is a foreign corporation. Five or fewer U.S. persons must own more than 50% of the vote or value. The scope of the attribution rules for FPHC status is broader than those for CFC status.

Stock ownership is attributed to a U.S. person from any lineal descendant or ancestor. It's not dependent on whether the relative is a U.S. person or a nonresident alien. Stock is attributed from siblings regardless of their U.S. tax.

To qualify as FPHC, the corporation's gross income must be at least 60% passive income. Once the corporation meets that threshold, it will continue to be treated as an FPHC if at least 50% of its gross income is from certain passive sources.

Passive Foreign Investment Company

A foreign company is a passive foreign investment company (PFIC) if one of two tests is met: 1) 75% of the gross income of the corporation is passive or 2) the corporation's assets consist of 50% or more of passive assets.

Passive assets are assets that produce passive income. There's no stock ownership threshold by U.S. persons for a corporation to qualify as a PFIC.

Reporting on Bequests and Gifts From Abroad

All bequests and gifts received by U.S. persons from foreign persons that exceed $100,000 in the calendar year are reportable to the IRS on Form 3520, Annual Return to Report Transactions With Foreign Trusts and Receipt of Certain Foreign Gifts. The amount and description of the bequest must be disclosed. However, the IRS does not require disclosing the decedent or donor's identity.