Structuring Inbound Investments into U.S. Markets

Scott A. Bowman spoke on investing in the U.S. markets by non-U.S. citizen non-residents and how they can avoid and/or minimize U.S. income and transfer taxes at the 57th Annual Heckerling Institute of Estate Planning.

He first set forth the premise that the best way is to avoid becoming a U.S. resident or domiciliary and defined two tests for U.S. residency under IRC Secs. 7701(b)(1)(A) and 7701(b)(1)(B). Resident aliens are taxed on their worldwide income.

1. Permanent Residency Test This would typically be the green card holder. As a green card holder, the non-U.S. resident would be treated as a resident alien and taxed on their worldwide income. To remove this classification, one would have to give up their green card. 
2. Substantial Presence Test If one spends more than 183 days in the U.S., they would be considered a U.S. resident for that year and taxed in the U.S. on their worldwide income. In addition, if they spend more than 31 days in a year and their total number of days exceed 183 days using 100% of the current year, 1/3 of the days in the previous year and 1/6 of the days in the year before that, they would be considered a U.S. resident.  They could in essence spend 120 days a year for each of the three test years and avoid this classification.  If the non-resident spends less than 183 days in the U.S. in the current year but still meets the Substantial Presence Test, they could still be classified as a non-resident if they maintain a foreign residence in another country and claim a closer connection in the foreign country and file Form 8840.  The other exceptions relate to students, teachers, athletes, etc. who obtain special VISAs.  Those days do not count in the physical presence test.   Also, there are treaty exceptions under the tie breaker rules.

Scott then summarized how income earned by a non-U.S. resident is taxed.

There are basically two types of income that are taxed by the U.S.

1. Fixed and Determinable Periodical Income (“FDAP”) This is usually income that is portfolio income and would consist of U.S. dividends, U.S. source interest (bank interest, U.S. treasury interest and portfolio income from registered portfolio obligations are excluded), rent and royalties. They are usually taxed at the 30% tax rate unless a lower treaty rate applies.  It is important that the non-U.S. resident files a Form W-8 BEN with the payor to notify them that they are a non-resident and whether a lower treaty tax rate or no withholding tax applies.
2. Effectively Connected Income (“ECI”) This is trade or business income that is considered U.S. source. It could be generated from wages or business conducted individually or through partnerships.  The tax on this income is based on graduated rates.  Real estate owned by non-residents is subject to the Foreign Investment Real Property Tax Act (“FRIPTA”) which will treat a sale or exchange of real property or real property interest as ECI and subject to a withholding tax rate of 10% or 15%.

It is important to note that there is no tax on gain from the sale of U.S. securities by non-U.S. residents or foreign corporations!

Scott then shifted gears and talked about estate and gift taxes and how they apply to non-U.S. residents. He made a distinction between non-residents who would be considered domiciliaries and non domiciliaries.

Non-resident domiciliaries are taxable on their assets that are situated in the United States under IRC Sec. 2103 and based on the same rates as U.S. citizens and domiciliaries.  There is a difference between estate and gift taxes.

1. Estate Taxes- Unlike U.S. citizens and U.S. domiciliaries, non-U.S. resident domiciliaries are only entitled to a $60,000 equivalent estate deduction on their U.S. situs property which includes:
   1. Stock in a domestic corporation (including mutual funds and money market funds). Cash in U.S. bank accounts are not considered U.S. situs property.
   2. Tangible personal property physically located in the U.S.
   3. Real property located within the U.S.
   4. Intangible property issued by or enforceable against a U.S. resident, domestic corporation or government unit. This is meant to encompass IP interest, life insurance on third parties, annuity contracts issued by U.S. insurance companies, domestic partnerships, limited liability companies and statutory trusts

Scott did discuss whether check-the-box entities that would treat foreign corporations as U.S. taxpayers for income tax purposes would treat them as U.S. corporations for purposes of the estate taxes and would be careful when making the check-the-box elections.

He also went into detail how real property owned directly or indirectly through a disregarded entity and how gifts of these interests would be subject to the gift tax.

1. Gift Taxes – Non-domiciliaries are subject to U.S. gift taxes on U.S. situs assets and have no lifetime exemption but can make annual exclusion gifts under IRC Sec. 2503(b) which in 2023 is $17,000 per donee. They could also make educational and medical exclusion gifts as well as unlimited gifts to a citizen spouse.   Gifts of intangibles, wherever located,  would not be subject to U.S. gift tax.  The big takeaway is that stock in U.S. Companies is subject to the estate tax but not subject to gift taxes.   Gifts of cash to U.S. beneficiaries should be made directly from their foreign bank account since cash in U.S. bank accounts is considered tangible property for gift tax purposes.  Non-U.S. residents are allowed to receive from their U.S. spouses up to $175,000 in lifetime gifts in 2023.

Scott went over some basic investment planning focusing on the ownership of U.S. real property.

Basic Investment Planning

There is always a balance between the income tax regime and the estate tax regime.

If the non-U.S. resident has a short-term horizon, conventional wisdom is that they should hold the investment personally and take advantage of the potential lower long-term capital gain rates.   However, to protect any estate tax liability, the non-U.S. resident may want to purchase term life insurance in case there is an estate tax.

If the investment is of real property, marketable securities or businesses where there is a long-term horizon, then the non-U.S. resident would need to consider having these investments owned by a foreign corporation which is owned by non-U.S. resident individuals or trusts.  Foreign corporations are also not subject tax on sale of U.S. securities but are subject to ECI and FDAP income.   Because of the branch profits tax and FIRPTA regime, many planners recommend that the foreign corporation own a U.S. corporation to hold their U.S investments. 

With the U.S. corporate rate at 21%, the U.S. corporation could accumulate profits at a low rate and then liquidate and not be subject to U.S. tax.

Scott did go into many more complex issues such as the use of a qualified domestic order trust (“QDOT”) for transfers of U.S. situs property transferred from a U.S. deceased spouse to the non-citizen spouse to take advantage of the marital deduction.  He also discussed that a non-domiciliary contribution to a charity for estate tax purposes need to be made to a U.S. charitable organization to be deductible.  He then finished off with the various IRS forms that individual non-U.S. residents need to file (i.e., 1040NR and 1120-F for foreign corporations).