An important question for many high net-worth individuals (HNWI) when planning their move to the United States is tax liability. The U.S. government taxes the worldwide income of all U.S. citizens and residents, and they do this efficiently and effectively.
When planning your move to the U.S. it is vital is to know when you become subject to U.S. taxation. Non-resident aliens are subject to taxation on all income earned from a U.S. source. Once you are determined to be a resident alien you will be taxed on your worldwide income.
One primary objective of a pre-immigration plan is to minimize post-immigration exposure to U.S. transfer taxes by removing non-U.S. situs property from the NCNR's (non-citizen non-residents or NCNRs) taxable estate before the NCNR establishes U.S. domicile.
This goal is often achieved by forming a properly structured irrevocable trust that the NCNR funds with non-U.S. situs property prior to immigrating. This type of trust is commonly referred to as a ‘‘drop-off'' trust. Drop-off trusts can be located onshore or offshore; either way, several precautions are needed to protect the assets from U.S. transfer taxation after the NCNR immigrates to the United States.
First, a drop-off trust should not be funded with all the grantor's assets, to avoid an implication that the NCNR grantor had an understanding or an arrangement with the trustee and expected the trustee to provide access to the assets either directly or indirectly, after the grantor moves to the United States. This is to prevent the inclusion of trust assets in the grantor's U.S. estate. In addition, no assets subject to U.S. transfer taxes should be added to drop-off trusts after immigration to the United States to avoid tainting the otherwise exempt trusts. Another important safeguard is to minimize or avoid distributions to the grantor of the trust. Multiple distributions made to the grantor or distributions that follow a pattern could be taken as evidence that the grantor retained an interest in the trust. As such, the entire trust corpus would be included in the grantor's U.S. estate when the grantor passes away, if the death occurs while the grantor is domiciled in the United States.
A properly structured drop-off trust, whether domestic or offshore, can protect assets from U.S. transfer taxes, but they do not shield the income that such assets generate from being subject to U.S. income taxes. Private placement variable universal life insurance (PPLI) can offer a unique opportunity to eliminate the U.S. income tax exposure of these trusts. From an income-tax perspective, the owners of life insurance policies do not realize any income from the policy's underlying investment accounts. Thus, investing drop-off trust assets in life insurance can reduce all or some of the trust's taxable income because income earned inside the policy is not taxed currently to the owner of the policy. Moreover, death benefits paid from the policy to the drop-off trust, including embedded policy earnings, are not subject to U.S. income tax. In effect, the benefits obtain stepped-up basis, even though they are not included in the grantor's estate.
PPLI may be a better planning vehicle than regular life insurance because PPLI policies are generally less costly and they offer more investment options. The potentially higher income and growth of the additional investment options, coupled with the tax savings and could justify the lower cost of PPLI. Moreover, funds up to basis may be withdrawn from the policy during the life of the insured tax-free and funds that exceed basis may be borrowed tax-free at favorable terms. The value of this combination is illustrated in the example below.
Mr. Reyes, a 50-year-old executive, is preparing to relocate with his 50-year-old wife and two daughters to New York City. The Reyes' total liquid net worth is $33 million, held primarily in Mr. Reyes' name. The Reyes expect to spend approximately $750,000a year after their move. Mr. Reyes' after-tax compensation should be sufficient to cover these expenses. If Mr. Reyes continues to work for 10 more years, the Reyes will not need to draw from their savings to support their spending needs until 2027, when they are both 60.The Reyes are working with an attorney to reduce their taxable estate by implementing a pre-immigration estate-planning strategy. Their attorney advised Mr. Reyes to create and fund a drop-off trust for the benefit of his wife and daughters, but the Reyes are concerned about parting with too much wealth, given their relatively young age. They want help determining how much they can afford to devote to funding a drop-off trust. They are also unsure whether the drop-off trust should be domestic or foreign. Our analysis began by quantifying Mr. and Mrs. Reyes' core capital requirement: the liquid assets they need to have today to support their lifestyle for many years, based on their spending rate and life expectancy. To determine core capital with a high degree of confidence, one should assume poor capital-market returns, higher-than-expected inflation, and the possibility that Mr. and Mrs. Reyes could live to a very old age. Using Bernstein's Wealth Forecasting System, we calculated the core capital required to sustain the Reyes' spending for the next 40 years to be between $24 million and $28.3 million, depending on how the assets are invested (Display 1)
The top three most common myths on the subject of pre-immigration tax planning are:
1) Pre-immigration tax planning must be completed at least five (5) years prior to immigration.
2) A pre-immigration trust that is disregarded for U.S. Income Tax purposes is also disregarded for U.S. Estate and Gift Tax purposes.
3) Pre-immigration U.S. Estate and Gift Tax planning must be completed before entering the United States
- Pre-Immigration Tax Planning Must be Complete 5 Years Prior to Immigration
The reason this is such a common statement and where the myth arises is from the U.S. Tax Code Section 679(a)(4). This section provides that a trust settled within five (5) years of a person becoming a U.S. person will be treated as a grantor trust. This means, for income tax purposes, the individual is taxed on the income of the trust as if the income was made by that person individually. What does this mean?
It may be better to have the trust taxed as a grantor trust if the individual plans to permanently immigrate to the U.S. If an individual permanently immigrates to the U.S. and is not paying the taxes on the foreign trust then the U.S. will apply what is called a “throwback” tax on the accumulated income in the trust. This can end up causing a tax on the trust that will cost more than the income produced by the trust. This leads directly into the second point, it is important to speak with a professional to help you understand if you need:
- Pre-Immigration Income Tax planning, or
- Pre-Immigration Estate and Gift Tax planning.
- A Pre-Immigration Trust Disregarded for U.S. Income Tax Purposes is also Disregarded for U.S. Estate and Gift Tax Purposes
A foreign trust, settled within five (5) years of immigration to the United States is treated as a grantor trust, or “disregarded” by the U.S. for Income Tax purposes. However, the U.S. Income Tax Code and the U.S. Gift and Estate Tax Code are separate subtitles on the overall U.S. Tax Code. This means that each has specific definitions, provisions, and considerations that apply only to that specific subtitle. Section 679(a)(4) is one of those provisions that applies only to the U.S. Income Tax Code. This is well established and has been recognized by a House Report and the U.S. Treasury.
This means that a pre-immigration trust can be a great tool to avoid U.S. Estate and Gift Tax. Anything contributed to an appropriately established pre-immigration foreign trust will not considered part of your estate for U.S. Gift and Estate Tax purposes. For those planning to establish permanent residency in the United States this allows net worth to be reduced so the U.S. Estate Tax exemption will not be used on your foreign assets but will be utilized to shield your U.S. assets when you pass away and transfer those assets to your heirs.
Even if the five-year waiting period, discussed above, cannot be observed, there are still significant transfer tax advantages to contributing foreign property to a trust prior to immigrating to the U.S. The creation of an irrevocable foreign trust prior to moving to the U.S. and its funding with some, but not all, of a non-resident alien's (NRA) foreign assets can be an effective tool in protecting such assets from exposure to U.S. transfer taxation after the NRA's immigration to the U.S. As long as certain precautions are observed, the NRA's non-U.S. assets that are in the trust will not be subject to any U.S. estate tax and the trust's income may also be exempt from state and local taxes, depending on local law
- Pre-Immigration U.S. Estate and Gift Tax Planning Must be Completed Before Entering the United States
The U.S. Income Tax and U.S. Gift and Estate Tax Codes differ in their application to immigrants. While it is easy to become subject to the U.S. Income Tax without intending to (simply being present in the United States for 183 days in a year is sufficient), it is much more difficult to become subject to the U.S. Gift and Estate Tax.
The Gift and Estate Tax does not make “residency” subject an individual to tax nor contingent on days in the United States or immigration status. The Gift and Estate Tax code defines “residency” as domicile. What country does an individual regard as home? There are some objective factors that are considered to make this determination such as: location of permanent home, location of family, location of business connections, and many others. However, there are many factors to consider and even an individual who has been living in the United States for five years is not automatically subject to U.S. Gift and Estate Taxes. Therefore, it is possible that even after several years of residence in the United States “pre-immigration” planning opportunities exist for U.S. Gift and Estate Taxes.
Pre-immigration tax planning steps to mitigate US tax
You can take various steps before immigrating to the US to help lower your US tax bill. For any of these, you should consult an experienced tax advisor. Not doing it correctly may expose you not only to US taxes but also to other unintended consequences.
- Sell assets with significant unrealized gains, e.g., stock, stock options, shares of a business.
- Place assets you don't want to sell into a foreign company and do the check the box election.
- Optimize your non-US business for US tax by restructuring or electing the best tax treatment.
- Avoid PFICs (Passive Foreign Investment Companies) by divesting assets that would be considered PFICs in the US, i.e. foreign mutual funds, certain type of life insurances
- Consider an offshore trust or pre-immigration trust to protect assets and for succession planning;
Explore the Use of Insurance
Pre-immigration planning solutions may involve the use of life insurance. Whether it is a traditional whole life policy or a private placement life insurance policy (PPLI), insurance can enjoy the benefits of tax-free growth and distributions if properly titled and funded. Drop-off trusts can also be used in combination with PPLI. Remember that in the event the drop-off trust was established within five years of immigration and there are U.S. beneficiaries, the immigrant would still be subject to income tax on the assets in the trust (even if he or she had no access to them and did not receive distributions). A PPLI policy could provide substantial income tax savings in this scenario as the assets in the policy would not be subject to income tax. This type of policy can be less expensive than a traditional life insurance policy (as the death benefit is typically smaller) but can provide access to more investment options and the ability to access funds in a tax-efficient manner.
 The key to any pre-immigration trust transfers is not Section 679, but rather the various provisions set forth in Subtitle B, including the application of Sections 2031 through 2044.