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Expatriation from the United States: The Inheritance Tax Under I.R.C. §2801

Jul 01 2022

Article Written for:  Florida Bar Journal

In addition to the Exit Tax, the Heart Act added a new federal transfer tax, which imposes an “Inheritance Tax” on certain gifts or bequests (testamentary dispositions) made by a “covered expatriate” to U.S. recipients.

This is the second article in our two-part series on the expatriation tax.

The Inheritance Tax is payable by the recipient of the gift or bequest, not the expatriate. There is no expiration of the potential applicability of §2801. Thus, a gift or bequest made by a covered expatriate several years (or longer) after expatriation could trigger the tax. The Inheritance Tax is imposed in addition to the mark-to-market tax paid by the covered expatriate upon exit.[1] Currently, the tax rate imposed by §2801 is 40% of the value of the gift or bequest.[2]

U.S. citizens and residents are generally subject to U.S. gift and estate tax on worldwide assets. Non-resident aliens are not subject to U.S. gift and estate tax on foreign-situs assets. Section 2801 taxes U.S. citizens or residents who receive gifts and bequests from covered expatriates, which would otherwise have escaped U.S. transfer taxes (as a consequence of the donor’s expatriation). Transfers by covered expatriates are subject to a tax similar to the gift and estate tax (imposed under Subtitle B of the code) but saddle the donee with the Inheritance Tax.

The U.S. Treasury issued proposed regulations on §2801 on September 10, 2015.[3] The proposed regulations apply to taxpayers who receive “covered gifts” or “covered bequests” on or after the final regulations are published in the Federal Register. The proposed regulations generally provide insight into the IRS’s intended application of the §2801 Inheritance Tax.

Definitions Under §2801

• “Citizen or Resident of the United States” — A citizen or resident of the United States is an individual citizen or a resident as defined in Ch. 11 (Estate Tax) and Ch. 12 (Gift Tax) of the code, at the time of receipt of the covered gift or covered bequest.[4] Under §2801, the definition of U.S. citizens also includes domestic trusts (as defined under §7701(a)(30)(E)), as well as foreign trusts (as defined under §7701(a)(31)) electing to be treated as a domestic trust under Prop. Treas. Reg. §28.2801-5(d).[5]

• “Covered gift or bequest” — §2801(e)(1) generally provides that a “covered gift” means any gift acquired from a “covered expatriate” (even if mark-to-market tax is paid under §877A), when received by a U.S. citizen or resident. The definition applies (regardless of the situs of the asset given or whether the property was acquired by the covered expatriate before or after expatriation from the United States).[6]

A “covered bequest” includes any property acquired directly or indirectly by reason of the death[7] of an individual who, immediately before such death was a “covered expatriate” (regardless of the situs or whether such property was acquired by the covered expatriate before or after expatriation).[8] The taxation of the covered bequest applies (even if mark-to-market expatriation, deemed sale tax is paid under §877A). Gifts or bequests made to a charity or to the spouse of a covered expatriate (to the extent such gifts or bequests would be deductible for estate or gift tax purposes, if the decedent or donor were a U.S. person) are not taxed as “covered gifts or bequests.”[9] Charitable giving may, therefore, be a potentially viable strategy for mitigating tax under §2801.

• “Expatriate and Covered Expatriate” — The term “expatriate” is defined in §877A(g)(2) as “any U.S. citizen who relinquishes citizenship and any long-term resident of the United States who ceases to be a lawful permanent resident of the United States.” The term “covered expatriate” is defined in §877A(g)(1), as expatriates falling within the applicable minimum income, wealth, and the tax compliance standards outlined in our initial article, “The Tax Implications of Expatriation: The Exit Tax.” The determination of whether an individual is a “covered expatriate” is made as of the “expatriation date” as defined in §877A(g)(3). If the expatriate meets the definition, the expatriate is considered a “covered expatriate” (for the purposes of §2801) at all times subsequent to the expatriation date.

An expatriate is not treated as a “covered expatriate” during any period beginning after the expatriation date during which such individual is again subject to U.S. transfer taxes (under Ch. 11 or Ch. 12 of Subtitle B), as a U.S. citizen or resident. An individual’s status as a “covered expatriate” is determined as of the date of the most recent expatriation (if more than one).[10]

• “U.S. Recipient” — a U.S. recipient includes a U.S. citizen, a U.S. domiciliary, a domestic trust, an electing foreign trust, and “the U.S. citizen resident shareholders, partners, members, or other interest-holders, as the case may be (if any) if a domestic entity that receives a covered gift or covered bequest.”[11] For purposes of §2801, an individual donee of a covered gift or bequest is a “resident,” if domiciled in the U.S.[12]

Exceptions to §2801 Tax

Under the proposed regulations, certain transfers are exempt from the application of the §2801 Inheritance Tax.

• Reportable Taxable Gifts — A transfer of property that is a taxable gift under §2503(a) and is reported on the donor’s timely filed Form 709 is not a “covered gift” under §2801 (provided the donor also timely pays any gift tax owed). Note that gifts of value less than or equal to the §2503(b) exclusion amount (currently $16,000)[13] are not excluded from the definition of a “covered gift” under §2801.[14]

• Properties Subject to the U.S. Estate Tax — Property included in the gross estate of the “covered expatriate” and reported on a timely filed Form 706 or Form 706-NA is not a “covered bequest” under §2801, provided that the estate also timely pays any estate tax due. For example, under §2801, estate tax imposed on distributions from the remainder of a qualified domestic trust (QDOT) are deemed to be reported on a timely filed Form 706, if the tax due thereon was timely paid.[15]

• Transfers to Charities — A gift to a donee described in §2522(b) or a bequest to a beneficiary described in §2055(a) is not a “covered gift” or “covered bequest” (under §2801), to the extent a charitable deduction under §2522 or §2055 would have been allowed if the “covered expatriate” had been a U.S. citizen or resident at the time of transfer.[16]

• Transfers to Spouse — A transfer from a “covered expatriate” to the covered expatriate’s spouse is not a “covered gift” or “covered bequest” to the extent a marital deduction under §2523 or §2056 would have been allowed (if the “covered expatriate” had been a U.S. citizen or resident at the time of the transfer).[17]

• Qualified Disclaimers — A transfer pursuant to a qualified disclaimer by a “covered expatriate,” as defined in §2518(b), is not a “covered gift” or “covered bequest” under §2801.[18]

Application of §2801

A “covered beneficiary” means a U.S. citizen, a U.S. domiciliary, a domestic trust, an electing foreign trust, and “the U.S. citizen and resident shareholders, partners, members, or other interest-holders, as the case may be (if any) of a domestic entity that receives a covered gift or covered bequest.” Section 2801, thus, taxes U.S. trust beneficiaries who are domiciled in the United States on gifts or bequests by “covered expatriates.”

For U.S. estate tax purposes (and, thus, the application of §2801), “domicile” is determined under the U.S. Treasury Regulations, based on two elements: 1) physical presence and 2) intent to remain in the U.S.[19]

Liability for §2801 Inheritance Tax

A “covered beneficiary” who receives a “covered gift” or “covered bequest” is liable for payment of the §2801 tax. A foreign trust (absent an election to be treated as a domestic trust), which receives a “covered gift” or “covered bequest” is not liable for the payment of the §2801 tax. Each U.S. trust beneficiary is liable for payment of the §2801 tax upon receipt, either directly or indirectly, of a distribution from the foreign trust, to the extent the distribution is attributable[20] to a “covered gift” or “covered bequest” made to the foreign trust.[21]

Computation of §2801 Inheritance Tax

• Calculation of Tax — The §2801 tax is calculated by multiplying the “net covered gifts and covered bequests” received by a U.S. recipient during the calendar year by the greater of (as applicable) 1) the highest rate of estate tax under §2001(c) or 2) the highest rate of gift tax under §2502(a) that are currently equivalent.[22] For the purposes of this calculation, “net covered gifts and covered bequests” means the total value of all “covered gifts” and “covered bequests” received by the U.S. recipient during the calendar year, less the §2801(c) per-donee annual exclusion (currently $16,000).[23]

• Example of Calculating §2801 Tax — In Year 1, A, a U.S. citizen, receives a $100,000 covered gift from B and a $180,000 covered bequest from C. Both B and C are covered expatriates. In Year 1, the highest estate and gift tax rate is 40% and the §2801(c) exempt amount is $16,000 (for tax year 2022). A’s §2801 tax for Year 1 is computed by multiplying A’s net covered gifts and covered bequests by 40%. A’s net covered gifts and covered bequests for Year 1 are $264,000, which is determined by reducing A’s total covered gifts and covered bequests received during Year 1, $280,000 ($100,000 + $180,000), by the §2801(c) exempt amount of $16,000 per done exclusion. A’s §2801 tax liability is then reduced by any foreign estate or gift tax paid under §2801(d). Assuming A, B, and C paid no foreign estate or gift tax on the transfers, A’s §2801 tax liability for Year 1 is $105,600 (i.e., $264,000 x 0.4).

• Tax Basis for Payment of §2801 Tax — The U.S. recipient’s tax basis in property received as a “covered gift” or “covered bequest” is determined under §1015 and §1014, respectively.[24] As “covered bequests” are not includable in the decedent’s gross estate under title 11 of Subtitle B, the property acquired (by the U.S. recipient) will not receive a “step-up” in basis to fair market value (regardless of the any §2801 tax paid).[25] Likewise, any “covered gift” will be governed by the tax basis rules of §1015; and, thus, maintain a carryover basis from the donor.[26] While §1015(d) generally permits a basis step-up for the gift tax paid (under Ch. 12 of Subtitle B), it does not apply for any tax paid under §2801 for “covered gifts.”[27]

§2801 Tax Treatment of Foreign Trusts

A foreign trust (absent an election to be treated as a domestic trust), which receives a “covered gift” or “covered bequest” is not liable for the Inheritance Tax. U.S. beneficiaries of the trust are liable for the Inheritance Tax upon receipt of distributions from the foreign trust, to the extent attributable[28] to a “covered gift” or “covered bequest.” Trust beneficiaries incur Inheritance Tax upon receipt of covered gifts contributed to the foreign trust.[29]

For the purposes of §2801, a U.S. recipient receives a “distribution” upon transfer of property, directly or indirectly, or a constructive transfer, from a foreign trust.[30] This determination is made without regard to whether any portion of the trust is treated as owned by a U.S. resident or any other person under the grantor trust rules (of Subpart E Part I, subchapter J, Ch. 1 of the code) and without regard to whether the U.S. recipient of the transfer is designated as a beneficiary (by the terms of the trust).[31] Distributions also include the exercise, release, or lapse of a power of appointment, whether or not general in nature.[32]

Distributions to U.S. beneficiaries may be partially attributable to covered gifts. In such case, the covered portion (subject to §2801 tax) is determined by multiplying the fair market value of the distribution, as of December 31 of the preceding tax year, by a §2801 tax ratio which generally apportions the distribution based on the ratio of “covered gift” to non-covered gift property in the trust.[33] If valid records are not available, the §2801 Inheritance Tax is imposed on the entire trust corpus.[34]

• Effect of Election to be Treated as Domestic Trust — Domestic trusts are treated as U.S. citizens under §2801, immediately liable for tax upon receipt of a covered gift.[35] If a foreign trust elects to be treated as a domestic trust for §2801 purposes, it must pay the Inheritance Tax on all “covered gifts” and “covered bequests” received in the calendar year for which the election (i.e., Form 708) is filed.[36] If the electing foreign trust received “covered gifts” and “covered bequests” in prior tax years, it must also report and pay the §2801 tax on such property’s fair market value, determined as of the last day of the calendar year immediately preceding the year of the election (on the portion of the trust attributable to “covered gifts” and “covered bequests”).[37] The covered portion (subject to §2801 tax) is determined by multiplying the fair market value of the foreign trust, as of December 31 of the preceding tax year, by the applicable tax ratio of covered to non-covered trust assets.[38]

• Tax Basis for Property Distributed by Foreign Trust — The U.S. recipient’s tax basis in the property received from a foreign trust is not increased by the amount of §2801 tax paid by such beneficiary. Likewise, the foreign trust’s tax basis in the property subject to §2801 (after electing to be treated as a domestic trust for purposes of §2801) is not increased by the amount of §2801 tax paid.

• Logic of §2801 Tax Regime — While imposing a double tax (income/exit and transfer/inheritance) on property transferred, this tax regime is consistent with the treatment of other gifts or bequests made by non-resident aliens to U.S. citizens or residents. The U.S. recipient generally receives the transferor’s basis when assets are removed from the U.S. transfer tax base.

Note that any property subjected to the mark-to-market regime of §877A will have already received a fair market value tax basis “step-up,” based on the expatriation event.[39] As such, the §2801 tax regime ensures that “covered expatriates” may not conduct tax arbitrage. An expatriate (non-resident non-citizen) could otherwise transfer foreign or intangible property with an increased basis (post-expatriation) to U.S. citizens or residents, free of transfer tax.

The imposition of the §2801 tax on assets acquired by the “covered expatriate” after expatriation may be onerous. “Covered expatriates” receive no exemption for foreign or U.S. intangible covered gifts (even if acquired after expatriation). All non-U.S. situs assets acquired by the “covered expatriate” (after the expatriation event) are taxed at 40% if transferred to a U.S. citizen or resident. Moreover, the U.S. recipient (liable for the tax) will not obtain a basis increase for the §2801 tax paid. Compared to nonresident noncitizens, who may make tax free gifts of foreign-situs assets and intangible U.S.-situs property to U.S. residents, the §2811 basis transfer treats the recipient of a covered gift in a similar manner.

Part VI — Potential Planning Strategies to Mitigate “Inheritance Tax” Under 2801

A few options permit the proposed expatriate to gift assets sufficient to reduce his or her net worth below the $2 million net worth test for characterization as a covered expatriate. Please see our analysis in Expatriation from the United States: The Exit Tax.[40]

Another strategy (to avoid U.S. transfer taxes on foreign assets) is utilizing transfers by a green-card holder who has departed the U.S. (but before actually expatriating under the code). Although the green-card holder would remain a U.S. resident for U.S. income tax purposes, establishing domicile outside of the U.S.,[41] avoids tax residency (under Chs. 11 and 12 of Subtitle B of the code, Estate and Gift Taxes). Transfers made while as a non-resident, non-citizen for the purposes of Ch. 11 and Ch. 12 of Subtitle B (Estate and Gift Taxes) are not subject to U.S. transfer taxes unless the property is tangible and located in the U.S.[42] Under such circumstances, neither §877A or §2801 is triggered when the non-resident, non-citizen makes such transfers.[43]

The §2801 “Inheritance Tax” is potentially triggered upon a “covered expatriate” making a “covered gift or bequest” to a “covered beneficiary.” The selection of donees from a covered expatriate is, thus, critical to avoid the tax. A “covered beneficiary,” is a U.S. citizen, a U.S. domiciliary, a domestic trust, an electing foreign trust, and “the U.S. citizen resident shareholders, partners, members, or other interest-holders, as the case may be (if any) of a domestic entity that receives a covered gift or covered bequest.” Where possible, a covered expatriate should coordinate gifts to a non-U.S. recipient (such as a non-U.S. citizen or domiciliary).

Lastly, charitable donations that would qualify for the estate or gift tax charitable deduction are not “covered gifts or bequests.” Charitable giving may, therefore, be a potentially viable strategy for mitigating tax under §2801.

Under current tax laws, expatriation is a minefield of unfavorable tax consequences, both for those expatriating, and those who stand to inherit from those who have expatriated. However, there are planning opportunities to mitigate these consequences.

 

[1] See Gary Forster and J. Brian Page, Expatriation from the United States: The Exit Tax, 94 Fla. B. J. 60 (Nov./Dec. 2020), available at https://www.floridabar.org/the-florida-bar-journal/expatriation-from-the-united-states-the-exit-tax/.

[2] I.R.C. §2801(c).

[3] Reg. 112997-10, 26 C.F.R. Part 28 (Dec. 10, 2015).

[4] Accordingly, whether an individual is a “resident” is based on domicile (presence in the U.S. and an intent to remain), notwithstanding that §877A adopts the income tax definition of the term.

[5] Prop. Treas. Reg. §28.2801-2(b).

[6] Prop. Treas. Reg. §28.2801-2(g).

[7] The same meaning under Ch. 12 of Subtitle B, including, but not limited to, any transfer upon death by bequest, devise, trust provision, beneficiary designation or other contractual arrangement, or by operation of law. See Prop. Treas. Reg. §28.2801-3(b).

[8] Prop. Treas. Reg. §28.2801-2(f).

[9] I.R.C. §2801(e)(3).

[10] Prop. Treas. Reg. §28.2801-2(h).

[11] Prop. Treas. Reg. §28.2801-2(e).

[12] Prop. Treas. Reg. §28.2801-2(b).

[13] IRS Rev. Proc. 2021-45, 2021-48 IRB 764.

[14] Prop. Treas. Reg. §28.2801-3(c)(1).

[15] Prop. Treas. Reg. §28.2801-3(c)(2).

[16] Prop. Treas. Reg. §28.2801-3(c)(3).

[17] Prop. Treas. Reg. §28.2801-3(c)(4).

[18] Prop. Treas. Reg. §28.2801-3(c)(5).

[19] For the purposes of the Internal Revenue Code, “domicile” is defined as living within a country with no definite present intent of leaving. Determining domicile for estate and gift tax purposes (Subtitle B of the code) is fact specific. Once a non-citizen establishes the United States as their domicile, they remain a United States domiciliary until a new domicile is established. If there is doubt as to the location of domicile, there is a rebuttable presumption that the decedent was domiciled within the country where he or she resided. See Treas. Reg. §20.0-1(b)(1).

[20] As determined by Prop. Treas. Reg. §28.2801-5(b) and (c).

[21] Prop. Treas. Reg. §28.2801-4(a)(3).

[22] Prop. Treas. Reg. §28.2801-4(b)(1).

[23] Prop. Treas. Reg. §28.2801-4(b)(2).

[24] Prop. Treas. Reg. §28.2801-6(a).

[25] Treas. Reg. §1.1014-2(b)(2) — the fair market value basis step-up under §1014(a) does not apply for “property not includible in the decedent’s gross estate such as property not situated in the United States acquired from a nonresident who is not a citizen of the United States.”

[26] Treas. Reg. §1.1015-1(a).

[27] Treas. Reg. §1.1015-5.

[28] As determined by Prop. Treas. Reg. §28.2801-5(b) and (c).

[29] Prop. Treas. Reg. §28.2801-4(a)(3); Prop. Treas. Reg. §28.2801-4(a)(3).

[30] Prop. Treas. Reg. §28.2801-5(b).

[31] Id.

[32] Id.

[33] Id.

[34] Id.

[35] I.R.C. §2801(e)(4)(A).

[36] Prop. Treas. Reg. §28.2801-5(d).

[37] Prop. Treas. Reg. §28.2801-5(d)(3)(iii).

[38] Id.

[39] Section 877A(a); see also ¶C of §3, I.R.S. Notice 2009-85 (Nov. 9, 2009).

[40] See note 1.

[41] See discussion in Part V regarding the establishment of domicile; see Treas. Reg. §25.2501-1(b).

[42] I.R.C. §2501; Treas. Reg. §25.2501-1(a).

[43] Note that §877A is located in Subtitle A (Income Taxes); see also I.R.C. §7701(b)(1).

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