Practitioner's Guide to Preserving the Latino Legacy
I. Article INTRODUCTION
With each generation, Latin American immigrants are becoming wealthier and more aware of the need to work with California estate planners to protect their legacies. However, when a client from Latin America seeks an estate plan from a California estate planning attorney, the risk is that—though all parties might be speaking English—their communications will be hampered because the attorney and the client begin with different assumptions.
This article is designed to introduce California estate planning attorneys to some of the assumptions, needs, and understandings that many Latino clients bring to the estate planning process. The article also highlights many of the tax traps that can catch an estate planner who is working with a Latino client. After reading this article, the California estate planner should have a better idea of how best to communicate with, understand, and serve Latino clients. For convenience, reference will generally be made to Mexican laws and practices.
II. LEGAL SYSTEMS OF THE UNITED STATES AND MEXICO: IMPORTANT DIFFERENCES
While countless differences exist between the legal systems of the United States and Mexico, there are key distinctions that the practitioner should be aware of at the outset. Knowledge of these distinctions will allow the practitioner to clarify misconceptions routinely held by the Latino client.
A. Authorized Practitioners
Latino clients commonly confuse the role of a notary public in California with the role of a “Notario Publico” in Latin American countries. Importantly, a Mexican “Notario Publico” is licensed to prepare an estate plan. A California notary public is not.
In the United States, the chief purpose of a notary public is to prevent fraud by certifying the identification of signers of important documents. California notary publics are prohibited from practicing law. However, in Mexico, a “Notario Publico” practices law. A “Notario Publico” in Mexico must be a Mexican citizen by birth, have full legal capacity, be between 25 and 60 years of age, have a law degree, have at least three years of experience in a notary public office, and pass several rigorous exams. The Federal District in Mexico specifically requires that wills be executed, issued, and signed before a “Notario Publico.”
The California estate planning attorney should take steps to communicate the distinctions between a notary public licensed under California law and a “Notario Publico” licensed under Mexican law to his or her Latino clients, especially because the fees charged by a California notary public are significantly more attractive than the fees charged by a California attorney.
B. Marital Property
California is a community property state. The default rule is that, “Except as otherwise provided by statute, all property acquired by a married person during the marriage while domiciled in [California] is community property.” The key statutory exception, of course, is separate property, defined in Family Code section 770.
In Mexico, there is no community property default rule. Instead, the marrying parties must immediately declare whether the property acquired during their marriage will be held as community property or as separate property. Not with standing their election, spouses have the freedom to enter into an agreement of their own.
If the spouses elect to hold their marital property as community property, the surviving spouse will be the owner of the deceased spouse’s assets that the spouses acquired during marriage. However, the deceased spouse’s property acquired before the marriage will be disposed of according to the separate property regime discussed below, or according to the deceased spouse’s will. The surviving spouse is permitted to stay in possession of the property until it is disposed of.
If the spouses elect to hold their marital property as separate property, then the separate property regime applies. The separate property regime provides that if a deceased spouse dies without surviving issue, parents, or siblings, then the surviving spouse will be the sole heir. If the deceased spouse has surviving children, the surviving spouse is entitled to a portion that is equal to the children’s portion if the surviving spouse has no assets. If the surviving spouse has assets but with a value that is not equal to the portion to be inherited by the children, then the surviving spouse is entitled to receive an amount that is equal to the difference.
If the deceased spouse has a surviving parent(s), but no surviving children, then the deceased spouse’s separate property will be divided into two portions—one portion to the surviving spouse and the other portion to the surviving parent(s). Finally, if the deceased spouse has surviving siblings, but no surviving issue or parents, then two-thirds of the estate goes to the surviving spouse and the remaining one-third goes equally to the surviving siblings.
Due to the marital property regime in Mexico, Latino clients are familiar with the concepts of community property and separate property. However, they are typically unfamiliar with the concepts of joint tenancy and the right of survivorship. It is important that the practitioner take the time to explain these property concepts since spouses commonly hold title to real property in that form in California.
C. No Estate and Gift Tax in Mexico
The most important difference between the United States and Mexican tax regimes for the California estate planning attorney to be aware of is that Mexico has no estate or gift tax. Another important difference is that, unlike in California, an inheritance in Mexico is considered income to the beneficiary. However, an inheritance is tax-exempt under the Mexican Income Tax Law if properly reported to the Mexican Tax Authorities.
D. Estate Planning Documents
California practitioners should be aware that the will, or “testamento,” is the primary estate planning document used in Mexico to transfer assets on death. Additionally, there are numerous types of “testamentos” that are classified as either ordinary wills prepared under ordinary circumstances by a “Notario Publico,” or as special wills created under extraordinary circumstances without a “Notario Publico.” It is beneficial to explain to Latino clients the somewhat more simplified approach to wills in California and that, in California, a will typically plays a secondary role when prepared in an estate plan that includes a revocable trust.
The notion that the will may not be the primary estate planning document is strange to the Latino client. When a Mexican citizen dies in Mexico with a valid “testamento” directing the disposition of his or her property in Mexico, there is no probate process as would be typical in California. Instead, there is an estate administration process comparable to trust administration in California. The executor, or “albacea,” of a Mexican “testamento” is tasked with managing, protecting, and dividing the property of the estate, and with carrying out the distributions set forth in the “testamento.” Because a will is all that is required to accomplish a transfer of assets upon death in Mexico and other Latin American countries without the necessity of a court-supervised administration, Latino clients in California often make the error of preparing only a will, believing that a will is all that is required to avoid a court- supervised probate administration in California as well.
California practitioners should also be aware that the trust is a creation of the common law system. Civil law countries, such as Mexico, have no equivalent to the revocable living trust. There are only comparable substitutes that accomplish “individual trust-like goals.” Mexico has a statutory trust substitute, or “fideicomiso,” that has only seen limited use as a family estate planning technique. The “fideicomiso” has failed to become an important estate planning tool largely because self-declared “fideicomisos” are not permitted and only Mexican banking institutions may serve as trustees. Furthermore, the discretion of the bank to make investments is quite limited and individuals born after the death of the settlor cannot be beneficiaries of the “fideicomiso.”
As a result, Latino clients are largely familiar with the “fideicomiso” as a bank trust loophole for foreign nationals, rather than as a family estate planning tool. Under Mexican law, foreign nationals and foreign entities “cannot acquire direct ownership of lands or waters within a zone of one hundred kilometers along the frontiers and of fifty kilometers along the shores of the country.” To work around this restriction, foreign nationals and foreign entities often set up a “fideicomiso” through Mexican banks. The bank holds title to the real property on the foreigner’s behalf and the foreigner is the sole beneficiary.
E. The Validity of California Wills and Trusts in Mexico
The validity of a California will in Mexico that addresses property in Mexico is a question commonly asked by Latino clients. According to the Federal Civil Code in Mexico: “Wills made in a foreign country shall be effective in the Federal District and Territories if made in accordance with the laws of the country where they were executed.” Therefore, as long as the will is valid in California, it will also be valid in Mexico. However, it is still recommended that Latino clients dispose of their property in Mexico with a Mexican “testamento” because the process of having a California will recognized in Mexico is lengthy and expensive, while the process of probating a “testamento” is quick and inexpensive.
As discussed previously, trusts are a creation of the common law system. Civil law countries, such as Mexico, generally deny recognition of United States trusts.
III. TAX CONSIDERATIONS FOR THE LATINO CLIENT
The tax liability of the Latino client ultimately depends on his or her citizenship and residence. The Internal Revenue Code differentiates between United States citizens, resident aliens, and non-resident aliens. United States citizens and resident aliens receive similar treatment for income tax and estate and gift tax purposes. However, non-resident aliens are treated much differently.
The determination of a person’s residence is complicated because “residence” means one thing for income tax purposes, but something entirely different for estate and gift tax purposes. As explained below, the federal income tax regime has one set of tests to determine residence, and the federal estate tax regime has another. The process of determining residence and the applicable tax system may be further complicated by the existence of a tax treaty between the United States and the foreign country in question. Currently, the United States is party to income tax treaties with 68 countries and estate and gift tax treaties with 17 countries. Several of these are treaties with countries in Latin America. Due to the treaties, it is possible for a Latino client to meet the requirements of residence in the United States under the rules of the Internal Revenue Code, yet nevertheless be classified as a non-resident alien pursuant to a tax treaty.
Given the complexity surrounding the determination of residence, it is important that the practitioner undertake the daunting task of determining the applicable laws and treaties as well as the Latino client’s activities in both the United States and his or her home country to advise the client on his or her tax situation.
A. Income Taxation
1. Residence Requirements
The residence requirements for income taxation as applied to the individual have a direct effect on the income taxation of trusts. According to Internal Revenue Code Section 7701(b), an “alien individual” is a “resident” of the United States for a calendar year “if and only if” the alien individual meets one of three bright line tests: 1) Permanent Residence Test; 2) Substantial Presence Test; or 3) First Year Election.
An alien individual will be deemed a resident of the United States for income tax purposes under the Permanent Residence Test if the United States has granted the individual permanent residency in accordance with immigration laws “at any time during such calendar year.” With certain exceptions, the alien individual meets the Permanent Residence Test if he or she is a lawful permanent resident by reason of possessing a Permanent Resident Card, or green card, issued by the United States.
An alien individual will be deemed a resident of the United States for income tax purposes under the Substantial Presence Test if he or she has a substantial presence in the United States. An alien individual has a substantial presence in the United States if he or she has been physically present in the United States for the total of at least 183 days over the course of the current calendar year and two preceding calendar years—a three-year period that includes the current year. Additionally, the foreign individual must have been present in the United States for at least 31 days during the current calendar year. To further complicate the determination of residence, Treasury Regulations Section 301.7701(b)-3 lists particular days of presence in the United States that are excluded for purposes of the 183-day requirement. Of particular note for the practitioner working with the Latino client is that days spent in the United States by a foreign individual who regularly commutes from Mexico to the United States for employment are not treated as days present in the United States on any day during which he or she commutes.
Finally, an alien individual will be deemed a resident of the United States for income tax purposes if he or she makes a First-Year Election. The alien individual may only make this election if he or she did not meet the Permanent Residence Test in the election year or in the immediately preceding year, but will meet the Permanent Residence Test in the following year. To make this election, the alien individual must be present in the United States for at least 75 percent of the 31 consecutive day testing period. This permits a 5-day absence during the 31-day period. If the individual meets the Substantial Presence Test for the following year, he or she may make a First-Year Election in the present year and will be treated as a resident of the United States for the election year.
United States citizens and alien individuals who are deemed residents of the United States under the foregoing tests are subject to income tax on their worldwide income.
2. United States – Mexico Income Tax Treaty
A client may be considered a resident of both the United States and Mexico for income tax purposes. In such cases, the bright line tests for residence discussed above are not necessarily determinative; the United States – Mexico tax treaty may override the Internal Revenue Code and deem the individual to be a nonresident for United States income tax purposes.
To reduce the double income taxation of individuals who meet residency requirements in both countries, the United States and Mexico signed in 1992 the Convention Between the Governments of the United States of America and the Government of the United Mexican States for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion with Respect to Taxes on Income (“the Treaty”). The Treaty applies to all persons who qualify as a resident of either or both the United States and Mexico.
According to Article 4 of the Treaty, if an individual is a resident of both the United States and Mexico under the laws of two countries, then for purposes of income taxation, the individual will be considered a resident of the country in which he or she has a permanent home. If the individual has a permanent home in both the United States and Mexico, then the individual is a resident of the country in which his or her personal and economic ties are “closer.” The Treaty refers to this as the individual’s “center of vital interests.”
If the country in which the individual has his or her center of vital interests cannot be determined, or if the individual does not have a permanent home in either country, then the individual will be considered a resident of the country in which he or she has “an habitual abode.” If the individual has no habitual abode in either country, or has an habitual abode in both the United States and Mexico, then the individual will be deemed a resident of the country in which he or she is considered a national. If, after all these considerations, the individual’s residency still cannot be determined, then the competent authorities of the United States and Mexico will determine the individual’s residence by mutual agreement.
3. Residence of Trusts: Domestic v. Foreign
The United States imposes income taxes on trusts and thus, like individuals, trusts are also subject to residency determinations. The residence of a trust is either domestic or foreign. Foreign trusts are subject to additional federal tax reporting requirements beyond the standard income tax filings for domestic trusts. As further discussed below, the California practitioner must be cautious not to convert a domestic trust to a foreign trust inadvertently.
Under the Internal Revenue Code, a “United States person” includes “any trust” if both a “court test” and a “control test” are satisfied.” The “court test” is satisfied if a court in the United States is able to exercise primary supervision over the administration of the trust. A trust generally satisfies the “court test” if the trust instrument does not direct that the trust be administered outside of the United States, the trust is in fact administered exclusively in the United States, and the trust is not subject to an automatic migration provision.
The “control test” is satisfied if one or more United States persons have the authority to control all substantial decisions of the trust. Substantial decisions are those that persons are required to make under the terms of the trust, such as whether and when to distribute income or corpus, the amount of any distribution, whether to remove or replace a trustee, and investment decisions. Ministerial decisions such as bookkeeping, collection of rents, and execution of investment decisions are not considered substantial.
A trust that does not meet both the court test and the control test is a foreign trust. Therefore, the residence of any person named in the trust with the authority to make substantial trust decisions, such as the trustee or successor trustee, is as consequential as the residence of the grantor in determining the residence of the trust.
The Latino client with United States citizenship or a green card will commonly designate a family member in Mexico as his or her successor trustee. Because the nomination of a non- resident trustee can expose the trust to additional United States tax reporting requirements and potential related penalties, the practitioner must inquire into the residence of every person involved in the trust, not just the grantor.
The residence of a substantial decision-maker may change over time, such as when a United States green card holder returns to Mexico or to his or her home country permanently. In such a situation, if the changed circumstances of the decision- maker were inadvertent (i.e., death, incapacity, resignation, or change in residency) and the change would cause the domestic or foreign residency of the trust to change, the trust is allowed 12 months from the date of the change to make corrective adjustments to the persons with decision-making power or the residence of such persons.
When drafting a trust for a Latino client whose residence is not completely clear or may come into question, or if it is foreseeable that the residence of a substantial decision maker will change, it is advisable to include a provision in the trust instrument that specifically states that only a court in the United States is able to exercise primary supervision over the administration of the trust, that only a “United States person” shall have authority to make substantial trust decisions, and that any provisions in the trust to the contrary will be void in favor of a United States court or person.
4. Reporting Requirements for Foreign Trusts
The Internal Revenue Code imposes additional reporting requirements on foreign trusts. Any responsible party with decision-making power over a foreign trust must report specific trust information to the Internal Revenue Service upon the occurrence of a reportable event. Reportable events include the creation of a foreign trust by a United States person, the transfer of money or property to a foreign trust by a United States person, and the death of a citizen or resident of the United States if the decedent was treated as the owner of any portion of a foreign trust or any portion of the foreign trust was included in the gross estate of the decedent. Responsible parties include grantors, transferors, owners, executors, trustees, and beneficiaries.
The responsible party must report the name of the trust, the aggregate amount of distributions received from the trust during the taxable year, and any other information the Secretary of the Treasury may prescribe. The penalty for failure to file the required information is the greater of $10,000 or 35 percent of the gross value of the property transferred to a foreign trust or the distribution from a foreign trust that is received. The practitioner should keep in mind that a foreign trust can easily be created by a grantor who merely designates a trustee who is not a resident of the United States.
5. Income Taxation of Grantor Trusts
Generally, the income and gains of a trust are taxed in one of two ways—directly to the grantor as part of his or her regular income taxes or as an entirely separate taxpayer.
A grantor trust is one in which the creator, or grantor, retains certain interests or powers over the trust property. Due to these retained powers, the grantor is considered the owner and the trust income is taxed directly to the grantor. The grantor trust is not a separate taxpayer apart from the grantor and income tax is based on the residence of the grantor; i.e., whether the grantor is a United States citizen or resident, or a non-resident alien.
When working with the Latino client, the practitioner must be sensitive to the following two common situations in which trusts that seem routine are actually (or can become) foreign grantor trusts, subject to additional reporting requirements.
First, if a trust is created by someone who is not a United States citizen or resident, and is therefore a non-resident alien for income tax purposes, the trust itself will still be considered a grantor trust for federal income tax purposes if: (1) the grantor alone, or with the consent of a related or subordinate party who is subservient to the grantor, has the power to revoke the trust; or (2) distributions from the trust may be made only to the grantor or the grantor’s spouse during the grantor’s lifetime. This is what is known as a “foreign grantor trust” and commonly occurs when a non-resident alien creates a standard revocable living trust to benefit his or her children (who are United States residents or citizens) after his or her death.
Another common way that a foreign grantor trust can inadvertently come into being is when a Latino client who is a United States citizen or resident nominates a successor trustee who is a citizen and resident of a foreign country. Since it is common for the Latino client to wish to place trusted family members who may still reside outside of the United States in positions of responsibility, the practitioner should be aware of the danger that a trust that seems routine may, in fact, become a foreign grantor trust. As discussed above, the Internal Revenue Code imposes additional reporting requirements on foreign trusts and the penalty for failure to file the required information is the greater of $10,000 or 35 percent of the gross value of the property transferred to a foreign trust or the distribution from a foreign trust that is received.
6. Income Taxation of Non-Grantor Trusts
A non-grantor trust is one in which the creator of the trust funds the trust with his or her own assets but has given up all ownership and control of those assets. Because of this, the non-grantor trust is treated as a taxpayer separate from the grantor. The income tax on a non-grantor trust is based on the residence of the trust.
As discussed in the section above, the residence of a trust is either domestic or foreign. A domestic non-grantor trust, which is treated similarly to a citizen or resident of the United States, will pay income tax on its worldwide income and capital gains. A foreign non-grantor trust, which is treated similar to a non-resident alien, will pay income tax only on United States source income and capital gains.
In calculating the taxable income of a non-grantor trust, the trust receives a deduction against current year income for the amount of distributable net income (“DNI”) that is actually distributed to the beneficiaries. In turn, the beneficiaries of a non-grantor trust are taxed on their share of the trust’s DNI. Therefore, the trust’s taxable income is reduced by the amount of DNI distributed, and the United States beneficiary’s taxable income is increased by the amount of DNI received. This is the case for both domestic non-grantor trusts and foreign non- grantor trusts with United States beneficiaries.
7. Income Taxation of Foreign Non-Grantor Trusts
The difference in taxation between a domestic non- grantor trust and a foreign non-grantor trust arises from the accumulation of income. Currently, domestic trusts are taxed at higher rates than individuals. Therefore, trustees have an incentive to distribute income to the beneficiaries of a domestic non-grantor trust each year rather than accumulate it.
In the case of foreign non-grantor trusts, the incentive is just the opposite. There is an incentive to accumulate income in the foreign non-grantor trust rather than distribute it to the beneficiaries because the trust pays United States income tax only on income from United States sources. Trust income can be accumulated in a foreign trust and the United States tax on foreign source income deferred until a distribution is made to a United States beneficiary.
To disincentivize this deferral of tax, the DNI of a foreign non-grantor trust, unlike a domestic non-grantor trust, includes capital gains in current year income. Other current year income will be taxed as ordinary income to the United States beneficiary, and the capital gains portion will be taxed at the capital gains rate. Capital gains of a domestic non-grantor trust are taxed to the trust rather than the United States beneficiary.
As a further disincentive, DNI of a foreign non-grantor trust that is not distributed within 65 days of the end of the year in which it was made becomes undistributed net income (“UNI”). If, in the future, a distribution is made that exceeds the DNI made by the trust that year, the excess amount is treated as UNI from the previous year or years. Interest is charged on this UNI for the underpayment of tax and is compounded over the length of time that the income accumulated in the trust. This “throwback tax rule” was added to capture the amount of tax that would have been paid if income had been distributed from the trust and taxed to the beneficiary in the years it was originally earned.
Finally, as discussed above, United States beneficiaries must also comply with foreign trust reporting requirements.
B. Estate and Gift Taxation of United States Citizens and Residents
1. Residence Requirements
As noted previously, the residence of an individual for United States income tax purposes is defined differently than for United States estate and gift tax purposes. Residence for income tax purposes can be determined according to one of the three bright line tests outlined above. However, residence for estate and gift tax purposes depends on numerous less definitive factors and circumstances. As a result, it is possible for an individual to be deemed a resident of the United States for income tax purposes, but not a resident of the United States for estate and gift tax purposes.
A resident of the United States for estate and gift tax purposes is an individual who, at the time of his or her death or at the time the gift was made, was domiciled in the United States. An individual acquires domicile in the United States by physically living there, even for a brief period, with no definite present intent of later moving therefrom. Residence without the intent to remain indefinitely is insufficient to constitute domicile. Similarly, the intent to change domicile will not suffice without actual removal.
As physical presence is easily determined, the subjective element of intent is often the point of contention when transfer taxes are at issue. The courts consider a variety of factors to determine whether the individual possessed the requisite intent to remain in the United States indefinitely. These factors include the duration and purpose of each stay in the United States and other countries, immigration status, home ownership, the type and cost of dwelling places in the United States, location of business interests, location of close friends and family, places where the individual has a driver’s license or voter registration, and address or declaration of intent on legal documents.
The following cases demonstrate how nuanced the question of domiciliary intent can be. In Estate of Robert A. Jack v. U.S., the court held that even if an individual possesses a temporary, non-immigration work visa and even if that individual’s formation of an intent to remain indefinitely would violate the terms of that visa, the individual could have, as a factual matter, formed the intent to remain in the United States and could, therefore, be determined to be a resident of the United States for estate and gift tax purposes. In Estate of Khan v. Commissioner,101 the court found that a Pakistani citizen who lived in Pakistan all his life except for a period of seven years when he resided in the United States and tended to his business and property interests in the United States, and who died in Pakistan four years after returning there, was nevertheless domiciled in the United States for estate tax purposes. The court found domiciliary intent due to factors such as having entered the United States on a permanent resident visa and having obtained a green card and social security number with the intent to stay and tend to his more significant business interests in the United States. The court determined that he had only returned to Pakistan to resolve family and business matters there. Perhaps importantly, the decedent had attempted to obtain a United States re-entry permit when he left for Pakistan.
Due to the subjective nature of intent and the lack of a bright line test, the practitioner must carefully interview the Latino client about his or her family life and business interests in both countries, including his or her immigration history, lengths of stay in Mexico and the United States, and the purposes of such stays. These factors will determine how a court might rule on domicile for estate tax purposes at the time of the Latino client’s death.
2. No United States – Mexico Estate and Gift Tax Treaty
No estate and gift tax treaty currently exists between the United States and Mexico.
3. Gift Tax – Citizens and Residents of the United States
Citizens and residents of the United States are subject to a gift tax on all transfers of property by gift wherever located. Residents of the United States are treated much like citizens of the United States, with minor differences. The tax liability for both citizens and residents of the United States is determined by first calculating the amount of the taxable gift, which is the fair market value of the gift at the time it was made, less certain exclusions and deductions. Both citizens and residents of the United States are entitled to an indexed applicable exclusion amount (currently, $11,400,000) against gift taxation for lifetime gifts, an indexed annual exclusion for gifts (currently, $15,000), and an unlimited exclusion for gifts to qualified charities and for educational expenses and medical expenses.
The unlimited exclusion for gifts to spouses applies only to gifts to spouses who are themselves citizens of the United States. Citizens or residents who make gifts to non-citizen spouses are entitled to an indexed annual exclusion that is currently just $152,000.
4. Estate Tax – Citizens and Residents of the United States
Both citizens and residents of the United States are subject to an estate tax on their gross estate at death. The value of the gross estate is the value at the time of death of all property, real or personal, tangible or intangible, wherever situated. Citizens and residents are taxed similarly, except as to the marital deduction.
Both citizens and residents are entitled to the unlimited charitable deduction. Also, both are entitled to an indexed applicable exclusion amount (currently, $11,400,000). However, as with gifts, the unlimited marital deduction applies only to transfer to spouses who are themselves citizens of the United States. Transfers at death to a resident or non-citizen spouse are eligible for the estate tax marital deduction only if they meet the Qualified Domestic Trust (QDOT) requirements discussed below.
C. Estate and Gift Taxation of Non-Resident Aliens
A non-resident alien for estate and gift tax purposes is an individual who is not a citizen or resident of the United States and is also not domiciled in the United States at death or at the time the gift is made.120 Because the requirements of domicile in the United States are met easily, it is unlikely that the typical Latino client will be considered a non-resident alien for estate and gift tax purposes. Often, the Latino client is physically present in the United States with the intent to remain indefinitely.
The Latino client’s situation may change in the future. Many immigrants hope to return to their home countries when their children are adults. After the return home, the Latino client becomes a non-resident alien for estate and gift tax purposes and a foreign grantor for income tax purposes. The foreign grantor provisions discussed previously will apply.
1. Gift Tax – Non-Resident Aliens
Non-resident aliens are subject to a gift tax only on gifts of real property and tangible personal property located in the United States. As opposed to citizens and residents, a non- resident alien’s gifts of intangible personal property, even if situated in the United States, are generally exempt from gift taxation. The amount of the taxable gift is the fair market value of the gift at the time it was made less certain exclusions and deductions.
Non-resident aliens are entitled to the indexed annual gift tax exclusion (currently $15,000) and unlimited exclusions for gifts for education and medical expenses. Non-resident aliens may also make unlimited gifts to United States charities. Similar to citizens and residents of the United States, a non- resident alien may claim an unlimited marital deduction for property transferred to his or her spouse, but only if the spouse is a citizen of the United States. If the spouse is not a citizen, then the marital deduction is capped at an indexed amount that is currently $152,000. Lifetime gifts in excess of the indexed marital deduction amount to a non-citizen spouse will require the transferring spouse to use a portion of his or her applicable exclusion amount.
Gift splitting allows one spouse to make a gift to any person other than his or her spouse and the gift will be considered as made one-half by the gifting spouse and one-half by the other spouse. Non-resident aliens are not entitled to gift splitting because gift splitting requires that both spouses be citizens or residents of the United States.
The practitioner should pay close attention to which assets are considered property with situs in the United States and which are not. Assets that are considered as having situs in the United States for estate tax purposes and subject to the estate tax are not necessarily subject to the gift tax. Stock is an example of this distinction. Gifted shares of domestic stocks are considered intangible personal property and are not subject to the gift tax. For estate tax purposes, domestic stock is considered property with its situs in the United States and is subject to the estate tax.
2. Estate Tax – Non-Resident Aliens
The gross estate of a non-resident alien includes all property, real or personal, tangible or intangible, that is situated in the United States at the time of death. Assets that are generally considered to be situated in the United States and therefore included in the gross estate of a non-resident alien are real property located in the United States, tangible personal property located in the United States (except for works of art on loan for exhibition), shares of stock issued by a domestic corporation (regardless of the location of the certificates), United States debt obligations, deposits with a domestic branch of a foreign corporation that is engaged in the commercial banking business, and property transfers by the decedent that are taxable under Internal Revenue Code sections 2035-2038 if situated in the United States at the time of death or transfer.
Assets that are normally not considered to be situated in the United States and not subject to estate tax include real property outside the United States, tangible personal property located outside the United States, shares of stock issued by a foreign corporation (regardless of the location of the certificates), life insurance proceeds on the life of a non-resident decedent if owned by the non-resident decedent, deposits at a bank, savings institution, or insurance company described in Internal Revenue Code section 871(i)(3), and deposits with a foreign branch of a domestic corporation if that branch is engaged in the commercial banking business. Certain debt obligations and certain original discount obligations are also not considered as property situated in the United States.
The non-resident decedent’s gross estate is then reduced by certain deductions. Deductions are permitted under sections 2053 and 2054 for expenses, indebtedness, and taxes, and for losses whether they were incurred within or without the United States. Estates of non-resident decedents are also allowed a deduction for charitable gifts, but the deduction is limited to charitable gifts made to the government of the United States for public purposes, domestic charitable organizations, or domestic charitable trusts.
Important to note for the practitioner is that the amount that the non-resident decedent’s estate may deduct is determined by the proportion of the value of the gross estate situated in the United States to the value of all estate property located outside the United States. This information must be reported on the resident decedent’s estate tax return for the deductions to be taken. Because citizens and residents of the United States are taxed on their worldwide income, clients may not wish to disclose their property located outside of the United States to receive these deductions, even though such asset disclosure is required.
While estate tax rates are the same for citizens and residents of the United States and for non-resident aliens, non-resident aliens are entitled to an indexed unified credit that is currently just $60,000 compared to the current $11,400,000 allowed to citizens and residents of the United States. Non-resident aliens are nevertheless entitled to an unlimited marital deduction for transfers to a spouse if that spouse is a citizen of the United States. If the spouse is a resident or non-resident alien, then the estate tax martial deduction can only be utilized if the assets are transferred to the non-citizen spouse by a QDOT.
D. TheQualifiedDomesticTrust:EstatePlanning for Transfers to a Non-Citizen Spouse
The practitioner may work with mixed-status families in which one spouse is a citizen of the United States and the other is not. Fearful of disclosing his or her presence in the United States, the non-citizen spouse may either remove his or her name from title to marital property or never take title to marital property. In such cases, marital assets are frequently held either only in the name of the citizen spouse or the name of the citizen spouse along with one or more of their adult children (as discussed above). Both spouses tend to mistakenly believe that the citizen spouse cannot leave assets to the non-citizen spouse upon his or her death because he or she is not a legal resident. This is a common misconception.
Although the non-citizen spouse will likely satisfy the easily met requirements for domicile and qualify as a resident of the United States for estate tax purposes when the citizen spouse dies, the deceased citizen spouse will not be able to take advantage of the unlimited marital deduction without utilizing a QDOT. On the other hand, if the non-citizen spouse passes first and is found to be domiciled in the United States, the non- citizen spouse will be able to take advantage of the unlimited marital deduction without use of the QDOT because the surviving spouse is a citizen.
Because of the risk that the non-citizen surviving spouse will leave the country permanently after the death of the United States citizen spouse, the QDOT rules were imposed to ensure that the federal taxes deferred at the death of the first spouse are paid at the second spouse’s death. To qualify as a QDOT, the trust instrument must satisfy several requirements: 1) it must require that at least one trustee of the trust be an individual citizen of the United States or a domestic corporation; 2) it must provide that no distribution (other than distribution of income) may be made from the trust unless a trustee who is a citizen of the United States or a domestic corporation has the right to withhold from such distribution the tax imposed by Internal Revenue Code section 2056A; and 3) if the assets being transferred to the QDOT exceed $2 million, it must require that the trustee be a domestic bank, the trustee post bond in an amount equal to 65 percent of the value of the trust, or that the trustee must furnish an irrevocable letter of credit issued by a domestic bank in the amount of 65 percent of the value of the trust.
A QDOT trust instrument cannot allow principal distributions to anyone other than the surviving spouse during his or her lifetime. Any principal distributions, except those made for hardship, will be subject to estate tax as if it had been included in the decedent’s taxable estate at death. The executor of the deceased spouse’s estate must elect to apply the QDOT rules on the estate tax return. If the trust instrument ceases to meet the QDOT requirements, the estate tax is imposed on the value of the trust upon the date it ceases to comply.
If the non-citizen spouse become a United States citizen before the decedent’s estate tax return is filed, the QDOT is no longer required as long as the surviving spouse resided in the United States during the time between the decedent’s death and acquiring citizenship.
The following table, originally created by E. M. Lanza, and updated here, summarizes the tax issues discussed above.
IV. OTHER CONSIDERATIONS: DEPORTATION PLANNING
When working with Latino clients, the practitioner may be asked to assist an individual who is undocumented. Because of his or her undocumented status, this individual’s estate plan may require non-traditional documents or special provisions in traditional estate planning documents. Individuals who face the possibility of detention or deportation should always be advised to seek the legal advice of an immigration attorney. However, anticipatory planning using an estate planner’s tools also can assist the client in dealing with the difficulties inherent in deportation.
A. Power of Attorney Effective Immediately
If an undocumented Latino client is detained or deported, it will be difficult for him or her to sell real property, manage financial assets, wind down a business, negotiate contracts, or hire counsel. A power of attorney allows the Latino client to authorize another person to act for him or her in these types of transactions in the event of detention and/or deportation. It is recommended that the Latino client’s power of attorney be one that is effective immediately, rather than upon incapacity, as the determination of the capacity of a person deported to Mexico could be problematic.
Typically, time is of the essence in detainment and deportation proceedings, so the agent must be able to act quickly and without having to notify financial institutions of the Latino client’s capacity or immigration status. The agent, or attorney-in-fact, should have the power to manage, dispose of, sell, and convey the Latino client’s real and personal property, or use the property as security if the agent must borrow money on the Latino client’s behalf. The agent should be a citizen of the United States or legal permanent resident, so that the agent’s status, itself, does not come into question.
B. Childcare Plan
The undocumented Latino client should be advised to create a childcare plan to provide for minor children if he or she is detained and/or deported. A childcare plan involves appointing another adult who can raise the child in the parent’s absence until the child reaches 18 years of age. The most formal method for accomplishing this is the appointment of a guardian by a California probate court. However, given the Latino client’s status, this may not be the best course of action.
An alternative to a formal guardianship is the Caregiver’s Authorization Affidavit. An adult with whom a child is living has the power to complete a statutory form “Caregiver’s Authorization Affidavit” giving the caregiver, at a minimum, the power to “enroll the minor in school and consent to school-related medical care on behalf of the minor.” If the caregiver is a relative of the minor, and properly completes the form, the caregiver has “the same rights to authorize medical care and dental care of the minor that are given to guardians under Section 2353 of the Probate Code.” The Caregiver’s Authorization Affidavit terminates when the minor stops living with the caregiver.
Although the Caregiver’s Authorization Affidavit does not grant legal custody of a minor, as would a formal guardianship, it is a simpler and less costly method of providing short-term care for a minor child in an emergency such as deportation.
Due to the differences in succession planning between the United States and Latin America, and sometimes a language barrier, California attorneys and Latino clients may begin the estate planning process with different assumptions. Awareness of the issues discussed in this article will enable the practitioner to better serve the Latino client.
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