Estate and Elder Law

A New (2008) Tax On You At The Top Gift And/Or Estate Tax Rate If You Receive A Gift Or Bequest From A “Covered Expatriate”; Who Is That?

Section 301 of the Heroes Earnings Assistance and Relief Tax ("HEART") Act of 2008 added new sections 877A and 2801 to the Internal Revenue Code ("IRC").  These sections generally apply to any U.S. citizen who relinquishes his or her U.S. citizenship and any long-term resident of the U.S. who ceases to be a lawful permanent resident of the U.S. (referred to in the HEART Act as an "expatriate") on or after June 17, 2008.

COVERED EXPATRIATE

A "covered expatriate" is an expatriate who either (1) satisfies (a) the "tax liability test" with respect to his or her average annual net income tax liability for the five preceding taxable years ending before the date of expatriation or (b) the "net worth test" as of the date of expatriation, or (2) fails to certify, under penalty of perjury, that he or she is in compliance with all U.S. tax obligations for the five taxable years preceding the taxable year that includes the expatriation date (the "tax compliance test") as of the date of expatriation.

DEEMED SALE

Section 877A(a)(1) provides that in general, all property of a covered expatriate "shall be treated as sold on the day before the expatriation date for its fair market value."  The 23‑page Notice 2009-85 (Internal Revenue Bulletin: 2009-45) provides helpful guidance for individuals who are subject to that section, pending the issuance of regulations under it.  IRC Section 877 (Expatriation to Avoid Tax) continues to apply to individuals who relinquished U.S. citizenship or ceased to be lawful permanent residents before June 17, 2008.

TAX ON RECIPIENT - AND AT TOP RATE

Section 2801 generally imposes a tax on the value of property transferred by gift or bequest from a covered expatriate to a U.S. citizen or resident (including a domestic trust) equal to the product of (1) the highest estate or gift tax rate in effect at that time and (2) the value of that "covered gift or bequest."  Unlike gift and estate taxes, the tax under Section 2801 is imposed on the person receiving the gift or bequest rather than the donor or the decedent's estate.  However, the amount of tax is reduced by the amount of any gift or estate tax paid to a foreign country with respect to the covered gift or bequest.  The special estate and gift tax rules under IRC Sections 2107 and 2501(a)(3) applicable to expatriates under prior law do not apply to covered expatriates, but they continue to apply to estates of, and gifts by, individuals who are subject to tax under IRC Section 877(b).

The property subject to Section 2801 has no relationship to the expatriate's property at the time of expatriation, and the tax generally is imposed on every covered gift or bequest following the expatriation date.  However, Section 2801 only applies to the extent that the value of all covered gifts and bequests received by any U.S. citizen or resident during the calendar year exceeds the dollar amount in effect under Code Section 2503(b) for that calendar year, relating to annual exclusion gifts.  There is no present-interest requirement applicable to this exclusion, and it applies to bequests as well as gifts.  Surprisingly, covered gifts or bequests in the form of payments on behalf of a U.S. citizen or resident as tuition to a qualified educational organization or for qualified medical care, described in IRC Section 2503(e), apparently do not qualify for this exclusion.  Not surprisingly, Section 2801 also does not apply to (1) any property shown on a timely filed gift or estate tax return with respect to a gift by, or the estate of, a covered expatriate subject to tax under the U.S. gift or estate tax laws, or (2) any property which would qualify for a marital or charitable gift or estate tax deduction if the expatriate were a U.S. person.

If a covered gift or bequest is made to a foreign trust, Section 2801 applies to a later distribution of income or principal from that trust to a U.S. beneficiary in the same manner as if the distribution were a covered gift or bequest; and the tax imposed by that section would be allowed as an income tax deduction to the extent such tax is imposed on the portion of that distribution which is included in the beneficiary's gross income.  Solely for purposes of Section 2801, a foreign trust may avoid this result by electing to be treated as a domestic trust.

Notice 2009-85, referred to above, does not provide guidance with respect to Section 2801.  However, Section 9 of that notice provides that separate guidance will be issued for U.S. persons who receive covered gifts or bequests on or after June 17, 2008, and satisfaction of the reporting and tax obligations with respect to such gifts or bequests will be deferred pending the issuance of that guidance; and a reasonable period of time thereafter will be provided to comply with those obligations.

It is noteworthy that unlike the gift and estate tax, there is no unified credit against the Section 2801 tax nor a graduated rate schedule.  Thus, an individual planning to expatriate should consider making substantial gifts before doing so to persons to whom covered gifts or bequests would likely be made by him or her after becoming a covered expatriate.  For individuals who have already expatriated, there might be planning opportunities available this year for making sizeable covered gifts to U.S. beneficiaries, because of this year's relatively low 35% top gift tax rate that would apply under IRC Section 2801 - which will rise to 55% in 2011.

Section 2801 applies to a gift or bequest by a covered expatriate to a U.S. citizen or resident, but the term "resident" is not defined in that section.  The definition of a "resident" in Section 7701(b)(1) does not apply for purposes of Subtitle B of the IRC, which is where the estate and gift tax law and Section 2801 reside.  The definition of resident for estate tax purposes in Regs. §20.0-1(b)(1) (which provides that a "resident" decedent is a decedent who on the date of death was domiciled in the U.S.) indicates that the Section 2801 tax only applies to gifts or bequests to U.S. citizens or domiciliaries.  (The gift tax regulations do not contain a section comparable to Regs. §20.0-1(b)(1).)  Presumably, clarification of this issue will be provided in the forthcoming guidance with respect to Section 2801 referred to above.

 

Morrison & Foerster's Trusts and Estates group provides sophisticated planning and administration services to a broad variety of clients.  If you would like additional information or assistance, please contact Patrick McCabe at (415) 268-6926 or PMcCabe@mofo.com.

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