Tax series Part 7 - US Estate Tax Implications: American and non-American Investors

This is a complex topic, but simply speaking, American decedents (those who decease) leave behind assets, called an estate.  This estate may be subject to estate tax in the US.

A probate estate is different from the federal gross estate.  For the purpose of 'probate', assets are included for distribution or passing purposes by will or if the person passes away intestate. To be clear, they do not include property such as life insurance death benefits (where the proceeds to a named beneficiary other than the estate), property owned as joint tenants with right of survivorship, and property owned as tenants by the entirety.  However, if the death benefit is instead payable to the probate estate, it will included in the estate to be distributed in accordance with the will and are subject to probate costs.

For estate tax purposes, the federal gross estate generally comprises:

• Personal or real property owned at time of death, including properties owned as joint tenants with right of survivorship.  Included in this category are the value of business interests at time of death, employee death benefits, vested or accrued qualified retirement benefits, present value of non-qualified deferred compensation plan benefits, etc
• Property with incidents of ownership
• Life insurance death benefits which the decedent owned; if there is a named beneficiary with no incident of ownership by the decedent, the death benefits proceeds will not be subject to estate tax if the insured lives for 3 years after taking out such policy
• Gift taxes paid within 3 years prior to death

Surviving US spouses may avoid the estate tax by utilising the unlimited marital deduction upon the death of the first spouse.  Subsequent death will then trigger the estate tax on the estate.

The IRS Form 706 titled “United States Estate (and Generation-Skipping Transfer) Tax Return” is the return that must be filed no later than 9 months from date of death.

The value of the estate is important and it is either assessed based on date of death or an alternative valuation date (generally 6 months after the date of death) in case of loss of value of assets in this time due to death.  If the second method is used, ALL the estate assets must be valued on this date.

Prior law had many different thresholds for filing which varied from year to year.  From 2012, the American Taxpayer Relief Act of 2012 was signed to extend the basic estate tax provisions of the 2010 Tax Act so as to continue the estate tax exemption adjusted for inflation ($5,450,000 in 2016) and to increase the maximum estate tax rate to 40%.  Hand in hand with this comes the term Estate Tax Unified Credit which is the corresponding amount of credit against taxes ($2,125,800 in 2016). 

Before we proceed with a simple example, gift taxes must first be discussed as this is another concept walking hand in hand with estate tax.  For 2016, a person may make a gift (completed gift of a present interest) of upto $14,000 without being subject to any gift tax.  The threshold is per donee so if a taxpayer has 4 children and one nephew, he may gift each of them of $14,000 in a year.  Gift-splitting is allowed with a spouse so that this may be increased to $28,000 per year.

Gifts above these thresholds are subject to gift tax or can utilize a portion of the Estate Tax Unified Credit but in year of death, any credit available will be reduced by the amount previously utilized for gift tax. 

Spouses are able to gift each other unlimited amounts (completed gift of a present interest) under the unlimited marital deduction unless the spouse is not a US citizen, in which case the annual gift is limited $148,000 in 2016.

A simple example will highlight all the concepts above:

Lets say that John passed away in 2002 leaving a federal gross estate of $7,000,000.  His wife chooses to invoke the surviving spouse unlimited deduction thereby not paying any estate tax at the time of his death.  She gifts her family some of her property in 2014 that exceeds the annual gift exclusion triggering a gift tax of $40,000 for which she utilized a portion of the unified credit.

She then passes away in 2016 leaving a federal gross estate of $7,500,000 since she has made some good investments since Joe’s death.  Referring to the table below, her tentative tax liability would be:

($7,500,000-$1,000,000) X 40% plus $345,800 = $2,945,800

She may then utilize the unified credit for 2016 ($2,125,800 less the $40,000 utilized in 2014) = $2,085,800

Her net estate tax should be $860,000

The above example, being a simple illustration does not factor in expenses which are deductible against the federal gross estate:

• Funeral expenses
• Net losses during administration / costs of administration (eg probate court costs, appraisers, etc)
• Debts
• Income and property taxes
• Charitable and public bequests

In general, estate tax seeks to tax people with relatively high net worth (2016 $5,450,000) so this is a topic that may not be relevant to many Americans.  High net worth individuals may also note that there is significant scope to reduce the estate tax implications on estate above this threshold by uses of credit shelter trusts, qualified terminable interest trusts and irrevocable life insurance trusts.  Each have key features which can help to minimize the estate tax burden to be faced by the family/beneficiaries upon the death of the decedent.

Finally, note there are State level taxes which need to be considered.  State death taxes comprises estate taxes as well as inheritance tax.  Estate taxes are calculated differently in different states and are payable by the estate.  The estate should then deduct such state taxes from the federal estate tax liability in arriving at the net federal estate tax. Inheritance taxes are paid by the beneficiary and vary based on the value of the property transferred as well as the relationship to the decedent.

US Estate Tax For Non-Americans

Non-residents are subject to estate tax on US situated assets, such as real property, tangible personal property and securities of US companies, e.g. shareholdings.  The Form 706NA is used and the threshold is if the fair market value at death of the decedent's US situated assets exceeds $60,000.