Tax Lawyer Blog

A Blog written by the Tax Attorneys for Individuals and Businesses

What Everyone Should Know About Estate Planning

Many people think of estate planning as something only needed by a few wealthy individuals. As such, a good number of people simply believe they do not need an estate plan. This could be a costly mistake that may be past on to the family members and loved ones of an individual without an estate plan. We invite you to read further to gain a better understanding of estate planning and how an estate plan may benefit you, your family, and loved ones.

A will is the most basic estate planning tool. A will identifies who acquires a person’s property when they die. A will can also service as a devise designating a personal guardian to rear an individual’s child or children. Unfortunately, there is a significant downside to having a will. Property transferred by a will must usually go through a probate. Probate is a process whereby a court supervises the transfer of assets from a deceased person to his or her heirs. For most people, the very mention of the term “probate” conjures up thoughts of being taken advantage of by “high priced” lawyers. Unfortunately, the probate process can be notoriously difficult. The probate process often requires the filing of particularized forms which tend to be complicated. In addition, the probate process usually takes at least six months. To make matters even worse, the probate process can take substantially longer in the event of a will contest, heirs not being timely notified, or if the estates of the estate at issue are not timely sold. 

Since probate can be costly and time consuming, many individuals choose to establish estate plans that bypass the probate process. There are six methods most individuals use to either eliminate or reduce the probate process. These methods are: trusts, joint tenancies, pay-on-death designations, life insurance, individual retirement plans, and state law exemptions. A trust is a legal entity that individuals transfer property of value to. The individual who transfers property to the trust keeps control of the trust during their lifetime. Upon the grantor’s death, the property transferred to the trust goes to the beneficiary of the trust. There are two types of trusts available: revocable and irrevocable. Property that is transferred into a revocable trust is subject to the grantor’s creditors during his or her lifetime. However, if properly established, a grantor could transfer his or her assets into an irrevocable trust that cannot be reached by his or her creditors.

Joint tenancy is an anther way many people avoid the probate process. Joint tenancy can be used by a couple who own a share of property. Joint tenancy usually contains a “right to survivorship” clause. This means that when one joint tenant dies, his or her ownership is transferred to the other joint tenant. In some circumstances this can be a very effective way to avoid the probate process. Like joint tenancy, individuals have successfully used pay-on-death designations to avoid probate. Pay-on-death designations been used extensively with bank and security brokerage accounts. Under a pay-on-death designation, when the holder of the account dies, the account is transferred directly to the named beneficiary. In addition, individuals have successfully used life insurance and retirement accounts to avoid probate. However, any individual contemplating using life insurance or retirement accounts to avoid probate must consider the tax consequences of utilizing these vehicles. Finally, some individuals may avoid the probate process altogether if state law allows property to be left by will to be transferred up to a certain dollar threshold. It should be noted that in most states this amount is usually very small.

Many people do not understand transferring property before and after death can result in a significant assessment of Estate and Gift Taxes. To make matters worse, Estate and Gift Taxes are confusing and complex. Compounding this problem are the recent changes in the Internal Revenue Code. Recent changes in the Tax Code have made the understanding Estate and Gift taxes even more difficult.

All United States citizens and individuals who own property in the United States are subject to the Estate Tax. The Estate Tax is levied on all property owned by a decedent whether it goes through probate or not. Currently, an individual can distribute as much as $2 million in property at death. This amount increases to $3.5 million in 2009. The Estate tax is completely repealed in 2010. However, in 2011, an individual can only transfer $1 million in property at death without being subject to the Estate Tax. Although the Estate Tax exclusion is scheduled to decrease to $1 million dollars in 2011, this amount could change.

The amount of the estate subject to tax depends on the value of the property in the estate. The taxable estate includes the value of all the property in the estate at the time of death. In addition, for Estate Tax purposes, the taxable estate will include the following:

  • Life insurance proceeds payable to the decedent’s estate or, if the decedent owned the policy with his or her heirs listed as beneficiaries;
  • The value of certain annuities payable to the estate or his or her heirs;
  • The value of certain property that was transferred out of the decedent’s estate within 3 years of death;
  • Trusts or other interests established by the decedent to others that he or she may have had certain powers.

Some people may believe that they can give away their property before they die to avoid the Estate tax. Unfortunately, Congress has also levied a tax on gifts made during one’s life. This is referred to as the Gift Tax. Currently, the Internal Revenue Code exempts from federal tax the first $12,000 given away as a gift to others annually. This amount can be combined for married couples. All annual gifts over $12,000 or $24,000 for married couples must be reported to the Internal Revenue Service. Aside from this annual exclusion, the federal Tax Code imposes a $1 million lifetime exemption on the gift tax. If an individual gives away more than $1 million of gifts in his or her lifetime, that individual will be subject to the gift tax. While the Estate Tax exemption increases to $3.5 million on 2009. There are no provisions in the Internal Revenue Code to increase the maximum Gift Tax Exclusion.

Given the complexities of the Estate and Gift Tax, careful tax planning is critical for individuals with moderate to larger estates.

US Tax Consequences to Foreign Investors

During the past few decades the United States has received a massive influx of foreign investment from abroad. Much of these international investors are unaware of the domestic tax consequences of investing in the United States. Foreign investors may be subject to US domestic taxation simply by investing or traveling to the US. Whether an individual will be subject to US taxation is depend on numerous factors. However, whether or not an individual will be subject to US taxation depends on two critical factors. The first factor to consider is whether the individual is considered a US resident. The second factor concerns the source of the income received.

The United States taxes its citizens on their world-wide income. The United States Federal Tax Code provides two basic tests for determining whether or not an alien is a resident of the United States during a particular year. If the conditions of either test are met, then the taxpayer is a US resident for all or some part of that year. These two tests are generally known as the “green card test” and the “substantial presence test.” 

Under the “Green Card Test,” an alien will generally be taxed as a resident of the United States during any year in which he or she is considered a lawful permanent resident of the US by the US immigration authorities, i.e., during any year in which he or she holds a valid “green card” or visa stating residency status. See Section 7701(d)(1)(A)(i). If an individual is classified by the US immigration authorities as a resident, unless an applicable tax treaty provides an exclusion, he or she will be taxed as a U.S. resident on all world-wide income.

Under the “Substantial Presence Test,” an alien will generally be considered a resident during any calendar year in which he or she is present in the United States for 31 days during the current year, and 183 days during the 3 year period that includes the current year and the 2 years immediately before that, counting 1) all days the individual was present in the current year; 2) 1/3 of the days the individual was present in the first year before the current year, and; 3) 1/6 of the days the individual was present in the second year before the current year. See Section 7701(b)(3)(A); Treas. Reg. Section 301.7701(b)(1) and (2).

Below, see Illustration 1and Illustration 2 which demonstrates how the substantial presence test is applied.

Illustration 1.

An individual was physically present in the United States for 120 days in each of the tax years for 2002 through 2005. To determine if the individual meets the substantial presence test for tax year 2005, count the full 120 days of presence in 2002, count 40 days presence in 2004 (1/3 of 120), and 20 days in 2002 (1/6 of 120). In this case, the total for the 3 year period is 180 days. Thus, this individual is not considered a resident under the Substantial Presence Test for 2005.

Illustration 2.

An alien was present in the United States from August 27 through December 31 of the current year for a total of 158 days. This individual was also present for 50 days in each of the two prior years. The substantial presence test would be applied to this individual as follows:

All days present during the current year 158
1/3 of the days during the first preceding year 162/3
1/6 of days present during the second preceding year 81/3
Total days counted 183

According to the Substantial Presence Test, this individual became a resident for taxation purposes on August 27th.

Certain individuals are exempt from the substantial presence test. These individuals include diplomats and their families; teachers and trainees; students under an “F,” “J” or “M” visa; commuters from Mexico and Canada; persons who are in the US less than 24 hours who are in transit between foreign destinations out the US; persons who suffered a medical condition that incapacitated them while they were present in the US, and; some professional athletes competing in charitable sporting events. See Treas. Reg. 7701(b)(3). Even though the Treasury Regulations provide an exception to the counting of days toward the 183 day rule, the Regulations do not provide an exemption from the tax on income earned in the United States on those days.

Even if the alien satisfies the substantial presence test, he or she could still qualify for non-resident tax treatment under the so called “Closer Connection Test.” Under this exception, a foreign resident can avoid the consequences of the substantial presence 2 year look back rule if he or she can show the follow: 1) the individual has a tax home in a foreign country; 2) the individual has a closer connection to a country other than the United States; 3) presence in the United States for fewer than 183 days during the taxable year. Unfortunately, the closer connection test is not available to aliens who have applied for a “green card.” See IRC Section 7701(b)(3)(C).

Whenever an alien would was not a resident at any time during the prior tax year becomes a resident in the current year, under either test, a residence start date must be determined. In instances where an alien becomes a resident under the green card holder not meeting the substantial presence test, the alien becomes a resident for taxation purposes in the year which he or she is present in the United States as a lawful permanent resident. See IRC Section 7701(b)(2)(A)(ii). In the case of a green card holder not being physically present in the United States at any time during the year in question, the residency starting date is the first day of the following year. In the case of an individual meeting the substantial presence test, the first day of the presence in the United States during that year, he or she becomes a resident for taxation purposes. See IRC Section 7701(b)(2)(A)(iii). If both the substantial presence test and the green card test are met, the residency for taxation purposes is the earlier of the first day present as a green card holder or the first day physically present under the substantial presence test.

In determining the first day of presence under the substantial presence test, the Tax Code provides that an individual may be physically present in the United States for up to 10 days during the year without starting residency for US taxation purposes. In order to exclude these days for the purpose of determining residency starting date, an individual must be able to establish that during this time he or she had a tax home in a foreign country and a closer connection to that country on the days in question. See IRC Section 7701(b)(2)(C); Treas. Reg. Section 301.7701(b)-4(c)(1).

Many Green Card holders residing outside the United States could potentially benefit through tax treaties. However, they must refrain from taking advantage of a tax treaty due to risks associated with keeping their Green Card. Therefore, a full evaluation of U.S. immigration laws should be carefully evaluated in these situations.

The term United States includes the Following: 1) All 50 states and the District of Columbia; 2) The territorial waters of the united States, and; 3) The seabed and subsoil of those submarine areas that are adjacent the US territorial waters and over which the United States has exclusive rights under international law to explore and exploit natural resources. This term does not include U.S. possessions and territories or US airspace. See Publication 519.

A closer connection to a foreign country involves weighing factors such as the taxpayer’s permanent place of residence, employment or business, voting record, filing of tax returns, registration of vehicles, location of personal possessions, and location of religious and social activities. See IRC Section 7701(b)(3)(A)(i).

In order for an alien to take advantage of the closer connection exception, a special statement must be attached to his or her tax return. See Treas. Reg. Section 301.7701(b)-8.