The Tax Cuts and Jobs Act (TCJA) made significant changes to U.S. tax law, including various aspects related to international issues.
An important example is cross-border estate planning for non-U.S. families who have one or more U.S. beneficiaries and U.S. investment accounts. These families will need proper U.S. tax planning to minimize U.S. estate tax and income tax, and families who previously obtained advice need to revisit the issue following passage of the TCJA.
Whereas the United States imposes an estate tax on the worldwide assets of U.S. citizens and domiciliary residents, individuals who are neither citizens nor residents of the U.S. are subject to estate tax only on their U.S.-situs assets, including U.S. securities. However, U.S. citizens and residents who die in 2018-2025 have an exemption of $11,200,000 (adjusted annually for inflation) after the exemption was raised by TCJA, and nonresidents have an exemption of only $60,000 against their U.S.-situs assets.
In some cases, a relevant estate tax treaty may provide for a higher exemption amounts, but the U.S. has estate tax treaties with only 16 countries. Without the benefit of a treaty, an estate tax nonresident will owe U.S. estate tax if his U.S. assets exceed $60,000. Many non-U.S. investors hold U.S. investment portfolios well in excess of this amount.
A common estate tax planning strategy for estate tax nonresidents who own U.S. assets in excess of the $60,000 exemption amount is to hold those assets through a non-U.S. corporation.
As a result, the nonresident owns stock in a foreign corporation, which is not subject to U.S. estate tax even if the corporation itself owns U.S. investments.
This strategy can cause problems, however, if the foreign corporation will be inherited by U.S. citizens or residents upon the nonresident’s death, as it will likely be considered a controlled foreign corporation (CFC).
Controlled Foreign Corporations
A CFC is a foreign corporation in which “U.S. shareholders” own (directly, indirectly, or constructively) more than 50% of the total combined voting power of all classes of stock or more than 50% of the total value of the stock on any day during the year. A U.S. shareholder in this context is a U.S. person who owns (directly, indirectly, or constructively) 10% or more of the total voting power or value of the foreign corporation’s stock.
U.S. shareholders of a CFC are required to include in income each year certain types of passive income (“Subpart F income”) earned in the CFC, even if they do not receive a distribution from the CFC during the year. Subpart F income includes capital gains from the sale of property that gives rise to passive income.
TCJA made significant changes to the CFC rules that will make CFCs more common, all else equal.
First, TCJA expanded the definition of a U.S. shareholder to include an owner of 10% of the value of the corporation; the definition previously relied only on 10% voting power.
It also changed the attribution rules used to determine whether a U.S. person is a U.S. shareholder and whether a foreign corporation is a CFC, adding downward attribution of stock owned by a nonresident to 1) any U.S. partnership in which the nonresident holds an interest, and 2) any U.S. corporation of which the nonresident owns at least 50%.
In addition, before TCJA, a U.S. shareholder of a CFC had to report his share of Subpart F income of the CFC only if the foreign corporation qualified as a CFC for at least 30 consecutive days during the year.
TCJA repealed this “30-day requirement,” meaning that a U.S. shareholder may need to report Subpart F income from a CFC even if it qualifies as a CFC for only one day. This rule change has significant impact on certain estate planning strategies for nonresidents.
Estate planning before the repeal of the 30-day requirement
While the 30-day requirement was still in effect, a nonresident could take advantage of this rule along with a “check the box” election to avoid U.S. estate tax on U.S. securities and pass them on to U.S. beneficiaries in a tax-efficient manner, avoiding significant Subpart F income and providing a basis step-up on the securities.
The check-the-box regulations allow a taxpayer to elect to treat an “eligible entity” as a pass-through entity instead of a foreign corporation. The election can be effective up to 75 days prior to the date it is made.
A common structure was for a nonresident to establish a non-U.S. trust that would be treated as a “grantor trust” for U.S. federal income tax purposes, meaning the nonresident is treated as owning the assets and income of the trust. The nonresident is the trust grantor, and his U.S. heirs would be trust beneficiaries.
The foreign grantor trust then owns shares of a foreign eligible entity, which is not automatically considered a foreign corporation under the “per se corporation” rules, allowing for the potential use of check-the-box elections. The nonresident makes an initial check-the-box election to treat the eligible entity as a foreign corporation (if needed). The foreign eligible entity then owns the U.S. investment portfolio.
No U.S. estate tax would be due on the U.S. investment portfolio upon the death of the nonresident owner, since the nonresident owned shares in a foreign corporation, which is not a U.S. asset.
Absent any check-the-box planning, the foreign corporation would become a CFC when it is inherited by the U.S. beneficiaries of the foreign trust. However, making a check-the-box election to treat the foreign corporation as a pass-through entity that is effective within 30 days after the date of death would mean the foreign corporation is a CFC for fewer than 30 days during the year, and therefore the U.S. beneficiaries do not need to report Subpart F income, and they would get a stepped-up basis in the U.S. securities held by the foreign entity.
Estate planning after the repeal of the 30-day requirement
The above strategy was made largely obsolete by TCJA, as a U.S. shareholder who owns a foreign corporation that is considered a CFC for even one day must report Subpart F income in the CFC, including the deemed gain on any U.S. securities in the foreign entity as a result of a check-the-box election. Therefore, making a check-the-box election effective even a few days after the date of death may result in significant capital gains taxable to the U.S. beneficiaries.
Making a check-the-box election effective prior to the date of death could avoid the Subpart F issue, but it would result in U.S. estate tax exposure for the decedent, as he would own the U.S. investment portfolio through a foreign pass-through entity as opposed to a foreign corporation.
Estate planning for nonresidents after the repeal of the 30-day requirement therefore requires some new strategies.
Two-tiered corporate structure
One possible alternative following TCJA is using a two-tiered holding company structure.
This strategy should avoid U.S. estate tax, provide a step-up in basis, and avoid any substantial Subpart F income to the U.S. beneficiaries.
The nonresident would hold, through a foreign grantor trust, two top-tier foreign eligible entities, which in turn each own 50% of a lower-tier foreign eligible entity. The lower-tier entity owns the U.S. investment portfolio. All three entities make an initial check-the-box election to be treated as a foreign corporation, if needed.
Upon the nonresident’s death, a check-the-box election is made to treat the lower-tier entity as a pass-through entity for U.S. federal income tax purposes, effective prior to the date of death. The resulting deemed liquidation will not be a tax-free liquidation since neither of the top-tier entities owns 80% of the lower-tier entity.
As the deemed liquidation occurs prior to any U.S. beneficiaries acquiring an ownership interest in the entities, they do not need to report any Subpart F income from the liquidation, but they will receive a step-up in basis on the U.S. securities held by the lower-tier entity.
Check-the-box elections can then be made for the top-tier entities, effective a few days after the date of death.
While the top-tier entities will have become CFCs, the deemed liquidations will not result in significant Subpart F income to the U.S. beneficiaries, since there likely has not been enough time following the lower-tier check-the-box election (and resulting basis step-up) for the U.S. securities to significantly increase in value.
Domestication of foreign entity via “F” reorganization
A second possibility may be helpful where a nonresident, whose beneficiaries are all U.S. persons, owns 100% of a foreign per se corporation (which is not eligible for check-the-box elections) that owns U.S. securities.
In this scenario, it may be preferable to domesticate the foreign corporation following the date of death via a non-taxable “F” reorganization.
When the U.S. beneficiaries inherit the foreign corporation, it will become a CFC. Generally, domesticating a CFC into the U.S. results in a non-taxable “F” reorganization, where the CFC is treated as transferring its assets to a U.S. corporation in exchange for the U.S. corporation’s stock. A U.S. shareholder of the CFC is treated as exchanging his shares in the CFC for shares of the U.S. corporation.
The U.S. shareholder must also include in income as a dividend his share of the net positive earnings and profits of the CFC, but this amount should not be significant since the foreign corporation will have been a CFC for only a short time.
After the above domestication transaction, the new U.S. corporation could convert into an S-corporation, which generally is not subject to income tax at the entity level.
However, when a C-corporation converts into an S-corporation, any built-in gains within the C-corporation must be recognized if the underlying asset is sold within five years of the conversion to S-corporation status.
If the S-corporation does not sell or exchange the underlying U.S. securities for five years, it can avoid recognition of the built-in gains on those securities held by the C-corporation immediately prior to the conversion, essentially providing a step-up in basis for the U.S. heirs if they are able to wait to sell the U.S. securities.
Churning the U.S. investment portfolio
A third option could be to frequently sell and repurchase the U.S. securities owned in the foreign corporation.
Depending on market movements, this could allow for a cost basis in the underlying securities that is fairly close to their fair market values. The foreign corporation will not be taxed on the capital gains resulting from the sale of U.S. securities, and the U.S. beneficiaries can avoid significant Subpart F income on the liquidation of the foreign corporation after it becomes a CFC since there will be little in the way of built-in gains.
This strategy naturally results in higher investment costs, and it should not be used for any U.S. real property interests, as those gains would be taxable to the foreign corporation.
Churning U.S. real property interests could have very negative ramifications, so this strategy should be limited to U.S. personal property (securities).
 Internal Revenue Code Section 2010(c)(3)(C). Under current law, after 2025, the exemption will return to pre-TCJA levels.
 By way of the $13,000 unified credit provided for in IRC Section 2102(b)(1).
 IRC Section 957(a).
 IRC Section 951(b).
 IRC Section 951(a).
 IRC Section 954(c)(1)(B).
 Treasury Regulations Section 301.7701-3(c)(1)(iii).
 IRC Section 332.
 IRC Section 334.
 IRC Section 368(a)(1)(F).
 Treas. Regs. Section 1.367(b)-2(f).
 Treas. Regs. Section 1.367(b)-2(d).
 IRC Section 1363.
 IRC Section 1374.