Under IRC Sec. 2107(a), if a U.S. citizen terminates U.S. citizenship primarily for tax avoidance purposes, the application of the U.S. estate tax is more expansive to the estates of these individuals than for non-resident aliens. Absent the applicability of these special estate tax rules, the estate of a non-resident alien (i.e. a former U.S. citizen) would only include property situated or deemed situated in the U.S. that is owned by the non-resident alien at the date of death (IRC Sec. 2103), which includes stock of and debt obligations of U.S. corporations, as well as real and tangible personal property that is physically located in the U.S. (IRC Sec.2104).
The special expatriation estate tax rule (former U.S. citizens) requires the inclusion in their gross estate of a portion of the value of the stock owned by a decedent in a foreign corporation if:
1. The decedent owned directly 10% or more of the voting power of all classes of stock in the foreign corporation, and
2. The decedent owned directly and by attribution more than 50% of the voting power of all classes of stock of the foreign corporation.
The estate tax includable amount in the decedent’s U.S. gross estate is determined by applying to the fair market value of the stock owned outright by the decedent a fraction, the numerator of which is the fair market value of the corporation’s U.S. assets and the denominator of which is the total fair market value of the corporation’s entire assets (IRC Sec. 2107(b)).
Ownership includes stock that was previously transferred but that would be subject to U.S. estate tax transfer provisions (IRC Sec. 2035-2038, IRC Sec. 2107(b).
Determination of the estate tax includable amount (i.e. the fraction computation) is based on a gross assets test (debts and liabilities are ignored for purposes of this computation). If a significant risk exists that this element of tax expatriation provision will apply, the foreign assets could be leveraged upward to reduce the percentage of corporate stock value that is includable in the gross estate.
Once the IRS establishes that it is reasonable to believe that the individual’s loss of U.S. citizenship would result in a substantial reduction in transfer taxes, the burden of proving the lack of a principal tax avoidance purpose is on the executor of the estate (IRC Sec. 2107(e)).
The executor’s rebuttal must include income, estate and gift taxes.
Unlike a U.S. citizen, if an alien resident in the U.S. permanently relocates to his home country (or to a third country) his status as a U.S. resident terminates for U.S. estate tax purposes, and the exposure of his estate to U.S. estate tax terminates except as to assets located in the U.S. Unlike the U.S. income tax, no tax expatriation provision applies for U.S. estate tax upon the termination of U.S. residency (as determined for U.S. estate tax purposes) by an alien individual.
Under the U.S. Estate Tax Treaty Model Rules (Article 1(3)), “citizen” includes a former citizen whose loss of citizenship had as one of its principal purposes the avoidance of tax (Including for this purpose, income tax) but only for a period of 10 years following loss of citizenship. These treaty provisions do not apply to alien residents who terminate their U.S. residency status for U.S. estate tax purposes.