Income Tax for Foreign Beneficiaries of Estates and Trusts
By Cowles Liipfert
It is more common now than it was, even a few years ago, for United States citizens to make financial provision in their estate planning documents for non-US citizens and nonresidents of the United States.
We have linked an article concerning Qualified Domestic Trusts (QDOT’s) for noncitizen spouses of United States citizens or residents. Bequests to non-citizens do not qualify for the federal estate tax marital deduction, even where the noncitizen spouse has been married to a US citizen or resident and has been living in the United States for many years. Perhaps he or she has several children who are US citizens. That discussion deals with United States Estate Tax, which is a special tax on large transfers of wealth from a person at death to other persons, which is separate and apart from income tax. Large lifetime gifts to non-citizens, including non-citizen spouses, are subject to United States Gift Tax, linked is a discussion of Gift Tax, Estate Tax and GST tax. Gift Tax was originally adopted to prevent individuals from avoiding Estate Tax by making lifetime gifts. Estate Tax and Gift Tax work in tandem with each other.
This article deals with a tax with which most of us are very familiar – income tax. The rules are very complicated for nonresident alien beneficiaries of US estates and trusts, as discussed below.
That is, this article discusses the income tax complications when an estate or trust has beneficiaries who both are noncitizens and nonresidents of the US – called nonresident aliens.
For income tax purposes, a non-US citizen who is a resident of the US pays income tax on his or her income just like citizens, and he or she is considered a “US Person” for income tax purposes.
Beneficiaries may be classified for US tax purposes as “US persons” and not as nonresidents, under certain fact situations. US persons include United States citizens, resident aliens (holders of green cards), and residents who meet the “substantial presence” test (generally those in the United States for 183 or more days each year over a 3-year period), or residents of Mexico or Canada who regularly commute to jobs inside the US. Others who may be classified as U.S. persons include certain government-related individuals, certain teachers and students, and some individuals with medical conditions which were originally contracted within the United States.
Generally traditional estate planning tools such as wills, trusts, life insurance, Section 529 educational savings plans, and annual gifting may be used for transfers to nonresident beneficiaries who are not US citizens. Some financial institutions require the completion of special forms and registrations for life insurance or for brokerage accounts that are payable to a nonresident alien beneficiary. But the transfer of income-producing assets to nonresidents can create income tax complications, whether or not they pass through an estate or trust.
Naming nonresident aliens as beneficiaries of US estates or trusts can be tricky because they may be subject not only to US tax laws, but also the laws of the country where foreign beneficiaries reside. There may be US taxes to be paid and/or taxes of the foreign country, and there are regulations, tax treaties, tax credits, etc. which may be applicable.
When a decedent dies and leaves assets to foreign beneficiaries, the executor or administrator of the decedent’s estate must determine the tax status of each foreign beneficiary, and whether it is necessary to withhold United States income tax on distributions of income from the US estate to each foreign beneficiary. The executor or administrator is required to file tax forms which are not required for estates that have no foreign beneficiaries.
Similar issues arise when a trust is created which has nonresident beneficiaries. Unlike most decedents’ estates, which are temporary in nature, trusts often last many years, during which time the trust must continue to comply with the laws of the United States and the laws of the applicable foreign country or countries.
In order to determine the tax status of a foreign beneficiary, the executor, administrator or trustee (collectively as referred to as Fiduciary) should provide to each foreign beneficiary a Form W-8BEN, to be filled in by the beneficiary and returned to the Fiduciary. That form requires the name of the individual beneficiary, his/her country of citizenship, personal residence address and mailing address, and foreign tax identification number, if any. If a foreign beneficiary also has a US Tax Identification Number (e.g. SSN), it must be included also.
Generally, a Fiduciary can rely on the information provided by the foreign beneficiary on that form for up to three years, but a new Form W-8BEN must be obtained from each foreign beneficiary every three years, updating his/her information, if he or she remains an income beneficiary.
The withholding rate for income distributions to foreign beneficiaries is usually 30%, which a Fiduciary is required to withhold from income distributions. The Fiduciary has a legal responsibility to pay those withheld income taxes to the United States Treasury each year. In many instances the foreign beneficiary receives a deduction or credit on his or her income tax return in his or her home country for US taxes paid, which softens the impact of the high US withholding tax rate but that does not simplify the filing requirements for the Fiduciary.
Withholding tax is required for a foreign beneficiary, for income which is distributed to the beneficiary – as a general rule there is no withholding tax on distributions of principal, such as a monetary bequest which does not include income earned on the monetary amount.
The withholding rates for some countries are sometimes less than 30%, due to tax treaties between the United States government and the foreign country. The rules for tax credits also vary from country to country.
Another complication for a US estate or trust is the requirement that the estate or trust must file Forms 1042, 1042-T and 1042-S in a timely manner for each applicable tax year. Form 1042 concerns how much income will be withheld for income tax withholding purposes for US-source income, for tax withholding purposes. Form 1042-S is concerned with payments of US source income made to foreign persons, and a separate Form 1042-S is required for each beneficiary. Form 1042-T is the Annual Summary and Transmittal of Forms 1042-S for the estate or trust.
Nonresident aliens who have US income from an estate or trust are required to file a Form 1040NR or a Form 1040NR-EZ in the United States, as well as any necessary tax filings in the beneficiary’s home country.
In summary, it is important for someone administering an estate or trust to know of these requirements when there are foreign beneficiaries of the estate or trust. They should also be aware of foreign beneficiaries of retirement accounts or life insurance policies, or persons who will receive assets as a surviving co-owner of assets, even if those assets do not go through probate. Often even an experienced estate planning or administration professional should seek advice and assistance from other professionals who deal regularly with nonresident beneficiaries.