It is increasingly common for individuals living in the United States or U.S. citizens living abroad to receive an inheritance from a non-U.S. person (for purposes of this article a non-U.S. person is defined as someone who is not a U.S. citizen, permanent resident, or otherwise considered a U.S. domiciliary). Receiving an inheritance from a non-U.S. family member or friend may be a very emotional time. Between mourning a loss and thinking about the future, individuals may eventually have questions about their newfound wealth.
Under most circumstances, inheriting assets is a complex process with possible taxes to file, legal proceedings to complete, and more. The inheritance process is even more intricate when it involves a non-U.S. person or international component (non-resident alien (NRA)) and/or a foreign legal jurisdiction. Oftentimes, no immediate financial decisions must be made, but ultimately individuals must review their long-term financial plan and focus on international tax compliance concerns that may arise between multiple countries when receiving non-U.S. assets.
Importantly, a U.S. taxpayer owes no U.S tax directly on the receipt of an inheritance or gift from an individual living outside the United States. However, there are important financial and tax considerations to review. New U.S. tax laws, including the Foreign Account Tax Compliance Act (FATCA), create an increased focus on offshore compliance matters. Individuals must assume that owning foreign financial assets will be heavily scrutinized by the IRS and possibly taxed at higher rates due to special U.S. tax laws related to non-U.S. investments. This introductory article reviews several cross-border estate planning issues that U.S. citizens, green-card holders, and other U.S. taxable individuals should consider if they are the beneficiary of a foreign bequest or gift from outside of the United States.
What is the U.S. tax on Inheritances from a Non-U.S. Person to U.S. Citizen and/or Other U.S. Taxpayer?
Again, it is important to stress that there are no U.S. taxes owed by a U.S. citizen or green card holder directly on receiving any inheritance (whether received from a U.S. or non-U.S. person). However, there are IRS informational reporting requirements when receiving a gift or inheritance from a non-U.S. person (non-resident alien and/or non-U.S. domiciled). More importantly, ownership of foreign financial assets creates other U.S. tax reporting issues that must be properly handled or there may be a risk of significant IRS penalties and large fines. Three common U.S. tax questions on receiving an inheritance from abroad:
- Do U.S. taxpayers pay tax on inheritance money from overseas? No.
- How much money can you receive as a gift from overseas? Unlimited.
- What IRS tax form do I need to file if I received a gift or inheritance from a foreigner? IRS Form 3520.
Although there are no U.S. taxes or restrictions on U.S. citizens, green card holders, or taxpayers from receiving non-U.S. assets, all bequests and gifts received by U.S. persons from foreign persons that exceed $100,000 in a calendar year must be reported to the IRS on Form 3520 (“Annual Return to Report Transactions With Foreign Trusts and Receipt of Certain Foreign Gifts”). The amount and description of the bequest must be disclosed on Form 3520, but the IRS does not require disclosure of decedent or donor’s identity. The IRS is mostly concerned about knowing what new assets are entering the U.S. tax system and the possibly income generated by these non-U.S. assets that would be subject to full U.S. taxation going forward (often with unique international reporting requirements).
It is essential to properly file a timely IRS Form 3520 to report a foreign inheritance or foreign gift received by a U.S. person as large penalties may be imposed on a taxpayer if the IRS later discovers that an inheritance was not properly declared when received using Form 3520. As one will see throughout this article, the IRS has a keen interest in learning about U.S. taxpayers receiving foreign assets and the continued reporting of income from these non-U.S. assets. The initial reporting of a foreign inheritance on IRS Form 3520 is a mandatory starting point and absolutely critical to complete in a timely fashion.
Do Inherited Foreign Assets Receive a Step-up in Cost Basis for U.S. Tax Purposes?
Another common question asked when receiving an inheritance from outside the United States is about the U.S. cost basis and receiving a step-up in basis on foreign assets owned by a non-U.S. person. Understanding the U.S. cost basis is important when assets are eventually sold as gains may be subject to U.S. taxation. There are a few nuances related to cost-basis for inherited non-U.S. assets.
What is a “step-up” in cost basis at death?
Under current U.S. tax law, the income tax basis of inherited assets is updated to the fair market value of the assets on the decedent’s date of death (or six months later, if elected). This is referred to as the “step-up” in basis at death. Receiving assets at their fair market value may be a tremendous benefit, especially if assets increased significantly in value since their purchase or if the original purchase price is unknown. This applies broadly to stocks, private business ownership, real estate, collectibles, and other assets.
Do foreign assets get a U.S. cost-basis step-up at death?
Foreign assets received by a U.S. taxpayer due to death may also receive a step-up in basis. Even though the foreign inherited property was not subject to an estate tax in the United States, the IRS states through various revenue rulings that foreign property is entitled to a step-up in its basis. Section 1014(b)(1) of the U.S. tax code adds that inherited property is deemed acquired under IRC Section 1014(a)(1) which may be useful for making other U.S. tax claims.
For example, an individual who inherits a Mumbai apartment currently valued at $2m that their deceased mother originally purchased for $500,000 would be entitled to receive a cost basis of $2m on the property. If the apartment continues to appreciate, the amount above $2m would be taxed as long-term capital gains in the event the apartment was sold at a later date. This is tremendous tax benefit for the U.S. taxpayer who inherits the appreciated assets (however, be aware that local country tax laws may still also apply and the property may be subject to other taxation in the local jurisdiction). This U.S. taxpayer must of course report the foreign inheritance on IRS Form 3520 in the year it was received. This form will also be an important part of claiming a future cost-basis when the asset is sold.
What Additional Reporting Does the IRS Require of Foreign Inherited Assets?
“Death may be an avenue of escape from many of the woes of life, but it is no escape from taxes.” U.S. v. Wolin, 126 AFTR 2d 2020-6348 (DC NY) (quoting Kahr v. Commr., 414 F.2d 621, 626 (2d Cir. 1969).
Although the IRS will not tax the actual inheritance, U.S. citizens and green card holders are subject to tax on their worldwide income. This means that income outside of the United States is subject to IRS reporting and U.S. taxation. After satisfying the initial compliance obligations on Form 3520 when receiving a foreign inheritance, it must be assessed what type of IRS foreign asset reporting is required on an ongoing annual basis going forward. In the event that the inherited assets remain outside the US, there may be substantial income tax reporting requirements for foreign assets beyond the normal IRS Form 1040.
These reporting requirements include, but are not limited to, the timely filling of a FinCEN Report 114 (FBAR) and IRS Form 8938 (Statement of Specified Foreign Financial Assets) which merely report the existence of such assets. The IRS uses information reporting as a starting point to determine potential tax noncompliance. Inheritances come in many shapes and forms which require unique U.S. tax reporting:
Reporting Foreign Bank Accounts Holding Cash – Cash held in a foreign bank account is a relatively easy to report to the IRS. In addition to reporting the actual inheritance on Form 3520, there may be additional requirements on the FinCEN Report 114 (FBAR) or IRS Form 8938 (Statement of Specified Foreign Financial Assets). Interest earned must also be reported as income and is taxed no differently than interested earned in a U.S. bank account.
Foreign Investment Accounts (Stocks, ETFs, Mutual Funds, and other pooled investments) – Non-U.S. investment accounts and funds require more complicated U.S. tax reporting. Commonly, non-U.S. investment accounts hold non-U.S. investment products such as non-U.S. listed ETFs, mutual funds, and private investments. The IRS may classify these investments as passive foreign investment companies (PFICs). It is not a violation of U.S. tax law to own a non-U.S. fund classified as a PFIC, but complicated and ongoing annual reporting is required, even if no investments are bought or sold. Oftentimes selling a non-U.S. listed fund, even at punitive taxation rates, immediately upon receipt is the best action. A more detailed discussion of the PFIC problem can be found in the following white paper: “The PFIC Problem.” In addition to the complex reporting of investments in these accounts, disclosure of these accounts is required on the FBAR and FATCA 8938 form.
Non-U.S. Business Ownership – Inheriting ownership of a closely held non-U.S. business presents significant U.S. tax reporting obligations. Extensive reporting may extend deep into the corporate structure and even requires additional U.S. tax reporting by non-U.S. owners. Newer U.S. tax laws related to controlled foreign corporations and global intangible low-taxed income (GILTI, Section 951A) are incredibly complex. These topics are beyond the scope of this article and inheriting ownership in a foreign business requires extensive assistance from an international tax attorney and/or an international tax accountant (ideally prior to the inheritance to possibly create a more efficient ownership structure).
Art and Collectibles – When inheriting paintings, sculptures, clothing, furniture, books, jewelry, or other tangible items with potential for value, it is important to obtain a professional appraisal. An appraisal will document the current value which may be necessary for estate or inheritance tax purposes (filing Form 3520) and is useful for proper insurance estimates. No ongoing U.S. tax reporting is required of tangible items located in another country. However, should items be sold at a profit, there may be gain to report.
International Real Estate – The reporting of foreign real estate owned directly is relatively easy. Apart from the initial Form 3520, there is no special ongoing reporting required of non-U.S. real estate. This may change if the property is rented (requiring income tax reporting of rental income). A sale of property abroad may also need to be reported on U.S. tax filings.
Non-U.S. Life Insurance and Annuity Contracts – For many non-U.S. life insurance policies, there is no U.S. tax upon the death benefit received. However, there still may be decisions to review as some insurance companies will try to convert the deceased’s policy into an annuity, another insurance contract, or other non-U.S. investment vehicle. These investments will often use non-U.S. investment vehicles that will be classified as PFICs (and thus taxed at potentially higher tax rates) and create burdensome U.S. tax reporting issues. In rare circumstances, proceeds from a non-U.S. life insurance policy paid to a beneficiary may be considered taxable income.
Non-U.S. Trust Structures – U.S. taxpayers may become beneficiaries of a non-U.S. trust due to a death. A U.S. taxpayer who is a beneficiary of a foreign trust faces complicated U.S. tax reporting required by the trustee and beneficiary. Transfers to, distributions from and annual income and expenses of foreign trusts must be reported and could possibly be taxed in the U.S. Like ownership of a non-U.S. business interest, it is highly recommended that individuals who are settlors, trustees, or beneficiaries of a foreign trust (non-U.S. trust) obtain specialist tax advice.
Are There Any Non-U.S. Tax Issues in the Decedent’s Home Country?
As part of the Tax Cut and Jobs Act of 2017, the United States estate tax exemption amount increased to approximately $11.7 million per individual or $23.4 million per couple (2021). As a result, many Americans are no longer subject to federal estate tax due to the high exemption amounts. However, other countries have significantly smaller exemption amounts or even apply the “death tax” on the recipient of the bequest rather than on the decedent’s estate. Depending on the jurisdiction, type of asset, relationship to the decedent, and other factors, a U.S. recipient of an inheritance abroad may have to deal with other non-U.S. tax issues.
Forced Heirship – Many non-U.S. jurisdictions impose restrictions on who may receive assets at death. Families in the United States are familiar with the U.S. common law system that allows for a free disposition of a decedent’s estate and may be surprised to see that foreign legal codes often compel individuals to distribute a decedent’s assets under forced heirship principles. In civil law systems such as France, Italy and many Latin American countries, children must inherit a portion of the assets upon the first parent’s death. Sharia law, common in the Middle East, also places restrictions on how assets are transferred.
Estate Tax versus Inheritance Tax – U.S. families are most familiar with planning for an estate tax which is levied on the net value of property owned by a decedent on the date of their death. In contrast, inheritance taxes are levied on the recipients of property left by a decedent. Many countries around the world impose transfer taxation on the person receiving the assets rather than the decedent. The relationship between the decedent and beneficiary plays a critical role in determining the amount of tax that is owed. A closer lineal relationship (parent to child) generally implies less tax than than to an unrelated person receiving assets. Before transferring assets to the United States local tax obligations may need to be settled first.
Transferring Inherited Foreign Assets to the United States
Receiving a foreign inheritance may put individuals in a terrific position to be able to make progress toward their financial goals. However, as a U.S. beneficiary of a foreign inheritance, it is vital to take the time to develop a plan on maintaining the foreign assets (proper U.S. tax reporting) or moving these assets to the United States (if possible). There may be consequences to the timing and implementation of these international asset movements.
A common misconception is that foreign stock investments must be held in a non-U.S. stock account. If continued ownership of foreign publicly listed companies is required, these shares may likely be transferred to a U.S. custodian for easier administration and tax reporting. U.S. taxable investors should seek to maintain financial assets in U.S. institutions to avoid regulations imposed by FATCA and other U.S. foreign asset reporting requirements. Additionally, maintaining foreign investment funds (PFICs) may also be unsuitable long-term. These PFIC investments (foreign ETFs and mutual funds) are likely best liquidated and transferred to more appropriate U.S. investment vehicles.
Transferring foreign financial assets to the United States is often the best decision, but careful planning is required to minimize the impact of foreign currency fees and other taxes. For example, international private banks that have multi-currency accounts often charge excessive fees on currency conversions and also embed high fees into foreign investment products. Instead, there are many U.S.-based custodial solutions that can accommodate international financial circumstances, multiple currencies, and complex financial assets. Working with an objective advisor can help formulate a plan to remit these funds to the United States and implement a strategy to grow them in a U.S. compliant manner.
Advanced Planning for Non-U.S. Individuals Giving Assets to a U.S. Citizen or U.S. Permanent Resident (Green Card Holder)
Although this article primarily focuses on what to do when receiving an inheritance in the United States from abroad, advanced planning by a non-U.S. person giving assets to a U.S. taxable person is the best course of action. There may be certain structures and techniques that can simplify the transfer of assets at death and reduce overall global taxation. However, these planning strategies take time to implement, and many must be created well ahead of a death by an international family. Sufficient advanced planning will always produce the most optimal result and least amount of frustrating cross-border logistical headaches!
Setting up U.S. and Non-U.S. Trust Structures – Appropriately planned trust structures may be useful to help plan for an eventual inheritance. A U.S. trust for U.S. beneficiaries may make tax reporting much easier. Certain states, such as South Dakota and Nevada, allow for trusts to be setup by a non-resident alien for U.S. beneficiaries and may serve as a valuable multi-generational planning tool. Due to South Dakota’s competitive and unique trust, asset protection, income tax, and private family trust company laws, this jurisdiction is very favorable for non-U.S. citizens establishing long-term trusts.
However, trustees and settlors of trusts moving to a new country must carefully examine how the new jurisdiction views trusts. Many jurisdictions do not recognize trusts, including many continental European countries. The United Kingdom and New Zealand may impose entry and exit taxes on trust assets. Moving a trust, possibly unknowingly by actions of a trustee or settlor, may create unforeseen tax consequences. This is another area where expert counsel familiar with U.S. tax law and the local law of the grantor’s jurisdiction is essential. Trusts have great planning value but must be used properly.
Beyond taxation issues, other laws of the foreign jurisdiction may make trusts less desirable. Forced heirship regimes, marital rights, and other foreign property laws, may apply and may alter the interest’s beneficiaries may have in the trust property that differ from the trust terms. It is highly recommended that individuals who are settlors, trustees, or beneficiaries obtain specialist tax advice before relocating to a new country.
Using U.S. Investment Accounts and U.S. Funds – There is nothing stopping a non-U.S. citizen from setting up investment accounts in the United States which may be transitioned more easily to U.S. taxable beneficiaries (avoid the PFIC tax problem). For example, a non-U.S. individual may open an account as a non-resident alien at a variety of U.S. financial institutions. They may then make purchases in U.S. domiciled investments funds and stocks.
However, depending on the country of residence of the account owner, there may be significant U.S. estate tax implications to this ownership strategy. Many countries do not have an estate tax treaty with the United States and not structuring U.S. investment accounts properly may lead to extra tax and legal complications. Thus, this strategy may not make sense for all and a careful analysis of income tax and estate/gift tax treaties is required.
Creating a U.S. Life Insurance Strategy – U.S. life insurance products are heavily regulated, stable, relatively inexpensive (compared to non-U.S. insurance solutions) and regarded as financially secure investments. This makes the United States one of the “top destinations” for global life insurance purchasers relative to other jurisdictions. Using a U.S. domiciled life insurance policy may be an effective way for a non-U.S. family member to structure an inheritance destined for a beneficiary in the United States. Due to the contractual nature of life insurance policies, U.S.-based life insurance products may also offer a unique solution to address some of the local country tax, legal, and investment concerns.
Conclusion: Building a Long-term Portfolio from a Foreign Inheritance
Whether someone is a U.S. citizen, a permanent legal resident (green card holder), or a foreign national on a visa, foreign assets received in the form of an inheritance or a gift may be subject to U.S. taxation and reporting requirements. A small mistake or oversight can quickly magnify into a larger long-term U.S. tax problem. It is essential to understand U.S. tax reporting obligations from the beginning and what transactions may create long lasting tax implications. Rules and regulations of these reporting requirements are constantly being altered and updated.
Ultimately, moving financial assets to the United States may be the best solution to build a long-term portfolio for a U.S. taxable individual or family. However, this decision and other options must be carefully thought out. Receiving a gift or inheritance is a great time to review long-term financial strategies with a financial advisor. This is especially true when there is a U.S. and non-U.S. jurisdiction involved. An advisor can help you draft a financial plan with your windfall factored in and decide how to invest your new funds efficiently and in compliance with the respective regulations. Round Table Wealth Management has been helping global families make sense of complex cross-border tax and investment issues for over 20 years. We look forward to reviewing your individual circumstances with you.