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Estate Tax Implications for US Beneficiaries – What You Need to Know

Note: All references in this article to “US beneficiaries” refer to those considered US residents for income tax purposes, i.e. either US citizens or those who meets the Green Card Test or Substantial Presence Test, that receive a distribution of assets from an estate.

So, you’re a US citizen residing in Australia about to receive an inheritance or become the beneficiary of an estate (US beneficiary). You now have two issues to consider: 1) How do I protect my new assets? And 2) What are my reporting obligations to the US government?

Fortunately, there are no Australian tax implications in these circumstances (estate tax was abolished in Australia in 1979). Furthermore, US beneficiaries are not responsible for the payment of any US federal estate tax due from the distribution of an estate (as the executor of the estate is responsible for all such taxes), with no other implications for the receipt of proceeds except possibly those of a superannuation fund

Nevertheless, if you mean to protect your assets beyond just keeping them in your own name, then you may need to consider using one or more asset protection strategies, the use of which may incur reporting obligations depending on the nature of the strategy.

Asset Protection for US Inheritances via Trusts

The main asset protection option we’ll discuss here is transferring your assets to a trust. The first two points to consider regarding the use of this strategy are:

  1. the residence of the trust (where the US government considers the trust to be located); and
  2. the type of trust to be employed (realising that different types of trusts may incur differing reporting obligations – more on this shortly).

Trust Residence

A trust’s residence impacts several things including:

  1. whether the trust is taxed on its worldwide income (true for domestic US trusts), or only on income that is derived from US sources or that is effectively connected with US trade or business (true for foreign trusts); and
  2. how US beneficiaries are taxed on distributions from the trust, and reporting obligations for both US beneficiaries and US grantors (i.e. the creator of a particular type of trust called a grantor trust – more on this shortly).

The residence of a trust is determined according to a two-part test based on both jurisdiction and control over the trust.

Note that Australian trusts, including discretionary (family) trusts, are considered “foreign trusts” for US tax purposes if they do not meet both the:

  • “court” test – where any US court is able to exercise control over the administration of the trust; and
  • “control” test – where one or more US persons have the authority to make all substantial decisions with no other person having power of veto (except the grantor).

For the purposes of this article we will discuss only foreign trusts, e.g. trusts created within Australia by US persons.

Foreign Grantor Trusts

US Persons who are grantors must annually report on Form 1040 all items of trust income and capital gains, regardless of source. The trust itself is ignored and is not subject to tax but rather the grantor is required to include the trust’s income, deductions, credits, gains and losses in his or her Form 1040.

Therefore, a US beneficiary residing in Australia:

  • is subject to US federal income tax on their share of the trust;
  • is subject to US federal tax on all of the trust income (where the US beneficiary is also the grantor);
  • must declare that income in their Australian income tax return together with any foreign tax credits;
  • must annually file Form 3520 to report any transfer to the foreign trust. Filing of Form 3520 must occur annually whilst remaining a beneficiary of a trust even if no activity occurs, i.e. no income from or transfers to the trust; and
  • prepare and file with Form 3520-A – Annual Information Return of Foreign Trust with US Owner;

Trustees of foreign grantor trusts must provide a Foreign Grantor Trust Beneficiary Statement to each US beneficiary who was entitled to a distribution from the estate during the relevant year.

(Note: For US purposes, the term “distribution” also includes loans to beneficiaries.)

Foreign Non-Grantor Trusts

Foreign non-grantor trusts will only be subject to US tax if the trust earns US source or effectively connected income. 

For estate and other Australian trust purposes, where there are investments in US funds, then US tax will be levied at the withholding rate of 30%, or 15% where a double tax treaty is available and is applied. Any tax withheld at the US end will be claimed back on the Australian tax return.

Other Points to Consider

  • Use of Property: The use of foreign trust property by a US beneficiary is treated, for US purposes, as a trust distribution measured by the fair market rental value of the asset used (e.g., primary residences and holiday homes) and is subject to the income tax and reporting rules as described above.
  • Transfer of Assets: Transfer of assets by US beneficiary to a foreign non-grantor trust may be treated as a sale of property to the trust. This may result in a capital gain on which tax must be paid. 
  • Death or Cessation of US Owner: Upon the death of the US owner (i.e. grantor, trustee) or the US owner ceasing to be a US resident (for US tax purposes), the trust may cease to be considered a grantor trust and become a foreign non-grantor trust in which case the capital gains recognition rules apply, and therefore the estate then must pay any US tax on the gain in asset values as at the date of death or cessation of residency.
  • Identification Numbers: Once the estate is ready to be administered, the executor requires details of each beneficiary’s tax identification number (TIN), that is a Social Security Number issued by the Social Security Administration, or an Employer Identification Number (EIN) (for a business), Individual Taxpayer Identification Number (ITIN), etc., issued by the IRS. An ITIN is a tax processing number only available for certain non-resident and resident aliens, their spouses, and dependents who cannot obtain a SSN. To obtain an ITIN, IRS Form W-7 – Application for Individual Taxpayer Identification Number must be completed and filed. Form W-7 requires documentation substantiating foreign/alien status and identity for each individual.

Make Sure You’re Covered

Although this article outlines some of the basics relating to estate tax implications for US beneficiaries, the best way to ensure you have your bases covered is to talk to us

Contact us today for a friendly, no-obligation discussion about your circumstances, and take advantage of our personally tailored financial advice.

This material has been prepared for informational purposes only, and is intended for general information purposes only and should not be used as a substitute for professional advice. It has been prepared without taking into account your objectives, financial situation or needs. Before acting on this advice you should consider the appropriateness of the advice, having regard to your own objectives, financial situation and needs.

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