While an American may feel a mix of joy and sorrow when receiving a foreign inheritance—happy about the financial windfall but grieving the loss of a loved one—they must also navigate the complexities of U.S. tax obligations. In today’s global economy it is increasingly common for Americans whether living abroad or stateside, to receive an inheritance from a non-U.S. person.
Here’s 4 important takeaways from understanding what can be taxed, to IRS reporting requirements and beyond:
1. In the usual case, the inheritance is a true windfall and is not taxed by the U.S. An inheritance is not always easy money, however. If the decedent was a former U.S. person and met certain requirements as a “covered expatriate” (CE), the American recipient must pay 40% of the value of the inheritance to the IRS. Planning can often avoid this problem.
2. Even if the inheritance is not taxed, the American recipient must report its receipt to the IRS, or risk losing 25% of its value as a penalty.
3. Depending on the type of asset inherited, other reporting obligations can arise.
4. The basis of the asset inherited can get tricky but is critical to know for a future sale or other transaction involving the asset.
Receiving An Inheritance From a Covered Expatriate
Under the general U.S. tax rules, when an American receives a gift or inheritance, these are received tax-free. However, the rules change if one receives a gift or inheritance from a CE.
A CE is a U.S. citizen or long-term resident who renounced citizenship or long-term residency and met certain criteria related to income, net worth, or tax compliance, resulting in onerous “expatriation” tax consequences. The expatriation tax regime impacts not only the CE, but U.S. persons within his or her close circle. Gifts or bequests from CE’s are not received tax-free; they can be taxed to the U.S. recipient at the highest gift or estate tax rate in effect at the time of receipt, currently, 40%.
Prior to expatriating, steps can be taken to avoid CE status altogether, protecting American recipients from a 40% take by the IRS. Nonetheless, the burden of proving to the IRS that something was not received from a CE, falls on the American recipient. While planning can and must be done in advance to meet this burden, most people are simply unaware and fail to take precuationary action. Having certain of the former U.S. person’s tax returns and IRS filings, for example, is critical to proving non-CE status.
Reporting Requirements
IRS Form 3520: If a U.S. person receives a foreign inheritance exceeding $100,000 from a non-U.S. person, they must file IRS Form 3520, “Annual Return To Report Transactions With Foreign Trusts and Receipt of Certain Foreign Gifts”. This form reports the receipt of the inheritance to the IRS and is typically due on the same date as the individual’s income tax return, including extensions. Failure to file the form can result in a hefty penalty of 25% of the inheritance. The IRS has indicated in proposed Treasury Regulations, that the $100,000 amount will become indexed for inflation.
FBAR and FATCA: If the inheritance is a foreign bank account or other foreign financial account (e.g., a foreign mutual fund), in the aggregate of all foreign accounts exceeding $10,000 annually, the U.S. person must file FinCEN Form 114, Report of Foreign Bank and Financial Accounts (FBAR). Penalties for unfiled FBARs can be draconian, so this is one form that must not be missed.
Additionally, the Foreign Account Tax Compliance Act (FATCA) requires filing IRS Form 8938, “Statement of Specified Foreign Financial Assets”, if the total value of foreign financial assets exceeds certain thresholds each year. The annual thresholds are much lower for Americans residing stateside when compared to those for Americans living abroad. Not only do penalties apply for not filing this form when required, the failure to file results in an open statute of limitations for the entire tax return. This means the IRS can make adjustments at any time in the future. Only when the form is filed will the 3-year statute of limitations begin.
Basis of the Inherited Asset
When inheriting a foreign asset from a non-U.S. decedent, the U.S. tax “basis” of the asset is very important to accurately determine and document to ensure proper tax reporting and compliance going forward. The basis of a foreign asset received by “bequest, devise, or inheritance” from the foreign decedent will be “stepped up” to its fair market value at the date of the decedent’s death. This is so even if that asset is not taxed in the foreign decedent’s U.S. estate (for example, real estate in a foreign country). A good example of a “bequest” is receiving an asset under the decedent’s last will and testament. Nuances apply in many situations, especially with assets in trusts, and a step-up is not obtained.
Special Considerations
If the inheritance includes foreign businesses or entities or interests in foreign trusts, special tax and information reporting rules will apply. In addition, the U.S. person may need to deal with foreign tax obligations. In these situations, it is all the more important to obtain professional guidance from qualified U.S. tax advisors as well as local counsel.
Send a note about an area of tax you’d like to see me write about.
Read the full article here
