IRS, Estates, and Nonresident Spouses

Does the IRS every make a push for or against domicile when it comes to resident/nonresident spouses? They may have reason to!

For estate and gift tax purposes, the treasury states “A person acquires a domicile in a place by living there, for even a brief period of time, with no definite present intention of later removing therefrom. Residence without the requisite intention to remain indefinitely will not suffice to constitute domicile, nor will intention to change domicile effect such a change unless accompanied by actual removal.” (Treas. Reg. 20.0-1(b)(1)). The reason why this is important to know, is because though you may not be a U.S. resident for income tax purposes, if the IRS deems you to be a domiciliary of the U.S. than you may be liable to the IRS for your worldwide estate assets. If you are not deemed a domiciliary but you have U.S. situs property, you are taxed on that U.S. situs property.

The preceding statement may come across as vague and arguably could be said to point in either direction when looking into a person’s domicile. Obviously, the tourist who has a freak accident while running through Times Square would never be considered a domiciliary, but what about the nonresident spouse who jointly owns a coop in Manhattan with his resident wife. How would the IRS determine domicile for this person?

What if it depended on the current estate/gift tax rate?

As of 2018, the tax exemption amount for an estate or gift is $11,180,000 per individual U.S. domiciliary. What this means is that if you are considered to be a U.S. domiciliary and your worldwide estate assets are valued in excess of $11,180,000, you have an estate tax liability of anywhere between 18% – 40% of the excess. If you are considered a non-U.S. domiciliary, but you have U.S. situs property, your tax exemption on that property is only $60,000. Regardless of domicile, if your estate transfers to a resident spouse, the IRS allows this transfer free of tax. However, if the transfer is from a resident to a nonresident spouse, the individual exemption still applies. When both spouses are residents, any unclaimed exemption of the first spouse to die will be transferred to the remaining spouses estate.

Let’s look to our example of the couple who shared a coop in Manhattan. Let’s say that the coop is worth $2.5M, and the nonresident spouses worldwide assets in 2018 are valued at $12M. The resident spouse passed away in 2017 and at the time of her death her estate (FMV $5M) transferred tax free as it was below the $5.49M exemption for 2017. Last month the nonresident spouse died in his coop kitchen when he choked on a cherry. If the IRS determines that the nonresident spouse is a U.S. domiciliary for estate/gift tax purposes, his worldwide estate assets ($12M) would be taxed a maximum 40% on the $820,000 over the exemption amount ($11.18M), totaling $328,000 in estate taxes. If the IRS were to deem him a non-domiciliary, his U.S. situs property would be taxed a maximum 40% on the $1.9M over the exemption amount ($60,000), totaling $760,000. In this scenario the IRS would benefit if the nonresident spouse were deemed a non-domiciliary.

But, let’s change the facts just a little bit. Let’s say the resident spouse passed in 2016, and the nonresident spouse passed in 2017. In this instance there still would be no estate taxes on the resident spouse as her estate was below the 2016 $5.45M exception. However, when non-resident yet IRS determined “domiciled” spouse passed in 2017, his worldwide estate assets ($12M) would have been taxed a maximum 40% on the $6.55M over the exemption amount ($5.45M) totaling $2.62M in estate taxes. Yet, should he be considered to not be domiciled, his estate taxes on the coop would be the same, $760,000. In this instance it would be more beneficial for the IRS to deem the nonresident spouse to be a domiciliary.

How about this one: a resident spouse and a nonresident spouse own a $22M dollar property in Brazil which makes up their entire asset base (for hypothetical purposes); they have no U.S. situs property, except an apartment that they rent year round in Estes Park CO.; but they generally just spend their summers and Holidays there. Brazil is a community property country and therefore the $22M dollar property is considered owned 50/50 by both spouses. If the resident spouse passes first in 2018, then her estate will still pass tax free as her portion is under the $11.18M exception. Should the nonresident spouse be deemed to be domiciled in the U.S. then he has a maximum estate tax of 40% due on the $10.82M over the exemption amount ($11.18M) totaling $4,328,000. However, if the IRS were to determine that the nonresident spouse is not a domiciliary, since none of the estate’s assets are U.S. situs property, the IRS would get zero! So in this situation the IRS would benefit from a finding of domicile.

The preceding was discussed to show the nature of estate taxes and the issue of domicile which is far less strict than that of residence. With the proper planning and documentation, you can prevent your nonresident spouse from being deemed a domiciliary for estate tax purposes.

Note: The reason that these hypotheticals don’t look into the situation of the nonresident spouse passing first, is because the IRS allows any and all assets to transfer from a nonresident spouse to a resident spouse tax free. If the U.S. domiciled nonresident’s estate tax return is filed properly, the $11.18M exemption can be passed on to the resident spouse giving an exemption of $22.36M on their estate taxes at death. If the nonresident spouse is deemed to not be domiciled and there is U.S. situs property, the $60,000 exemption can be transferred to the nonresident spouse, making their final estate exemption $11.24M.