The Transfer Tax Tale of Disenfranchised U.S. Citizens

Journal of Financial Planning: May 2019​​

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Fabio Ambrosio, J.D., LL.M., CFP^®, EA, CPA/PFS, is an assistant professor of accounting at Central Washington University and a recurring lecturer at Swiss and Chinese universities. He is a former appeals officer in the estate and gift tax program at the IRS.

Editor’s note: For additional information and data, please click HERE​ for the online appendix. 

This column focuses on the transfer tax implications affecting people who acquired U.S. citizenship by birth in Puerto Rico, Guam, the U.S. Virgin Islands, or the Northern Mariana Islands, which are referred to here as “the possessions.” And anyone who acquired U.S. citizenship by birth or citizenship in the possessions is referred to in this column as a “citizen” of a possession.

The relationship between the federal transfer tax system and the possessions has been travailed since the estate and gift tax were first introduced by the Revenue Act of 1916.¹ Congress and the courts have spent the last 100 years rewriting and reinterpreting the same few keywords in the hope that citizens of possessions would fare no better and no worse than any other U.S. citizen. They have been unsuccessful.

Factors Leading to Disenfranchisement

Further developments in the estate and gift tax regime since 1960 have effectively disenfranchised citizens of possessions. The term “disenfranchising” is intended as the point where citizens of possessions begin faring worse than any other U.S. citizen in the same situation. The transfer tax regime, as it currently stands, is more advantageous to citizens of possessions who hold assets outside the United States, while it taxes more heavily those who hold assets within the United States.

Until 1958, citizens of possessions²were able to escape the estate and gift tax through two loopholes created by earlier Tax Court decisions in Smallwood and in Rivera.³ In 1958, Congress closed the Smallwood loophole by adding Section 220 to the Internal Revenue Code of 1986 and its gift tax counterpart, Section 2501(b). And in 1960, Congress also closed the Rivera loophole by adding Section 2209.⁴ Because of these new Sections, citizens of possessions were no longer exempt from transfer taxes.

Three further developments in the estate and gift tax regime since 1960 have effectively disenfranchised citizens of possessions, discouraging them from investing in the contiguous United States and incentivizing them to keep their assets offshore.

First, when Congress initially passed Sections 2208 and 2209, the transfer tax exemption was $60,000 for both estates of citizens/residents as well as non-citizens/non-residents. Therefore, any non-citizen/non-resident whose estate was situated entirely within the United States would enjoy the same exemption as a citizen/resident. The exemption had stayed at $60,000 for all estates since 1942 and remained at $60,000 for all estates until 1976. There was effectively no exemption-related disadvantage to being classified as a non-citizen/non-resident.

At the time Sections 2208 and 2209 were enacted, perhaps nobody envisioned the future trend of the estate tax exemption for citizens/residents. Starting in 1977, the exemption amount for citizens/residents began to climb—and has climbed steadily and steeply until reaching $11.2 million in 2018. On the other hand, the exemption amount available to estates of non-citizens/non-residents remains $60,000.⁵

Second, currently no possession levies transfer taxes on their residents or citizens. Guam, the U.S. Virgin Islands, and the Northern Mariana Islands never imposed their own estate and gift tax system. Puerto Rico, on the other hand, repealed its estate and gift tax system on August 6, 2017.

Third, citizens of possessions who reside in the possessions are treated as non-citizens/non-residents, which means that they are exposed to federal transfer taxes insofar as they hold assets in the contiguous United States and are subject to an exemption of only $60,000. The result is a dramatically higher estate tax liability than any other U.S. citizen.

Incentivizing Offshore Assets

In the last 60 years there has been one attempt to alleviate the transfer tax burden on citizens of possessions when, through the Tax Reform Act of 1976,⁶ Congress slightly increased the unified credit for citizens of possessions compared to any other non-citizen/non-resident. As of 2018, Section 2102 provides that the unified credit available to estates of citizens of possessions is the greater of $13,000 (the amount allowed to any non-citizen/non-resident) or “that proportion of $46,800 which the value of that part of the decedent’s gross estate which at the time of his death is situated in the United States bears to the value of his entire gross estate wherever situated.”⁷

Example. Suppose that a decedent was born in Puerto Rico, where he resided throughout his life until death. At the time of death in 2015, the decedent’s estate was composed of only one parcel of land located in the Dominican Republic. The fair market value of the land on the date of death was $10 million. The decedent is deemed a U.S. citizen by virtue of birth in a possession. Without Section 2209, this estate would be subject to tax on worldwide assets pursuant to Section 2001. Assuming, arguendo, a flat estate tax rate of 35 percent, the gross estate tax would be $3.5 million. Despite the $2,117,800 unified credit available in 2015 (based on the exemption amount of $5.43 million), the net estate tax would amount to $1,382,200. However, Section 2209 treats this decedent as a non-citizen/non-resident and because his only asset consists of property situated outside the United States, the taxable estate for U.S. tax purposes would be nil. In this instance, where assets are held offshore, Section 2209 saved the estate $1,382,200 in federal estate tax.

Suppose again the same facts above except that the decedent’s estate was composed of only one parcel of land worth $10 million dollars located in Florida. In this instance, after applying Section 2209, the decedent is neither considered a U.S. citizen nor a resident, and his estate is taxed according to Section 2101 as a non-citizen/non-resident. Although the gross estate tax would still be $3.5 million, the unified credit would only be $46,800.⁸ The net estate tax would amount to $3,453,200, which means that Section 2209 cost this estate $2.07 million.⁹

As soon as the exemption amounts were no longer the same for citizens/residents and non-citizens/non-residents, Section 2209 began incentivizing citizens of possessions to keep their wealth offshore. In the simplest of terms, citizens of possessions are better off keeping all their wealth offshore as this permits them to escape the federal estate tax completely. In this column, however, the focus is on the point of disenfranchising, which is the point where citizens of possessions begin faring worse than any other U.S. citizen in the same situation. This point can be expressed as:

where m represents the assets situated in the United States; g represents all assets wherever situated; r represents the estate tax rate; and c represents the unified credit available to citizens/residents.

Suppose that a lifetime resident of Guam holds $7 million in cash in a Swiss bank account and a residence in Guam with a fair market value of $2 million. Suppose further that the unified credit available to citizens/residents is $3 million and that the estate tax rate is 35 percent. The point of disenfranchising can be computed as:

The $435,034 figure represents the point when this taxpayer, a U.S. citizen by virtue of birth in a possession, begins to be taxed more than any other U.S. citizen in the same shoes. The only way for this taxpayer to avoid being taxed as a second-class citizen is by keeping any wealth in excess of $435,034 offshore.

The key factors in determining when citizens of a possession begin to be taxed less favorably than any other U.S. citizen in the same situation are: (1) the size of the unified credit available in the year of death; and (2) the proportion of wealth in the contiguous United States. Assuming that a given citizen of a possession holds half of his or her assets in the contiguous United States, the point in time where he or she began faring worse than any other U.S. citizen was the year 2000 for a gross estate totaling $1 million; the year 2009 for a gross estate totaling $5 million; and the year 2012 for a gross estate totaling $10 million.10 Therefore, smaller estates were adversely impacted first.

Exceptions. The disenfranchising impact on citizens of possessions would be devastating if it were not for two important exceptions. In the estate tax arena, Section 2105 lists a series of assets that are definitionally excluded from being deemed situated within the United States. This includes life insurance proceeds, bank accounts, and stock in U.S. companies. In the gift tax arena, Section 2501(a)(2) excludes all intangible property from being deemed situated within the United States.

If it were not for these key exclusions, a citizen of a possession would be discouraged from opening a bank account with any U.S. bank, or buying stock in any U.S. company, or purchasing a life insurance policy from any U.S. insurer. After incorporating the mitigating impacts of Sections 2105 and 2501(a)(2), it can be concluded that citizens of possessions are discouraged from investing in the contiguous United States only insofar as acquiring real estate or other tangible assets.

Moving Forward and Advising Clients

The interplay of Sections 2209 and the ever-increasing estate tax exemption available for citizens/residents has inadvertently discouraged citizens of possessions from owning land or tangible assets in the contiguous United States, while it encourages them to own land and tangible assets anywhere else in the world. This can be mitigated two ways by Congress and one way unilaterally by the taxpayer.

The first alternative would be to exempt citizens of possessions from estate tax only insofar as they hold assets in the possessions while treating them as citizens/residents with respect to everything else. This would allow a lifetime resident of Puerto Rico with assets only in Puerto Rico to escape the estate tax entirely, while at the same time it would permit those Puerto Ricans with assets in the United States to enjoy the larger exemption amount available to all other citizens/residents.

The second alternative would be to allow estates of citizens of possessions to elect whether they wish to be taxed as citizens/residents or non-citizens/non-residents, thus permitting those estates for which Section 2209 is not beneficial to opt out.

It is unclear whether and when Congress will act. Until then, a citizen of a possession adversely impacted by Section 2209 can ameliorate his/her situation by: (1) not holding any assets in the contiguous United States not defined in Section 2105; or (2) taking domicile in the United States; or (3) limiting the amount of wealth kept in the contiguous United States based on the formula discussed previously.

Endnotes

1. ​See the Revenue Act of 1916, U.S. Statutes at Large 39 (1916): 756-801, available at www.loc.gov/law/help/statutes-at-large/64th-congress/session-1/c64s1ch463.pdf​.
2. The online appendix provides a historic background on the annexation of the possessions and the key transfer tax developments.
3. Estate of Smallwood v. Comm’r, 11 TC 740 (1948), and Estate of Rivera v. Comm’r, 19 TC 271 (1952), affd. 214 F.2d 60 (2nd Cir., 1954).
4. Internal Revenue Ruling 74-25 later explained that the same tax treatment would apply to anyone who, having acquired U.S. citizenship by birth in a U.S. possession, dies residing in another U.S. possession.
5. The online appendix​ provides a chart and further details.
6. See the Tax Reform Act of 1976, Public Law 94-455, U.S. Statutes at Large 90 (1976): 1520-1933, available at www.govinfo.gov/content/pkg/STATUTE-90/pdf/STATUTE-90-Pg1520.pdf​.
7. U.S. Code 26, § 2102(b)(2).
8. Ibid.
9. The difference between what the net estate tax liability would be using the same unified credit available to all other citizens/residents (net tax, $1,382,200) and what the net estate tax is based on the $46,800 unified credit (net tax, $3,453,200).
10. See endnote No. 5.

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