U.S. Taxation of Foreign Estates Owning U.S. Stock

The American satirist, H. L. Mencken, once said “injustice is relatively easy to bear, what stings is justice.”  No case more aptly illustrates Mencken’s view than a 2009 United States Tax Court case called Charnia Estate v. Commissioner, 133 T.C. 7 (September 14, 2009).  The story involves true injustice from an evil dictator, and ultimately painful, blind “justice” as meted out by the IRS.

The case can be very instructive, however, to those of us who give tax or financial advice to non-resident alien (NRA) clients or clients who have NRA family members.  Please, bear with a few background details about the case.  You’ll find it entertaining.  Guaranteed, or your money back.

Some Background

Mr. and Mrs. Charnia were born and raised in Uganda in the 1930s of Asian parents.  Uganda was at the time a British protectorate, so its people were considered U.K. citizens.  In 1962, Uganda became independent of Britain, but Mr. and Mrs. Charnia remained UK citizens, living in independent Uganda.  Mr. and Mrs. Charnia were married in Uganda in 1967.  In 1972, Idi Amin, President of Uganda, ordered the expulsion of all Ugandans of Asian descent—giving them 3 months to leave the country.  Mr. and Mrs. Charnia left Uganda forever in October 1972, leaving all their property in Uganda.

A truly tragic injustice was done.

Eventually, the Charnia family chose to make Belgium their home because of Mr. Charnia’s prior business dealings there.  They lived and prospered in Belgium for many years until Mr. Charnia’s death in 2002; but Mr. and Mrs. Charnia remained UK citizens their entire lives.

The Charnia family was eventually very prosperous in their business, and when Mr. Charnia died on January 31, 2002, Mr. Charnia owned 250,000 shares of Citigroup common stock.  At $47.16 per share, Mr. Charnia’s estate held $11,790,000 worth of common stock of Citigroup (a U.S. corporation).  Six months later, unfortunately, the stock was only worth $33.25 per share, or $8,312,500.

Mrs. Charnia must have been a compulsive law abider, because despite no known public evidence of ever having set foot in the United States of America, Mr. Charnia’s estate filed a U.S. Estate Tax Return  (as it properly should have), reporting its interest in Citigroup stock.  Because Belgium recognizes community property law, the estate excluded Mrs. Charnia’s one-half, community property interest (125,000 shares) from the taxable estate.

The IRS challenged the community property claim by the estate, saying that since the couple was married under UK law, and the UK does not recognize community property, the entire 250,000 shares should be subject to US estate tax.  The IRS demanded in excess of $2,000,000 in estate taxes and penalties from the estate.  The estate disagreed, and sued in U.S. Tax Court.

Why Care about This Sad, Strange Story?

The real issue of this court case involved an analysis of the arcane conflict-of-laws rules between Belgium and the UK.  And in the end, the IRS won the case—the Tax Court held that UK property law governed this couple’s rights to their marital property and so all the Citigroup stock was taxable in Mr. Charnia’s estate.  But that’s not really what matters to those of us not living in Belgium.

This case teaches us (or reminds us of) some important pieces of advice for those clients who either, a) are NRAs, b) have NRA family members, or c) have large, undiversified holdings.

Specifically, here are some things we should learn:

  1. Nonresident aliens are subject to estate tax on their holdings in U.S. corporations.  This is not new law, but this case is a reminder that in this “information age” we cannot expect to do tax planning based on “playing the tax audit lottery.” It is generally a bad idea for wealthy foreign persons to die in possession of U.S. stock.

a.     The Charnias might have avoided $2MM (or even more) in U.S. estate taxes by taking some very simple planning

steps, like:

i.     transmuting the property to community property in a written agreement prior to death (this might have
avoided including the extra 125,000 shares in the taxable estate);

ii.     giving the stock away during lifetime (the U.S. generally does not subject NRAs to gift taxes for gifts of stock—even U.S. corporation stock); or

iii.     holding the U.S. corporation stock in an LLC or similar entity incorporated under the laws of another
country (this may have avoided including the stock in the taxable estate—and saved $4MM in taxes).

iv.     Devising the stock at death to a Qualified Domestic Trust (QDOT), with a U.S. bank as trustee.

b.     Selling the stock and putting the proceeds in a U.S. bank account (as long as the bank account is not effectively connected to a U.S. trade or business) would also have avoided estate taxes, as personal depository bank accounts are generally exempt from the taxable estates of NRAs.

2.   Diversification is still a very important component to wealth management success.  On the date of Mr. Charnia’s death, his Citigroup stock was valued at $47.16 per share.  Six months later, on the estate tax alternate valuation date, the value was $33.25 per share.But, on the date the U.S. Tax Court handed down its decision that the tax was owed, the value of Citigroup shares was about $4.50 per share.  Hopefully the Charnia estate had sold its Citigroup shares by that time; otherwise, the taxes and penalties due were about four times the value of the underlying shares.

3.   The United States government is getting very aggressive (and being very successful) in pursuing opportunities for tax revenues– particularly those related to assets “located” outside the U.S.

Fiscal issues with the U.S. government, combined with political pressure in light of our current economic environment, have made tax compliance for offshore assets even more important to the IRS.  And now that the government is armed with detailed information, available to them thanks to legislation such as the USA Patriot Act, FATCA (and others), in concert with sophisticated electronic verification and cross checking methods, the IRS’ reach is now in fact very, very long.

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