Sonderfall from grace
Key points
What is the issue?
When non‑US investors die owning US shares, they may leave their heirs with a substantial US estate tax liability.
What does it mean for me?
For individuals holding substantial US‑situs investments, advisors must discuss the potential tax consequences at death and whether mitigation by application of a treaty or other means is preferable.
What can I take away?
An understanding of how US estate tax rules apply to international investors and how Swiss residents may benefit from a larger exemption by application of the estate and inheritance tax treaty concluded between Switzerland and the US.
Investing in US stocks is a common, if not essential, part of any risk diversification or performance investment strategy. However, even without any other connections to the US, non‑US individual investors holding shares of outperforming securities at death may leave a US estate tax bill.
For Swiss citizens and residents, the 1951 Convention between the Swiss Confederation and the United States of America for the avoidance of double taxation with respect to taxes on inheritances (the Treaty) provides a possible avenue to minimise their US estate tax liability. Depending on the particular circumstances, Swiss investors may be entitled to a large exemption from US estate tax, which may encourage increased exposure to the US stock market.
US estate tax
A person is considered to be domiciled in the US for estate and gift tax purposes if they live in the US and have no present intention of leaving. Determining domicile for US estate and gift tax purposes is different than determining residence for US income tax purposes. Therefore, it is possible to be a resident for income tax purposes but not US‑domiciled for estate and gift tax purposes. US citizens and domiciliaries are subject to estate and gift taxation on the value of their worldwide assets transferred by gift during life or held until death1 at rates ranging from 18–40 per cent with a current combined lifetime exemption amount of USD10 million, adjusted for inflation.2 For 2021, the indexed exemption amount is USD11.7 million. Under current law, the existing lifetime exemption amount will be automatically reduced to USD5 million (adjusted for inflation) in 2026.
In contrast, non‑US domiciliaries are subject to US estate and gift taxation with respect to certain types of US‑situs assets at the same rates,3 but with the equivalent of only a USD60,000 exemption from estate (but not gift) taxes.4
For gift tax purposes, intangible property, such as shares in a US corporation and debt obligations, is not treated as a US‑situs asset.
US estate tax return
As explained, if the decedent was a non‑US citizen and was not domiciled in the US at death, the US estate tax will be due on the transfer of US‑situs assets only. In that case, if the value of the decedent’s US‑situs assets exceeds USD60,000, then the executor (if any) must file IRS Form 706‑NA within nine months of the date of death, unless an extension of time to file was granted.
The tax computations require that the total fair market value of US‑situs assets on the date of death be stated. The executor may elect to value the assets on a date that is six months after the date of death. The total value of non‑US‑situs assets must also be reported if the executor will claim any deductions (such as funeral and administration expenses, claims against the estate, unpaid mortgages and liens or certain uncompensated losses).
The Swiss ‘Sonderfall’5
Swiss citizens and residents investing in the US market can benefit from the Treaty, which applies to US estate tax and any estate or inheritance taxes imposed by a Swiss canton and any political subdivision thereof. Unlike more modern US estate tax treaties, the Treaty grants a larger exemption for Swiss citizens or Swiss‑resident decedents who were not US citizens and were not domiciled in the US at the time of their death (i.e., more than the standard USD60,000).
Article 3 of the Treaty provides that this larger exemption will be equal to the ‘specific exemption’ that would be allowable under US law had the decedent been domiciled in the US,6 multiplied by the proportion that the value of the estate’s US‑situs assets bears to the value of the estate’s worldwide assets (whether US‑situs or not).
Example
Imagine a Swiss resident who passed away in 2021 in Geneva, leaving to their spouse and children living in Switzerland an estate worth USD10 million. The estate comprises:
- a residence in Geneva valued at USD3 million;
- Swiss francs on deposit at banks in Geneva and Luxembourg valued at USD2 million;
- private equity (shares in a Swiss company) valued at USD3 million; and
- a portfolio of shares in US corporations valued at USD2 million.
From a Swiss and, in particular, Genevan perspective, there would be no inheritance taxes due, as successions in direct line and between spouses are tax exempt.7
Under domestic US tax law, US estate tax would be payable due to the decedent’s ownership of the US shares, given the exemption of only USD60,000. However, by application of the Treaty, the estate would benefit from an exemption of USD2.34 million, which corresponds to one‑fifth of the USD11.7 million exemption (one‑fifth corresponding to the proportion that the value of US shares bears to the value of the total worldwide property, both US‑situs and non‑US‑situs, of the deceased). To claim this benefit, the estate must file Form 706‑NA, along with Form 8833, disclosing the US‑situs assets and at least the value of the total estate.
Therefore, in this example, no US estate tax would be due as the value of the US shares upon death (USD2 million) is lower than the Treaty‑adjusted exemption amount of USD2.34 million.
Conclusion
Under the Biden administration,8 the US Congress may look to speed up the reduction of the lifetime exemption amount or reduce it even further than USD5 million while increasing the top marginal rate to 45 per cent (from 40 per cent currently). Although these changes would not affect the application of the Treaty to Swiss investors, they would proportionally reduce the potential benefit available.
The advantage of the Treaty, with the potential to increase drastically the exemption amount for Swiss investors, would encourage Swiss investors to enter and stay in the US market. Further, owning US investments directly would also entitle the investor to a reduced US withholding tax (from 30 per cent to 15 per cent) on any dividends paid by application of the Swiss‑US Income Tax Treaty.
Each case is different, so specific legal and tax advice should be obtained. With the pandemic still around and a new administration on board, one certainty is that US estate taxes will remain a concern for international investors during the years to come.
1 There is a third transfer tax applicable called the generation‑skipping transfer tax, which applies to gifts or bequests that ‘skip’ one generation or more or to individuals more than 37.5 years younger than the donor. There is a separate lifetime exemption amount available for generation‑skipping transfer taxes equal to the lifetime exemption amount for estate and gift taxes.
2 In fact, §2010 of the US Internal Revenue Code of 1986, as amended (the Code), provides for a unified credit against estate taxes. The credit is equal to an applicable exclusion amount, which is USD10 million. For simplicity, we refer to a ‘lifetime exemption amount’ throughout this article.
3 For non‑US citizens not domiciled in the US, US‑situs assets generally include US real estate, tangible, physical property in the US, shares in corporations organised in the US, and obligations issued by US persons.
4 §2102 of the Code technically provides for a credit of USD13,000.
5 Sonderfall is a German term that translates to ‘exceptional case’.
6 Even though the Treaty predates the current lifetime exemption amount system, past case law has held that art.3 continued to apply after legislative changes to US estate tax laws switched from an exemption to a credit system. See, Mudry v United States, 11 Cl. Ct. 207 (1986).
7 art.6A, Loi sur les droits de succession. However, such exemption would not apply if the decedent benefited from the lump‑sum tax regime for at least three years before their death. In such a case, heirs consisting of the surviving spouse and children would be subject to a marginal inheritance tax rate of 6 per cent.
8 In particular with the Democrats controlling the House and holding Vice President Harris’ likely tie‑breaking vote in the Senate.
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