In today’s global economy, U.S. citizens and residents frequently receive inheritances from non-U.S. persons. This may occur due to more globalized families, expatriates returning to the U.S., or other reasons. While inheriting foreign assets can provide financial opportunities, it also presents complex reporting requirements and tax implications that must be properly handled.
This comprehensive guide covers key considerations and steps to take when receiving an inheritance from outside the United States as a U.S. taxpayer. We’ll explore the U.S. tax rules, ongoing reporting requirements, strategies for transferring assets, and tips for non-U.S. persons planning to leave an inheritance to someone in the U.S.
Understanding the cross-border nuances is crucial, as even small mistakes can become costly penalties. However, with proper planning, a foreign inheritance can be a smooth process that sets you up for long-term financial success in the U.S.
No Direct Taxes, But Strict Reporting Rules Apply
The first question that often arises when inheriting foreign assets is – will I need to pay U.S. taxes on this? The good news is there are no U.S. taxes directly owed on receiving an inheritance from a non-U.S. person, whether it’s cash, real estate, business interests, or other assets. The value of the inheritance itself is not subject to U.S. income or capital gains tax.
However, just because it’s tax-free doesn’t mean you can ignore reporting the inheritance to the IRS. There are strict requirements to disclose foreign gifts and bequests over certain thresholds. Any gift or inheritance valued at more than $100,000 received from a non-U.S. person each year must be reported to the IRS on Form 3520. This form is titled “Annual Return to Report Transactions with Foreign Trusts and Receipt of Certain Foreign Gifts.”
On Form 3520, you must disclose details including:
- Description of assets received
- Date the inheritance was received
- Value of the assets on the date of receipt
While Form 3520 requires listing the inherited assets, you do not have to disclose the identity of the person who left you the inheritance.
One thing to note is that it’s not just one-time gifts that require reporting. If you receive multiple gifts valued at over $100,000 in total within a year from the same foreign person, these must also be reported on Form 3520.
In addition to Form 3520, receiving an inheritance from a foreign estate may trigger filing requirements on IRS Form 3520-A and IRS Form 706-NA. It is highly recommended that you speak with a cross-border tax attorney or accountant to ensure you meet all IRS reporting rules.
Failing to properly disclose foreign gifts and inheritances can lead to steep penalties from the IRS. Penalties start at 5% of the value of the inheritance per month, up to a maximum of 25%. There is also potential for criminal liability if non-compliance is deemed willful tax evasion.
The key takeaway is while a foreign inheritance itself is not taxed, reporting the assets to the IRS is mandatory. This allows them to keep tabs on foreign funds entering the U.S. tax system. Consult a professional to ensure you meet all IRS requirements from the outset.
Inherited Foreign Assets Get Stepped-Up Tax Basis
Another common inheritance question involves the tax basis of foreign assets. This refers to the value of an asset for tax purposes, which impacts capital gains taxation when the asset is eventually sold. The U.S. tax code provides a significant benefit here – inherited assets receive a stepped-up basis to their fair market value at the time of the decedent’s death.
This means if you inherit foreign real estate or securities worth $1 million at the time of death, your basis will step up to $1 million. If you later sell for $1.5 million, you will only pay capital gains tax on the $500,000 increase rather than the full amount.
Without this rule, inheriting appreciated assets could trigger massive tax bills based on gains that accrued under the previous owner. The step-up provision helps avoid this issue, but while U.S. tax law allows for the stepped-up basis on inherited foreign assets, local country taxes may still apply. Some things to be aware of include:
- Some countries tax inheritances based on the recipient rather than the estate
- Basis step-up may not be recognized for local tax purposes
- Tax treaties may impact how the basis is calculated across countries
It’s important to consult with advisors familiar with both U.S. and foreign tax law to fully understand your basis and potential tax exposure when inheriting foreign assets.
Proper Disclosure of Foreign Assets to the IRS
Receiving a foreign inheritance is just the beginning. Once the assets are in your possession, ongoing U.S. tax reporting and disclosure requirements apply based on holding foreign assets. The IRS reporting rules depend on the type of asset and how much control you have over it:
Foreign Bank Accounts
- Must file FBAR if the combined value exceeds $10,000
- Also report on Form 8938 if the value exceeds threshold
- Requires disclosing account details and maximum value
Foreign Stocks/Securities
- Disclose on Form 8938 if the value exceeds threshold
- May need to report dividend/interest income
- Additional rules for Passive Foreign Investment Companies
Foreign Real Estate
- Disclose ownership on Form 8938
- Report any rental income
- Must report on sale for U.S. capital gains tax
Foreign Business Ownership
- Complex reporting beyond just Form 8938
- Rules for Controlled Foreign Corporations, Global Intangible Low-Taxed Income
- U.S. tax on portion of foreign business income
Foreign Trusts
- Form 3520/3520A for U.S. beneficiaries of foreign trusts
- Annual reporting of trust assets/distributions
- Taxable distributions subject to accumulation tax
The penalties for not properly disclosing foreign assets and related income can be severe and up to 40% of the amount not reported. Criminal charges may even be pursued. A foreign inheritance often brings with it complicated, ongoing reporting rules. The best way to avoid problems is to work with an experienced international CPA or tax attorney to ensure full compliance.
Navigating Taxes and Laws in the Non-U.S. Jurisdiction
While U.S. tax implications are a major consideration, local country taxes and regulations may also apply when inheriting foreign assets. Some key things to be aware of include:
Forced Heirship Laws
Many foreign countries have “forced heirship” laws that require a certain portion of assets to go to children or a surviving spouse, regardless of what the will states. This is common in civil law countries like France, Italy, Brazil, and various others. Attempting to transfer assets out of the country before settling forced heirship rights can create legal issues. Forced heirship laws are legal statutes in certain countries that limit the freedom of individuals to dispose of their estate as they wish. They require that a portion of a person’s assets must pass to certain heirs, typically children, upon their death.
Forced heirship originated in civil law legal systems, such as those in France, Spain, Italy, and Latin American countries. The rationale was to prevent disinheritance of children and provide for their financial security.
How do forced heirship laws work?
Forced heirship laws designate a reserved portion of the estate that must go to heirs rather than allowing it to be distributed any way the deceased wishes. For example, a French forced heirship law requires:
- At least 50% of the estate must go to children if the deceased has one child.
- 66% must go to children if there are two children.
- 75% for three or more children
- The reserved portion is split between children equally. The rest of the estate can be disposed of freely to other beneficiaries.
The heirs entitled to the forced share cannot legally be disinherited or left out of the will. Attempting to do so would trigger clawback provisions after death.
Which countries have forced heirship regimes?
While the specifics differ, forced heirship is common globally. Countries with some form of forced heirship laws include:
- Most of continental Europe – France, Germany, Spain, Italy, Netherlands
- Latin America – Brazil, Mexico, Argentina, Colombia
- Japan and South Korea
- Some Middle East and North African countries
Implications when inheriting across borders:
Forced heirship laws can create complications for cross-border inheritances. If U.S. heirs are set to receive assets from a country with forced heirship, local children may have a claim to some of those assets regardless of will provisions. Attempting to transfer foreign real estate or tangible property to the U.S. before resolving forced heirship claims can stall the process and create legal problems.
Similarly, forced heirs in another country could challenge a will probated in the U.S. that disinherits them by local laws. This can disrupt the inheritance and result in lengthy court disputes. To avoid problems, inheriting foreign assets may require proactively settling forced heirship rights in the origin country before assets can be released. Understanding relevant laws is key to a smooth process.
Inheritance Tax vs. Estate Tax
In the U.S., inheritance tax is levied on the estate before transfers to heirs. Other nations tax inheritances based on the recipients and their relationship to the deceased. For example, a foreign country may impose a higher tax rate when assets are left to a non-relative. Understanding the local laws is crucial.
Tax Treaties
The U.S. has estate and inheritance tax treaties with some countries that impact cross-border transfers. This can affect the taxes owed by both the estate and beneficiaries. Reviewing if a tax treaty exists and its specifics is an important step.
Probate Requirements
Some assets like foreign real estate may need to go through probate in the foreign jurisdiction before being transferred internationally. Trying to bypass local probate can make establishing legal ownership difficult later.
Death Certificates
Most countries require official death certificates issued locally before releasing inheritances. This can mean delays in retrieving assets while foreign death certificates are obtained. Knowing the right process can prevent holdups. Getting expert guidance on both the U.S. and foreign legal and tax requirements is highly advisable when inheriting international assets. Rules are complex on both sides, but coordinating properly can alleviate headaches.
Strategic Options for Transferring Foreign Assets to the U.S.
Once you’ve received a foreign inheritance, an important decision is whether to transfer the assets to the U.S. or keep them abroad. There are pros and cons to each approach.
Keeping Assets Outside the U.S.
Some reasons you may want to maintain inherited assets outside the U.S.:
- Avoid fees associated with asset transfers
- Preserve geographic diversification of holdings (assets may be affixed to the foreign jurisdiction, like land and buildings)
- Ability to take distributions directly in foreign currency
- Maintain proximity for foreign real estate or business interests
- Sidestep U.S. estate tax on illiquid assets held until death
However, the downsides often outweigh the benefits, including:
- Ongoing IRS reporting requirements still apply
- Taxable investment vehicles like foreign mutual funds are subject to punitive tax treatment by the IRS
- Cumbersome account administration across borders
- Foreign institutions may not understand U.S. requirements
- Potentially being subject to local country estate taxes at death despite being a U.S. resident
Given the headaches, moving assets to the U.S. is often the preferred choice. Some tips for executing the transfer:
- Liquidate foreign stocks/funds that would be PFICs and transfer cash
- Work with U.S. custodians to accept international asset transfers
- Use a qualified intermediary to facilitate tax-deferred exchange of foreign real estate
- Get an appraisal of art, and collectibles to establish a tax basis before import to U.S.
- Transfer foreign business ownership shares to a U.S. holding company structure
With the right planning, foreign assets can usually be moved to the U.S. smoothly. Just be sure to model the tax impacts beforehand.
Advanced Planning Tips for Non-U.S. Persons Leaving an Inheritance to U.S. Heirs
So far, we’ve covered what U.S. taxpayers should do upon inheriting foreign assets. But what if you’re a non-U.S. person who wants to leave an inheritance to U.S. heirs in the future? Advanced planning is key to simplifying the process for your beneficiaries.
Some steps to consider:
Set Up a U.S. Trust
A U.S. trust funded with assets for U.S. beneficiaries can streamline inheritance tax reporting compared to personally owned foreign assets. Some U.S. jurisdictions like Delaware, Nevada, and South Dakota offer advantageous trust laws for non-U.S. grantors.
Use a U.S. Bank Account
Deposit cash you want your heirs to receive in a U.S. bank account. This avoids cross-border transfer issues. Name beneficiaries directly on the account.
Purchase U.S. Life Insurance
A U.S. life insurance policy with U.S. heirs as beneficiaries can provide an income tax-free inheritance that avoids probate.
Invest in U.S. Securities
Purchasing U.S. stocks, bonds, and mutual funds in a U.S. brokerage account typically avoids forced heirship issues and simplifies inheritance.
Fund a U.S. Retirement Account
Naming a U.S. person as the beneficiary on your 401(k) or IRA passes funds directly at death while avoiding probate.
Draft a U.S. Will
Creating a U.S.-based will to specify bequests to U.S. persons and naming a U.S. executor can help carry out wishes efficiently. Consulting U.S. estate planning counsel can reveal other creative solutions for non-U.S. persons planning an inheritance for U.S. heirs. Act sooner rather than later for best results. Coordinate between the US and foreign counsel to ensure smooth transfers.
Conclusion
Inheriting foreign assets as a U.S. taxpayer brings unique challenges but also provides financial opportunities if handled correctly. While a foreign inheritance itself may not generate U.S. taxes, there are strict reporting rules and ongoing requirements for holding international assets.
Navigating the web of cross-border taxes, regulations, and legal constraints can feel daunting. But with the right guidance and strategic planning, your inheritance can be successfully transferred to the U.S. and integrated into your long-term investment and estate plans.
At JDKatz, P.C. we’ve been helping members of the international community plan their estates for over twenty years. We regularly represent members of the diplomatic community, and employees of international organizations such as the World Bank, and the United Nations resident within the United States on G4 visas to comply with their specific nuanced tax issues. Over this time, we’ve seen that the most important takeaway is that failing to comply with tax reporting requirements can result in steep penalties and other issues down the road. Working with advisors familiar with both U.S. and foreign tax law is highly recommended. An ounce of prevention is truly worth a pound of cure when inheriting foreign assets.
By: Jeffrey D. Katz, Esq.
Jeffrey D. Katz, Esq. is the managing partner of JDKatz, P.C.
To learn more about inheriting assets from abroad, or if you have any further questions, schedule an appointment for a consultation.