Withholding on Distributions to Foreign Beneficiaries of U.S. Estate Six-Step Process

Determining the U.S. tax to be withheld on distributions made to foreign beneficiaries of U.S. estates requires consideration of several factors. These six steps can help fiduciaries in navigating this process.

One: Determine the Tax Status of the Beneficiary

This step entails confirming that the Beneficiary is in fact a nonresident alien (NRA) and not a U.S. citizen, Lawful Permanent Resident (Green Card holder), or tax resident. The NRA must also not satisfy the Substantial Presence Test (SPT).

A beneficiary will be considered a 'resident alien’ for US tax purposes if he or she satisfies the SPT for a tax year.  To fulfill this test in the 2022 tax year, they must be physically present in the US for at least:

1. 31 days during the current (2022) year; and 
2. 183 days during the 3-year period that includes this year and the 2 years before that, counting:
   • All the days they were present in the current (2022) year; and
   • 1/3 of the days they were present in the first preceding year (2021) and
   • 1/6 of the days that they were present in the second preceding year (2020).

If the total calculated in this manner equals at least 183 days, the beneficiary would be a U.S. resident for tax purposes in the 2022 tax year (i.e., the U.S. tax year ending December 31, 2022)¹. 

Even if the beneficiary satisfies the SPT, they could still be treated as an NRA if they were present in the U.S. for less than 183 days during 2022 and maintained a tax home in another country and could demonstrate a “closer connection” to that country during the year². 

To satisfy the closer connection exception, the beneficiary need to³:

1. have been in the U.S. for less than 183 days in the year; and
2. have a closer connection to the other country during that year; and
3. have maintained a “tax home” in the other country throughout the whole year; and
4. not have taken any steps towards, and not have an application pending for a change of immigration status (i.e., green card)⁴.

An individual's tax home is considered to be located at the individual's regular or principal (if more than one regular) place of business, and if the individual has no regular or central place of business because of the nature of the business, or because the individual is not engaged in carrying on any trade or business, the individual’s tax home is the individual's regular place of abode in a real and substantial sense⁵.

In determining this, the Internal Revenue Service (IRS) considers factors such as the location of a person’s⁶:

• permanent home
• family
• personal belongings, such as cars, furniture, clothing, and jewelry
• social, political, cultural, or religious affiliations
• routine personal banking activities
• business activities (other than those that constitute your tax home)
• jurisdiction in which they hold a driver's license
• jurisdiction in which you vote
• country of residence designated on forms and documents; and
• types of official forms and documents filed by the individual, such as Form 1078 (Certificate of Alien Claiming Residence in the United States), Form W-8 (Certificate of Foreign Status) or Form W-9 (Payer's Request for Taxpayer identification Number).

If the beneficiary satisfies the closer connection test, then they are treated as a NRA. Once tax status is determined, each beneficiary must complete a Form W-8BEN and return it to the executor, administrator, or trustee (Fiduciary) of the estate. The information on the form will be relevant for three years.

Two: Is Income Being Distributed To The Beneficiary?

Income consists of the interest, dividends, or other return earned on the corpus or principal, or the amount originally received in the estate. The distribution to the beneficiary must be of U.S. sourced income.

Three: Is the Payment Being Made Directly to the Beneficiary?

No foreign person is assuming responsibility for withholding as a qualified intermediary (such as a foreign financial institution or clearing organization with a qualified intermediary withholding agreement with the IRS) or an authorized federal agent.

Four: Default Withholding Rate

If the U.S. source income is being paid directly to a NRA, then 30% must be withheld, in the absence of a contrary provision in the applicable Treaty between the U.S. and the NRA beneficiary’s country of residence.

Five: Does A Tax Treaty Apply?

If the beneficiary’s country of residence is a Treaty country, the Fiduciary can withhold at the applicable (lower) rate outlined in the Treaty. The IRS Tax Treaty Table summarizes applicable Treaty rates for specific types of income, and can be a useful guide for fiduciaries.

Fiduciaries should be careful in ensuring that a Treaty is in fact in effect – i.e., that it has been signed and ratified. For example, the U.S.-Chile treaty, signed in 2010, is awaiting Senate consideration and has not been ratified. 

If the NRA beneficiary’s country of residence is not a Treaty country, the default withholding tax rate of 30% will apply.

Six: File Applicable IRS Forms

The estate must file IRS forms 1042, 1042-T, and 1042-S for each applicable tax year to disclose the amount of tax withheld on payments of U.S. source income to foreign persons. 

The beneficiary, as an NRA with U.S. source income, must file Form 1040NR or Form 1040NR-EZ in the U.S., as well as any applicable tax filings in the beneficiary’s home country.

Disclaimer

No Attorney-Client Relationship or Legal Advice
Contributed by Renuka Somers

1. note exceptions below, which I include for future reference purposes
2. Treasury Regulations Section 301.7701(b)-1(b)(2); Simon would need to file IRS Form 8840 to claim the closer connection exception
3. See Treasury Regulations Section 301.7701(b)-1(b)(2) and IRC Section 7701(b)(3)(C)
4. IRC Section 7701(b)(3)(C)
5. Treasury Regulations Section 301.7701(b)-2(c)
6. Treasury Regulations Section 301.7701(b)-2(d)(1)