United States: Estate Planning: Where usufruct and US tax laws collide

Last Updated: October 24 2018
Article by Matthew Ledvina

Usufruct is typically used as an advantageous estate planning technique in Europe and in particular in France. However, in situations where US tax laws come into play, the advantages of using it can be diminished or negated, depending on the specific details of the arrangement and situation.

Ownership in two parts: Usufruct and 'bare' ownership

Usufruct is similar to the concept of the life interest or life estate you typically find in common law jurisdictions. In the civil law system ownership can be split in two parts:

  • Usufruct – the word 'usufruct' comes from the Latin words 'usus' - to use - and 'fruct' - to enjoy. The usufruct holder has the right to use and enjoy the property during their life time (or for a specific period of time). He is entitled to receive the rental incomes or interests and dividends generated by the asset. The usufruct holder is similar to a 'life tenant' (for real estate property) in the common law system.
  • 'Bare' or 'Naked' ownership – the "bare owner" holds the title of the property and has full rights to the property once the usufruct right ends (upon death or the end of its term). He is the one entitled to sell the asset and will benefit from the growth and capital gain deriving from it.

Depending on the nature of the asset which ownership is split between usufruct and bare ownership, there may be a need for an agreement between the life-tenant and the bare owner in order to govern the rights or each of them.

Usufruct – treated as a trust or life interest in the US?

The US Internal Revenue Service (IRS) has held in several rulings that a usufruct relationship between the usufruct holder and the bare owner is comparable to the relationship between a life tenant and a remainderman under common law, and not as a trust. However, in at least one case, the IRS classified the relationship as a trust because the usufruct holder had the duty to conserve and protect the estate for the bare owners.  So although the usufruct relationship is generally treated as one between a life tenant and a remainderman, the US tax classification will be based on all relevant facts and circumstances.

Estate planning scenarios involving usufruct

While there are a wide range of scenarios involving the existence of or creation of a usufruct interest, two common situations arising from estate planning in France are: 

1. The full property owner (of both usufruct and the title) keeps the usufruct right during their lifetime but transfers the bare ownership.

For example, while still living, parents gift the bare ownership of property to their children, while keeping the usufruct right for themselves (i.e. they can possess, enjoy, and derive an income from the property during their lifetime). By transferring only the bare ownership, and keeping the usufruct interest, less gift tax is paid at the time of the transfer because the value of the bare ownership is necessarily lower than the value of the "full ownership". Upon the parent's death, the usufruct right is then "passed on" to the children without inheritance tax imposed. Technically, the usufruct of the parent just extinguishes by death (without triggering any taxation) and the rights of the children are freed from the usufruct of their parent so that they can enjoy the full ownership of the asset.

When this estate planning technique comes into contact with the US tax system, the tax benefits may be negated. It also may trigger additional gift tax reporting. So the following situations should be looked at very closely:

  • US persons domiciled in France should be careful about the usual tax planning that their French notary could suggest on their worldwide assets;
  • French nationals transferring their tax residence and may be their domicile to the US should also carefully review their tax planning;
  • The contact between the US tax system and the French tax system will also arise for US residents and domiciled owning French properties or French residents owning US properties.

2. The death of the full property owner creates an usufruct interest for one party and bare ownership for another.

Using real estate property as an example, the usufruct right is similar to the creation of a life tenant in common law jurisdictions following a death of the decedent. For example, one spouse dies and an usufruct right is created for the surviving spouse (due to a will, a previous agreement or just by application of law) while the bare ownership is transferred to the children. This technique is effective from a tax perspective in France where there is a spousal exemption for the transfer of the life-tenancy while the children will enjoy a reduced taxable basis for the computation of the inheritance taxes. The surviving spouse is able to enjoy and derive an income from the property, while the children own the title. Upon the surviving spouse's death, the usufruct interest will extinguish and the children will have full ownership of the property.

In this situation in the US, the value of the decedent's taxable estate might not be reduced based on the usufruct interest as would generally be the case in civil law jurisdictions. This could affect, for example:

  • a decedent who was domiciled in the US out of his French properties or
  • a US citizen domiciled in France at the time of death.

If both the usufruct holder (life tenant) and the bare owner (remainderman) come together to sell property burdened by a usufruct, if the sale proceed is split between the life tenant and the bare owner, the life tenant can realize a gain (loss) attributable to the disposition of the life or income interest while the remainderman can realize a gain (loss) attributable to the disposition of the remainder interest.

When usufruct meets US tax law

When a property exists with a usufruct right, there may be unintended consequences when the situation comes into contact with US tax law due to decedents or beneficiaries residing in the US

  • US Gift Tax - For a US person, the gift tax applies to transfers of tangible, intangible, or real property, regardless of its location.  By contrast, for a non-US person, the gift tax applies only if the property is situated in the US and it is tangible or real property. Gift transfers of intangible property (e.g. stock or debt obligations) by a non-US person are not subject to the US gift tax. Accordingly, a non-US person may make a complete gift of US securities to the naked title holders while reserving an income interest as a usufruct holder and not be subject to the US gift tax because the securities are intangible property. By contrast, a complete gift transfer of title in a US real estate property by a non-US person should result in gift tax consequences even though the donor has only a usufruct right. In practice it means that French tax resident individuals owning a property in the US should think carefully before implementing a traditional French estate planning and gifting the bare-ownership of such property to their children while keeping the usufruct during their life.
  • US Estate Tax – In general, the estate for tax purposes includes the value of all property in which the decedent had an interest (or held certain powers) at the time of death.  For a non-US person decedent, the gross estate includes only property situated in the US  (US property includes stock issued by US corporations regardless of where the share certificates are located). Estate tax rules in the US can lead to problems for donors who have moved to the US and already have a usufruct arrangement in place because the value of the entire property (both the usufruct interest and the naked title) may be included in the estate. This could be the case for French individuals transferring their tax residence to the US

Given the different rules for gift and estate taxes, a tax trap awaits the unwary: while a gift transfer by a non-US person donor of US intangible property (e.g., US stock) with a usufruct right should not incur the US gift tax, a retained life estate or income interest in such property would very likely cause it to be included in the donor's US gross estate unless otherwise stated by a double tax treaty. Fortunately, a French tax resident holding US intangible property would be protected from US estate tax thanks to the French-US double tax treaty covering gifts and inheritance taxes.

  • US information reporting requirements - A US person who receives or holds the naked title to usufruct property located outside the US or from a non-US person may have several US information reporting requirements, including Forms 8938 and 3520.
  • US reporting requirements for financial accounts and assets (FATCA) – if a US person holds a usufruct account at a Foreign Financial Institution (FFI), the US person is required to report the account in FBAR reporting and the FFI may be required to report the account to the IRS or home country tax authority under FATCA.

A final note: PFICs and usufruct

Absent planning or special elections, a US person owning stock in a passive foreign investment company (PFIC) is subject to harsh tax rules.  Notably, certain distributions from PFICs and gains from the disposition of PFICs are taxed at the highest ordinary income tax rates with an added interest charge. 

Certain assets acquired from a decedent obtains fair market value basis (step up basis), which can reduce the gains realized by the heir or other recipient when he later sells them.  However, there is no step up basis in property unless, as relevant here, (i) the property is acquired by bequest, devise, or inheritance, or by the decedent's estate from the decedent or (ii) the property is included in the decedent's gross estate for US federal tax purposes.  Usually condition (i) does not occur in the case of a usufruct because the whole point of it is to avoid death transfers.  And, in the case of PFICs, condition (ii) does not occur if the decedent is not a US person.  Let's imagine a French tax resident owning a French holding company. He would likely make a French traditional estate planning by gifting bare-ownership of his shares while keeping the usufruct during his life. Now let's imagine that one of his children is a US tax resident, upon his parent's death, he could face PFIC issues in the US without any step up basis.

To obtain step up basis, the PFIC may need to be held through a company that can make a special election to be classified as a flow-through entity, e.g., a disregarded entity or partnership, for US federal tax purposes.  The election is made after the decedent's date of death.  With an appropriate structure and proper timing, US person heirs could not only obtain step up basis in the PFIC but also avoid the so-called controlled foreign corporation regime with respect to the holding company (if it is non-US).

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