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The German–American Estate Plan
You Say Tomato and Ich Sag Tomate
By Max Riederer von Paar
Max Riederer von Paar is a partner in the Washington, D.C., firm of Rubin, Winston, Diercks, Harris & Cooke LLP.
Estate planning for German citizens who are U.S. domiciliaries can be a challenging task. Concepts familiar to the U.S. estate planner may not work if the client is a German citizen or has German beneficiaries.
Different Systems
The legal systems for estate planning in both countries are very different and seemingly incompatible:
• Germany does not recognize the probate estate as a separate entity, as generally perceived for U.S. probate law and U.S. estate and fiduciary income tax purposes. Under German law, the institution of a legal representative of an estate is recognized. This legal representative sees that the testator’s wishes are fulfilled but does not hold legal title to the property.
• German law treats the beneficiaries as receiving the property directly from the decedent. Under the concept of universal succession, which can be found in many civil law jurisdictions, the property of the decedent vests immediately, and no intermediary (such as an executor or an administrator of the probate estate) exists for managing and transferring the property held by the decedent at the time of death.
• The concept of “forced heirship” is alien to U.S. law, and courts have refused to recognize forced heirship claims. See, e.g., In re Estate of Renard, 437 N.Y.S.2d 860 ( Sur. Ct. 1981). German law, on the other hand, requires the distribution of a significant portion of a decedent’s properties to certain people, notably the surviving spouse, the decedent’s children, and, if the decedent left no children, his or her parents. Ownership of those properties is deemed vested in those successors as of the moment of death.
• Germany does not tax the estate but levies its taxes on the beneficiary—a classic inheritance tax system. In its decision of November 7, 2006 (published on January 31, 2007), the Federal Constitutional Court ruled that existing inheritance and gift tax law is not compatible with the principle of equality in Article 3 of the German Constitution, because the current law assesses the value of real estate and business assets in a manner that violates the principle of equitable taxation. The Federal Constitutional Court has given the German government until December 31, 2008, to revise the current inheritance and gift taxation law. Until that point, the existing provisions will remain applicable. See BVerfG, 1 BvL 10/02 (Nov 7, 2006).
• Trusts, beloved and often used by U.S. estate planners, are not recognized by German law as legal entities. German courts have refused to allow the transfer of real property situated in Germany into trusts. German Supreme Court Decision of June 13, 1984, in Recht der Internationalen Wirtschaft 1985, at 154.
• Finally, one must consider the question of which jurisdiction’s laws apply to the disposition of the decedent’s property. Under Virginia law, for example, a decedent’s personal property passes according to the law of the state where he was domiciled at his death, but his real estate passes according to the law of the state where the property lies. French v. Short, 151 S.E.2d 354 ( Va. 1966).German international private law applies the law of the jurisdiction of the deceased’s citizenship at the time of death to the transfer of the decedent’s property regardless of the property’s situs. § 25(I) Introductory Law to the German Civil Code. If the deceased had dual citizenship (for example, German and U.S.) at the time of his or her death, German law will prevail and is the applicable law regardless of deceased’s domicile or other citizenships. § 5(I) Introductory Law to the German Civil Code. German law recognizes one exception: the treatment of real property depends on its situs. § 3(III) Introductory Law to the German Civil Code.
Applicable Transfer Tax Regime
How should the estate planner approach planning in light of the above-mentioned obstacles? The easiest issues to deal with are actually the estate and gift tax planning issues.
As mentioned above, the German inheritance tax system levies a tax on the beneficiary of an asset transferred by virtue of death or as a gift. German inheritance taxes apply without restriction and are unlimited (that is, they cover the worldwide assets) if the decedent and/or the beneficiary are residents of Germany or have their habitual abode in Germany. The same rule applies to German nationals not domiciled in Germany, if they established permanent residency abroad for less than five years before death or the time of a gift, and to certain specific groups like state employees. The concept is similar to the one the United States uses, except that the operative word in U.S. law is citizenship, not residency.
The applicable tax rate depends on the relationship between the deceased or donor and the beneficiary. Beneficiaries are organized into three different classes:
• Class I applies to the deceased’s spouse, children, stepchildren, and grandchildren, and to parents and forebears in the case of transfer by reason of death.
• Class IIapplies to parents and ascendants in the case of transfers by gift and to brothers and sisters (also half-siblings), nephews, nieces, stepparents, sons-in-law, daughters-in-law, parents-in-law, and divorced spouses.
• Class IIIapplies to all other beneficiaries and to the transfer of property for particular purposes, including the transfer from a trust (to be discussed below).
The rates range from 7% for an inheritance of €52,000 for a member of Class I to 50% for an inheritance of over €25,565,000 for a member of Class III. The inheritance tax rates and classes also apply to gifts. § 10 German Inheritance and Gift Tax Law.
German inheritance and gift taxes allow for certain personal exemption amounts from €307,000 for the surviving spouse to €5,200 for a beneficiary who is a member of Class III. If neither the deceased nor the beneficiary was a resident of Germany at the time of death, the personal exemption is reduced to €1,100. These amounts can be applied every 10 years. To ensure that allowances are claimed only once within a 10-year period and that the graduated tax rates are applied, all assets transferred to one person by the same donor/deceased during the 10-year period are aggregated for tax purposes, thus being treated as one single transfer. The surviving spouse and children up to 27 years of age can claim an additional special support allowance that applies only to inherited property. This allowance is reduced by the capital value of tax-exempt pension payments accruing to the surviving spouse or children, if applicable.
German law recognizes discounts for business property if the transferred property remains with the beneficiary for five years or more. This exemption also applies to farm and forestry assets as well as to the transfer of shares in a corporation if the decedent or donor’s holding reflects at least one-quarter of the nominal business capital.
The estate and gift tax system in the United States works differently, as it is a classic estate tax system. The estate (or the donor, if it is a gift) is liable for the transfer tax. The estate of a U.S. domiciliary is taxed on the deceased’s worldwide assets at rates up to 47% regardless of the relationship between the deceased and the beneficiary. U.S. domiciliaries are entitled to the full exemption amount (currently $2 million), as long as they are domiciliaries at the time of death (gift).
The attempt to combine the applicable tax rates and exemption can be confusing and frustrating. At first glance, it looks as complicated as the task of assembling a three-dimensional, 1,000-piece puzzle of Schloss Neuschwanstein, one of the romantic castles designed and built by the slightly crazy King Ludwig of Bavaria. Happily, the application of the Convention between the Federal Republic of Germany and the United States of America for the Avoidance of Double Taxation with respect to Taxes on Estates, Inheritances, and Gifts, signed on December 3, 1980 (as modified by a Protocol signed Dec. 14, 1998, entered into force Dec. 14, 2000) (the “Convention”), provides help and guidance.
The question of which estate and gift tax system applies to a U.S.–German estate depends on the domicile of the deceased at the time of death (or the donor at the time of the gift). Article 4 of the Convention defines fiscal domicile. A person has a fiscal domicile in the United States if he or she is a resident or citizen of the United States. Fiscal domicile will be located in Germany if the person has a domicile (Wohnsitz) or habitual abode (gewöhnlicher Aufenthalt) in Germany.The use of the word “resident” in the treaty is confusing, because it has the technical meaning of “domicile.” See Technical Explanation of the Estate and Gift Tax Convention between the United States and the Federal Republic of Germany, 87 TNI 33-26:
For this purpose, a resident is an individual living in the United States who has the intention to remain in the United States indefinitely or an individual who has lived in the United States with such an intention and who has not formed the intention to remain indefinitely in another country. This may be contrasted with the use of the term “resident” for purposes of the Federal income tax; an alien present in the United States who is not a mere transient or sojourner is a resident of the United States for income tax purposes.
A German fiscal domicile also exists if the person is otherwise subject to unlimited tax liability. See Convention art. 4(1)(b). Article 4(2) of the Convention provides tie-breaker rules if an individual is a domiciliary in both countries.
The Convention changes the asset situs rules under the Internal Revenue Code. Special rules also apply to certain types of property, permitting a treaty country that is neither the country of citizenship nor of domicile to tax the property:
• Immovable property can also be taxed by the country in which it is situated. Convention art. 5. Whether property is immovable is to be determined by the country in which the property is situated. See Convention art. 5(2).
• Business property of a permanent establishment and assets pertaining to a fixed base used for performance of personal services is taxed by the country in which it is situated. Convention art. 6e.
• Partnership interests may be taxed by the country in which such property is situated to the extent a portion of the interest is attributable to immovable property or business property of a permanent establishment. Convention art. 8.
Nothing in the Convention, however, precludes the United States from taxing the transfer by gift or at death of an individual domiciled in the United States of any of the listed property groups because of German situs.
Property not otherwise expressly provided for above can only be taxed by the domiciliary country. Convention art. 9. This rule will not apply to the extent the United States is taxing a U.S. citizen donor or decedent, or Germany is taxing a German domiciliary heir, devisee, or beneficiary. Convention art. 11 (also known as “Savings Clause”). For example, shares of a U.S. corporation held by a German national domiciled and residing in Germany when he died were excludable from the decedent’s gross estate for U.S. estate tax purposes. Although the shares would generally be includable in the gross estate under Code §§ 2103 and 2104, the IRS said, article 9 of the U.S.–Federal Republic of Germany Estate Tax Treaty states that Germany has “the primary right” to tax such shares. TAM 9128001. In addition, article 10 of the Convention changes the standard Internal Revenue Code rules regarding the deduction of debts, charitable transfers, and exemption for certain pensions.
One of the most important parts of the Convention deals with the transfer tax implications of transfers between spouses. The Convention allows two separate marital deductions that are not mutually exclusive but can be applied together to limit the tax liability.
Article 10(4) of the Convention contains the first marital deduction. It reduces taxes on noncommunity property that passes to a spouse to the extent that the property passing to the spouse exceeds 50% of all property included in the base of property that may be taxed by the country of situs of the property passing to the spouse. In the case of the United States, the reduction cannot result in a lesser tax liability than if the deceased/donor had been a U.S. domiciliary. In the case of Germany,the provision may not yield an exclusion in excess of the marital exemption available under German law for a transfer to a spouse subject to unlimited inheritance or gift tax liability (a spouse who is a German domiciliary, for example). The marital deduction under article 10(4) of the Convention is not available to a U.S. citizen domiciled in Germany, or a former U.S. citizen, or long-term U.S. resident during the 10-year period following departure from the United States.
Article 10(6) of the Convention contains the second marital deduction available to certain estates subject to the treaty. To the extent that any property passes to the surviving spouse (within the meaning of U.S. law) that qualifies for the U.S. marital deduction because the surviving spouse is a U.S. citizen, the estate then will be entitled to a marital deduction in determining the U.S. tax, even if the transfer is not in the form of a qualified domestic trust (QDOT). The amount of the deduction is limited to the lesser of the value of the transferred property or the applicable U.S. exclusion amount under the unified credit, not taking into account any gifts made by the decedent. To qualify for this limited deduction, it is necessary that (1) the decedent was domiciled in the United States or Germany; (2) the surviving spouse was domiciled in the United States or Germany; (3) if the decedent and the surviving spouse were both U.S. domiciliaries, one or both of them were German citizens; and (4) the executor elects the limited marital deduction on the estate tax and waives the right to claim any other marital deduction under U.S. law, including for a QDOT.
Last, but not least, the Convention provides for a pro rata unified credit, based on the unified credit available to U.S. citizens and residents. Under new article 10(5), the estate of any decedent (other than a U.S. citizen) domiciled in Germany is entitled to a fraction of the unified credit available to U.S. citizens, with the numerator being the value of the portion of the estate situated in the United States under treaty rules and the denominator being the value of the worldwide estate. The estate, however, can take the Code § 2102 credit allowed to foreign estates if it should be greater. Article 10(5) of the Convention does not apply to gifts.
Applicable Estate Law
German international private law makes matters more complicated by applying the law of the jurisdiction of the deceased’s citizenship at the time of the death to the transfer of a decedent’s property regardless of the laws of the deceased’s domicile. § 25(I) Introductory Law to the German Civil Code.
Needless to say, this position can create a true conflict of law. The conflict does not arise when a German citizen who is a U.S. domiciliary and whose assets are all in the United States leaves a U.S. will and everything is distributed to his U.S. beneficiaries. A notable exception is the forced heirship issue, discussed below. If such a German citizen dies intestate, the conflict issues need to be addressed. For example, if a German citizen dies in the District of Columbia intestate without heirs, the estate would escheat to the mayor of the District for the benefit of the poor. D.C. Code § 19-701 (2001). Under German law, the estate would pass to the Federal Republic of Germany. § 1936 German Civil Code. It would be interesting to see how a probate judge in Washington, D.C., would decide this matter.
Fortunately, estate planners often deal with people during their lifetimes and can address certain issues in the estate plan of a German citizen-U.S. domiciliary client.
Forced Heirship
German law applies German estate law, including the forced heirship rules, to its citizens. If, for example, a German citizen who is domiciled in Virginia creates an estate plan that disinherits his German children, these children have a right to the forced heirship share. The children can sue the beneficiaries of the decedent’s estate—for example, his U.S. children—in Germany. The German citizen could give up his German citizenship to avoid such lawsuit.
German courts, recognizing that the regime of forced heirship does not exist in the United States, have ruled that real estate located in Florida should not be considered when calculating the forced heirship share. OLG Celle ZEV 2003, 509 (2003). The court based its decision on § 3(3) of the Introductory Law to the German Civil Code, which states that real property is governed by the law of the state in which it has its situs. BGH XII ZR 248/91, in Neue Juristische Wochenzeitung 1993, at 1921 (Apr. 21, 1993). The result is a “split of the estate,” with German law governing one part and U.S. state law governing the other part (the real estate) of the estate. Both parts of the estate are considered legally separate and independent. See BGH IV ZR 16/57, in BGHZ 24, at 355 (June 5, 1957).
The enforcement of forced heirship rights in the United States is problematic. U.S. courts are generally reluctant to enforce these rights. The children of the German citizen living in Virginia in the example above, however, could sue in Germany and enforce the German judgment under the Uniform Foreign Monetary Judgments Recognition Act, which has been adopted in 21 states, including California, New York, and Virginia.
Formal Validity of a U.S. Will Under German Law
Generally, German law recognizes two types of wills (instruments) as capable of transferring property at death. These recognized wills are known as the notarial or public will and the holographic will. A notarial will is drafted by a notary and executed before the notary and witnesses. A holographic will is drafted by the testator in the testator’s handwriting and executed without witnesses. German law also provides for other forms of testamentary disposition, including, for example, the use of joint wills or a contract of inheritance.
A typical U.S. will that is typed and witnessed by two independent witnesses and (potentially) notarized should be recognized as formally valid under German law if presented for probate of German situs assets owned by a U.S. domiciliary. Germany adopted The Hague Convention Concerning the Conflicts-of-Laws Relating to the Forms of Testamentary Dispositions (Concluded October 5, 1961), an international convention with the purpose of expanding the scope of the laws governing the validity of the various forms of testamentary dispositions. Under the convention, a will is valid in form, if the form concurs with the laws of one of the following countries:
• in which the decedent executed the will,
• of which the decedent held citizenship at death or when the will was executed,
• in which the decedent was domiciled at death or when the will was executed,
• in which the decedent had his or her habitual abode at death or when the will was executed, or
• in which the real property is located.
Using a U.S. will in a German probate procedure, however, may be more complicated than anticipated. First, an apostille must authenticate the original will in accordance with The Hague Legalization Convention Abolishing the Requirement of Legalisation for Foreign Public Documents (Concluded October 5, 1961). In addition, a court-certified translator must translate the will into German before it can be presented to a German probate court, a time-consuming and not inexpensive endeavor. This can become even more complicated if the U.S. will uses testamentary trusts or other instruments unknown to German estate law.
Why a Trust May Not Be a Good Idea
One planning approach often used by U.S. estate planners can create a higher-than-necessary inheritance tax liability under German inheritance tax law and may result in uncertainty regarding the treatment of the trust under German law.
German civil law does not recognize trusts, and Germany is not a signatory state to The Hague Convention on the Law Applicable to Trusts and on Their Recognition. The German Supreme Court hinted that it may be possible to reclassify the Anglo-American trust as Treuhand, a fiduciary relationship recognized under German law. See German Supreme Court Decision of June 13, 1984, in Recht der Internationalen Wirtschaft 1985, at 154. The purpose of delivering an estate plan to the client that provides for an easy transfer of wealth from one generation to the next is clearly defeated, however.
The taxation of trusts under German tax law is not without complications and may lead to a greater-than-expected tax liability for the trust, the grantor, and the beneficiaries.
A German taxpayer should never serve as trustee of a U.S. trust, because the trust may qualify as a foreign trust under U.S. tax law, see Code § 7701(a)(30), which has its own burdensome U.S. tax consequences. To make matters worse, the trust will in all likelihood be considered a German taxpayer under Article 10 Abgabenordnung (“AO,” roughly translated as “General Tax Code,” comparable to Subtitle F of the Internal Revenue Code) and subject to German income taxes. Even if the trust has a trustee who is not a German taxpayer and resides outside Germany, German tax law may apply to the trust’s income if the grantor and/or the beneficiaries are subject to German taxes. See § 15 Aussensteuergesetz (AStG—Foreign Taxation Law).
Beneficiaries who are subject to German taxes will also be subject to German income taxes on distributions that are made on a more or less regular basis. German tax law apparently does not distinguish between a distribution of trust income and trust principal, but treats both equally. The German Tax Court, however, made it clear that a beneficiary who is subject to both taxes can only be taxed under one.
In addition, Germany taxes both the transfer of assets to the trust as well as the transfer of assets from the trust to the beneficiaries. German tax law does not differentiate between irrevocable or revocable trusts; it treats them equally for German tax purposes. Of course, if the grantor of a U.S. revocable trust is a U.S. domiciliary for tax purposes, the transfer of assets into a trust will not be taxed, because Germany lacks proper jurisdiction to tax the event. Transfers by a German taxpayer to a trust (revocable or irrevocable) are taxed as Class III transfers, resulting in higher tax rates and lower exemption amounts.See §§ 3(2) and 7(1) Erbschaftssteuergesetz (ErbStG—German Inheritance Tax Code)
The distribution of trust principal (for purposes of the trust’s dissolution but also distributions made before the final dissolution) also is subject to German transfer tax, if the final beneficiaries are subject to German taxes. See § 7(1) ErbStG. The beneficiary can enjoy a small break, however, if, depending on the relationship between grantor and beneficiary, the transfer taxes in these instances can be taxed as Class I or II transfers. See § 15(2) ErbStG.
Conclusion
If a U.S. domiciliary has a German beneficiary to whom he or she would like to make a bequest, it might be beneficial to create a bequest payable out of the U.S. estate (and not the trust) for the benefit of the German beneficiary. Such a bequest could be designed in a way that takes advantage of the different tax exemptions under German and U.S. estate and gift tax law.
An interesting planning option available to U.S. domiciliaries with German assets is the use of a U.S. partnership to hold such German assets. Once the assets are transferred, the estate planner could transfer the partnership interest into the client’s U.S. trust.
In any circumstances, it is a good idea to spend some time with a German estate planning attorney to discuss the potential planning opportunities for German clients who are U.S. domiciliaries.
Estate planning for German citizens who are U.S. domiciliaries can present a challenging task. An estate planner who is aware of the pitfalls of cross-border estate planning in general, and German–American estate planning in particular, will find the planning interesting and rewarding and will have a client who can live with both: a tomato and eine tomate.
