Love may conquer all in fiction, but in reality, it cannot conquer the Internal Revenue Code. Some married couples may want to consider a qualified domestic trust, or QDOT, to ensure Uncle Sam doesn’t cut in if one of the spouses is not an American citizen.
According to the United States Census Bureau, more than 4 million American marriages involve one partner born in the U.S. and one born abroad. Of those, nearly 40% are marriages between a U.S. citizen and a noncitizen. An additional 7.3 million American marriages involve two foreign-born partners; in about 20% of those cases, one partner has become a naturalized citizen but the other has not. (These figures reflect 2010 census data, as the updated data from the 2020 census was not available at the time this article was written.) These couples will have to think carefully about their estate plans to ensure they don’t run afoul of limits particular to their circumstances. While relatively few couples need to worry about the federal gift and estate tax, regardless of citizenship, the potential impact is significant for those affected. As of 2021, the top federal estate tax rate is a hefty 40%.
Couples in which both spouses are U.S. citizens receive the unlimited marital deduction on federal estate and gift taxes. Transfers from a U.S. citizen to a noncitizen spouse do not benefit from this deduction. Instead, lifetime transfers are only tax-free up to the annual exclusion amount. This exclusion, $159,000 in 2021, is periodically adjusted for inflation. Once the annual exclusion amount is exceeded, the donor must file a gift tax return. The amount of any gifts in excess of the annual exclusion amount reduces the giver’s lifetime exemption. If the taxpayer has no lifetime exemption remaining when he or she makes a gift, the giver owes gift taxes on the transfer. When the citizen spouse dies, transfers to the noncitizen spouse exceeding the value of the deceased spouse’s remaining lifetime exemption amount (if any) are subject to the estate tax, in the absence of further estate planning steps.
Citizen spouses may benefit from a concept called portability. This mechanism can also help noncitizen spouses, as long as they are considered U.S. tax residents. Apart from the marital deduction, each U.S. resident for tax purposes receives a “unified credit,” which is a lifetime estate and gift tax exemption amount ($23.4 million per married couple, or $11.7 million per individual, in 2021). When used in conjunction with a “gift-splitting” election for lifetime gifts, portability means that spouses who are citizens or resident noncitizens can treat their exemptions as a single, combined amount. Thanks to portability, any unused exemption can be carried over from a deceased spouse to the survivor. This mechanism is not automatic. The deceased spouse’s executor must file an estate tax return, and make a portability election on it, within nine months of the death. (For more on the relatively new option of portability, read my colleague Rebecca Pavese’s article “Planning For Portability.”) Note that if the noncitizen spouse dies first and he or she is not a U.S. tax resident, portability is not an option.
In some cases where one spouse is not a citizen, tax treaties between the U.S. and the spouse’s country may reduce or even remove some of these limitations. Certain treaties may allow for noncitizen spouses to take the marital deduction outright. Others may offer a credit to offset U.S. tax obligations. That said, not every tax treaty is the same, and the United States does not have estate or gift tax treaties with every country. Couples planning for a noncitizen spouse should investigate what protections may or may not exist.
International Estate and Gift Tax Treaties
|Tax Treaty Type
|Estate & Gift
|Estate & Gift
|Estate & Gift
|Estate & Gift
|Estate & Gift
|Estate & Gift
|Estate & Gift
Source: https://www.irs.gov/businesses/small-businesses-self-employed/estate-gift-tax-treaties-international, accessed July 14, 2021
If the surviving spouse is not a U.S. citizen on the deceased spouse’s date of death, but he or she becomes a citizen by the estate tax return’s due date and resides in the U.S. the entire time between his or her spouse’s death and receiving citizenship, then the transfer of property from the deceased spouse to the survivor will qualify for the marital deduction. That said, the naturalization process usually takes years. In order to beat the deadline, the survivor would need to already be close to securing citizenship when his or her spouse died.
In the absence of a treaty or a timely path to citizenship, couples still have options. Before portability, tax and estate planners applied various solutions to optimize their clients’ lifetime exemptions. These older options are no longer necessary for most couples, but they still can prove useful to couples navigating mixed citizenship. This brings us back to the qualified domestic trust. QDOTs can allow couples to apply the martial deduction to a transfer even when one spouse isn’t a citizen – if the trust is structured correctly. To work, this strategy requires careful planning.
QDOTs As A Tool For U.S. Citizens Married To Noncitizens
By design, a properly structured QDOT is a trust that allows noncitizen spouses of a deceased U.S. taxpayer to take advantage of the marital deduction on estate tax. Any assets that would have qualified for the federal estate tax marital deduction if both spouses were citizens can be left in trust. A QDOT’s trustee must be a U.S. citizen or U.S.-based corporation, such as a bank. If trust assets exceed $2 million in value, or more than 35% of the trust is funded with foreign real estate, the trustee must be a bank or an individual able to post a bond or a letter of credit to the Internal Revenue Service equal to 65% of the trust assets’ value at the deceased’s date of death. In addition, the trust must require that the trustee cannot distribute any principal from the trust unless the trustee has the right to withhold the QDOT tax imposed on the distribution. These are not the only requirements, but they are among the most important. Trust administration can be complex, so couples should consult a lawyer with experience in trusts to ensure the QDOT works as they intend.
To set up a QDOT, the deceased spouse, known as the decedent, must leave instructions for his or her executor to make an irrevocable QDOT election on their timely filed federal estate tax return, including extensions. Property that passes to a correctly structured QDOT for the benefit of the noncitizen spouse qualifies for the martial deduction. This means that, in many cases, it can ultimately pass to the surviving spouse without triggering estate tax.
Even if the decedent left assets directly to his or her spouse, the surviving noncitizen spouse may still elect to establish a QDOT. He or she can irrevocably assign the property to the trust. Such a transfer to a properly structured QDOT will still allow the noncitizen spouse to take advantage of the marital deduction. There is a time limit for making the election, though. The surviving spouse must make the election by the deceased spouse’s estate tax return due date.
Once the trust is funded, the trustee will distribute trust income to the beneficiary at least once a year throughout his or her lifetime. These distributions of trust income are subject to income tax, but not estate tax.
It is important to understand that a QDOT does not eliminate the obligation to pay estate tax that is otherwise due. It simply moves that responsibility to the trust itself. The surviving spouse may also have to pay estate tax under certain circumstances. Under Internal Revenue Code Section 2056A, if the trustee distributes any of the principal that would have otherwise been subject to federal estate tax, in most circumstances that distribution triggers the tax. Exceptions include payments made due to an “immediate and substantial financial need.” This may include payments to fund the surviving spouse’s health care or living expenses, or support of the surviving spouse’s legal dependents. To be exempt, the distribution must also be made in the absence of any other “reasonably available” assets. These include easily liquidated assets such as stocks, but not illiquid assets such as real estate. If the distribution is not covered by these exemptions, it triggers estate tax obligations besides the usual income tax.
Section 2056A tax can be avoided entirely if the noncitizen spouse eventually becomes a U.S. citizen. Depending on the survivor’s residency following their spouse’s death and whether there were any taxable distributions from the QDOT before the spouse became a U.S. citizen, the QDOT’s trustee may need to make additional elections and adjustments to the spouse’s unified credit. At the time the surviving spouse becomes a citizen, the trustee must notify the IRS by filing Form 706-QDT.
Whether due to a taxable distribution during the survivor’s lifetime or for the final tax triggered at the surviving spouse’s death, estate tax on the trust’s assets is calculated as if the assets had been included in the decedent’s original estate. Any taxable distributions during the survivor’s lifetime reduce the final amount due. For both types of taxable event, the rates in force when the first spouse died will apply, regardless of any subsequent legislative changes. Once the surviving spouse dies, the trust pays any estate taxes owed. Any assets left in the trust after paying estate tax obligations pass to the trust’s beneficiaries, often the couple’s children.
Making a QDOT election allows a noncitizen spouse to opt for portability – with caveats. If the deceased spouse has some amount of unused exemption (practitioners use the jargon “DSUE” to refer to this amount), and if certain technical requirements are met, the estate can report a preliminary unused exemption amount. However, the final amount of the deceased spouse’s unused exemption amount is subject to adjustments. At the surviving spouse’s death, or when the trust is terminated, the value of the DSUE is reduced by the value of the assets in the QDOT. This means that the noncitizen spouse will only benefit from portability if the value of the assets in the QDOT are less than the DSUE upon the trust’s termination. In addition, the noncitizen surviving spouse cannot use the DSUE to offset lifetime gifts while the QDOT is operating.
As this section suggests, the rules for QDOTs are complex and strict. The possible complications extend beyond the scope of this article. Couples considering this strategy must consider these complications when making their estate plans, however, since failure to operate within the rules can derail an estate plan’s intended results.
Is A QDOT Right For You?
A few factors should weigh in your decision when considering a QDOT as part of a larger estate plan.
Basis Step-Up. A powerful tool in the estate planning toolbox is the “basis step-up.” The value, or cost basis, of inherited assets resets when such assets pass to heirs after the original owner’s death. This eliminates any unrealized capital gains that occurred between the decedent’s acquisition of the asset and his or her death. By eliminating the capital gains, step-up in basis also eliminates the capital gains tax obligation for the previous gains. This increases the asset’s value to the beneficiary.
Using a QDOT creates complications in getting the full benefit of the basis step-up rules. By default, property passing through a QDOT would typically get a basis adjustment at the death of the first spouse, but not at the second spouse’s death. There are several planning techniques that can allow a second basis step-up at the eventual death of the noncitizen spouse, but it will require careful drafting and consideration of other tax and nontax implications.
Couples should also consider that tax rules are not set in stone. At this writing, President Joe Biden has proposed ending basis step-up for gains in excess of $2.5 million for couples ($1 million for individuals). This proposal seems unlikely to make it into law in the short term, but estate planning will always require periodic updates to reflect a changing legislative environment.
Annual Exclusion. For couples that reasonably anticipate having a number of years together before facing the prospect of death, it can make sense to take advantage of the annual exclusion to systematically transfer property from the citizen spouse to the noncitizen spouse while both spouses are still alive. Depending on the amount of property involved, this strategy may allow you to mitigate many estate and gift tax complications.
Couples who were married under community property laws, or who reside somewhere that operates under such laws, should be mindful that the benefits of this strategy will be limited. Under community property laws, a couple is considered a single economic unit and each spouse is considered to own one-half of all the couple’s assets, regardless of title (with some exceptions). If the noncitizen spouse receives a gift, in most cases the citizen spouse who gave it still owns half of the assets, and the recipient owned half of them in the first place. This makes the gift moot for estate tax purposes. Couples subject to community property law should strongly consider consulting a lawyer or financial planner with estate planning experience to determine whether lifetime gifts are a viable estate planning strategy.
Other Details. In estate planning, as in any other financial plan, there is no one-size-fits-all solution. The details of a given taxpayer’s situation could mean that using a QDOT will not maximize the wealth he or she passes on to a spouse or other heirs. While QDOTs have clear applications for reducing estate tax, they are also expensive to set up and complicated to administer. Couples with complex situations will likely find it worthwhile to consult a professional, especially one with experience in tax concerns for noncitizens.
Couples likely to be subject to the federal estate tax face a more complex picture than those who will not have to navigate it. Adding a noncitizen spouse complicates the situation further. But with careful planning and experienced help, a QDOT may serve as a useful option to ensure that, no matter which spouse outlives the other, the survivor can live comfortably without paying Uncle Sam more than his fair share.