Married couples love each other and want the best for each other. Establishing a comprehensive estate plan is one way to provide the best for each other. Not only does an estate plan protect you when you are unable to care for yourself during your lifetime, but it also protects your hard-earned money and property after your death for those you love. When your spouse is not a US citizen, it becomes even more crucial to have the proper estate planning tools, especially if you have a high net worth.
The Marital Deduction
One of the benefits associated with marriage in the United States is the unlimited marital deduction. With this tool, a person can transfer unlimited money and property to their spouse during their lifetime and upon their death without estate and gift taxes being owed. One rationale for this deduction is that married couples are assumed to rely on their joint accounts and property to fund their needs and wants during their marriage and to support the survivor. The Internal Revenue Service (IRS) is not concerned about assessing estate tax to what is left to the surviving spouse, because whatever is left over will usually be subject to estate tax at the surviving spouse’s death.
However, the unlimited marital deduction's favorable tax treatment is usually only available if the surviving spouse is a US citizen (except in certain limited situations). For noncitizen surviving spouses, additional planning must be done to take advantage of the marital deduction's estate tax benefits.
Why a Noncitizen Spouse Cannot Use the Marital Deduction
When a surviving spouse is not a citizen, the IRS is concerned that collecting the estate tax owed on the first spouse’s money and property may be more difficult when the surviving spouse dies. Because the surviving spouse is not a citizen, it is possible that they will return to their country of citizenship, which may make it impossible for the IRS to collect the estate tax.
A Qualified Domestic Trust Could Be the Answer
The qualified domestic trust (QDOT) balances the IRS's interest in collecting estate tax and the public policy argument against requiring a surviving spouse to pay substantial estate taxes and be left with less than they need to survive.
What Is a Qualified Domestic Trust?
A QDOT is a trust created by the US citizen spouse during their lifetime to hold accounts and property on behalf of the noncitizen spouse. Alternatively, a QDOT can be made by the noncitizen spouse by irrevocably assigning the accounts and property they received from their deceased US citizen spouse to the QDOT before the deceased spouse’s estate tax return is due (including extensions). The accounts and property passing to a QDOT can qualify for the marital deduction with either option. However, the estate tax is deferred, not eliminated.
How Does a QDOT Work?
While the noncitizen surviving spouse lives, they will receive income from the trust. This income will not be subject to estate tax but will be subject to income tax. If any principal distributions are made from the QDOT to the surviving spouse, then the Internal Revenue Code § 2056A estate tax will be owed on that distribution. However, an exception may be made if the distribution is being made because of a hardship.
When the noncitizen spouse passes away, the money and property remaining in the QDOT will be subject to the estate tax. That is why we say that a QDOT does not eliminate the estate tax; it just defers it until the noncitizen surviving spouse passes away. Once the taxes are paid and other administrative tasks are completed, the remainder of the trust is distributed to the named beneficiaries.
What Are the Requirements for a QDOT?
For the QDOT to be legally effective, the following requirements must be met:
- Accounts and property given to the noncitizen spouse at the citizen spouse’s death must be transferred to the QDOT before the deadline to file the decedent’s estate tax return[1]
- The trustee must elect the trust as a QDOT on a timely filed estate tax return[2]
- US state laws or the laws of the District of Columbia must govern the trust’s administration[3]
- The trust must qualify as an ordinary trust under Treasury Regulation §301.7701-4(a)
- The trust must include terms that qualify the trust as a power of appointment trust, a qualified terminable interest property trust, a qualified charitable remainder trust, or an estate trust if created by the US citizen spouse[4]
- At least one trustee must be a US citizen or a US corporation[5]
- The trustee must have the right to withhold estate tax in making distributions of principal to the surviving spouse and when the balance of the QDOT is distributed at the noncitizen surviving spouse’s death[6]
Additional requirements must be met depending on the overall value of the accounts and property that are in the trust.[7]
What Happens If the Noncitizen Surviving Spouse Becomes a US Citizen?
The surviving spouse may choose to become a US citizen. This could be because of the administrative burdens of a QDOT or a firmly held desire to change their citizenship status. If a change of citizenship occurs, the surviving spouse may become eligible to use the marital deduction without using the QDOT.
If the surviving spouse becomes a US citizen before their deceased spouse’s estate tax return is filed and stays a US resident after their deceased spouse’s death, then the deceased spouse’s estate will be eligible to use the marital deduction for any assets transferred to the now-citizen spouse.
If the surviving spouse becomes a US citizen after the QDOT was created and stays a US resident after their deceased spouse’s death, and either does not receive any principal distributions from the trust or treats the distributions as taxable gifts, then the QDOT can be terminated, and the remaining balance of assets in the trust can be eligible for the marital deduction.
Conclusion
We know that no one likes to think about death and dying, and most people do not want to pay more taxes than required. You need to plan proactively to minimize tax consequences upon your death. We are here to assist you and your spouse in creating a plan to protect your futures and each other. Please call us to learn more about qualified domestic trusts or discuss other important estate planning considerations when dealing with noncitizens.