One of the most important tools used in federal estate taxing planning is the estate tax marital deduction. This deduction normally provides for an unlimited deduction for any transfers made to the surviving spouse.
Unfortunately, this deduction is not automatically available when the surviving spouse is a non-citizen. The rationale for this distinction is that a surviving spouse was viewed by Congress as likely to return to his or her country of origin, taking his or her inheritance with her and thus, avoiding estate taxes on the surviving spouse’s death as well.
Currently, there is a unified credit of $5,000,000.00, which generally allows an estate of up to that amount (subject to adjustments for past gifts) to pass without estate taxes being imposed. Thus, currently the availability of the marital deduction is not an issue for estates valued at less than $5,000,000.00. However, if the citizen spouse has an estate of greater than $5,000,000.00, transfers to the surviving, non-citizen spouse at death would, unless otherwise planned for, be subject to tax.
There is one widely recognized planning method used to avoid this problem. This is the “Qualified Domestic Trust” (or QDOT), which is the Internal Revenue Code’s way of providing for relief from estate taxes upon the death of the first to die while still maintaining its ability to tax those assets in the future (at latest, upon the death of the surviving spouse). In other words, it is a way of deferring the estate tax, but not necessarily a way of avoiding it.
A QDOT trust is essentially a marital trust (as recognized by the Internal Revenue Code), with three additional requirements that
- One trustee must be an individual citizen of the U.S. or a domestic corporation;
- No distribution may be made from the trust unless an individual citizen of the U.S. or a domestic corporation has the right to withhold taxes from it; and
- The decedent’s executor must make the QDOT election on the appropriate estate tax return.
Additionally, for larger QDOT trusts, one trustee must be a U.S. bank, and certain other security provisions (such as the posting of a bond or a letter of credit) are required of that trustee.
As noted above, assets flowing into such a trust avoid taxes on the death of the citizen spouse, however, withdrawals from the principal of such a trust may be taxable at the time of withdrawal and the assets of the trust would be taxable at the time of the death of the surviving spouse.
This comprehensive, over-simplified example, demonstrates the benefit (deferral) and ultimate downside (tax payments) of such a trust:
Assume wife, a citizen of the U.S., has a “gross estate” for estate tax purposes of $6,000,000.00. Her husband is a resident of the U.S., but a citizen of Brazil. She had a reasonably common estate plan for someone in her position – a will utilizing a credit exemption trust, with the residue flowing into a QDOT trust. She passes away in 2012 (when the $5,000,000.00 unified credit is still in effect). Upon her death, the first $5,000,000.00 in her estate would pass into the credit exemption trust in favor of her husband. It would not be taxed at this time or, for that matter upon the subsequent death of her husband. The remaining million would pass into the QDOT trust. These assets would escape taxes at that time. However, assume that Husband withdraws $100,000.00 in 2013. He would pay estate taxes based on the wife’s rate of 35% at that time ($35,000.00). Further, assume that he passes away in 2015. He will then have to pay tax at the same rate on the assets in the trust.
This quirk of the tax law currently only affects a limited class of individuals – specifically, non-citizen spouses whose estates exceed $5,000,000.00 and their spouses. For most couples, citizens or otherwise, the unified credit will continue to do the brunt of the necessary estate tax avoidance work. While, we do not expect the credit to revert to $1,000,000.00 (which is the effect of Congress failing to take action prior to January 1, 2013), we do recognize that there may be some fluctuation/reduction in the amount of that unified credit. This is a contingency that married couples with a non-citizen spouse should be aware of. In the event that you feel yourself in the danger zone on this issue, please do not hesitate to call. Further analysis of the estate assets or an aggressive (or even temperate) program of making gifts may be all that is needed.
– Rod Fluck