Question: My spouse is not a U.S. citizen. Can I leave assets to her upon my death without incurring estate tax?
Answer: You can do so if you properly structure the bequest. One of the cornerstones of basic estate planning is leaving assets to a surviving spouse. Generally speaking, assets passing to a surviving spouse qualify for the so-called marital deduction and are not subject to estate tax on the death of the first spouse to die; assets left to a surviving spouse will be subject to estate tax on the second spouse’s death, unless of course the spouse remarries and assets are left to the second spouse in a manner that qualifies for the marital deduction. The marital deduction is allowable for assets left to a non-citizen surviving spouse but there are additional steps that must be taken to secure the deduction.
Bequests to surviving spouses who are not U.S. citizens do not qualify for the marital deduction unless they are held in a special type of trust, a qualified domestic trust (a “QDOT”). Various requirements must be satisfied to constitute a QDOT. One significant requirement is that the QDOT must have at least one trustee who is either an individual U.S. citizen or a domestic corporation. Unlike conventional planning where surviving spouses are often trustees of marital trusts created for their benefit, a QDOT requires at least one U.S. trustee. The surviving spouse who is a non-U.S. citizen can be a co-trustee but cannot be the sole QDOT trustee.
Trust agreements typically distinguish between trust principal, the assets which are originally transferred to the trust, and trust income, the earnings generated from the trust principal. To qualify as a QDOT, there can be no distributions of trust principal unless the trustee has the right to withhold tax from the distribution. For example, if a spouse dies and leaves $1,000,000 of assets to his/her non-citizen surviving spouse, any distributions of the $1,000,000 of trust principal are potentially subject to withholding. The withholding requirement does not apply to income generated from the $1,000,000 of trust principal so the income earned by the QDOT, while required to be distributed under QDOT rules, does not trigger a withholding obligation for the trustee. Note that tax withholding from principal distributions does not mean that tax must be withheld. Rather, the trust agreement must simply allow for such if the IRS directs that taxes be withheld.
The QDOT requirements are more cumbersome in certain respects. If the QDOT assets are greater than $2,000,000, there must either be a U.S. bank as trustee or the trustee must hold a bond or letter of credit equal to 65% of the value of the trust assets. Other restrictions may apply to QDOTs holding assets of less than $2,000,000 where real estate assets comprise part of the trust.
Proper planning can alleviate the harshness of some of the QDOT requirements. Even though principal distributions are potentially subject to tax withholding, this requirement can be avoided if the distributions to the non-citizen spouse are limited to distributions for what is considered an ascertainable standard. Principal distributions made only for a surviving spouse’s health, education and support will fit within the definition of an ascertainable standard. On the other hand, a trust which allows for principal distributions for a spouse’s best interests, comfort, luxury or travel will potentially be subject to tax withholding. Since taxpayers who create marital trusts for their spouses often create other trusts for their spouses which are not intended to qualify for the marital deduction, non-citizen spouses can be given more extensive distribution rights in non-QDOT trusts as they will not be subject to the more stringent QDOT requirements. Of course, distributing assets from a non-marital trust to a surviving spouse may be inefficient from an estate tax perspective as this could eventually subject more assets to estate tax upon the surviving spouse’s demise.
It is noteworthy that the unavailability of the marital deduction to a non-citizen spouse also impacts other gifts left to a surviving spouse. The disallowance of the Federal estate tax marital deduction applies not only to gifts of assets left in trust but gifts of assets outside of trust. Taxpayers with estates potentially subject to estate tax may need to minimize the amount of gifts being made outright to their surviving spouses.
Passing assets to a non-citizen spouse poses challenges. The obstacles are not insurmountable as proper planning can accomplish the desired result.
The Tax Corner addresses various tax, estate, asset protection and other business matters. Should you have any questions regarding the subject matter or if you have questions you want answered, you may contact Bruce at (312) 648-2300 or send an e-mail to firstname.lastname@example.org.