International Estate Planning: Transfers to Non-Citizen Spouses Require Special Planning

By: Fredrikson & Byron, P.A.

Provided by World Services Group


International Estate Planning: Transfers to Non-Citizen Spouses Require Special Planning

   Published November 3, 2005 - Minnesota, USA

Although the future of the federal estate tax in the United States remains uncertain, recent news stories about pending Congressional actions that would make permanent the repeal of the so-called “death tax” have familiarized many with the basic rules that apply to federal estate tax and gift tax.

Many believe that a legislative compromise will be reached in which the federal estate tax is not completely repealed but exemption amounts are significantly increased and tax rates decreased.

The basic rules that pertain to the estates of U.S. persons – that is, U.S. citizens and permanent residents – provide that all worldwide assets are included in the taxable estate.

When a U.S. person dies, assets that exceed the applicable exclusion amount (sometimes called the unified credit equivalent) are subject to federal estate taxes. In 2005, this amount was $1,500,000 of assets. In 2006, it will increase to $2,000,000. At the same time, the top federal estate tax rate of 47% will drop to 46% in 2006. While the applicable exclusion amount for estate tax should continue to rise, the exemption to federal gift taxes for lifetime gifts remains $1,000,000.

In general, U.S. gift and estate tax laws permit unlimited tax-free transfers of property between spouses if the recipient is a U.S. citizen. These transfers are authorized by the so-called "marital deduction" under applicable U.S. gift tax and estate tax laws. Assets that are transferred during lifetime or that pass to a U.S. citizen spouse at death can generally qualify for an unlimited marital deduction, which defers any estate tax until the surviving spouse’s death.

The marital deduction is not allowed if the spouse receiving property is not a U.S. citizen, even if he or she is a permanent resident of the United States. If the spouse is a U.S. citizen, transfers of unlimited value can be made to the citizen spouse during lifetime. If, however, the spouse is a non-citizen, gifts in excess of $100,000 per year (indexed for inflation) are subject to federal gift tax. For 2005, the indexed amount is $117,000. This annual exclusion amount is expected to continue to rise in future years.

At death, if the surviving spouse is not a U.S. citizen, the transfer will not qualify for the unlimited marital deduction unless it passes to a qualified domestic trust (sometimes referred to as a “QDOT” – see “Requirements for a Qualified Domestic Trust (QDOT) below.

Although widely criticized, this important exception is based on a concern that the non-citizen spouse might move to another country and subsequently transfer property he or she received tax-free without being subject to U.S. gift and estate taxes.

This rule, along with other federal gift tax and estate tax laws, complicates estate planning when one or both of the spouses is a non-citizen.

Determine Estate Planning Objectives First

Although tax considerations are important, if the spouse is not a U.S. citizen, basic objectives should be considered first without the complications presented by the citizenship issue.

For instance, consider whether to make gifts outright to the spouse or in a trust for the spouse's benefit with the property eventually to pass to other named beneficiaries. Once this is settled, a decision can be made about how best to qualify the spouse's gift for the marital deduction.

Lifetime Transfers

Each year, gifts of up to the annual exclusion amount discussed above can be made to the spouse without a gift tax even if the spouse is a non-citizen. A series of annual gifts to the non-citizen spouse may be undertaken. If the wealth of spouses is substantially unequal, these gifts will tend to equalize them. If only one spouse is a citizen, gifts from the citizen to the non-citizen will reduce the impact of the marital deduction restrictions at death.

In addition, property held jointly can cause a problem in the estate of the first spouse to die if the surviving spouse is a non-citizen. Under federal law, the entire value of jointly owned property is included in the decedent’s gross estate if the surviving spouse is not a citizen, subject to a reduction for any contribution by the surviving spouse. However, under state property law, the surviving spouse succeeds to the ownership of all the property through survivorship. If the surviving spouse cannot prove his or her contribution to the joint property, he or she can pay an estate tax or contribute all the property (including his or her interest) to a QDOT and defer the tax.

To avoid this, spouses may consider undoing the joint ownership during their lifetime. Unwinding a joint tenancy in real property can be problematic; if spouses end up with ownership percentages that differ from their actual contributions, a taxable gift could result. Part of the gift may be sheltered by the annual exclusion for gifts to non-citizen spouses, as discussed above. However, the amount transferred to the non-citizen spouse may be greater than the the annual exclusion. To do this properly, the appropriate contributions of the spouses should be determined and ownership vested accordingly on the termination of the joint tenancy. The subject of jointly owned property is complex when one or both spouses is a non-citizen; such couples should seek advice about tax implications of their actions, whether creating or unwinding joint tenancies.

Transfers at Death

At death, gifts to the non-citizen spouse can qualify for the marital deduction and postpone estate tax only if the property is held in a QDOT.

Outright Gift to Non-Citizen Spouse. If the estate plan includes an outright gift to the spouse, the will may provide for this. If the spouse is a non-citizen, it should include an option for the spouse to "disclaim" part or all of the outright gift, causing the property to instead pass to a QDOT for the spouse's benefit. This structure gives the surviving spouse several choices:

Become a Citizen: The spouse may avoid the marital deduction problem by becoming a U.S. citizen before the due date for filing the estate tax return (normally nine months after the death, but often extended to 15 months).

Pay the Tax: The surviving spouse may prefer to pay the tax and have unrestricted ownership of the assets. This will not make sense for most people, but might be appropriate for a spouse who plans to leave the United States. Special tax rules apply to permanent residents who make that decision. Several provisions of the Internal Revenue Code are designed to discourage and penalize tax-motivated expatriation by U.S. citizens and long-term residents. Among those is a presumption that long-term residents who meet certain income tax liability or net worth thresholds “expatriate” for tax reasons.

Establish a Separate QDOT: The U.S. estate tax rules permit the surviving spouse to establish a QDOT with terms selected by the surviving spouse, as long as it is established and the property transferred to it by the due date of the U.S. estate tax return (nine months after death, or 15 months with an extension). This allows the spouse to customize the trust to accommodate the requirements of U.S. tax laws at that time.

Disclaim to a QDOT in the Will: Finally, the spouse may reject all of the above options and disclaim the outright gift so that it passes to the QDOT. This allows use of this trust but does not require it, thus preserving planning flexibility for the surviving spouse. This must be done within nine months of the decedent spouse's death.

Of course, Congress might change the rules applicable to non-citizen spouses, and the surviving spouse might not need to take any of the above actions if the rules change.

Gift in Trust for a Non-Citizen Spouse. A trust for the gift to the spouse may be appropriate. For example, a trust may be used so that, at the surviving spouse’s later death, the trust property passes to named beneficiaries (such as children) rather than permitting the surviving spouse to control how such property passes upon such spouse’s death. There are relatively few requirements to convert an ordinary marital trust to a trust that satisfies the QDOT rules. The primary requirement is that the spouse cannot be the sole trustee; instead, a U.S. citizen or bank must be designated to act as an additional trustee.

The IRS May Require a Security Arrangement. When property is left to a QDOT for the non-citizen surviving spouse, the IRS may impose special arrangements to ensure that estate tax will be paid at the surviving spouse's death. The requirements differ depending on the value of the trust and its foreign real property, if any; a U.S. bank may be needed as trustee or the trustee may need to furnish a bond or other security.

Retirement Plan Benefits. Planning for the distribution of retirement plan benefits may raise additional complications if those benefits are to qualify for the marital deduction. Options are best considered on a case-by-case basis, with assistance from counsel.

Foreign Real Property. It is not clear how the QDOT rules apply to real property located outside the United States. It may be impossible for foreign real property to be transferred to a QDOT and qualify for the marital deduction. This matter is still the subject of some debate by the IRS and tax practitioners, and no definite conclusions may be drawn at this time.

Distributions to a surviving non-citizen spouse of trust income (or of principal "on account of hardship") are not subject to the QDOT tax. However, other distributions of trust principal will be subject to federal estate taxes calculated at the marginal estate tax rate of the deceased spouse’s estate.

In a very few instances, an estate tax treaty may provide adequate relief. In particular, the U.S.–Germany estate tax treaty or the U.S.–Canada income tax treaty may provide a workable alternative to a QDOT-based marital deduction.

Requirements for a Qualified Domestic Trust (QDOT)

The basic requirements are:

The QDOT must have at least one trustee who is an individual U.S. citizen or a domestic corporation.

The U.S. trustee must be able to withhold taxes due on any distributions of the trust principal.

The executor of the estate must make the QDOT election to qualify for the marital deduction.

If the QDOT has assets exceeding $2,000,000, the U.S. trustee must be a bank, or the individual U.S. trustee must furnish a bond or letter of credit to the U.S. Treasury for 65% of the value of the QDOT assets at the first spouse’s death.

Essentially, the QDOT is a trust designed to allow the non-citizen spouse to take advantage of the estate tax marital deduction. All the income of the trust must paid to the surviving spouse (subject to income, but not estate, tax). When the non-citizen spouse dies, the estate tax is paid and any remaining principal is distributed as directed in the trust document, usually to the children.
To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. tax advice contained in this communication is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code, or (ii) promoting, marketing, or recommending to another party any matters addressed herein.