US Estate Tax Planning When Married to a Non-US Spouse: Use of a “QDOT”

This post will describe the usefulness of something called a “qualified domestic trust” (“QDOT”) as a possible estate tax planning tool for the US person who is married to a non-US citizen spouse. 

How the US Estate Tax Works

 By way of very general background, US Estate tax is imposed on the estate of the decedent (note, tax is not assessed on the heirs inheriting the assets). The Estate tax rates currently range from 18-35% on the value of assets passing at death. The maximum rate will increase from 35% to 55% on January 1, 2013 unless the US Congress takes action and announces a different maximum Estate tax rate. 

The estate of a US person includes his or her assets located all over the world.  For 2012, there is an Estate Tax exemption amount for assets totaling US$5,120,000.  Thus, US$5,120,000 in value of assets can be passed to any person without imposition of Estate Tax.  (This amount will decrease to US$1 million in 2013 unless the US Congress takes action and announces a different exemption amount).   

In addition to this Estate Tax exemption amount, a so-called “unlimited marital deduction” is permitted.  Under the general US Estate Tax rules, one spouse may leave an unlimited amount of property at his or her death to the surviving spouse and such property will not be subject to Estate Tax.  This is called the “unlimited marital deduction”.  Take the case of a wealthy US citizen married to a US citizen and having 3 children.  Assume the worldwide assets comprising the total estate are valued at US$11,120,000.  Assuming the US citizen dies in 2012, he can leave assets totaling US$5,120,000 to his children and the balance of US$6 million to his US spouse and not pay any Estate tax.

However, if the decedent had been married to a non-US citizen, property he leaves to that spouse is not entitled to the unlimited marital deduction.  As a result of this rule, any property left to a non-US citizen spouse that exceeds the Estate Tax exemption amount, will be subject to US Estate Tax. 

Non-US Citizen Spouse

Why might this rule exist? The reason is that upon death of a US citizen married to a non-US citizen, there is nothing to hinder the surviving non-US citizen spouse from remaining abroad or leaving the US and returning to his or her native country and taking all the property along that was inherited earlier.  In such cases, none of this property would be subject to US Estate tax  upon death of the surviving non-US citizen spouse. To prevent this, the unlimited  marital deduction is denied for any property given to a surviving spouse who  is not a US citizen.  From a tax perspective, the US citizenship requirement may be easy to justify. In reality, however, its  application can be extremely unforgiving in certain circumstances.  Take the case of a couple who have resided in the  United States for  numerous years, but for whatever reason, without the non-citizen spouse  ever having obtained US citizenship. This spouse may have no  intention of ever returning to his or her homeland and thus, under the US rules, would be treated as a US tax resident and would be subject to US Estate tax at death. Since the person is not a US citizen, however, the decedent spouse’s estate would be deneid the unlimited marital deduction. For this reason, the  federal government created the QDOT – it is an alternative way to qualify for the unlimited  marital deduction when property is given to a non-US citizen spouse.

Using a Qualified Domestic Trust

Using the QDOT would enable a US spouse to leave property exceeding the personal Estate Tax exemption amount to a non-US citizen spouse and defer Estate Tax.  All property, no matter how much it is worth, left by one spouse to a non-citizen spouse in what is known as a QDOT is allowed the marital deduction.  The Estate Tax that would otherwise be assessed on the property at death is deferred until the non-citizen spouse dies (or, earlier, if principal as opposed to income is distributed to the spouse from the QDOT, unless for reasons of “hardship”).  The QDOT can be created in one’s last Will and Testament and therefore can come into being at the time of death. 

Other Important Points to be Noted When Using a QDOT

  • Income received by the non-citizen spouse from the QDOT is taxable as regular income for US income tax purposes.  This is true for any person (whether US on non-US) receiving income from an ongoing US trust.  Also, the tax rules require that the surviving spouse be entitled to receive all income from the QDOT. 
  • It was mentioned earlier that US Estate tax is merely “deferred” when using the QDOT.  Estate tax is imposed on a distribution from the corpus or principal of the QDOT made before the death of the surviving spouse beneficiary. Estate tax is also imposed on the value of the property remaining in the QDOT on the date of death of the surviving non-US spouse. In these instances, Estate tax must be withheld and paid over to the IRS.
  • The trustee can be held personally liable for the taxes imposed, so it is critical that the trustee be meticulous in its QDOT undertakings.
  • The corpus or principal placed in the QDOT may be left to one’s children or other persons if desired.   The assets need not be left to the non-US spouse; so the QDOT provides a certain degree of flexibility. 
  • An election must be made on the decedent’s Form 706, US Estate Tax return, to treat the trust as a QDOT.
  • There must be at least one US citizen serving as trustee of the QDOT.
  • If the assets funding the QDOT exceed US$2 million (not including a personal residence with a value of up to $600,000), the trustee of the QDOT must be either a United States bank, or the US trustee must meet certain bond or letter of credit requirements.

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