One of the most important estate tax planning tools available to married couples is the unlimited marital deduction. The deduction allows one spouse to pass an unlimited amount of property to the other spouse without incurring any federal estate or gift taxes. It permits the deferral of estate taxes on the property until the surviving spouse disposes of it, either by gift or at death. The estate of the surviving spouse is then entitled to $1,500,0001
estate exempt amount and excess amounts are subject to federal estate taxes up to 47 percent.
But what if one spouse is a not a citizen of the United States? Up until 1988, non-citizen spouses could receive property tax-free from their spouses either through inheritance or by gift -- by taking advantage of the marital deduction -- and then move back to their native countries with the property. Congress changed the law to generally disallow any marital deduction for either an inheritance received by a surviving non-citizen spouse or for lifetime gifts made to such a spouse because of concerns that such property would be out of the reach of the I.R.S. and entirely escape federal gift and estate taxes.
Without the marital deduction, spouses who aren't U.S. citizens can only receive $1,500,000 from their spouses free from federal estate taxes. Every U.S. resident, regardless of citizenship, gets a $1,500,000 estate exemption amount. Unfortunately, any assets over that amount may be substantially reduced by taxes, resulting in the depletion of funds available for the spouse's support.
Lifetime gifts to non-citizen spouses are also subject to restrictions. While there is no limit on the amount of money that a husband and wife who are citizens can receive tax-free from each other during their lifetimes, the maximum annual gift amount to a non-citizen spouse is $117,000. Gifts exceeding $117,000 in any year will either reduce the donor spouse's available credit or result in gift tax if his or her credit has previously been consumed.
This rule makes careful tax planning an imperative. Otherwise, a couple - where one spouse is a non-citizen -- transfers title of an asset from one of their names to the other name or from both their names to one name, may be hit with substantial taxes. Non-citizen spouses also face special restrictions when inheriting property owned jointly with their spouses who are citizens.
Special Trust Provides Relief
A special marital deduction is permitted however, for property passing at the death of one spouse to a surviving non-citizen spouse if that property is put into a qualified domestic trust (QDOT) for the benefit of the surviving spouse. Properly structured, a QDOT can postpone estate taxes until the death of the second spouse. The QDOT is similar to the unlimited marital deduction used by couples who are both citizens.
Under the QDOT rules, which are detailed and complex, the inherited property is not subject to estate tax so long as it stays in the trust. Here's how it works. A QDOT is typically created in a will or in a separate trust document prior to the death of the first spouse. A bit of flexibility in the rules, however, permits the trust to be set up even after the death of the first spouse by his or her executor or surviving spouse if completed within certain time limits. This leeway permits couples who weren't aware of the QDOT, or who delayed setting it up, the opportunity to do some post-death tax planning.
Once the assets are transferred to the trust, the surviving spouse is entitled to receive income from the trust free from estate taxes. When the trust terminates, usually at the death of the surviving spouse, the QDOT must pay estate taxes calculated as if they were a part of the taxable estate of the first deceased spouse.
Watch Out For Restrictions
As with most trusts, the QDOT is subject to a host of restrictions that can trip up the unwary. For instance, any distributions of principal made to the non-U.S. citizen surviving spouse are subject to estate taxes and the trustee must withhold funds equal to the tax. The estate tax is determined at the highest rate applicable to the deceased spouse's estate. Exceptions are made, however, for principal distributions due to hardship. Thus, if the surviving spouse takes the principal for an immediate and substantial financial need relating to his or her health, education, or support, or the needs of a child or other person whom he or she is legally obligated to support, no estate tax will be imposed.
Other I.R.S. restrictions are meant to ensure the collection of the estate tax due upon the assets ceasing to be held in a QDOT, whether as a result of the non-citizen spouse's death or otherwise. If the assets passing to a QDOT exceed $2 million, the trust agreement must provide that either a United States bank be appointed as trustee, or that a bond or letter of credit be posted equal to a certain percentage of the fair market value of the trust assets as of the date of the first spouse's death.
If the fair market value of the assets transferred to the QDOT are $2 million or less, the trustee must either satisfy one of the security arrangements described above for trusts in excess of $2 million, or limit the fair market value of any real estate held by the trust located outside of the U.S. to no more than 35 percent of the value of all the trust assets. In determining whether the value of the trust assets exceed the $2 million threshold, up to $600,000 in value of a personal residence passing to the QDOT and which is lived in by the surviving spouse can be excluded.
Most couples plan their estates with the goal of insuring that the survivor of them will have enough assets to live on comfortably. Providing financial security for your loved ones after your death and minimizing estate taxes is a challenge for spouses who are both U.S. citizens. It's an even tougher task when one spouse is a foreign citizen. Since the estate and gift tax laws are quite different for non-U.S. citizens, its important to consult with a knowledgeable financial professional who can answer your questions and help you take the necessary steps to meet your estate planning goals.
The Economic Growth and Tax Relief Reconciliation Act of 2001 attempted to reduce or eliminate estate taxes, but the result was a tax system with three phases: relief, repeal and reappearance. Transfer tax rates are scheduled to decrease, and the amount that may be transferred free of estate tax (the credit equivalent) is scheduled to increase, until the estate tax is repealed in 2010. However, the rates return to 55% and the credit equivalent to $1,000,000 in 2011