Editor: Rick Klahsen, CPA
Under current U.S. tax law, a U.S. citizen may transfer property to his or her U.S. citizen spouse without any tax consequence or limitation. However, a U.S. citizen married to a noncitizen can make only a limited amount of bequests to his or her spouse. Any excess bequests are taxed at the estate tax rate, which can be extremely high. From 2007 to 2009, the maximum estate tax rate was 45% (Sec. 2001(c)(2)).
In 2010, the estate tax is repealed for one year, but it is scheduled to return in 2011 at a 55% maximum rate.
This item addresses various estate tax planning rules and techniques used to benefit U.S. citizens with noncitizen spouses. Gift tax will be mentioned as well, since it is an important factor in the estate tax planning process.
Gift Tax Exclusion and the Unified Credit
Estate and gift tax are related to each other. Individuals are entitled to a unified credit against estate tax at the time of their death. Any gifts made in excess of the annual exclusion amount reduce the unified credit. For 2009, the applicable exclusion amount was $3.5 million. After 2010, the unified credit reverts to $1 million.
Each individual is allowed an annual gift tax exclusion. The first $10,000 (adjusted for inflation) of gifts made is not taxed and does not reduce the unified credit (Sec. 2503(b)(1)). In 2009 and 2010, any gifts in excess of $13,000 for single individuals and $26,000 for married individuals who split gifts ($13,000 for each spouse) will reduce the credit. Gifts made to a U.S. citizen spouse are unlimited and therefore do not reduce the credit. However, gifts made to noncitizen spouses have certain limitations. Instead of the annual exclusion amount for all gifts made, the spousal annual exclusion amount is $100,000 for gifts made to noncitizen spouses. The inflationary adjusted spousal amount in 2009 was $133,000. For example, if a U.S. citizen gives his or her spouse a gift of $200,000 and the spouse is a noncitizen, $67,000 of the gift would reduce the donor’s unified credit ($200,000 – $133,000).
Qualified Domestic Trusts
Prior law allowed U.S. citizens to make bequests to their spouse and receive an unlimited federal estate tax marital deduction for all transfers to the surviving spouse (Sec. 2056(a)). Citizenship of the spouse was not an issue at that time. Current law denies the unlimited marital deduction to transfers made to noncitizen spouses (Sec. 2056(d)). In order to receive a similar benefit of the estate tax marital deduction, the assets must be transferred to a qualified domestic trust (QDOT). If property passes directly from the decedent to the surviving spouse, it will be treated as passing to a QDOT if the property is transferred to the QDOT before the decedent’s estate tax return is filed or the property is irrevocably assigned to the trust under an irrevocable assignment made on or before the date the return is filed (Sec. 2056(d)(2)(B)). Keep in mind that if the surviving spouse becomes a U.S. citizen before the U.S. estate tax return is filed, there is no need to transfer the property to a QDOT, and the unlimited marital deduction will apply.
To satisfy the QDOT rules and obtain the marital deduction, not only does the property have to be transferred to a QDOT and a timely election made on the estate tax return, but the marital deduction trust requirements must also be satisfied. In order to satisfy the QDOT requirements, the trust must meet the following requirements:
- There must be at least one U.S. citizen trustee;
- Any distribution made from corpus must have the right to withhold any estate tax that would be imposed on the distribution;
- An election must be made on the decedent’s U.S. estate tax return to treat the trust as a QDOT; and
- If the assets passing to the QDOT have a value in excess of $2 million (not including a personal residence with a value of up to $600,000), the QDOT must either have a U.S. bank as a trustee or the U.S. trustee must satisfy the U.S. bank, bond, or letter requirement.
In addition to the requirements mentioned above, there are special tax treatments that apply to a QDOT. An estate tax is imposed on any distribution from the QDOT made before the death of the surviving spouse, as well as on the value of the property remaining in the QDOT on the date of death of the surviving spouse. Any QDOT property that was used to pay the above-mentioned tax is considered a distribution and is therefore also subject to tax. In addition, if the trust ceases to qualify as a QDOT, the fair market value (FMV) of property in the QDOT as of the date of disqualification will be taxed (Sec. 2056A(b)).
Furthermore, certain lifetime distributions are exempt from tax. Distributions of income from a QDOT to the surviving spouse are not subject to the QDOT tax. In addition, distributions from corpus for hardship purposes are not subject to tax. Even though the distributions for hardship are tax free, they must be reported on Form 706-QDT, U.S. Estate Tax Return for Qualified Domestic Trusts. Note that there is no real definition of the term “hardship.” The regulations provide that a payment is treated as being made on account of hardship if it is made “in response to an immediate and substantial financial need” for the surviving spouse’s health, maintenance, or education or for such needs of any dependents of the surviving spouse (Regs. Sec. 20.2056A-5(c)(1)).
The trustee of the QDOT is personally liable for the tax imposed. If there is more than one QDOT and more than one trustee, an election should be made to report the designated return filer of the Form 706-QDT. The QDOT tax is due on the fifteenth day of the fourth month of the year after the year in which the taxable event took place. An extension of no more than six months can be requested under Sec. 6081(a) if the conditions set forth in that section are met.
In addition, the United States currently has 16 bilateral tax treaties that alter the rules mentioned above. The treaties are with Australia, Austria, Denmark, Finland, France, Germany, Greece, Ireland, Italy, Japan, Netherlands, Norway, South Africa, Sweden, Switzerland, and the United Kingdom. Many of these treaties include nondiscrimination provisions that do not allow the burden of tax in the United States to be more than the tax imposed on U.S. citizens in the treaty country.
After reviewing the relevant tax rules pertaining to U.S. citizens with noncitizen spouses, it is evident that proper tax planning is important. Making use of the tax planning tools available will increase the dollar amount that the surviving spouse will have available. The rules and regulations are very different for U.S. citizen spouses and noncitizen spouses. There are more limitations on gifts and transfers to noncitizen spouses. In order to avoid paying higher taxes when transferring property to a noncitizen spouse, one must become familiar with the techniques available.
Since income distributions are nontaxable, the main focus should be to distribute as much income as possible to the surviving spouse. Having the QDOT funded with income-generating assets will enable the surviving spouse to receive a greater income. Another option, in addition to the QDOT, is to set up a charitable remainder trust, which distributes a percentage of the initial FMV or the annual FMV depending on the type of trust. Upon the death of the beneficiary (the surviving spouse), the remaining corpus is donated to a charitable organization. By using these techniques, the surviving spouse will have a secure distribution annually, which will be estate tax free.
Another tax planning tool is gifting property on which future appreciation is expected to occur. For example, if the donor owns property worth $100,000 today but believes the value will increase significantly in the future, he or she can gift it to the spouse at today’s value and therefore avoid tax on the appreciation of the property.
Life insurance policies are another important tax planning tool. A U.S. citizen can gift $133,000 annually to his or her noncitizen spouse or to a trust for the benefit of the noncitizen spouse. The trust then purchases a life insurance policy on the life of the U.S. citizen spouse. Upon the death of the U.S. citizen, the proceeds of the policy pass to the noncitizen spouse tax free.
Changing the spouse’s citizenship status from noncitizen to citizen will alleviate some of the tax consequences and will change the limitations on transfers and gifts to the surviving spouse. However, this change will expose the noncitizen’s worldwide assets to U.S. estate tax. If the surviving spouse has significant worldwide assets, changing citizenship status may not be advisable.
In summation, if there is no advance planning, a noncitizen surviving spouse may be left with less than anticipated. By using a QDOT, the property will be in trust and the income distributions will be estate tax free. In addition, gifting certain property before the property appreciates will potentially reduce estate tax. Advisers may want to consider changing the surviving spouse’s citizenship status before the estate tax return due date; however, careful planning is recommended.
Rick Klahsen is managing director, Tax Services, with RSM McGladrey, Inc., in Minneapolis, MN.
Unless otherwise noted, contributors are members of or associated with RSM McGladrey, Inc.
For additional information about these items, contact Mr. Klahsen at (952) 921-7630 or firstname.lastname@example.org.