Planning For A Spouse Who Is Not A US Citizen-The Qualified Domestic Trust
By: Randall A. Denha, J.D., LL.M.
A Qualified Domestic Trust (QDOT) is designed to achieve a very particular goal: deferring federal estate tax when a U.S. citizen dies and leaves a large amount of money to a spouse who is not a U.S. citizen. The purpose of creating this type of trust is that Congress is worried that a non-US Citizen spouse will attempt to move assets overseas to avoid the Federal Estate Tax, a non-US Citizen spouse is not given an unlimited spousal exemption. Without a QDOT and provided you have a non-citizen spouse and an estate in excess of the federal estate tax exemption, an estate may pay estate tax at an accelerated rate if assets are left to a non-US spouse.
The Estate Tax Problem for Noncitizens
Why do you need a special kind of trust if you’re married to a noncitizen? The answer is that for federal estate tax purposes, citizens get a big tax break that noncitizens don’t. When a married couple are both U.S. citizens, the first spouse to die can leave any amount of money to the survivor, completely free of estate tax. This is called the unlimited marital deduction.
The marital deduction does not apply, however, if the surviving spouse is not a citizen. A noncitizen survivor must pay estate tax just like anyone else who inherits. If the taxable estate is very large—more than $11.18 million, for deaths in 2018—then federal estate tax may be due
To avoid paying estate tax at the death of the first spouse, couples have two main options: get U.S. citizenship for the noncitizen spouse or create a QDOT trust.
How a QDOT Works to Defer Estate Tax
With a QDOT, at the first spouse’s death, assets go to the trust instead of to the surviving noncitizen spouse. The survivor receives benefits (such as interest generated by trust bank accounts) from the trust assets, but doesn’t own them. When the second spouse dies, assets pass to other beneficiaries named in the trust document—typically, the couple’s children. If the estate is valuable enough, estate tax is paid then, as if the assets were in the estate of the first spouse to die. Trust assets are not included in the estate of the second spouse to die.
To get this tax break, detailed IRS rules must be followed when the trust is set up. For example, the trustee, who is has control over the trust assets, must be a U.S. citizen. If the amount of trust assets exceeds $2 million, one of the trustees must be a U.S. bank. (If it isn’t, the trustee must put up bonds for much of the trust’s value.) And after the first spouse dies, the executor must choose, on the federal estate tax return filed for the deceased spouse’s estate, to qualify for the marital deduction. This is called “making a QDOT election” and is irrevocable. The return must be filed nine months after the death. In some cases, if a non-citizen couple is preparing their estate plan and they are planning to become U.S. citizens in the near future, they may not need to have QDOT provisions in their living trusts; if they die before they actually become U.S. citizens, their executor can elect post-mortem for their marital trusts to qualify as QDOTs.
The surviving spouse is entitled to receive any income earned by trust assets, and typically, all income is distributed to the survivor at least annually. These distributions of income are subject to income tax, but not estate tax.
If the trustee gives the surviving spouse any of the trust principal—the assets that were put in trust—estate tax may be due. No estate tax will be due, however, if money is distributed in circumstances that fall under the IRS hardship exemption. If the spouse has an “immediate and substantial” need for money relating to “heath, maintenance, education or support”—either his or her own, or that of someone he or she is legally obligated to support—a distribution of trust funds may qualify for a hardship exemption if the surviving spouse doesn’t have other reasonably available liquid assets.
Other issues and strategies for consideration that citizens married to non-citizens should be aware of include:
- Gifting. Gifts from the citizen spouse to the non-citizen made during life are eligible for an annual exclusion ($152,000 in 2018). Gifts from the non-citizen spouse to a citizen spouse are eligible for the full marital deduction. To avoid inadvertent gifts, it is recommended that joint accounts be avoided when one spouse is not a citizen.
- Life Insurance. While proceeds of a life insurance policy of a non-citizen are not subject to the U.S. estate tax, proceeds of a life insurance policy owned by a U.S. citizen are subject to U.S. estate tax. Because the requirements of a QDOT are complex and may not provide a true deferral of estate taxes if the non-citizen surviving spouse needs principal distributions during his/her lifetime, a spousal lifetime access trust (SLAT) funded with life insurance on the life of the citizen spouse can provide greater flexibility and liquidity for the non-citizen spouse and be drafted and administered in the same way for non-citizens as U.S. citizens. In this way, life insurance helps transfer assets from the citizen spouse to the non-citizen spouse without the restrictions of the QDOT. Depending on the design of the life insurance trust, it can also provide supplemental income for a non-citizen spouse and access to cash value during the grantor’s lifetime while keeping all the trust assets outside the taxable estate.
- Retirement Assets. Since assets passing to a non-citizen surviving spouse will only receive the marital deduction if they are included in a QDOT, one of the best options for a non-citizen surviving spouse who receives qualified plan assets or IRA assets is to rollover the plan benefits into an IRA-QDOT. The IRA-QDOT will allow the surviving spouse to continue deferring income tax on the retirement assets that remain in the IRA and receive income from the IRA estate tax free. However, principal distributions to the surviving spouse will be subject to both estate and income tax, as with a standard QDOT.
Creating a QDOT is technical and complex so you’ll need advice from an expert about the advisability and mechanics of setting up this kind of trust.
