Couples in which both spouses are U.S. citizens receive the benefit of the unlimited marital deduction on federal estate and gift taxes. The idea is that the surviving spouse pays the estate at their death. But what if you have a foreign spouse? Transfers from a U.S. citizen to a noncitizen spouse do not enjoy this same benefit. The IRS figures they may return home to their own countries and avoid U.S. estates taxes at their death. Instead, lifetime transfers are only tax-free up to the annual exclusion amount. According to the IRS’s annual Revenue Procedure, the annual exclusion for gifts to non-U.S. citizen spouses is $159,000.00 for 2021.
As a basic rule, the marital deduction is not permitted for transfers to a surviving spouse who is not a U.S. citizen. Remember, with the current high federal estate tax exemption, a U.S. citizen can gift up to $11.7 million dollars during their lifetime or at their death to anyone, including a non-citizen spouse. But, for high net worth couples or those planning for when the historically high federal estate tax sunsets in 2026 (or before), a Qualified Domestic Trust (“QDOT”) is as an exception to this rule.
What is a QDOT?
This type of trust allows for the marital deduction for property passing to a non-citizen surviving spouse. A QDOT permits deferral of U.S. estate taxes on the surviving spouse’s death, not avoidance. Upon the death of the surviving spouse, assets remaining in the QDOT are subject to estate tax as though they were in the estate of the first spouse to die.
Importantly, a QDOT addresses the IRS’s biggest problem with leaving assets to foreign spouses. The overall purpose of the QDOT is to ensure that the government will eventually be able to tax property for which a marital deduction is claimed. The requirement that the surviving spouse place property in a QDOT (or, in the alternative, become a U.S. citizen) ensures that if the marital deduction is allowed for property, the property will still ultimately be subject to transfer tax.
A QDOT is much like a qualified terminable interest property trust (“QTIP”), which mandates that all income be paid to the surviving spouse and that no other person have an interest in the trust during the surviving spouse’s lifetime. However, there are additional requirements:
- At least on Trustee must be a domestic corporation or a U.S. citizen.
- The trust must be subject to and administered under the laws of a particular state or the District of Columbia. A trust is maintained under the laws of a state of the United States or the District of Columbia if the records of the trust are kept in that state.
- The QDOT must be an “ordinary trust,” meaning that a trustee takes title to property for purposes of conserving it for beneficiaries and not for conducting business.
- Income distributions are tax free, but any distributions of principal to the surviving spouse requires that estate tax be paid at that time unless a “hardship” can be proven. “Hardship” distributions are those that are made in response to an immediate and substantial financial need relating to health, maintenance, education, or support of the spouse or of any person whom the spouse is legally obligated to support. If the spouse has other resources, the distribution will not qualify as being made on account of a “hardship.”
- Property placed in the QDOT must pass from the decedent to the surviving spouse in a form that would have qualified for the marital deduction if the surviving spouse was a U.S. citizen.
- The trustee must have the right to withhold the estate tax and pay it to the IRS.
What Happens if the Surviving Spouse Leaves the US?
The IRS keeps tabs on QDOTs. When death or a distribution from principal occurs, the U.S. trustee must file an annual statement, and federal estate tax is imposed. The law imposes security requirements (e.g., posted bond equal to 65% of the fair market value of the trust assets) to ensure the payment of the estate tax. These requirements are dependent upon whether the estate exceeds $2 million dollars, whether the trustee is a U.S. Bank, and what percentage of the trust property is located within the United States. Due to the requirement that a U.S. corporate fiduciary be appointed or a bond posted, it is unlikely that the IRS would not get its due on the surviving spouse’s death.
Do You Need a QDOT?
If you have assets exceeding the federal estate tax exemption, and either you or your spouse is not a U.S. citizen, then a QDOT should play a part in your estate plan. Yet, all is not lost if a decedent did not set up a proper QDOT. Under certain circumstances, a trust created for the spouse which fails to meet all of the requirements can be amended to qualify as a QDOT. Moreover, the surviving non-citizen spouse may create the QDOT after the death of the U.S. Citizen spouse. This irrevocable election may be made if the executor reasonably believes that there is a bona fide issue that concerns:
- the residency or citizenship of the decedent;
- the citizenship of the surviving spouse;
- whether an asset is includible in the decedent’s gross estate; or
- the amount or nature of the property to which the surviving spouse is entitled.
A QDOT would not be needed if the surviving spouse becomes a U.S. citizen before the deceased spouse’s estate tax return is filed. This is usually nine months from date of death, but can be extended another six months. Seek out an experienced estate planning attorney if either you or your spouse is not a U.S. citizen or own foreign property, as the rules are complex and always changing.