This is Part 2 in a three-part series about Estate Planning for Non-Citizens. In Part 1, I discussed general issues involving non-citizen planning. In Part 3, I discuss the various ways foreigners can own U.S. real property.
Who Needs a QDOT?
One of the lesser known benefits of US citizenship is something called the “unlimited marital deduction” (UMD). It is outlined in Section 2056(a) of the Tax Code and allows for the unlimited transfer of assets between married couples, but only if the spouse receiving the asset is a US citizen. This is an incredible estate planning tool because without the UMD, a lifetime transfer made between spouses (e.g., adding your spouse to a bank account or adding them to a property deed) would otherwise trigger the gift tax and a testamentary transfer made at death (e.g., when one spouse dies and leaves his assets to his wife) would otherwise trigger the estate tax. Thus, if the recipient spouse is a US citizen, the transfer is tax-free.
However, if the recipient spouse is not a US citizen, things get more complicated. In Part 1, I outlined a two-part test to determine how much can be transferred tax-free between spouses if one spouse is not a citizen. Specifically, if the recipient spouse is not a citizen, then we must look to the donor spouse’s exemption amount in the year that the transfer was made, but if the donor spouse was not a US domiciliary, the amount that can be transferred is severely limited ($60,000 lifetime exemption or, if the recipient is the spouse, $164,000 annual exemption in 2022). If a spouse passes away and leaves more than the exemption amount to their non-US citizen spouse, a brutal 40% estate tax will normally apply.
Fortunately, there is some relief for situations like this, by way of a special trust called a Qualified Domestic Trust (QDOT). Property passing through a QDOT from the donor spouse to the non-citizen recipient spouse at death qualifies for the UMD, as though the surviving spouse was a citizen. Alternatively, a surviving spouse can irrevocably assign the property to a QDOT before the deceased spouse’s estate tax return (Form 706) is due, including extensions.
Elements of a QDOT
To legally be a QDOT, a trust must be a US trust that meets the following requirements:
- It must be structured as a power of appointment trust, a qualified terminable interest property trust (QTIP trust), a qualified charitable remainder trust (qualified CRT), or an estate trust. This rule does not apply if the surviving spouse irrevocably assigns the property to a QDOT in a timely manner and, under such a trust, the surviving spouse need not even be a beneficiary of the QDOT;
- Require at least one trustee to be a U.S. citizen or a U.S. corporation;
- Allow for the trustee the right to withhold any distributions from the trust, except distributions of income; and
- One of the trustees must be a US bank if the property transferred to the QDOT exceeds $2 million (ignoring any indebtedness on the property). If the trustee is not a bank, then the trustee must post a bond with the IRS equal to 65% of the fair market value of the property transferred to the trust, or the trustee must furnish the IRS with a letter of credit of 65% of the fair market value of the property transferred to the trust. If the property transferred to the QDOT is less than $2 million, then no more than 35% of the trust property (determined annually on the last day of the trust’s tax year) can consist of foreign real property. If it does, then the rules applying to a QDOT greater than $2 million will apply.
The executor of the deceased spouse must make a timely QDOT election on the estate tax return for the decedent.
Distributions from a QDOT
A QDOT serves as a deferral of the estate tax — not an elimination of it. Thus, when the surviving spouse passes away, the amount of assets in the QDOT are still subject to the estate tax, unless the surviving spouse becomes a US citizen, in which case the assets in the QDOT qualify for the UMD as though it were transferred directly to the surviving spouse.
The surviving spouse is permitted to withdraw income (defined as fiduciary accounting income, not taxable income) from the trust without any penalty. However, if principal is withdrawn, then those distributions of principal will be subject immediately to the estate tax unless it can be established that the withdrawal of principal was on account of a hardship (discussed below). Moreover, distributions or transactions are permitted without penalty if they are related to ordinary and necessary expenses of the trust, or tax payments on the trust’s tax liabilities, or sales of trust property for full and adequate consideration.
Principal distributions made because of a hardship is defined as withdrawals made “in response to an immediate and substantial financial need relating to the spouse’s health, maintenance, education, or support” or similar needs for a person for whom the surviving spouse is legally obligated to provide. If the surviving spouse has other sources reasonably available to pay the amount, then a hardship will not be found. However, the surviving spouse is not required to liquidate closely held business interests, real estate, or tangible personal property.
If there is not a taxable withdrawal during the lifetime of the QTIP and if the surviving spouse was a US resident at the time of the deceased spouse’s death and then becomes a citizen, then there is no estate tax as long as the survivor reports it to the IRS on a Form 706-QDT.
Portability Rules Involving Non-Citizen Spouses
Previously, I wrote about portability and explained why everyone who can should apply for portability when their spouse passes away. By not doing so, you run the risk of subjecting your heirs to an estate tax at your own death if you end up leaving behind an amount greater than the exemption allows in the year of your death. However, if you elected to port your Deceased Spouse’s Unused Exemption (DSUE), this is a guaranteed amount that can be transferred tax-free to your heirs.
Can a non-citizen surviving spouse apply for portability of their deceased spouse’s unused exemption?
If the decedent was a non-US domiciliary, then the answer is “no.”
If the decedent was a US domiciliary, but the surviving spouse is a non-domiciliary, then the answer still is “no” unless a tax treaty permits for portability of the DSUE.
But, if the decedent and surviving spouse are US domiciliaries, then the answer depends on: (1) whether the QDOT amount was less than the DSUE amount (because the DSUE essentially gets reduced by the QDOT amount); and (2) whether the surviving spouse becomes a US citizen (because then the QDOT can be used by the surviving spouse without penalty, thereby reinstating the DSUE for purposes of portability). At no time is the surviving spouse permitted to gift QDOT assets using the DSUE amount. It should be emphasized that in the event a tax treaty conflicts with any standard rules regarding a QDOT, then the tax treaty of course trumps.
In any situation where the surviving spouse is not a citizen, it is advisable still for the executor to always apply for portability, especially if the surviving spouse becomes a US citizen.
If the assets left to a surviving spouse are expected to grow in value, then one should consider using a bypass trust to house the deceased spouse’s exemption, with the balance moved into the QDOT. Otherwise, everything will be part of the surviving spouse’e gross estate.
Each case is different based on each client’s situation. There is no one-size-fits-all solution. Therefore, work with professional advisors to plan your estate.
In Part 3, I discuss the various ways foreigners can own U.S. real property.