Estate planning professionals commonly encounter married couples with mixed nationalities. That is, one spouse is an American citizen and the other is not. The U.S. estate and gift tax rules are generally the same for U.S. citizens and resident aliens. However, the estate tax marital deduction differs significantly as applied to non-U.S.-citizen surviving spouses.
The unlimited gift and estate tax marital deduction generally allows U.S. citizens and U.S. resident non-citizens to make unlimited transfers of property to their U.S. citizen spouses, whether during lifetime or at death, without gift or estate tax consequences. The marital deduction defers estate tax on assets passing to a surviving spouse until his or her death. However, the unlimited estate tax marital deduction does not apply to gifts to a surviving spouse who is not a U.S. citizen. Therefore, the resulting amount of estate tax liability can be significantly increased for those with non-U.S. citizen surviving spouses.
Given this background, estate planners should be aware of several planning methods to help mixed-nationality couples minimize their tax liability.
1. Maximize Lifetime Gifts.
Lifetime gifts to non-citizen spouses are eligible for a special annual exclusion of $145,000 (for calendar year 2014, indexed for inflation). A gift qualifies for this annual exclusion if the gift: (1) passes a present interest, and (2) would otherwise qualify for the marital deduction for lifetime gifts if the donee spouse were a U.S. citizen.
Following the gift, there are several ways in which the non-citizen spouse may avoid or minimize U.S. estate tax. First, if the non-citizen spouse resides in the U.S. at the time of the gift, then he or she can avoid U.S. estate tax by removing the property from the U.S. and establishing residence outside of the U.S. before the time of his or her death. Second, a non-citizen spouse who resides in the U.S. may also use his or her applicable exclusion amount (currently $5.34 million) to reduce the estate tax on all property included in his or her estate (an advantage not available for assets transferred to a QDOT, discussed below). Third, if the non-citizen spouse does not reside in the U.S. at the time of the gift (for example, the non-resident, non-citizen spouse of a U.S. citizen domiciled abroad), he or she will avoid U.S. estate tax entirely, unless the gifted property is sitused in the United States at the non-citizen spouse’s death.
Mixed-nationality couples may also minimize transfer taxes by using the special annual exclusion to make lifetime gifts of jointly held property to the non-citizen spouse. The transfer of jointly held property from a U.S. citizen to a non-U.S.-citizen spouse may be subject to gift tax when the non-citizen spouse ultimately sells or otherwise transfers the property. The gift tax applies to such transfers to the extent the non-citizen spouse receives proceeds in excess of his or her proportionate share, if any, paid to acquire the property. By strategically utilizing the special annual exclusion, the U.S.-citizen spouse can gift joint property over time and avoid the imposition of gift tax when the non-citizen spouse later sells or otherwise transfers the property.
2. Utilize a Qualified Domestic Trust (QDOT).
Although the unlimited marital deduction is generally not allowed for transfers to non-citizen spouses, an exception exists for property transferred from the estate of a U.S. citizen or U.S. resident non-citizen to a QDOT for the benefit of his or her surviving non-citizen spouse. The QDOT rules allow a marital deduction and provide a jurisdictional basis to tax the property in the QDOT if the surviving spouse does not become a U.S. resident or leaves the United States.
A QDOT must meet the following requirements:
a. The trust instrument must require that at least one trustee of the trust be a U.S. citizen or domestic corporation, unless this requirement is waived by the IRS.
b. The trust instrument must provide that no distribution (other than distribution of income) may be made unless the U.S. trustee has the right to withhold the estate tax imposed on the distribution.
c. The trust must meet the requirements of any rules issued to ensure the collection of the estate tax imposed on the trust. These rules generally apply if the QDOT holds property in excess of $2 million or foreign property which has a fair market greater than 35% of the QDOT.
d. The executor must irrevocably elect QDOT treatment for the trust on the last federal estate tax return filed before the due date (including extensions). Alternatively, if a timely return is not filed, the election must be made on the first federal estate tax return filed less than one year after the due date for such return, including extensions.
Even if a decedent did not create a QDOT as a part of his or her estate plan, a surviving spouse can create a QDOT to defer estate taxes. In doing so, the surviving spouse must transfer the property to the QDOT before the decedent’s estate tax return is filed. It is important to note that the transfer of property by the surviving spouse to the QDOT could be subject to gift tax if (1) the surviving spouse is a U.S. resident, or (2) the transfer involves property with a U.S. situs. In such cases, care must be taken to avoid a completed gift on the transfer. Planners can avoid a completed gift by giving the surviving spouse a testamentary power of appointment over the QDOT property.
A QDOT defers estate taxes until principal is distributed from the trust to the surviving spouse, or until the surviving spouse’s death. Whenever principal is distributed from a QDOT, the amount of the distribution is added back to the decedent spouse’s estate and taxed at the rates effective on his or her death. This results in a tax equivalent to the highest marginal rate applicable at the first spouse’s death. However, principal distributions made as a result of an immediate and financial “hardship” of the surviving spouse, or of those he or she is legally obligated to support, are not subject to the QDOT estate tax.
When the surviving spouse dies or the trust fails to meet the QDOT requirements, the estate tax applicable at the deceased spouse’s death is recalculated by including the remaining QDOT property in the deceased spouse’s taxable estate. The prospect of redetermining the deceased spouse’s estate tax undermines the surviving spouse’s ability to make large lifetime gifts in reliance on the deceased spouse’s unused exemption amount (DSUE), if any, because the DSUE is “redetermined” at each taxable event rather than being fixed at the deceased spouse’s death.
3. Surviving Spouse Becomes a U.S. Citizen.
A non-citizen surviving spouse can take advantage of the unlimited marital deduction if he or she meets two conditions. First, the surviving spouse must become a U.S. citizen before the due date of the deceased spouse’s estate tax return. Second, the surviving spouse must have been a U.S resident at all times from the date of the deceased spouse’s death until the date he or she obtains citizenship. If citizenship remains pending at the time the estate tax return is filed, it may be advisable to file a protective QDOT election because such election must be made no later than one year after the due date for the U.S. estate tax return.
Additionally, if a QDOT has been established, the estate tax imposed on QDOT distributions will cease if the surviving spouse later becomes a U.S. citizen and either (1) has been a U.S. resident at all times after the decedent’s death until obtaining citizenship, or (2) has not been a U.S. resident but has received no taxable distributions from the trust. The trustee must timely notify the IRS of the change in the surviving spouse’s citizenship status for these rules to apply.
Mixed-nationality couples present unique estate planning considerations, and such couples can benefit greatly from advance planning. The strategies described above enable mixed-nationality couples to minimize their estate and gift taxes.