An Explanation of the International Estate Planning Challenge
When a U.S. citizen or permanent resident dies, assets that the person owned at the time of his or her death are subject to federal estate taxes. However, an estate tax payment is required only from those people whose assets exceed a threshold, known as the “exclusion amount” (and sometimes called the “unified credit equivalent”). In 2011, the amount of assets that were excluded before computing the estate tax was $5,000,000; for 2016 the exclusion is $5.45 million. Amounts in excess of that amount are taxed at as much as 35%. Generally, for the estates of U.S. citizens and permanent residents, all assets, no matter where they are situated in the world, are included in computing the taxable estate.
An important companion rule is the exception for transfers between married people. As a basic rule, U.S. gift and estate tax laws permit unlimited tax-free transfers of property between spouses. However, this exception applies only if the recipient is a U.S. citizen. The marital deduction is not allowed if the spouse receiving property is not a U.S. citizen, even if he or she is a permanent resident of the United States. This means that when one spouse (or both) is not a U.S. citizen, there is a possibility that a heavy estate tax could be due when one spouse dies, imperiling the financial stability of the other spouse.
One of the implications of this rule is that property held jointly with a non-citizen spouse can cause a problem in the estate of the first spouse to die if the surviving spouse is a non-citizen. This is because under federal law, the entire value of jointly-owned property is included in the decedent’s gross estate when the surviving spouse is not a citizen. This allocation of the entire value can be reduced by the amount of any contribution by the surviving spouse. This can cause an unexpected tax burden. Furthermore, there can be a conflict between the notion that the jointly-owned property is taxed to the decedent’s estate but under state property law the surviving spouse is the owner of the property upon the death of the spouse. The surviving spouse must either pay the tax at the time of decedent spouse’s death or contribute all of the property (including his or her own interest) to a QDOT, thereby deferring the tax.
Alternatively, the spouses might undo the joint ownership. Bear in mind, however, that typically splitting jointly-owned property results in equal ownership. However, if the spouses end up with ownership percentages that differ from their actual contributions, a taxable gift could result (some of which might be sheltered by the annual exclusion for gifts to non-citizen spouses, discussed above). If the amount transferred to the non-citizen spouse will be greater than the the annual exclusion, the spouses might choose to vest ownership accordingly.
This restriction also relates to spousal gifts. If a spouse is a U.S. citizen, transfers of any amount can be made to the spouse during lifetime. If, however, the spouse is a non-citizen, gifts in excess of $128,000 per year are subject to federal gift tax. (This amount is indexed for inflation, increasing each year.)
Because the marital deduction is not allowed if the spouse receiving the property is not a U.S. citizen, transfers at death to that spouse can qualify for the unlimited marital deduction only if they pass to a qualified domestic trust (usually referred to as a “QDOT”), either created as part of an estate plan or created by the surviving spouse after the death of the other. The Government’s goal is to ensure that the non-citizen spouse does not move to another country after receiving the funds, thereby avoiding being subject to U.S. gift and estate taxes on assets that originated from a U.S. citizen. In this regard, the U.S. Government might require the surviving spouse to provide security to ensure that the tax will be paid on the QDOT property. Also, note that some property cannot or may not be able to be transfered to the QDOT (such as real estate located outside of the U.S.).
Distributions from a QDOT to a surviving non-citizen spouse of trust income or of principal when distributed “on account of hardship” are not subject to the QDOT tax. However, other distributions of trust principal will be subject to federal estate taxes calculated at the marginal estate tax rate of the deceased spouse’s estate.
You should note that tax treaties between the U.S. and certain foreign countries (including Canada and Germany) provide better alternatives to the QDOT.
To address this problem, some families make annual gifts (up to the exclusion amount) to the non-citizen spouse as a way of reducing the impact of the marital deduction restrictions at death.
The basic requirements for a Qualified Domestic Trust (QDOT)
The QDOT must have at least one trustee who is an individual U.S. citizen or a domestic corporation.
The U.S. trustee must be able to withhold taxes due on any distributions of the trust principal.
The executor of the estate must make the QDOT election to qualify for the marital deduction.
If the QDOT has assets exceeding $2,000,000, the U.S. trustee must be a bank, or the individual U.S. trustee must furnish a bond or letter of credit to the U.S. Treasury for 65% of the value of the QDOT assets at the first spouse’s death.