Estate planning can become a bit tricky if your spouse is not a U.S. citizen. Why? For estate tax purposes, U.S. citizens have a huge tax advantage over non-citizens.
Your estate will have to pay federal estate taxes when you die if the net value (assets minus debts) is more than the exempt amount at that time. Currently the federal estate tax exemption is $5 million per person, or $10 million for a couple (adjusted for inflation). This is the amount that passes free of estate tax, hence why it’s call the estate tax “exemption” amount. However, every dollar over the exempt amount is taxed at 40%. Some individual states also have an estate or inheritance tax. State estate/inheritance taxes vary, but because they typically apply at a lower threshold, your estate could be exempt from federal tax and still have to pay a state tax. Arizona residents can breathe easy on this one – Arizona does not have an estate tax.
If your spouse is a U.S. citizen, you can leave him or her an unlimited amount of assets with no estate taxes due when you die by using what’s called the unlimited marital deduction. The unlimited marital deduction is the law that lets you leave everything to your spouse without him or her having to pay any estate tax when you die. The IRS lets you do this when your surviving spouse is a U.S. citizen because it plans to collect the taxes when your surviving spouse dies.
However, if your spouse is not a U.S. citizen, he or she could try and take the assets after you die and leave the country. Needless to say, the IRS wouldn’t like this very much as it wouldn’t be able to collect any estate tax when the non-citizen spouse dies. As a result, the IRS doesn’t want non-citizen spouses to inherit large estates and then return to their country of citizenship without paying any estate taxes. This is why Congress eliminated the unlimited marital deduction for non-citizen spouses.
So what ultimately happens is that if your spouse is not a U.S. citizen, you have a taxable estate and you do not plan ahead, everything in your estate over the amount of the estate tax exemption when you die will be subject to estate taxes. A Qualified Domestic Trust (QDOT) can prevent this from happening.
Using a QDOT
With a QDOT, the citizen spouse’s assets are transferred to the QDOT upon his or her death. As a result of being transferred to the QDOT, no estate taxes are due at that time. This leaves the entire estate available to provide for the surviving non-citizen spouse. Although the trust (not the surviving non-citizen spouse) owns the assets, the surviving spouse can receive income from the trust (such as income from investments or interest on bank accounts). These distributions should happen at least annually, and are subject to income tax, but not estate tax.
The surviving non-citizen spouse may also receive principal from the QDOT with the trustee’s approval. Any distribution of principal the non-citizen spouse receives may be subject to the estate tax. However, if the distribution is made as a result of “hardship” as defined by the IRS, no estate taxes will be due. “Hardship” requires an immediate and substantial need for funds relating to the health, maintenance, education or support of the surviving non-citizen spouse, or someone he or she is legally obligated to support. The IRS will only grant a “hardship” exemption if the surviving non-citizen spouse doesn’t have other reasonably available assets.
When the non-citizen surviving spouse dies, the assets in the QDOT will pass to the other beneficiaries named in the trust – usually the couple’s children. At this point, if the assets in the QDOT exceed the estate tax exemption, estate taxes are paid then as if the assets were in the estate of the first spouse to die (the citizen spouse). The assets in the QDOT are not counted in the estate of the second spouse to die (the non-citizen spouse).
QDOTs must be set up in accordance with detailed IRS rules. One rule is that the trustee who has control over the assets in the trust must be a U.S. citizen or institution. After the death of the citizen spouse, the deceased spouse’s personal representative must make the “QDOT election” on the estate tax return filed for the deceased spouse’s estate in order to qualify for the unlimited marital deduction. The estate tax return is irrevocable and due nine months after the death.
In sum, if a married couple has a taxable estate and one spouse is not a U.S. citizen, estate taxes would need to be paid when the citizen spouse dies. By using a QDOT, estate taxes are delayed until the non-citizen spouse dies, leaving more assets available to provide for the surviving spouse.
Estate planning is a must for married couples with a non-citizen spouse. A qualified domestic trust can save big money on estates subject to the estate tax. Call Scottsdale Trust Attorney Abigail Neal at (480) 699-7992 to learn how this can work for you and your family.