Siskind's Immigration Bulletin - September 22, 2003

Steven Weiser is a tax lawyer with a practice focusing on international tax matters. His contact information and information on his practice can be found on his web site at http://www.lw-law.com/.

As if estate and gift tax planning for U.S. citizens wasn’t already complicated enough, here comes the Internal Revenue Code once again to make an already difficult situation even worse. In the May 31, 2003 Bulletin, we addressed estate-planning considerations for nonresident alien individuals. In this article we focus on estate and gift tax planning for U.S. citizens that have non-citizen spouses.

In general, an individual may make unlimited lifetime or post-death transfers of property to a spouse free of estate and gift taxes- unless the recipient spouse is a non-citizen. For example, H and W are a married couple. H is a U.S. citizen. H provides in his will that all property he owns at his death is left to W. If W is a U.S. citizen H’s estate is not liable for any estate taxes. However, if W is a non-citizen, to the extent the value of H’s estate exceeds the estate tax exemption amount, H’s estate is liable for estate taxes imposed on the value of property passing to W.

Let’s look at another example. H and W are a married couple and jointly hold title to their primary residence. In an effort to protect his assets from creditors, H decides to title the home solely in W’s name. If both H and W are U.S. citizens no adverse tax consequences result. However, if one spouse is a non-citizen a taxable gift may very well occur simply by altering title to the home.

Prior to 1988, the above described transfers ordinarily escaped taxation because U.S. citizens and resident aliens were allowed to transfer unlimited amounts of property to their spouse’s free of any U.S. estate and gift tax. This was, and still is, known as the unlimited marital deduction (because the amount transferred to the spouse was deducted from the gross taxable gift or estate). In 1988, Congress determined that the unlimited marital deduction could be abused where one spouse is a non-citizen. Assets could be transferred to the non-citizen spouse who would return to her home country, relinquish U.S. residency and escape U.S. taxation on all property other than those assets situated in the U.S. In order to remedy this perceived abuse, Congress enacted a series of laws that place substantial burdens and restrictions on transfers to non-citizen spouses. Understanding these laws and planning accordingly will insure that you maximize the amount of wealth you transfer to your non-citizen spouse and family, while minimizing or eliminating Uncle Sam’s share.

Congress has altered the rules applicable to non-citizen spouses in the following ways (all discussed in more detail below):

The unlimited estate tax marital deduction for transfers to non-citizen surviving spouses is disallowed, unless such property is placed in a qualified domestic trust (QDOT);

The unlimited gift tax marital deduction for transfers to non-citizen spouses is disallowed, but the annual exclusion from the federal gift tax is increased;

The full value of jointly held property is includible in the estate of the U.S. citizen spouse; and

In certain situations taxing the creation or termination of a joint tenancy where one spouse is a non-citizen.

The federal estate tax is imposed on the value of all property owned by an individual at the time of death. Items ordinarily including in the taxable estate include bank accounts, investments, personal property, residences, and even life insurance proceeds payable to the surviving spouse. Ordinarily, when calculating the amount of the taxable estate, a deduction is allowed for the value of all property passing to a surviving spouse (the marital deduction) thereby insuring that such property is not taxed. However, if the surviving spouse is a non-citizen, no marital deduction is allowed unless the property passes to the spouse through a QDOT and the personal representative of the deceased spouse’s estate makes a timely QDOT tax election.

Here’s how it works: H dies, leaving a non-citizen spouse, W, and two children with the following assets:

H’s will provides that all property passes to W. Ordinarily, H’s estate would owe no estate taxes since all property passes to his spouse. However, since W is a non-citizen no marital deduction is allowed. H may still use his unified credit equivalent to exempt $1 million from estate taxation, but the remaining $310,000 results in a tax liability of $91,200 in 2003. However, if H’s will had provided that all property passes to a QDOT for the benefit of his wife and children, estate taxes would have been avoided.

A QDOT actually serves to defer payment of any estate tax liability on the deceased spouse’s estate so it is not a perfect answer to the lost unlimited marital deduction. QDOT taxes are due only upon the occurrence of certain events such as the death of the surviving non-citizen spouse, distributions of trust principal to the spouse, or the termination of a trust as a QDOT. The QDOT tax is determined using the same estate tax rates otherwise imposed against the estate of the decedent spouse. The amounts subject to tax are equal to the amount of distributed money or value of distributed property. Distributions of QDOT income, as opposed to distributions of trust principal, are not subject to QDOT tax.

The spousal and familial support provisions of QDOTs are usually very similar to ordinary marital trusts. All income must be paid to the to the surviving spouse no less frequently than quarterly (limited exceptions to this rule exist). Generally, the trustee of the QDOT is allowed to make additional discretionary distributions to the surviving spouse, provided such distributions meet certain ascertainable standards (e.g., surviving spouse and children’s health, education maintenance and support). Often, the trustee is granted the right to terminate the trust if doing so will not result in an additional estate tax liability. This right may be useful where the surviving spouse later becomes a U.S. citizen. Upon the surviving spouse’s death, trust principal may be distributed outright to surviving family members, friends, charities, etc., or may remain in trust for the benefit of such persons.

QDOTs are subject to numerous statutory requirements, which are most easily met with a properly drafted last will and testament, revocable trust or similar estate planning document. Occasionally, if an outright property transfer to the non-citizen surviving spouse has been made, the marital deduction is available if the surviving spouse subsequently transfers the property to a similar QDOT prior to the date on which the estate tax return must be filed.[1] Because of the complexities involved, a QDOT should only be drafted by a qualified estate planning attorney.

At least one trustee of a QDOT must be a U.S. citizen or domestic corporation. If an individual, the trustee must have a regular place of business or abode in the U.S. The QDOT document must also provide that the U.S. trustee has the right to withhold any QDOT tax on any distributions of trust principal. Trust records must be kept in any state or the District of Columbia. As a practical matter, records are usually maintained at the location of the trustee.

QDOTs are divided into two classes: those with assets in excess of $2 million (Large QDOTs), and those with assets of $2 million or less (Small QDOTs). Large QDOTs must have a trustee that is a U.S. bank, furnish a bond in favor of the IRS equal to 65% of the value of the trust assets, or furnish an irrevocable letter of credit equal to 65% of the value of trust assets. Small QDOTs need to comply with these provisions only if the amount of real property located outside the U.S. accounts for more than 35% of all trusts assets.

There is no federal gift tax marital deduction for lifetime transfers to a non-citizen spouse. Instead, an individual may transfer up to $100,000 annually to a non-citizen spouse without gift taxes being imposed, provided the gift would otherwise qualify for the marital deduction (for example, a gift of a future interest in property would not qualify).

As an example, assume on January 1, 2004 H transfers title to his family residence worth $250,000 to his wife, W, a non-citizen of the U.S. Also assume on January 1, 2005 W becomes a U.S. citizen. The transfer to W in 2004 is a taxable gift. No marital deduction is available, but H can exclude $100,000 of the value of the residence from the taxable amount, but the remaining $150,000 is a taxable gift. The fact that W becomes a U.S. citizen in 2005 makes no difference because she was a non-citizen at the time of transfer.

Generally, the Internal Revenue Code provides that upon the death of a spouse, one-half of the value of property held jointly with the surviving spouse is included in the deceased spouse’s taxable estate. For example, H and W hold joint title to their primary residence. H dies when the home is valued at $200,000. Only $100,000 is included in H’s taxable estate.

However, where the surviving spouse is a non-citizen, this rule is completely eliminated. In the above example, if W is a non-citizen spouse, H’s estate may be subject to estate taxes on the full $200,000 value of the residence. Upon W’s death, she could claim a credit for estate taxes previously paid, but only if her estate is subject to U.S. estate taxes.

Generally, the creation of a joint tenancy in real property (real estate) between a husband and wife has no tax consequences, regardless of which spouse actually furnishes consideration for the purchase price of the joint property. However, upon the termination of a joint tenancy in real property, other than by reason of death, a spouse may be considered to have made a gift to the other spouse. The amount of the gift to the donee spouse is dependent upon the value of the interest in property received, multiplied by the percentage of consideration the donee spouse provided towards the original purchase of the property. For instance, H, a U.S. citizen, and W, a non-citizen, purchased a residence. H provided all of the consideration paid for the purchase of the home, which was titled jointly in both spouses’ names. For liability protection purposes, the home is later transferred into the sole name of W. A taxable gift occurs. Since W is a non-citizen the unlimited marital deduction is not available, and to the extent the amount of the gift exceeds $100,000, federal gift tax is due.

The creation of a joint tenancy in personal property is ordinarily treated as a gift. However, special rules exist for certain types of personal property. For example, the creation of a joint bank account does not result in a taxable gift. The taxation of terminations of joint tenancies in personal property is less clear. It appears that an equal separation of personal property or proceeds from the disposition of such property does not result in a taxable gift, regardless of which spouse furnished consideration for the original purchase of the property.

Many estate and financial planning professionals often overlook special considerations that should be made where one spouse is a U.S. citizen and the other is not. Care needs to be taken, not only in planning for a spouse’s well-being following the death of the first spouse, but also in structuring acquisitions of wealth, disposition of property, or asset protection matters. You should always consult with a professional with experience in international tax and estate planning matters to insure that you avoid unnecessary taxes, and that your spouse and family are adequately provided for in the event of your untimely death.

[1] A rarely used exception to these rules allows certain transfers of nonassignable annuities or other arrangements to qualify for the marital deduction, provided other requirements are met.