With careful planning, the US federal tax cost of making transfers to a surviving non-US citizen spouse can be minimised, according to Northern Trust’s Suzanne Shier and Benjamin Lavin. Here, they explain how, with the help of something called a “QDOT Trust”, this may be done.
In today’s global economy and mobile society, it’s increasingly common for individuals to own assets and invest internationally; for executives to have international assignments; and for families to have members who live abroad, and/or who may be citizens of different countries.
It shouldn’t be surprising, therefore, to discover that it’s also not unusual for individuals to find love abroad.
In fact, more than 4.1 million households in the US today have at least one foreign-born spouse, according to the most recent US Census. Of these households, 39% of the foreign-born spouses are not naturalised US citizens, meaning that some 1.6 million US households need to address the wealth transfer planning issues that come with planning for a surviving non-US citizen spouse.
This issue also comes into play when such mixed-citizenship couples relocate abroad, or when an American expat marries while overseas, with the intention of returning to the US. Even US citizens who intend to stay abroad indefinitely remain bound by US tax constraints.
Nor can we forget about non-US citizen married couples who own property in the US.
When it comes to setting up a married couple’s future wealth transfer arrangements in a tax-efficient and compliant way, especially if one or more of them is American, therefore, it’s important to recognise that citizenship matters.
Under US law, “US citizen married couples” – that is, where both spouses are US citizens – are generally treated as a single economic unit, able to transfer assets between each other during life or at death without US federal gift and estate tax consequences, because of the so-called “unlimited marital deduction”.
Then, at the death of the surviving spouse, any tax due is paid.
Thus, tax for the US citizen married couple is deferred until the death of the surviving spouse, but it is not avoided.
However, if the surviving spouse is not a US citizen or a US domiciliary at death, the tax deferred at the first death could potentially be avoided altogether.
It is for this reason that the generous marital deduction available for US citizen spouses is only available in limited circumstances for transfers to a non-US citizen spouse.
From the US planning perspective, cross-border couples give rise to a multitude of complex US tax consequences that stand as ready traps for the unwary who have failed to undertake proper wealth transfer planning.
Overview of US Transfer Taxes
Before we continue, let’s take a quick look at how the US taxes gifts and bequests of assets.
US citizens and US “domiciliaries” (that is, persons who live in, and intend to remain in, the US but who are not US citizens) are subject to federal gift and estate taxes on the value of all gifts made during life, and bequests at death, wherever the property is located.
There is, though, an exclusion amount – US$5.45m in 2016 – for tax-free transfers.
For gift and estate tax purposes, individuals are considered to be domiciled in the US if they are physically present there, with the intention of remaining there indefinitely.
Non-US citizens not domiciled in the US – (known as NCNDs) – are subject to gift tax only on transfers of tangible personal property and real property located in the US.
NCNDs are subject to estate tax on transfers of tangible and intangible personal property, and real properly, located in the US. (Tangible property includes such non-land objects that can be moved or touched as furniture, art, jewelry or cars; whereas intangible property includes stocks, securities and intellectual property).
A US$13,000 credit, the equivalent to an exclusion of US$60,000, is available for the estate tax, but not the gift tax, for NCNDs, subject to adjustment by treaty.
Gifts and bequests in excess of the available exclusions are subject to a maximum 40% tax rate.
Transfers made during life or at death to a US citizen spouse are eligible for an unlimited gift and estate tax marital deduction.
However – and this is key – transfers to a non-US citizen spouse are not eligible for such marital deductions, absent specialised planning.
Furthermore, only half of the value of joint-tenancy property held by US citizen spouses is included in the gross estate of the first deceased spouse, regardless of individual contribution, whereas the full value is included if the surviving spouse is not a US citizen, unless contribution by the surviving spouse can be shown.
An increased annual gift tax exclusion amount of US$148,000 in 2016 is available for gifts to a non-US citizen spouse. Gifts may be made annually using the full annual non-US citizen spouse exclusion amount, as adjusted for inflation each year.
Fortunately for cross-border couples, there is a way to make temporary use of the estate tax unlimited marital deduction by using a Qualified Domestic Trust (QDOT) to defer – not avoid – estate tax liability.
Transfer to QDOT
For bequests to a non-US citizen spouse, there is a marital deduction-qualifying exception for property that is properly transferred from the estate of the first spouse to a QDOT for the benefit of the surviving non-US citizen spouse.
The QDOT temporarily qualifies the property passing to it for the marital deduction until the surviving spouse receives a distribution of principal from the trust, or until the death of the surviving spouse.
Creating the QDOT
QDOTs can be created by the will or revocable trust of the first spouse to die, or by the surviving non-US citizen spouse.
If property passes outright to the surviving non-US citizen spouse, that spouse may be able to transfer – or irrevocably assign – the property to a QDOT, to qualify the transfer for the marital deduction.
No matter who creates it, the QDOT must be funded by the time the US federal estate tax return for the deceased spouse is filed, and the executor must irrevocably elect to treat the trust as a QDOT on the deceased spouse’s estate tax return.
It is important to understand that QDOTs defer US estate tax liability; they don’t eliminate or avoid it.
The QDOT tax is triggered upon (1) distribution from the QDOT before the surviving non-US citizen spouse’s death, (2) the surviving non-U.S. citizen spouse’s death, and (3) ceasing to qualify as a QDOT.
Distributions of income, however, are not subject to the QDOT tax, nor are distributions for hardship.
For example, a distribution of principal would not be subject to the QDOT tax, if made in response to an immediate and substantial need relating to the surviving non-US citizen spouse’s health, maintenance, education or support.
The QDOT tax is generally equal to the amount of estate tax that would have been imposed, if the amount involved had been included in the taxable estate of the first spouse to die, and had not been transferred to the QDOT.
The amount of the QDOT tax is computed using the applicable law and tax rates in force at the time of the first spouse’s death.
If the surviving non-US citizen spouse becomes a US citizen prior to the filing of the first-to-die’s estate tax return, there will be no need for a QDOT.
If the surviving spouse become a US citizen after the QDOT was established and funded, distributions from the QDOT will not be taxed if: (1) the surviving spouse either had been a US resident from the date of death of the first spouse to die, or no taxable distributions were made from the QDOT prior to obtaining US citizenship; and (2) the US trustee notifies the IRS that the surviving spouse has become a US citizen.
Marriage, taxes and citizenship – they each have a bearing on the transfer of wealth between spouses. With careful planning, the US federal tax cost of making transfers to a surviving non-US citizen spouse can be minimised.
Not planning, on the other hand, may be seriously costly.
LEGAL, INVESTMENT AND TAX NOTICE: This information is not intended to be and should not be treated as legal advice, investment advice or tax advice. Readers, including professionals, should under no circumstances rely upon this information as a substitute for their own research or for obtaining specific legal or tax advice from their own counsel.
Northern Trust Corp is a Chicago-based, NASDAQ-listed, internationally -focused financial services specialist, offering investment management, asset management, fund administration, fiduciary and banking service around the world. Suzanne Shier is chief wealth planning and tax strategist for Northern Trust; Benjamin Lavin is a wealth planner, also for Northern Trust.