Estate Planning for Non-Citizens

With the evolution of the global business phenomenon, marriages among citizens of different countries are becoming quite common. In representing a person who is, or is married to, a non-citizen, it is important to recognize and understand the application of the United States estate and gift tax (as well as income tax) laws to non-citizens and persons married to non-citizens. Without a full understanding of these unique rules, unexpected estate and gift tax liabilities could be incurred. For example, the estate tax unlimited marital deduction, as well as applicable provisions of the Internal Revenue Code (the “IRC”) allowing for certain income tax exclusions in connection with transfers incident to property settlements do not always apply in the event that a spouse is a non-citizen. With proper planning at the beginning of a marriage or prior to an anticipated divorce, you may be able to protect your client from unexpected tax burdens.

Federal Estate Tax and the Use of the Unlimited Marital Deduction

The federal estate tax is imposed on the transfer of the “taxable estate” of every decedent who is either a resident of the U.S. or has property situated in the U.S., regardless of the decedent's country of citizenship. The “taxable estate” is determined by deducting from the value of the gross estate certain deductions provided for under the IRC, including, but not limited to, the marital deduction.

The so-called unlimited marital deduction allows any married person who is subject to U.S. estate taxation to transfer property to his or her spouse during his or her lifetime and at death without exposure to an estate tax liability. However, the applicable provisions of the IRC allowing for the marital deduction were not intended to allow married couples to escape the reach of the estate tax indefinitely, and anticipate that the estate tax on property transferred to a spouse will be paid at the death of the transferee spouse.

To assure that there is a reasonable certainty that the transferred property will be subjected to estate taxation at the surviving spouse's death, the IRC requires that, for the marital deduction to apply: 1) the property must be transferred to a bona fide spouse; 2) the spouse must be a U.S. citizen; and 3) the spouse cannot receive a terminable interest in the transferred property. Thus, where property is transferred at death to a non-citizen spouse upon the death of his/her spouse, whether or not the deceased spouse is a citizen or a non-citizen, the transfer is subject to federal estate tax and the estate is not entitled to claim the marital deduction. The reason for this is that a non-citizen is readily able to leave the U.S. and return to his or her native country, remove gifted or inherited property to that country, and potentially fall outside the reach of U.S. taxing authorities.

The Qualified Domestic Trust

There is a solution that enables a U.S spouse to transfer property to his or her non-citizen spouse, at death, and still enjoy the tax deferral benefit afforded by the marital deduction. To achieve this objective, property intended for a non-citizen spouse should be transferred (at death only) to a Qualified Domestic Trust (“QDOT”), rather than to the non-citizen spouse directly. (A lifetime gift to a trust qualifying as a QDOT does not qualify for the gift tax marital deduction.)

The QDOT is created under the deceased spouse's will or revocable trust. However, in the event that a QDOT is not provided for in the applicable testamentary document, a QDOT can be created after the decedent's death by or for the benefit of the surviving non-citizen spouse, so long as the QDOT is funded prior to the filing of the decedent's federal estate tax return. Upon the death of the surviving non-citizen spouse, the QDOT assets are included in the non-citizen spouse's taxable estate, and the trustee is required to pay over an appropriate amount of the assets of the QDOT as necessary to satisfy such liability.

A QDOT is qualified as such only if it meets certain requirements as set forth in the IRC, the most important of which is that the executor make an irrevocable election to qualify the QDOT for the marital deduction on a federal estate tax return filed within nine months after the decedent's date of death. In addition, at least one trustee of the QDOT must be a U.S citizen, and in the case of larger estates, the U.S citizen trustee should be an institutional trustee.

Distributions of income from a QDOT to a non-citizen spouse are not subject to an estate or gift tax. However, distributions of principal to a non-citizen spouse will be subject to estate taxes unless the distribution is made for the health, education, maintenance or support of the surviving non-citizen spouse or a child or other person whom the non-citizen spouse is legally obligated to support, as long as substantial financial need exists. The trustee is required to withhold funds equal to the estate tax payable before making taxable distributions of principal to a non-citizen spouse.

Any property that passes from a decedent outright to a surviving non-citizen spouse (e.g., directly by right of survivorship, in the case of jointly owned property, or under a will or other testamentary device) may be transferred by the non-citizen spouse to a QDOT prior to the date upon which the estate tax return is due. Any such subsequent transfer will qualify the decedent's bequest or other testamentary transfer for the marital deduction. If the decedent's will does not provide for a QDOT, the executor or the surviving spouse may elect to establish a QDOT and transfer the assets to such QDOT before the date upon which the deceased spouse's federal estate tax return is due.

It is recommended, when structuring a pre-marital agreement that contemplates certain delineated transfers of property to a surviving spouse at the death of his or her spouse, that the parties agree that such property will/must be held in a QDOT if the surviving spouse is a non-citizen at the time of his or her spouse's death. The pre-marital agreement should also include the designation of an appropriate U.S. institutional trustee to manage the QDOT. A QDOT may not always be desirable, notwithstanding the beneficial tax treatment, due to the limitations imposed on the amount of property that can be distributed from the QDOT without incurring an estate tax liability.

Property Owned Jointly with a Non-Citizen Spouse

If a U.S. citizen spouse is the first spouse to die, the entire value of all property owned jointly, and that passes to a non-citizen spouse by right of survivorship, is included in the citizen spouse's gross estate, except to the extent that the non-citizen spouse can establish by credible evidence that he/she contributed to the acquisition cost of the jointly held property. However, as noted above, the includible portion may be transferred to a QDOT by the non-citizen spouse to avoid an immediate estate tax liability. If a non-citizen spouse dies first, the normally accepted rules will apply, and one-half of the value of the property will be included in the non-citizen spouse's gross estate for estate tax purposes. It is important for planners to advise the spouses to maintain adequate records of their respective contributions to the acquisition cost of jointly held assets, to avoid the need to undertake this often difficult burden after one spouse has died

Gifts to a Non-Citizen Spouse

For federal gift tax purposes, where there is a transfer of property between spouses during their lifetime, provided the donee spouse is a U.S. citizen, the transfer qualifies for the unlimited gift tax marital deduction, and will not be subject to federal gift tax or be charged against the donor spouse's lifetime gifting exemption. (Each U.S. taxpayer is entitled to transfer assets to one or more non-spouse donees, in the aggregate, during his or her lifetime, totaling $1 million) Where the donee spouse is a non-citizen, any lifetime transfer to the donee spouse by the donor spouse is not protected from gift tax by the marital deduction, which is not applicable to such transfers. However, notwithstanding that the marital deduction is not available, a donor spouse may transfer property to his or her non-citizen spouse worth up to $134,000 per year. (The IRC provides for a special gift tax annual exclusion for gifts to a non-citizen spouse, in the amount as noted. Such amount is indexed for inflation after 2010. The gift tax annual exclusion for gifts to any person other than a non-citizen spouse is currently $13,000 per donee per year.)

Gifts in excess of such amount are taxable gifts and are applied against the donor spouse's lifetime gifting exemption. If aggregate lifetime gifts not covered by the special annual exclusion amount exceed the donor spouse's lifetime gifting exemption, a gift tax will be due.

  Estate-Planning Strategies in Anticipation of Divorce 

The process of estate-planning is complex and ever-changing, and requires regular attention. When a married couple is divorcing or starts to contemplate divorce, it is critical to examine the estate plan then in place, and consider the material tax impact on the plan, particularly the loss of the marital deduction, that will occur as a result of the divorce. Accordingly, an important step in planning for a divorce will be to consult a qualified tax adviser.