Preserving
the Marital Deduction with a Qualified Domestic Trust
Tax Planning for
a Non-Citizen Spouse
The United States Estate and Gift
Tax System
Like many countries, the United States imposes a transfer tax on
worldwide transfers of property owned by citizens of the United States. Unless
modified by treaty, these rules also apply to transfers by citizens of other
countries living in the United States. Under U.S. tax law, lifetime gifts that
exceed $10,000 per year must generally be reported to the IRS by April 15 of the
year following the year of the gift on IRS Form 709. Although gifts in excess
of $10,000 must be reported annually, Gift Taxes are not payable until the
cumulative total of lifetime gifts exceeds a threshold “Exclusion Amount”.
The Exclusion Amount for lifetime gifts is $675,000 in 2001. The
Exclusion Amount increases to, and is capped at, $1,000,000 for gifts made in
2002 and all future years. Gift taxes are assessed at marginal rates that begin
at 37% and reach 55% for gifts in excess of $3,000,0000. The top gift tax rate
is the same as the top Estate Tax rate. As a result of the 2001 tax act, the
top marginal tax rates are being reduced in stages over the next eight
years.
Estate Taxes are based on the total value of all lifetime gifts
plus the value of all property you die owning. If the total of all lifetime
gifts plus the value of your property at death exceeds the Estate Tax Exclusion
Amount, your estate will be subject to Estate Taxes. The following Table shows
the Exclusion Amount, Beginning Estate Tax Rate and Top Rate for estates of
decedents dying between 2001 and 2011, as amended by the Economic Growth and Tax
Relief Reconciliation Act of 2001.
Federal Estate Tax Rates and Exclusion
Amounts After 2001 Tax Act
Year Exclusion Amount Beginning Rate Top
Rate
2001 $675,000 37% 55% (60%)
2002 $1,000.000 41%
50%
2003 $1,000.000 41% 49%
2004 $1,500,000 45%
48
2005 $1,500,000 45% 47%
2006 $2,000,000 46%
2007
$2,000,000 45%
2008 $2.000,000 45%
2009 $3,500,000
45%
2010 Estate Tax Repealed for one year; then re-enacted at 2001 rates
in 2011
2011 $1,000,000 37% 55% (60%)
For decedents dying in
2001, the exclusion amount is $675,000. Under the 2001 tax act, the Estate Tax
Exclusion Amount increases gradually over the next eight years, and the top
estate tax rate declines gradually over that time. The estate tax (but not the
gift tax) is repealed for decedents who die in 2010. However, under the 2001
tax act, the current estate tax is restored in 2011 unless a future Congress
acts to change the rules.
Here’s How The Gift And Estate Tax Calculations
Work
Each time you make a lifetime taxable gift, you must report it to the
IRS on a gift tax return (IRS Form 709). The gift tax return enables you and
the IRS to keep a running tally of all gifts you make. As soon as you exceed
the exclusion amount ($675,000 in 2001, $1,000,000 in 2002 and all future
years), you must begin paying gift taxes beginning at the rate specified in the
Table (37% in 2001; 41% beginning in 2002 and all future years).
At your
death, the value of any assets remaining in your estate is added to the value of
your lifetime gifts to determine your total taxable estate. Your estate must
then pay estate taxes at the rates shown in the Table. A credit is allowed for
lifetime gift taxes paid to avoid double taxation.
The Unlimited Marital
Deduction
If your spouse is a U.S. citizen, you can leave him or her as much
as you want without immediate payment of gift or estate taxes. Lifetime or
testamentary gifts to a U.S. citizen spouse qualify for an unlimited martial
deduction for both gift and estate tax. These taxes are not excused, just
deferred. At the surviving spouse’s death, they will be included in his or her
taxable estate and be subject to estate tax at that time.
Married couples
that are U.S. citizens can leave twice the exclusion amount completely free of
estate and gift taxes through “A/B” trust planning, using a combination of a
“credit shelter trust” for the Exclusion Amount and a “marital deduction trust”
or outright marital gift for amounts above the Exclusion Amount left to a
surviving spouse.
If Your Spouse Is Not A U.S. Citizen
Your spouse
does not qualify for the unlimited marital deduction if he or she is not a U.S.
citizen. Without the unlimited marital deduction, you must pay gift taxes on
lifetime gifts to your spouse at the rates shown in the table. (A special rule
permits a resident alien to make lifetime gifts of up to $100,000 per year to a
non-citizen spouse without paying gift taxes. Gifts to non-spouses are limited
to $10,000.) Following your death, any testamentary gifts to your spouse will
be subject to estate taxes. Estate taxes in excess of the Exclusion Amount are
payable within nine months of your death, at rates shown in the Table. Once
your estate exceeds the exclusion amount ($675,000 in 2001; $1,000,000 beginning
in 2002) gift and estate tax rates rise quickly to the highest tax rate.
The estate tax is imposed on everything you own or over which you
exercise control. Thus, property that passes automatically at your death to
your spouse or others is included in determining the size of your estate. This
includes such assets as life insurance, including proceeds of group term life
insurance, pension and retirement benefits, bank accounts with “pay on death
designations” and jointly titled property, including your home or other real
estate. In a special rule for non-citizens, unless the surviving spouse can
prove his or her contribution to the property, the full value of jointly titled
property will be taxed in the e estate of the first joint tenant to die.
Postponing Estate Tax With a Qualified Domestic Trust
In 1988,
Congress ended the unlimited marital deduction for noncitizen spouses to
eliminate any chance that the surviving spouse could expatriate money that was
inherited tax-free because of the unlimited marital deduction. The Qualified
Domestic Trust permits a non-citizen spouse to inherit property in excess of the
unified credit amount ($675,000 in 2001; $1,000,000 in 2002) without payment of
immediate estate tax.
A Qualified Domestic Trust is a special trust
designed to permit an unlimited marital deduction for transfers to a non-citizen
spouse. The Qualified Domestic Trust must contain the following provisions
:
• All income of the trust must be distributed to your spouse, who
must in turn pay income taxes on these distributions.
• If any principal
is paid to your spouse, estate taxes must be paid on each distribution of
principal. When your spouse dies, estate taxes must also be paid on any
principal that remains in the trust at the time of your spouse's
death.
Assets transferred to a Qualified Domestic Trust will qualify for
the marital deduction if (1) your personal representative makes a special
election on your estate tax return to claim the marital deduction and (2) the
trust ensures the ultimate collection of estate taxes by adding the following
requirements:
• The United States Trustee Requirement: The trust must
have at least one trustee who is a United States corporation, a resident
citizen, or a domestic trust. (An adult child or other relative may serve as
your trustee.)
• The Withholding Requirement: The trust must give the
United States trustee the right to withhold an estate tax from each distribution
of principal to your noncitizen spouse. The Qualified Domestic Trust can be
established by your will or, on your death, your personal representative can
create one in the course of estate administration.
Additional Rules for
Trusts that Exceed $2 Million or Hold Foreign Real Estate
Trusts whose value
exceeds $2 million or that hold foreign real estate that comprises more than 35
percent of the total trust assets must also meet one of the following
requirements:
• The Bank Trustee Requirement: At least one of the United
States trustees must be a bank.
• The Bond Requirement: If the United
States trustee is an individual, he or she must furnish a bond or security equal
to 65% of the value of assets in the trust or furnish a letter of credit to the
Internal Revenue Service under the same terms as the bond.
Trusts of $2
million or less may simply require that no more than 35% of the trust assets,
valued as of the last day of the trust's taxable year, consist of real property
located outside of the United States and that no other trust property is located
outside the United States other than personal residences with combined values of
less than $600,000.
When Will The Assets In My Qualified Domestic Trust
Be Taxed?
Your Qualified Domestic Trust will defer estate taxes until the
death of your noncitizen spouse or until he or she receives principal from the
trust. Any principal paid out of the trust during your spouse’s life will be
subject to estate taxes as it is paid unless it is distributed under the
“hardship” exception. The hardship exception is a very broad standard that
permits distribution of principal for the spouse’s “health, maintenance or
support”.
What If My Spouse Becomes A U.S. Citizen?
If your trust
allows it, your trustee may distribute principal once your spouse she becomes a
citizen without estate tax.
Is There Any Way To Avoid Paying The Estate
Tax When My Spouse Dies, With Or Without A Qualified Domestic Trust?
A
Qualified Domestic Trust operates similarly to a “QTIP Marital Trust” for U.S.
citizen spouses. It does not avoid estate taxes forever. It merely defers them
until your spouse's death.
There are a number of estate planning
strategies available to completely avoid estate taxes on both spouse’s deaths.
Such planning is appropriate for families whose assets exceed the Exclusion
Amount and that do not want to bother with the requirements of the Qualified
Domestic Trust at the first spouse’s death, for families that would like to
leave their property to their children in a way that is protected against loss
from a child’s divorce, lawsuits, or untimely death.
Conclusion
Estate
planning is not just about saving taxes. Providing guardians for your minor
children, a trust to ensure their care and education, and providing for yourself
and your spouse if you become disabled are far more important concerns for most
of us. The Qualified Domestic Trust is one tool available to help you achieve
your planning objectives.
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