Our diverse and international community affords individuals opportunities for work, business, education, investment — and love. It is common today to see foreign citizens marry U.S. citizens. In these situations, it is important to understand the estate tax implications involved and plan accordingly.
When a married couple has an estate greater than $5 million and one of them is not a U.S. citizen, they need a strategy and a structure to avoid estate taxes on the death of the surviving, non-U.S. citizen spouse. What are the consequences of leaving assets to a non-U.S. citizen and what are the alternatives available in order to successfully avoid further tax implications?
The unlimited marital deduction enables the transfer of an unlimited amount of assets between spouses at death — but only if they are both U.S. citizens. This allows the surviving spouse to be free from having to pay estate tax on the estate of the first spouse to die, provided that the spouse is a U.S. citizen.
An outright transfer of assets or gifts from the deceased spouse to the surviving non-U.S. citizen spouse creates a problem. The spousal transfer does not qualify for the marital deduction and will subject the assets transferred to U.S. estate tax. Currently the estate tax rate is 35 percent, but it is slated to revert to 55 percent in 2013.
This means that, for example, if a woman from another country marries a man who is a U.S. citizen, and he dies, she cannot receive or be gifted his assets at death without paying estate tax. How did this come to be?
In the late 1980s, Congress, in an effort to prevent asset flight and tax avoidance, passed several laws with the intent of preventing surviving, non-U.S. spouses from receiving the unlimited marital deduction. Congress did however grant a “limited” marital deduction for transfers to a foreign spouse, provided that such transfers were placed in a qualified domestic trust (QDOT), with the purpose of providing the surviving, non-U.S. citizen spouse with income throughout his or her lifetime.
There are several requirements the federal government imposes on spouses to qualify for a qualified domestic trust:
• A binding QDOT election must be established at least nine months from the date of death.
• Either a U.S. citizen, a U.S. bank or trust company must be one of the trustees.
• There are additional requirements if the trust owns real property either within the U.S. or abroad.
Principal distributions from the QDOT to the surviving spouse are subject to estate taxes; exceptions to this exist when there is “significant financial hardship”. This applies to the health, education or support of the surviving spouse, a child or other person the spouse is legally obligated to support.
The ideal way to ensure the eligibility of the unlimited marital deduction is to have the non-U.S. spouse apply for U.S. citizenship. Being a resident, having a work visa or even having a social security number is not sufficient. In circumstances where citizenship is not possible, the U.S. spouse should establish a QDOT in his or her will and/or trust, which would become effective upon death, to mitigate the estate tax consequences. Failure to understand the laws, to work with skilled advisors and to properly plan for the future can indeed be both emotionally and economically costly.
Joseph P. Nader is managing director and senior financial advisor, Wescott Financial Advisory Group LLC.