THE MARITAL DEDUCTION
If an individual’s estate exceeds the estate tax exemption amount ($1 million for federal and Minnesota estate taxes in 2011, if no Congressional action), he or she can avoid paying estate taxes by transferring all assets above the exemption amount to the surviving spouse. This is known as the estate tax marital deduction. Married couples can avoid estate taxes on the death of the first spouse; and instead, defer estate taxes until the second spouse passes away. However, the marital deduction is only available where the surviving spouse is a U.S. citizen. The marital deduction is NOT permitted if the surviving spouse is not a U.S. citizen.
Without the marital deduction, a surviving spouse who is not a U.S. citizen can only receive the current federal exemption amount ($1 million in 2011 if no Congressional action) free from federal estate tax from their deceased spouse. (Every U.S. resident, regardless of citizenship, gets the unified credit exemption.) Consequently, any assets exceeding the exemption amount are subject to estate tax and may be substantially reduced. This could result in fewer assets available to the surviving spouse for support.
A HISTORY LESSON
In 1981, Congress increased the marital deduction to its current unlimited amount. The rationale was that a married couple’s estate tax would be postponed until the death of the second spouse. Congress realized, however, that a surviving non-citizen spouse could avoid estate tax by moving abroad with all of the property.
Unsatisfied with this result, in 1988, Congress eliminated the federal marital deduction where the surviving spouse is NOT a U.S. citizen. (Related changes were implemented in the gift tax code sections as well.)
BIRTH OF THE QDOT
And so was born the qualified domestic trust (QDOT). A QDOT is a type of trust permitting taxpayers who are not U.S. citizens to postpone the payment of federal estate taxes. It evens the playing field for non-U.S. citizen surviving spouses, with some restrictions. Under the QDOT rules (which are detailed and complex), the inherited property is not subject to estate tax so long as the property remains in the trust for the benefit of the surviving spouse.
HOW IT WORKS
Upon the first spouse’s death, assets must be transferred into the QDOT for the benefit of the surviving non-U.S. citizen spouse. Estate tax will not be imposed on the assets within the trust at this time.
Income distributed from the QDOT to the surviving spouse is subject to income tax, but not estate tax. Distributions of principal from the QDOT to the surviving spouse are subject to estate tax, unless the distribution qualifies as being made for hardship reasons.
At the surviving spouse’s death, tax is imposed on any remaining trust amounts as if they were part of the taxable estate of the first deceased spouse.
Besides the taxes imposed on the income and principal distributions from the QDOT, another requirement for a valid QDOT is that the trustee must be either a U.S. citizen or a U.S. domestic corporation. Without a valid trustee in place, the QDOT itself will not be valid.
Given all of this, if either you or your spouse is not a U.S. citizen, you may be in for an estate tax surprise if you do not engage in estate planning.