By Cowles Liipfert

By Cowles Liipfert

If a US citizen or resident is married to a non-citizen, even if the non-citizen spouse has been a US resident for many years, the transfer of assets at the death of the US citizen or resident spouse to the non-citizen will not qualify for the estate tax marital deduction.

Due to the high estate and gift tax exemptions which are now in effect for the estates of US citizens and residents ($11.4 million in 2019, indexed for inflation), most people do not need to worry about those possible tax ramifications.  But for people with large estates, they can be a problem. 

If the surviving spouse is a US citizen, the decedent can transfer assets unlimited in value to the survivor without taxes at that time, claiming the estate tax marital deduction for assets transferred at death.  Those assets would become part of the taxable estate of the surviving spouse and would presumably be subject to US estate tax at his or her death. On the other hand, if the surviving spouse is a non-citizen, there would be no marital deduction and estate taxes would be payable on those assets, unless certain other steps were taken as described below.

That is, an altogether different set of rules applies to transfers to non-citizen spouses than to spouses who are US citizens.

The reason for the two different sets of rules is this: the estate tax marital deduction is not intended to avoid estate taxes altogether on assets left to a surviving spouse.  Instead, the marital deduction is supposed to postpone taxes until the second death between the spouses, at which time the transferred assets would presumably be subject to estate tax.

If the marital deduction were allowed for property left to a non-citizen spouse, the fear is that the surviving spouse might leave the US and establish residency elsewhere in a country without a treaty with the US to facilitate the collection of US estate tax at the death of the surviving spouse.  In that case the estate of the surviving spouse might not pay any US estate tax at his or her death.  

Because of the potential harshness of the rule denying the marital deduction for assets passing to a non-citizen spouse, based simply on the citizenship of the surviving spouse – and also  because another alternative could be designed to insure that estate tax would eventually be collected on the assets left to the surviving spouse – Section 2056A of the Internal Revenue Code was adopted, which allows assets transferred to a Qualified Domestic Trust (QDOT) to qualify for the estate tax marital deduction under certain circumstances.    

The QDOT must be created, and the assets transferred to the QDOT, before the estate tax filing deadline (nine months after the date of death, or if granted an extension, within 15 months), and the personal representative of the decedent’s estate must file the return in a timely manner and make a “QDOT election” on line 3 of Schedule M of the United States Estate Tax Return (Form 706).  There are additional rules which apply to a QDOT, including the following:  

The trustee, or at least one co-trustee must be a US citizen or a US corporate fiduciary.  An individual US trustee may be required to post a bond or a letter of credit with the IRS, and the trust agreement must provide that no distributions other than income may be made from the trust unless the trustee has the right to withhold the Section 2056A estate tax (discussed below) at the time of the distributions.  Also, a US corporate trustee is required if the assets transferred to the QDOT exceed $2 million in value on the date of death.

A QDOT can be clearly preferable to receiving no marital deduction whatsoever, if the deceased spouse has a taxable estate, but QDOTs are cumbersome, expensive to administer, and there are many negatives to go along with that tax benefit.

The rules applicable to QDOTs are complicated and strict, and they are designed to keep anything from “slipping through the cracks,” so to speak and escaping eventual estate taxes.  If those rules are not strictly adhered to, the penalties are severe.  

The IRS allows nothing to slip between the cracks!

The simplest and best way to deal with the marital deduction issue would be for the non-citizen spouse to obtain US citizenship while both spouses are living.  Once the spouse has been granted US citizenship, he or she will be treated just the same as though he or she had been born a US citizen. The citizenship process often takes some time, and if the other spouse dies before US citizenship is granted, it may be best to have made provision for a QDOT for the non-citizen spouse in the estate planning documents for other spouse.  If a QDOT is not created for the non-citizen spouse in those documents, he or she should at least leave assets to the surviving spouse, outright or in a trust which would have qualified for the estate tax marital deduction if the surviving spouse had been a US citizen.      

If citizenship has not been granted to the non-citizen spouse before the decedent’s death, and if the decedent’s estate planning documents leave the assets to the surviving non-citizen spouse in a manner which would have qualified for the marital deduction if the surviving spouse had been a US citizen, then the surviving non-citizen spouse can irrevocably assign or transfer the assets to a QDOT, and if all the legal details are properly attended to, the QDOT property will qualify for the estate tax marital deduction.  

There can be a number of reasons why a non-citizen fails to obtain US citizenship.  Sometimes a non-citizen is reluctant to give up his or her native citizenship, and people often are not aware of the possibility that they may have dual citizenship in both their native country and in the United States, which would give them full rights as US citizens.  The US allows dual citizenship, but some countries do not. Also a non-citizen spouse may not know that it makes any difference whether he or she has United States citizenship, and perhaps he or she does not want to go through the trouble and expense of obtaining US citizenship, in which case he or she never gets around to obtaining US citizenship before the death of his or her spouse.

A QDOT gives the surviving spouse a right to life income from the trust, but that spouse is only a beneficiary and is not the legal owner of the trust assets. When the surviving spouse dies, the remaining trust assets will be subject to US estate tax, and the trust assets will pass to the other beneficiaries under the QDOT trust agreement – often the couple’s children. 

Because we do not want to get bogged down in too many technical details, we will proceed in question-and-answer format for some common questions which you might have:

Q&A #1: Who receives the trust’s income from the QDOT?

For the QDOT to qualify for the marital deduction, no distributions may be made to anyone, other than the surviving spouse.  

Q&A #2: What income tax returns must be filed for the QDOT?

 Like other trusts, a QDOT is required to file a fiduciary income tax return annually, listing all income, deductions and trust distributions.  The trust beneficiary will receive a Schedule K-1 from the trust, showing items to be reported on his or her personal income tax return, arising out of the trust distributions to the beneficiary.

Q&A #3: If necessary, can the QDOT make distributions to the non-citizen spouse, other than income distributions?

If the governing instruments so provide, the trustee may make distributions of trust “principal” or “corpus” to the surviving spouse, but if that spouse is a non-citizen at the time of distribution, the distribution would be a “taxable event” and there would be estate tax consequences.  If any such distributions are made, Tax Form 706-QDT must be filed by the QDOT by April 15, reporting any principal distributions made during the prior year, and paying estate tax under Section 2056A attributable thereto.  This is a separate tax return from, and in addition to, the fiduciary income tax return for the QDOT.  

Q&A #4:  If the surviving spouse becomes a US citizen, (a) can the trust be terminated? and (b) would additional estate tax be payable on termination?  

As a general rule, a QDOT can be terminated if the trust instrument so permits.  But, if the QDOT was initially funded by the assignment of the non-citizen spouse’s interest in a trust which did not allow distributions of trust principal to the surviving spouse, the QDOT requirements would be simply “wrapped around” the terms of the prior trust, and the assets could not be distributed to the surviving spouse, even if he or she later became a citizen.  Outright transfers which were assigned to the QDOT, on the other hand, could be distributed to the surviving spouse on termination.

As to the tax consequences on termination: The 2056A estate tax, which would otherwise be required for principal distributions which are categorized as “taxable events,” does not apply under two circumstances if the surviving spouse has become a citizen: (a) if the surviving spouse was a US resident at all times from the date of death until the date on which the surviving spouse became a citizen, or if no “taxable event” occurred prior to the surviving spouse’s becoming a citizen, regardless of residence; or (b) if the surviving spouse cannot comply with (a) above and other technical requirements are met, an election may be made to keep the Section 2056A estate tax from applying.   

Q&A # 5:  If the QDOT was originally funded by irrevocable assignment from the surviving non-citizen spouse to the QDOT of an interest in another trust, which trust terms will apply to the QDOT?

As briefly alluded to under #3 and #4 above, the interest in a trust on behalf of a non-citizen surviving spouse which would have qualified for the estate tax marital deduction, if the surviving spouse had been a US citizen, can be assigned to a QDOT, in which case the original trust terms would essentially be retained, but the original trust would be “wrapped” in a QDOT.  For example, if the trustee of the original trust were a non-citizen or a non-US corporate fiduciary, then the QDOT rules would require a US trustee or corporate trustee to be appointed and a trustee power would have to be added, which authorizes the withholding of additional estate tax upon taxable events as described in #4 above, but the trust terms generally would otherwise remain the same.  

If assets from several sources are used to qualify for the estate marital deduction, it may be necessary to have more than one QDOT, because of the different dispositive provisions which would apply to the assets from each source. 

Q&A # 6:  Can lifetime gift planning help reduce the complications of a QDOT at death of the first spouse?

Yes.  Lifetime gifts may be made to the non-citizen spouse up to the annual gift tax exclusion for gifts to non-citizen spouses ($155,000 in 2019, and indexed for inflation), which would reduce the size of the decedent’s taxable estate, and would reduce the amount needed to qualify for the marital deduction at the decedent spouse’s death. 

Q&A # 7:  May a decedent’s estate elect both QDOT treatment and DSUE portability on the estate tax return of the deceased spouse?

A deceased spouse unused estate tax exclusion amount (DSUE) may be preserved for the surviving spouse’s later use, to the extent it has not been used on the decedent’s estate tax return, if certain technicalities have been met.  This is commonly called “portability” of the DSUE amount.

If the estate elects QDOT treatment and also portability of the DSUE amount, then the estate reports a preliminary DSUE, which is subject to reduction if distributions of trust principal are later made as taxable events, or if a tax treaty later modifies the applicable DSUE amount.  The DSUE amount is finally determined upon the death of the surviving spouse or other termination of the QDOT. This requires careful planning, both when the original estate tax return is filed and later, during the QDOT administration.

Q&A #8:  Can the surviving spouse’s life interest in a charitable remainder trust be transferred to a QDOT, and if so, would there be any tax benefits from doing so?

Yes.  At the death of the deceased spouse who was the grantor of a charitable remainder trust and who names a US citizen spouse as successor life beneficiary, followed by the charitable remainder beneficiary, the actuarial value of the surviving spouse’s life interest would qualify for the estate tax marital deduction and the actuarial value of the charitable interest would qualify for the estate tax charitable deduction.  But if the surviving spouse is a noncitizen, there would be no estate tax marital deduction, which would require the using part of the decedent’s $11.4 estate tax exclusion (in 2019, indexed for inflation) to avoid estate tax on the amount left to the spouse. If, however, the spouse’s life interest was left to the QDOT it would qualify for the estate tax marital deduction, thereby preserving more of the decedent’s estate tax exclusion for beneficiaries other than the spouse.

Q&A # 9:   Can there be estate tax payable on a QDOT, both as Section 2056A tax on the deceased spouse’s estate and for federal estate tax on the estate of the surviving spouse?

Yes,  The death of the surviving non-citizen spouse can be a taxable event for the decedent’s estate under Section 2056A, as well as an asset of the surviving spouse’s taxable estate for regular estate tax purposes, if (a) the QDOT is also a QTIP trust, (b) the QDOT is an “estate trust,” payable to the surviving spouse’s estate, (c) the QDOT is a “power of appointment trust” because the surviving spouse had a power of appointment over the trust assets, (d) the trust estate holds a “non-assignable asset” over an asset such as an IRA or retirement benefit, or (e) the surviving spouse created the QDOT and retained certain powers described in Sections 2035, 2036, 2037, 2038 or 2042 of the Internal Revenue Code. Also, credits may be available for estate taxes paid under Section 2056A for up to 10 years after the decedent’s date of death, under certain circumstances.

Q&A # 10:  Responsibilities and Potential Liability of Trustees.

The trustee or trustees of a QDOT is/are required to comply with the QDOT requirements and may be held personally responsible for their failure to comply.

QDOTs can involve millions of dollars and require compliance with a lot of complicated IRS rules, which necessarily will require legal advice and representation from a qualified attorney or law firm, about the advisability of setting up and administering a QDOT trust.  

We hope that this information will be useful if at least one spouse is a non-citizen spouse.