Spouses receive a special exemption under federal estate tax law known as the marital deduction. When the first spouse dies, any portion of his or her estate that passes to the surviving spouse is not subject to estate tax. No tax is assessed until the second spouse dies.
The marital deduction does not apply, however, when the surviving spouse is not a U.S. citizen. Any property left to a non-citizen spouse is subject to the estate tax. For estates of persons who die in 2013, that’s a maximum tax rate of 40% on gross assets exceeding $5.25 million.
If either or both spouses are non-citizens, there are two options to avoid estate taxes upon the first spouse’s death. The non-citizen spouse can obtain U.S. citizenship, making him or her eligible for the marital deduction. Alternatively, the spouse that plans to leave property to a non-citizen spouse may create a qualified domestic trust (or QDOT) as part of his or her estate plan. If both citizens are non-spouses residing in the United States, each spouse may create a QDOT for the benefit of the other.
Special Rules for Trustees and Distributions
A QDOT is a form of revocable living trust. It is made during the person’s lifetime–as opposed to a trust created under a last will and testament–and may be amended or revoked at any time before the creator’s death. Thus, if person creates a QDOT for the benefit of a non-citizen spouse who later obtains U.S. citizenship (while the first spouse is still alive), the trust may be revoked as it is no longer necessary.
Unlike other revocable living trusts used in estate planning, a QDOT is subject to strict regulation under the Internal Revenue Code. The trustee of a QDOT must be a U.S. citizen. If, at the time of the first spouse’s death, the fair-market value of the assets passing to the QDOT exceeds $2 million, at least one of the trustees must be a U.S. bank; otherwise, the trustee must furnish a bond (or an irrevocable letter of credit from a bank) in favor of the Internal Revenue Service equal to 65% of the trust’s value.
Once established, the QDOT may distribute any income earned on trust assets–i.e., dividends, interest, business profits–to the surviving spouse without incurring any estate tax liability. The trust instrument typically directs the trustee to distribute such income to the surviving spouse at least once a year.
Things are a little trickier with respect to the principal assets of the trust. Normally, any distribution of principal to the surviving spouse during his or her lifetime is immediately subject to estate tax. The Internal Revenue Code does make an exception for any distribution made “on account of hardship.” In broad terms, “hardship” means the surviving spouse (or any person that spouse is required to support, like a minor child) can demonstrate an “immediate and substantial financial need” for funds to provide for his or her “health, maintenance, education or support.” The hardship exception does not apply if the surviving spouse has other liquid assets–bank accounts, stocks, etc.–that can be used to meet the financial need.
Winding Down a QDOT
Upon the death of the surviving spouse, the trustee will distribute the principal assets according to the terms of the trust. If the original married couple had children, typically the QDOT will distribute the assets to those children. Regardless of the ultimate beneficiaries, at this point all assets are subject to the federal estate tax. In effect, this is similar to what would take place if the original couple had both been U.S. citizens and eligible for the marital deduction.
Obviously this level of estate planning only applies to married couples with significant assets. But if you are in a position where a QDOT or the marital deduction might affect you and your spouse, it’s important to work with an experienced California estate planning attorney. A QDOT requires a precise understanding of federal and state tax laws. If you have any questions or concerns, please contact the Law Office of Scott C. Soady at 1-858-618-5510.