One reader responded to the recent series of articles on trusts with a question on a situation that he and many other people face. This reader is a U.S. citizen, married to a citizen of another country, living outside the U.S. In addition to the typical challenges of estate and financial planning, what additional hurdles will this couple need to overcome to make a viable plan?
When all members of a family are U.S. citizens, the IRS can feel relatively certain that it will be able to collect any tax that may come due. Federal law gives the IRS strong powers of enforcement and collection over U.S. citizens. Especially in cases involving estates, the IRS can often pursue multiple family members to collect any taxes that the estate owes. Even U.S. citizens who work and live abroad are still subject to U.S. taxation on their worldwide income, although they may be able to take advantage of certain provisions that give them exemptions on earned income and tax credits for some of the tax they must pay to the countries where they work.
The IRS and non-citizens
On the other hand, when a family includes both U.S. citizens and citizens of other countries, the IRS gets concerned. Consider a typical simple estate plan in which each spouse agrees to leave everything to the surviving spouse at death. If the non-citizen spouse dies first, then the IRS has nothing to worry about; the surviving spouse will receive the estate, and because the surviving spouse is a U.S. citizen, the IRS will be able to collect any tax due after the surviving spouse dies. However, if the U.S. citizen dies first, then there's an apparent problem. If the non-citizen surviving spouse receives the entire estate and no longer has any connection to the United States, then it may be impossible for the IRS to collect any tax from that spouse's estate when he or she dies.
Indeed, until the late 1980s, the law allowed couples of mixed citizenship to avoid U.S. estate tax entirely. An unlimited marital deduction was available, regardless of the citizenship of the spouse who died first. When the U.S. citizen died, there was no estate tax due, because assets going to the non-citizen spouse were entitled to the marital deduction. Because the non-citizen spouse wasn't subject to the jurisdiction of U.S. tax law, all the assets that went to the non-citizen spouse escaped the estate tax. Given that estate tax rates at the time were sometimes considerably more than 50%, this provided a strong incentive for wealthy families to try to take advantage of this loophole to reduce or eliminate a potentially huge U.S. tax liability.
When faced with situations like this, Congress often acts by changing the tax laws to make it impossible for someone to take advantage of the law in a way that Congress deems to be unfair. In this case, Congress responded with modified provisions that made the unlimited marital deduction unavailable to non-citizen spouses. In place of the old marital deduction rules, the new law established a new type of trust called a qualified domestic trust, or QDOT. For an estate to take a marital deduction, assets could no longer go directly to a non-citizen spouse. Instead, the assets would have to go into a QDOT for the benefit of the non-citizen spouse.
Rules and consequences
To qualify as a QDOT, a trust has to include certain terms. First, it must be a valid marital trust; in other words, the trust must be written in a way that would allow the estate to take the marital deduction if citizenship were not an issue. Second, to ensure that the IRS will have jurisdiction over the trust, at least one of the trustees of the trust must be a U.S. citizen or a U.S. corporation. Depending on the amount of assets in the QDOT, it may be necessary either to have a U.S. bank act as trustee or to have the trustee post a substantial bond to provide security against any future tax liability. Third, the trust must allow the trustee to withhold U.S. tax from certain distributions made from the trust to the non-citizen spouse. If a trust includes these terms, then the person acting on behalf of the estate, known as the personal representative or executor of the estate, may elect to treat the trust as a qualified domestic trust.
The consequences of a QDOT are twofold. First, during the non-citizen spouse's lifetime, certain distributions from the QDOT will trigger immediate estate tax liability. Although the spouse is entitled to the income the trust generates without penalty, any distributions made from the principal of the trust will result in current estate tax unless they qualify as hardship distributions under fairly strict guidelines. Second, when the non-citizen spouse dies, additional estate tax will be due on the trust's undistributed assets.
So do I need one of those?
In deciding whether you need a QDOT, consider that its main purpose is to obtain a marital deduction for property passing to your spouse. If you do not need the marital deduction because your estate is small enough to avoid estate tax without it, there's no reason to set up a QDOT. Even if your estate is large enough to save tax with a QDOT, keep in mind that QDOTs are relatively rare, so many banks and trust companies are not as familiar with them as they are with more common types of trusts. In addition, by creating a QDOT, you require your spouse to maintain a major relationship with the U.S. for the rest of his or her life. If your spouse plans to return home upon your death, having to do business in the U.S. may be inconvenient and cumbersome, reducing the value of deferring the estate tax.
As global interaction increases, relationships among citizens of different countries are becoming more common. It's important for couples of mixed citizenship to understand the tax laws of both of their countries to plan well for their families.
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Fool contributor Dan Caplinger welcomes your feedback at email@example.com.