Planning for Non-Citizen Spouses in Large Estates

A married couple has special planning challenges if one spouse is not a citizen of the United States. Federal estate tax law requires that a spouse be a U.S. citizen in order to qualify for the unlimited marital deduction. The primary reason for this law is that the IRS does not want a surviving non-citizen spouse to leave the United States with property that has never been taxed.

The citizen spouse’s estate still has the individual estate tax exemption or applicable exclusion amount ($5,250,000 for 2013), and even though the surviving spouse is not a U.S. citizen there is no federal estate tax on this amount. The problem comes for married couples with large estates that exceed the applicable exclusion amount. The estate of the citizen spouse will have to pay federal estate taxes on everything over that exemption amount unless the surviving non-citizen spouse becomes a citizen before the deceased spouse’s estate tax return is filed, or if the non-citizen spouse is the beneficiary of a special trust called a Qualified Domestic Trust (QDOT).

A QDOT allows the deceased spouse’s estate to postpone paying federal estate tax if the trust meets certain requirements. With a QDOT, at the first spouse’s death, assets go to the trust instead of to the surviving non-citizen spouse, and the spouse can receive income distributions. When the surviving non-citizen spouse dies, the assets in the trust pass to other beneficiaries named in the trust document such as the couple’s children. That is when the estate tax is paid, as if the assets were in the estate of the first spouse to die, not as part of the second spouse’s estate.

In order for a QDOT to work, specific rules must be followed. For example, the trustee who controls the trust must be a U.S. citizen. If trust assets exceed $2,000,000 (very likely in the large estate situation we’re describing), the trustee has to be a U.S. bank or domestic corporation willing to be bonded for most of the value of the trust. The executor of the deceased spouse’s will, or trustee of his or her trust, must make an election on the deceased spouse’s estate tax return to have the trust treated as a QDOT.

As mentioned, the non-citizen spouse is entitled to distributions of income earned by trust assets, and although the distributions are subject to income tax, they are exempt from estate tax. However, distributions from trust principal to the non-citizen surviving spouse are not allowed – unless the U.S. trustee is given the right to withhold estate taxes on any distributions of principal.

There are also exceptions to the taxation of principal distributions if those distributions fall under the IRS hardship exemption. If the spouse has an “immediate and substantial” need for money relating to “health, maintenance, education or support”—either his own, or that of someone he legally obligated to support—a distribution of trust funds may qualify for a hardship exemption. However, the non-citizen surviving spouse would have to prove that he or she doesn't have other available assets to meet those needs.