What is your marital status? What is your family history? What is your net worth? How are your assets owned? These are the typical questions asked by an estate planner during an initial estate planning conference. One important and often overlooked question is: Are both you and your spouse citizens of the United States? The answer to this question is critical in any estate plan.
An important concept in estate planning for spouses is the unlimited marital deduction. The marital deduction allows a spouse to leave all of his or her assets to the surviving spouse without paying any Federal or Connecticut death taxes. However, in estates where the surviving spouse is a non-U.S. citizen, the marital deduction does not apply. Therefore, a couple's lack of planning can result in unnecessary and substantial death taxes on the death of the first spouse. It creates a real trap for the unwary leaving the surviving spouse with fewer assets and providing the federal government with substantially more of your assets earlier than is necessary.
Prior to 1988, the citizenship or residence status of the decedent spouse, not of the surviving spouse, was the controlling factor for purposes of the marital deduction. For example, if a husband was a citizen of the U.S., the marital deduction was available without regard to his wife's citizenship. Therefore, if the wife was not a U.S. citizen, the assets she received on her husband's death could easily be removed from the U.S. avoiding taxation on her death. However, the marital deduction did not apply if the husband was a non-U.S. citizen resulting in taxation of only his assets located in the U.S. In this scenario, double taxation could occur if the wife was a U.S. citizen since assets inherited from her husband are subject to U.S. estate tax on her death. The apparent loophole in the first instance and the unfairness in the second instance prompted new legislation in 1988. This legislation reversed the situation by making the surviving spouse's citizenship the critical factor in determining the allowance of the marital deduction. The intent of the new law is to prevent surviving spouses from returning to their home countries with their inheritances which were not taxed because of the unlimited marital deduction.
Couples with a non-U.S. citizen spouse and combined assets of less than $625,000 do not necessarily require a sophisticated estate plan. Generally, a simple Last Will and Testament will do. This is because decedents dying in 1998 can pass $625,000 of assets to anyone free of federal estate taxes without consideration of citizenship. This is called the applicable exclusion. However, assets exceeding $625,000 which are passed to a non-U.S. citizen spouse will be subject to federal estate tax unless they are placed in a qualified domestic trust or QDOT. By the way, the applicable exclusion will increase in future years to $1,000,000.00 by the year of 2006.
Federal death taxes alone can be costly starting with a graduated tax rate of 37% which increases to 55% as the size of the estate increases. It is important to note that the United States taxes all types of assets including life insurance proceeds, retirement benefits as well as assets owned in foreign countries. In addition, jointly-held assets are fully taxed in the estate of the first spouse unless the non-U.S. spouse can prove he or she contributed to those assets. Thus, the only way to avoid immediate taxation, besides becoming a U.S. citizen in such circumstances, is to leave the assets to a QDOT.
The purpose of a QDOT is to retain taxing jurisdiction over the trust assets in the United States by placing the following restrictions on the QDOT. (1.) The administration of the trust must be governed by U.S. law. (2.) One of the trustees must be a U.S. corporation or U.S. citizen. (3.) Copies of the trust records must be kept in the U.S. (4.) An election for QDOT status must be made by the executor of the will of the party who established the QDOT at the time of his or her death. If these requirements are met, the marital deduction will apply. The assets in the QDOT will then be subject to tax on the death of the surviving spouse.
A drawback of the QDOT is the taxation of principal distributions made to the surviving spouse during his or her lifetime unless they qualify as a hardship distribution. The regulations to the Internal Revenue Code define "hardship" as distributions made in response to an immediate and substantial financial need relating to the heath, education, maintenance and support of the spouse or of any other person the spouse is legally obligated to support.
To avoid the tough regulations of a QDOT, many couples may wish to transfer assets by gifting to the non-U.S. citizen spouse during their lifetimes. If the non-U.S. citizen spouse dies, the assets would qualify for the marital deduction if the surviving spouse is a citizen of the U.S.
Care must be taken, however, in making these gifts. Generally, spouses can transfer assets between each other without incurring any federal gift taxes but only if both spouses are U.S. citizens. Gifts to non-U.S. citizen spouses are limited to $100,000 per year. Any amounts transferred above this amount will be subject to federal gift taxation. This can be a troublesome matter where one spouse has significant assets. It can take several years to transfer enough assets to the non-U.S. citizen spouse to save death taxes. These additional issues certainly emphasize the importance of the QDOT if the spouse remains a non-U.S. citizen.
If a spouse decides to become a U.S. citizen, timing is also critical. No QDOT will be required if citizenship is granted within nine months of the spouse's death. While it is best to plan ahead, one last resort exists. The surviving spouse can ask a court for permission to set-up a QDOT.
Obviously, the issue of citizenship and estate planning is complex. Advance planning with an experienced estate planner is critical. Attorney Cravinho is an associate and Attorney Morris is a principal in the Groton and Norwich law firm of O'Brien, Shafner, Stuart, Kelly and Morris, P.C.