United States: Bequests to Non-Citizen Spouses Taxable Unless Special Trusts (QDOTs) Are Created

Last Updated: July 20 2009
Article by Brian L. Shetler

Tax treaties between the United States and other countries are often negotiated with debates at home and abroad about the benefits of free trade and the ills of protectionism. However, there is little or no debate in the U.S. with regard to protectionism in tax treaties affecting the relations of cross-border relationships between couples – protectionism remains firmly entrenched in this area of tax law. U.S. tax laws affecting married couples' gratuitous transfers encourage insular activity with heavier taxes than is imposed on almost any other transfer of assets between parties, commercial or otherwise. Gifts to non-citizen spouses are taxed at rates of 45% or more – even if the transfer is between non-citizens.

Generally, transactions such as a sale of property between spouses are not taxable events for U.S. income tax purposes. So, for example, you generally cannot generate a taxable gain or loss by selling assets to your spouse. However, "transfer" taxes, commonly in the form of "gift" or "estate" taxes, are commonly imposed on transfers if one or more of the spouses is not a citizen and the transaction is a gift or a transfer for uneven values. Transfer taxes can be 45% or more of the value gratuitously transferred over and above certain exemption amounts. However, the U.S. will allow transfers to non-citizen spouses to escape taxation if certain conditions are met. This article discusses some of those requirements.

Transfers to Citizen Spouses vs. Transfers to Non-Citizen Spouses

First, it is important to note that there is no tax on gifts, whether during your lifetime or at death, to spouses who are U.S. citizens. Oftentimes, that alone can make it worth the hassle of a spouse going through the process of becoming a U.S. citizen.

If you or your spouse is not a U.S. citizen, then there are annual limits on lifetime gifts to the non-citizen that can be made without taxes being imposed. In 2009, the annual exclusion limit for gifts made to a non-U.S. citizen spouse is $133,000. If any gift is made in excess of this amount, tax may be due.

Of course, many people don't make gifts of their assets to their spouse during their lifetimes, but leave everything to their spouse at death. There is no similar exclusion for transfers to a noncitizen spouse at death. If the person who dies is a U.S. citizen or permanent resident of the U.S., then there is only the flat estate tax exemption that applies for transfers at death, with no special exemption if the beneficiary is a spouse. In 2009, that exemption is $3.5 million, with a tax rate of 45% on the excess. In 2010, a one-year repeal of the estate tax is slated to take effect; although, there is some debate in Congress to extend the estate tax with a $3.5 million exemption. If there is no action by Congress, then the estate tax comes back in 2011, and the exemption will only be $1 million with the top tax rate on the excess set at 55% with an extra 5% for certain estates.

As with most tax laws, there is an exception. This exception involves a special trust. The exception to the taxability for a transfer to a non-citizen spouse is a gift that qualifies for (1) the annual exclusion for lifetime transfers ($133,000), (2) the exemption ($1 million after 2010), and/or (3) a qualified domestic trust or QDOT.

Exception for Bequests Made through Qualified Domestic Trusts (QDOT)

By providing that the excess of the estate tax exemption will go into a QDOT trust for the benefit of a non-citizen spouse, one can make a bequest to a non-citizen spouse without having to pay a 45% transfer tax. As with transfers in trust for U.S. citizen spouses that qualify for unlimited marital deductions, a QDOT trust allows for the deferral of estate taxes until the surviving spouse's death. The assets of the QDOT trust are then included in the surviving spouse's estate, but his or her flat estate tax exemption can be applied to it, which might allow another $3.5 million to pass estate tax free. This plus the original grantor's $3.5 million exemption in 2009 would result in $7 million passing estate tax free.

Typically, this is accomplished by the creation of a living trust that does not make any gifts until the transferring spouse passes away. At that time, it would allocate the deceased spouse's estate tax exemption amount to an "exemption" trust and the balance of the deceased spouse's estate to a QDOT (in the form of a marital trust or QTIP trust). During the non-U.S. citizen spouse's lifetime, the trustee of the exemption trust can provide the surviving spouse with income and principal as needed for health, education, maintenance and support. Upon the surviving spouse's death, the assets remaining in the exemption trust then pass – estate tax free – to the remaindermen (i.e., children and/or grandchildren). The surviving spouse also receives all the net income from the QDOT. Principal distributions (not income distributions) from the QDOT will only incur estate taxes (at the tax rate in place at the time of the first spouse's death) upon the happening of either of two events: (1) the trustee distributes principal without a showing of distress; or (2) the surviving spouse dies with enough assets in the QDOT and outside of it to have a taxable estate.

General QDOT Requirements

The basic requirements of a QDOT are the following:

  • The QDOT must have at least one trustee who is either
    (1) an individual U.S. citizen (who is of uncommon trustworthiness, smart with investments, and with deep pockets just in case he makes too many mistakes) who is able to obtain a bond;
    (2) a U.S. bank with trustee services.

An irrevocable QDOT election to qualify for the marital deduction must be made on the federal estate tax return (Form 706) within the time limits required for its filing.

The QDOT must be funded within one year of the filing of the return.

There are certain investment restrictions on holding assets overseas.

If the QDOT has assets exceeding $2 million, either:

(1) The U.S. trustee must be a bank,

(2) The individual U.S. trustee must furnish a bond; or

(3) The individual U.S. trustee must furnish an irrevocable letter of credit to the U.S. government.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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