Beware: Bequests to non-U.S. citizen spouses may not qualify for the Estate Tax Marital Deduction

Generally, for purposes of computing the Federal estate tax (as well as the New York estate tax), bequests to a surviving spouse qualify for the marital deduction under Internal Revenue Code (“Code”) Section 2056. The result of this, of course, is that assets passing to the surviving spouse are excluded from the deceased spouse’s taxable estate, thus deferring any potential estate tax until the surviving spouse’s death. However, unless certain conditions are met, Code Section 2056(d) disallows the marital deduction where the surviving spouse is not a United States citizen. The United States Government’s obvious concern here is that a non-citizen spouse will inherit a sizeable estate from his or her spouse, and then return to their homeland without paying any estate taxes. Unfortun­ately, the imposition of a costly federal estate tax upon a surviving spouse’s inheritance, especially in light of the minimal $1,000,000 federal unified credit amount for 2011, may be financially devastating in some cases.

In order to address the government’s tax policy concerns, while avoiding the imposition of estate tax under these circumstances, the Code requires that such property either pass into a qualified domestic trust (a “QDOT”) under Code Section 2056A or, alternatively, the surviving spouse must become a citizen of the United States before the estate tax return is filed (assuming the surviving spouse was a resident of the United States at all times after the death of the decedent and before becoming a citizen). Unfortunately, even if a surviving spouse anticipates applying for U.S. citizenship, such process can take many years to accomplish.

If the deceased spouse was mindful of the estate tax treatment of non-citizen spouses, the QDOT will already have been provided for in an intervivos or testamentary instrument executed by the deceased spouse. In the absence of forethought and careful estate planning, the Code provides that under certain circumstances, a trust created for the spouse which does not meet all of the QDOT requirements may be reformed in order to qualify as a QDOT. If no trusts for the benefit of the non-citizen spouse exist, all is not lost. A QDOT may also be created after the first spouse’s death by the surviving non-citizen spouse or the executor of the decedent’s estate, and the non-citizen spouse must thereafter irrevocably assign his or her inheritance thereto (Treas. Reg. §20.2056A-2(b)(2)).

Code Section 2056A sets forth the requirements of a valid qualified domestic trust. Generally, a QDOT is similar to a qualified terminable interest property trust (a “QTIP” trust) in that all income must be paid to the surviving spouse and no person other than the surviving spouse may have an interest in the trust during the surviving spouse’s lifetime. The income may be paid to the spouse without the imposition of estate tax. However, any distributions of principal from the QDOT will require concurrent payment of estate tax by the QDOT trustees. An exception to this rule is when distributions of principal are made to the non-citizen spouse on account of a “hardship.” A “hardship” is defined under the regulations to the Code as a distribution “made to the spouse from the QDOT in response to an immediate need relating to the spouse’s health, maintenance, education or support, or the health, maintenance, education or support of any person that the surviving spouse is legally obligated to support.” If the spouse has other resources reasonably available to meet these expenses, the distribution will not qualify as having been made on account of “hardship.” Any such distribution must be reported on a Form 706-QDT. Treas. Regs. §20.2056A-5(c)(1).

To make certain that estate taxes will be paid upon the death of the non-citizen spouse, or when principal distributions are made during the lifetime of the non-citizen spouse, the QDOT must have at least one trustee who is an individual citizen of the United States or a domestic U.S. corporation. Code §2056(a)(1)(A). When creating a QDOT, it is extremely important to follow the rules under Code Section 2056A and the regulations thereunder to ensure that the trust continues to qualify as a QDOT in order to continue to enjoy deferral of the estate tax.

Additional rules apply to QDOT’s containing assets in excess of two million dollars ($2,000,000). The terms of the trust must require the trustee to adhere to certain security requirements in order to further ensure the payment of estate tax. Treas. Reg. 20.2056A-2(d). The security options consist of either having a banking institution serve as a co-trustee, or furnishing a surety bond or bank letter of credit in favor of the IRS in an amount equal to sixty five percent (65%) of the fair market value of the trust assets. If the value of the QDOT does not exceed two million dollars ($2,000,000), these requirements do not apply.

For purposes of calculating the QDOT’s value to determine whether the security provisions above will apply, the executor of the estate may exclude up to six hundred thousand dollars ($600,000) in value attributable to real property (and related furnishings) which is used by the non-citizen spouse as a principal residence. If at any point in the future this real property is no longer used as a residence, the exclusion would no longer apply and the U.S. Trustee must file a written statement with the IRS reporting this event. Treas. Regs. §20.2056A-2(d)(l)(iv).

After the creation of a QDOT, if the surviving spouse attains U.S. citizenship, the assets in the trust can be distributed to the surviving spouse without the imposition of estate tax. Thus, there appears to be no downside to the post-mortem creation of a QDOT where the surviving spouse is a non-U.S. citizen. In fact, even if the amount passing to the surviving spouse is questionable, such as where the estate is involved in a bona fide will contest, it is prudent for the executor of the decedent’s estate to make a protective QDOT election. Treas. Regs. §20.2056A-3(c). The executor’s filing of the protective QDOT election assumes that the surviving spouse will concurrently assign, or make a protective assignment of, his or her right to all property passing to him or her, or which may pass to him or her, from the decedent’s estate to the QDOT. The time for filing the QDOT election is limited to one year after the due date of the Federal estate tax return, including extensions. This election, once made, is irrevocable. Treas. Regs. §20.2056A-3(a). As an aside, it is important to note that the rules propagated under IRC §2040(b) with respect to includibility of joint interests of spouses will not apply in cases where the surviving spouse is a non-citizen. Treas. Regs. §20.2056A-8. This means that the full value of joint property will be included in the deceased spouse’s estate under Treas. Regs. §20.2040-1(a)(2) unless the executor can prove otherwise. Obviously, this can further exacerbate the issues described herein where a QDOT election has not been made. Based upon the above, and the significant tax consequences for failure to do so, where property is to be, or may be, distributed to a non-citizen spouse, it is imperative that the decedent’s executor (or trustee of the decedent’s revocable trust) consider the formation of a QDOT and making the QDOT election, or a protective QDOT election, on the decedent’s estate tax return.

Patricia C. Marcin is an attorney at Farrell Fritz, P.C. concentrating in estate planning and estate administration. Jordan S. Linn is an estate planning and estate administration associate at Farrell Fritz, P.C.