Planning Ideas—The Non-Citizen Spouse
Even with increased annual exclusions and lifetime exemptions, wealthy clients married to non-citizens remain challenged to adequately provide for their spouses’ financial security.
In general, the transfer tax marital deduction is allowed on the premise that property passing under the deduction from the first spouse to die will be taxed at the death of the survivor. A non-citizen spouse has the potential to frustrate the goal of that underlying premise—taxation of the transfer of property at least once in a generation—because the non-citizen spouse can leave the country and escape the reach of the IRS.
Consequently, the amount of lifetime annual exclusion gifts to non-citizen spouses are capped, and transfers by bequest are restricted from qualification for the marital deduction in nearly all instances.
Knowing the limits, restrictions, and options available is the key to advising these clients.
While individuals may make unlimited lifetime gifts to citizen spouses without incurring gift tax, no gift tax marital deduction is allowed for transfers to non-citizen spouses. However, once the citizen spouse has exhausted his or her lifetime exemption ($5.25 million in 2013), gifts to non-citizen spouses may be sheltered from tax by an enhanced annual exclusion. The amount of the enhanced annual exclusion as indexed for inflation is $143,000 in 2013.
To qualify for the enhanced annual exclusion, the gift must be structured as follows:
- An outright gift of a present interest;
- A gift in trust providing the spouse with a life income interest coupled with a general power of appointment over principal;
- A gift in trust that distributes the remainder interest to the surviving spouse’s estate (estate trust); or
- A trust that meets the requirements of a qualified terminable interest trust (QTIP trust).
Note, non-citizen spouses can make unlimited gifts to their citizen spouses, and can participate in gift-splitting to double the value of the annual exclusion and lifetime exemption available to the citizen spouse.
The Estate Tax
As a general rule, bequests or transfers in trust to non-citizen spouses do not qualify for the estate tax marital deduction. This means that, as a general rule, once the citizen spouse has exhausted his or her transfer tax exemption, all further gifts to a non-citizen spouse are taxable.
An important exception to the general rule relates to transfers to a Qualified Domestic Trust (QDOT). The QDOT is designed to assure that even if the non-citizen spouse leaves the US, assets received under the marital deduction from the first spouse will be subject to US estate taxation at the death of the surviving spouse.
There are a number of requirements that must be met in order for a trust to quality as a QDOT. These include the following:
- At least one trustee of the trust must be an individual citizen of the United States or a domestic corporation, and no distribution (other than income) may be made unless the US trustee has the right to withhold transfer taxes with respect to such distribution.
- The trust must otherwise qualify for the marital deduction. Thus, the trust must be designed as one of the following:
- A life estate coupled with a general power of appointment in favor of the non-citizen spouse;
- An estate trust;
- A QTIP trust; or
- A charitable remainder trust in which the non-citizen spouse is the sole non-charitable beneficiary.
- An irrevocable election to treat the trust as a QDOT must be made before the estate tax return is filed. The election applies to the entire trust.
Distributions from the trust are subject to the transfer tax, but there are two exemptions: (1) income distributions; and (2) distributions on account of hardship.
In general only distributions for extraordinary health needs are likely to be considered hardship distributions.
When the surviving non-citizen spouse dies, a “deferred estate tax” is owed on the value of the QDOT property at the date of his or her death.
Calculation of the deferred estate tax is tricky. It is technically a tax on the estate of the first spouse to die that is delayed until the death of the surviving spouse. Accordingly, the tax is imposed using the exemption and tax rates in place when the first spouse died.
Example—Jack died in 2003 when the exemption equivalent was $1 million and the top rate was 49%. After leaving $1 million to his children, Jack deferred taxation of the balance to his $6 million estate by leaving $5 million in a QDOT/QTIP for the benefit of his non-citizen spouse, Jill, and eventually his children. Jill died in 2013, when the estate tax exemption is $5.25 million and the top rate is 40%. By the time of Jill’s death, the value of the QDOT assets doubled in assets to $10 million. Unfortunately, for Jack’s children the amount of estate tax due at Jill’s death is calculated using the 2003 exemption of only $1 million and the highest marginal estate tax rate of 49%.
Don’t fall prey to the worst case scenario. Resident aliens are taxed essentially like citizens. If a citizen client leaves property over the exemption amount to a resident non-citizen spouse in a manner not qualifying for the QDOT deferral, estate tax is due at the client’s death. In addition, if the surviving spouse remains resident, all of his or her property (above the exemption), including amounts received from the deceased spouse, are subject to estate tax when the surviving spouse dies. Ouch—that really hurts. Offsetting the sting somewhat is the fact that a resident’s exemption is the same as a citizen’s—$5.25 million in 2013.
The QDOT may be enhanced by combining it with a Wealth Replacement Trust (WRT). In this context a WRT is an irrevocable life insurance trust (ILIT) designed to replace the wealth lost in payment of deferred estate taxes from the QDOT.
In a nutshell, the WRT works as follows:
- The trustee applies for, owns, and is beneficiary of a life insurance policy, usually on the joint lives of the spouses; and
- The client makes annual gifts to the trust for the payment of premiums by the trustee.
The likely benefits of such an arrangement are as follows:
- The life insurance escapes estate taxation upon the donor’s death, leaving the income tax free death proceeds available to replace the wealth in QDOT used to pay deferred taxes; and
- The donor’s annual gifts should qualify for the annual gift tax exclusion, so long as the trust contains withdrawal powers for the beneficiaries.
The US Census Bureau has estimated that in 2005 there were about 27 million non-US citizens residing in the United States. Interestingly, while 2010 census collected information on immigrants, it did not distinguish between naturalized citizens and non-citizens. In any case, most would agree the number of non-citizens has risen significantly since 2005, and many of these non-citizens are married to US citizens. Chances are, you will encounter planning issues for non-citizen spouses in your practice sooner, rather than later.
Planning Ideas and similar topics are covered in great detail in many of Cannon’s professional development solutions. To find out more visit: www.cannonfinancial.com.
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Disclaimer: The materials and information contained herein are intended for educational purposes, to stimulate thought and discussion so as to provide the reader with useful ideas in the area of wealth management planning. These materials and information do not constitute and should not be considered to be tax, accounting, investment, or legal advice regarding the use of any particular wealth management, estate planning, or other technique, device, or suggestion, nor any of the legal, accounting, tax, or other consequences associated with them.
While the content herein is based upon information believed to be reliable, no representation or warranty is given as to its accuracy or completeness. For this reason, the program of study should not be relied upon as such. Although effort has been made to ensure the accuracy of these materials, you should verify independently all statements made in the materials before applying them to your particular fact pattern with a client. You should also determine independently the legal, investment, accounting, tax, and other consequences of using any particular device, technique, or suggestions, and before using them in your own wealth management planning or with a client or prospect. Information, concepts, and opinions provided herein are subject to change without notice.
The strategies contained within these materials may not be suitable for all clients. For many concepts discussed herein, clients are strongly urged to consult with their own advisors regarding any potential strategy and will need to strategy described herein is suitable for their particular circumstances.
Examples, provided throughout these materials, are for illustrative purposes only, and no representation is being made that a client will or is likely to achieve the results shown. The examples shown are purely fictional and are not based upon any particular client's circumstances.