Transfer Tax Rules for the Non-Citizen Spouse
Transferring wealth to a spouse who isn’t a U.S. citizen can create complex gift, estate and generation-skipping transfer tax challenges. Such transfer tax issues require careful planning, as well as a clear understanding of the differences in how citizens and non-citizens are taxed.
Unlike citizens and resident aliens, a non-resident alien must only pay transfer taxes on assets having a situs in the United States. Since the gross estate of such individuals is limited to U.S. situs assets, the exemption against estate tax is restricted, and deductions from the gross estate must be allocated.
Also, be aware that for federal transfer tax purposes, the term “resident” is defined differently than for income taxes.
For purposes of federal transfer taxes, the term "resident" means an individual domiciled in the United States -- a meaning that is not identical to the meaning of the same term in the income tax context. For income tax purposes, a taxpayer may have a dual residence, while a taxpayer can have only a single true domicile for transfer tax purposes. Determination of domicile is based on subjective review of a number of factors. The ultimate concern is whether the individual intends to remain in the United States for an indefinite period.
Because most countries will assert tax jurisdiction over their own citizens and residents with respect to the entire estate worldwide, and will also assert jurisdiction over assets having a situs within their borders, there is a great potential for double taxation when dealing with international clients.
For example, a resident alien having a domicile in the United States may also be subject to tax by the country of which he or she is a citizen, and may be subject to additional tax if real estate is owned in a third jurisdiction. Such conflicts are generally dealt with under treaties entered into by the respective jurisdictions. Two primary types of estate tax treaties exist:
If an estate is subject to taxation on worldwide assets by more than one country, then each country will allow a tax credit on property physically located in the other country.
If an individual is viewed as a domiciliary of two countries, he or she will be treated as a domiciliary of the country of citizenship if residence was established in the non-citizenship country less than a specific number of years prior to death. If the double domicile dispute cannot be settled by the number of years rule, the treaties contain other means of determining domicile.
The tax treaty provisions are complex, and vary for each country. Transfer tax planning for non-citizens cannot be carried out until all applicable treaties have been examined.
Where assets are located outside the United States, it will be necessary to examine the testamentary formalities required to effectuate a transfer of the foreign situs property at death. The country where assets are located will generally exercise ultimate control over those assets, although courts and legal authorities in other jurisdictions may attempt to assert jurisdiction. Sometimes, a jurisdiction may exercise indirect control over assets located elsewhere if the forum country has control over the interested parties. Even when it is determined which country has control over specific assets, it is not clear that that country's law will necessarily apply. The choice of law rules applied by the forum nation must be consulted. These rules are rarely clear. Foreign counsel may need to be consulted in order to assure that the estate plan is properly carried out.
Multijurisdictional wills may help prevent such confusion. In addition, careful consideration should be given to the use of diverse types of vehicles to hold assets. Use of corporate, trust and other entities may be helpful in collecting assets, avoiding probate in a multitude of jurisdictions, and pinning down questions of situs and choice of law.
Basic Rule: Marital Deduction Disallowed.
In 1988, Congress chose to disallow the marital deduction for transfers to non-citizen spouses, except under strictly controlled circumstances.
One of those circumstances is when the property passes into, or is promptly transferred by the surviving spouse to, a Qualified Domestic Trust (“QDOT”). A narrow exception is available where the surviving spouse becomes a citizen before the filing of the estate tax return, and was a resident of the United States at all times between the decedent's death and the attainment of citizenship status.
No marital deduction is allowed for lifetime transfers to a non-citizen spouse. The qualified domestic trust exception is not available. However, for gifts to a non-citizen spouse which would otherwise qualify for the marital deduction, a special annual exclusion limitation of $100,000 indexed for inflation ($149,000 in 2017), instead of the normal $14,000, is made available each calendar year, for gifts other than future interest gifts.
Where property is titled jointly with right of survivorship or tenants by the entireties and one of the spouses is a non-citizen, the "consideration furnished" test must be applied to determine whether and to what extent jointly-owned property will be included in the estate of the first spouse to die if the surviving spouse is not a U.S. citizen. The portion of the jointly-owned property includible in the estate will not be eligible for the marital deduction.
Legislative Solution: Qualified Domestic Trust
Transfers at death to a non-citizen spouse will qualify for the marital deduction to the extent that the assets pass from the decedent, or are promptly transferred by the surviving spouse, to a QDOT meeting the following requirements.
At least one trustee of the trust be an individual citizen of the United States or a domestic corporation.
No distribution (other than a distribution of income to the spouse) may be made unless the U.S. trustee has the right to withhold the QDOT tax from the distribution.
The trust instrument must also comply with regulatory requirements designed to ensure the collection of the QDOT tax.
Please note: A QDOT will qualify as such only if the executor elects QDOT treatment on the estate tax return.
Distributions made to the spouse from a QDOT are generally treated as taxable events. However, no QDOT tax is imposed upon the distribution of income. For this purpose, capital gains may not be treated as income, unless they would be so treated under prevailing state law principles, regardless of the provisions of the trust instrument. Principal distributions made to the spouse on account of "hardship" are also exempt from the QDOT tax. The distribution will be exempt only if other resources are not available to satisfy the spouse's need.
If the trust ceases to qualify as a QDOT at any time, as, for example, in the situation where there is no U.S. trustee, the entire value of the trust corpus will be subject to tax.
Since the property passing into the QDOT is eligible for the marital deduction, in most cases the property will be subject to taxation at the surviving spouse's death as part of his or her own estate and will receive a stepped-up basis.
Additional QDOT tax may be avoided if the surviving spouse becomes a citizen of the United States after the establishment of a QDOT.
If the spouse was at all times a resident of the United States between the date of death and the date of attainment of citizenship, or if no taxable distributions have been made from the QDOT prior to the attainment of citizenship (regardless of the residency status of the spouse), then upon attaining citizenship, the QDOT tax will no longer be imposed. If a QDOT tax has been imposed on prior distributions from the QDOT, and if the spouse was not at all times a resident of the United States, then the spouse must elect to treat the prior distributions as taxable gifts for purposes of determining the appropriate transfer tax rate and available unified credit for the spouse's future gifts and for the spouse's estate at death. If the decedent spouse's exemption was allowed against the prior distributions, the surviving spouse must reduce his or her exemption by a like amount. Future QDOT tax will be avoided if this election is made.