The population is getting more and more mobile. This mobility can create a number of tax mishaps. Many of these mishaps result from United States citizens marring non-citizens.
Failing to adequately plan for the loss of the estate and gift tax marital deduction is often one of the costliest mistakes made by wealthy US citizens who are married to non-United States citizens.
Generally gifts between spouses qualify for a 100% gift tax marital deduction. This deduction allows US citizen spouses to make gifts to each other without incurring a gift tax obligation. Gifts to US citizen non-spouses do not qualify for this 100% deduction, but they may qualify for the $12,000 per year annual gift exclusion (US citizens can also give up to $1,000,000 during their lifetime free of gift taxes to a non-spouse US citizen).
Gifts by a US citizen to a non-US citizen spouse do not qualify for the gift tax marital deduction. Instead, gifts from US citizens to non-citizens (be it a spouse or someone else) are subject to US gift tax, unless the gift is less than the $120,000 per year annual gift exclusion for gifts to non-US citizens.
These are the gift tax rules for transferring assets to citizens and non-citizens during one’s lifetime. Here are the estate tax rules for transferring assets to citizens and non-citizens at one’s death:
Transfers between US citizen spouses at death qualify for a 100% estate tax marital deduction. Transfers to non-spouses at death do not qualify for this deduction. However, the decedent spouse can transfer up to $2,500,000 (in 2007) at death to a spouse or non-spouse US citizen or non-US citizen without incurring an estate tax liability.
As the above rules provide, it is often advantageous for wealthy US citizens to implement a lifetime gifting program for the benefit of non-US citizen spouses. This could allow $120,000 to be transferred to a non-citizen spouse free of gift tax during the US-citizen spouse’s lifetime, plus an additional $1,000,000 for the US citizen spouse’s lifetime gift tax exemption amount. These amounts can be leveraged if the US citizen spouse transfers property to the non-US spouse that qualifies for a gift tax valuation discount (such as shares or an interest in a business that is not marketable or where the non-US spouse does not gain control of the business).
For most taxpayers, these lifetime gifts should be sufficient to reduce the US citizen’s taxable estate below the $2,500,000 estate tax exclusion amount. In the event that the couple will still incur a federal estate tax upon the demise of the US spouse, the couple might consider establishing a qualified domestic trust or QDOT.
The QDOT is simply a trust that, if the requirements are met, allows transfers at death to the trust for the benefit of the non-citizen to qualify for the 100% estate tax marital deduction. Generally, to qualify as a QDOT a trust must have at least one US trustee, no distribution (other than income) can be made unless the US trustee can withhold the applicable US taxes from the distribution, and the executor must make an irrevocable QDOT election.
Unfortunately, many taxpayers fail to properly account for inter-spousal transfers that they make during their lifetimes and they fail to plan for transfers at death to non-US citizen spouses. This often results in the spouses, under state law, owning property acquired or earned during marriage jointly. In this situation, if the surviving non-US citizen spouse cannot prove that he or she contributed to acquiring or improving the property, the full amount of the jointly owned property may be included in the US citizen’s taxable estate – resulting in a significant US estate tax liability.
Ideally the US citizen spouse’s estate documents would provide a QDOT that would receive any assets that the non-citizen spouse disclaimed. A disclaimer is a means for any person to renounce a gift or bequest prior to taking possession or receiving it, thereby allowing the gift or bequest to pass to the next person who would qualify for the gift or bequest.
This would permit the non-citizen spouse to determine whether he or she would like to accept some or all of a transfer from his or her US spouse or to allow some or all of it to pass to the QDOT.
The non-US citizen spouse might also be able to become a US citizen prior to the US citizen spouse’s estate tax return is filed (which is generally due nine months after the spouse’s death) – even if the non-citizen spouse becomes a US citizen after the US spouse died.
If these options fail but the assets pass to a trust for the benefit of the non-US citizen spouse, the trust may be reformed so that it qualifies as a QDOT.
Many US states that permit common-law marriage, which is a form of marriage that does not require an official wedding certificate or wedding ceremony. US citizens who meet the state common law marriage requirements may be able to successfully demonstrate that they are married, in order to reform a non-QDOT trust to be a QDOT trust.
If these rules are not complex enough, life insurance, retirement and employee benefits can present a whole host of other complexities. Taking the time to properly plan for these transactions can significantly reduce the tax liabilities and help transition the transfer of assets from the US spouse to the non-US citizen spouse.