QDOTs

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A QDOT (Qualified Domestic Trust) is a trust for the benefit of a surviving non-citizen spouse that defers the federal estate tax following the death of the first spouse. A Qualified Domestic Trust defers the federal estate tax because it qualifies for the unlimited marital deduction. A QDOT usually defers the federal estate tax until the death of the surviving spouse. However principal distributions can also trigger the tax. QDOTs are specifically permitted pursuant to Internal Revenue Code §2056A.

Why Does the Tax Law Treat Non-Citizen Spouses Differently?

Most people just assume that they can give or leave a spouse money without any tax consequences. This is because it public policy to try and treat a husband and wife as one unit for tax purposes. When it comes to an estate tax, the government generally feels it can wait until the death of the surviving spouse to collect any taxes that may be owed. The IRS codifies this right in I.R.C. §2056 by granting an unlimited estate tax deduction to a surviving spouse. There is also a corresponding unlimited gift tax deduction for gifts to a citizen spouse in I.R.C. §2523.

However, the rules are different if you are married to a person who is not a citizen. The government is afraid that a surviving non-citizen spouse may return to his or her home country after one spouse dies. If that happens, it will be difficult for the IRS to actually collect the estate tax.

In order to reconcile these two competing interests, the concept of a QDOT was created.

Requirements of a QDOT

In order for a trust to qualify as a QDOT, it must meet the following requirements:

  1. A QDOT must qualify for the marital deduction as provided for in Internal Revenue Code §2056.
    • The most common way to achieve this goal is for the Trust to pay all the net income to the surviving spouse annually. (Another option is to grant the surviving spouse a general power of appointment over trust property.)
    • The surviving spouse can be the only lifetime beneficiary of a QDOT.
  2. At least one trustee of the QDOT must be a citizen of the United States.
  3. A Bank with a US branch may be required to serve as trustee depending upon the size and types of assets involved.
    • A “large QDOT” is a QDOT with assets in excess of $2,000,000. A large QDOT requires:
      • At least one of the trustees must be a U.S. bank or a trust company; or
      • The U.S. trustee (an individual trustee) must furnish a bond or letter of credit equal to 65 percent of the fair market value of the assets in the trust.
    • A “small QDOT” is a QDOT with assets of $2,000,000 or less. A small QDOT requires:
      • No more than 35 percent of the trust assets can be real property located outside the United States; or
      • The requirements for a “Large QDOT” be met.
    • Note: Up to $600,000 of the principal value of a US based primary residence (and furnishings) may be excluded from the calculations for purposes of determining whether a trust should be treated as a “Large QDOT”.
  4. The trustee must have the right to withhold the estate tax and pay it to the IRS.
  5. The laws of a US state or the District of Columbia must govern the trust.
  6. The executor of the deceased spouse’s estate must elect to have the trust treated as a QDOT on a timely filed federal estate tax return.

Planning Considerations

Estate planning for clients who are married to a non-citizen spouse can be very complex. A surviving non-citizen spouse is not entitled to an unlimited gift tax deduction or an unlimited marital deduction. Portability is typically wasted. Moreover, simply re-titling U.S. assets from the name of one spouse to the name of both spouses can trigger horrible tax problems.

When should a QDOT be Created

If you have significant assets, we recommend creating a QDOT as part of an overall estate plan that includes life insurance trusts and credit shelter trusts. However, technically, a QDOT does not need to be created in the decedent’s Will (or in a revocable living trust). The surviving non-citizen spouse may create the QDOT provided it is funded prior to the due date for the federal estate tax return (including extensions).

Be careful not to fund a QDOT unnecessarily

If you fund a QDOT before using up a decedent’s estate tax exemption, you will lose the remaining exemption of the first spouse to die. Accordingly, it is best to consider the following strategies:

  1. If the two spouses do not have significant funds, then most likely no estate taxes will ever be due. In this scenario, it may not be wise to set up any QDOT structure. Currently, the federal estate tax exemption is $11.7 million. However, there are rumors of it dropping down. Therefore, for right now, many would suggest that if a couple has less than $2M of assets and it is unlikely to grow much beyond that, there is probably no need to do a QDOT.
  2. If the two spouses have significant assets, it will be imperative to utilize the tax exemptions of both spouses as much as possible. This may entail creating life insurance trusts, credit shelter trusts, disclaimer trusts, and/or a QDOT.
  3. If the two spouses have a moderate asset level, but above $2M, I would suggest putting failsafes in place that allow for the creation of credit shelter trusts and a QDOT if needed.
  4. It is generally not advisable to fund a QDOT until credit sheltered trusts are fully funded.

Be mindful that distributions from a QDOT can cause an Estate Tax

When principal distributions are made from a QDOT (either to a surviving spouse or to the remainder beneficiaries upon the death of the surviving spouse) it triggers an estate tax. A QDOT does not eliminate the estate tax on the death of the first spouse, it merely defers it. Accordingly, it would be wise to ensure that a surviving non-citizen spouse uses the QDOT to own a primary residence, for income, and for emergency funds. The surviving spouse should not plan to tap into the principal as a regular source of funds.

Lifetime Gifting

Normally, a spouse can give the other spouse an unlimited amount of money if they are citizens. In addition to an unlimited marital deduction for estate tax purposes, citizen spouses are also entitled to an unlimited marital deduction for gift to tax purposes. (See I.R.C. §2523(a))

The IRS limits tax free gifts to a non-citizen spouse to $100,000, indexed for inflation. See I.R.C. §2523(i). For 2021, the limit is $159,000. Note that this is higher than the $15,000 annual gift exclusion that you can gift to anyone under I.R.C. §2503(b).

To avoid the difficulties associated with QDOTs, it would be wise to ensure that both spouses have adequate assets in their own name. This may difficult to accomplish since the potential tax on a large gift to a non-citizen spouse disincentivizes pre-funding too many assets into the name of the non-citizen spouse. However, with patience and time, you can transfer significant funds into the name of a non-citizen spouse by using the annual I.R.C. §2523(i) exclusion amount. We also recommend leveraging life insurance and other planning tools such as ILITs.

Dealing with Retirement Assets (IRA/401k/ROTH) and Joint Property

A QDOT Rollover IRA should be considered for the decedent’s IRA and 401(k) assets to avoid an immediate income tax and estate tax. Treas. Reg. §20.2056A-4(c) provides for alternatives on handling non-assignable annuities and other such assets.

For joint property owned by the decedent and the non-citizen spouse, the surviving spouse may wish to consider using qualified disclaimers or funding part of a QDOT with 50% of the joint asset.

What if the Surviving Spouse Becomes a Citizen

It is imperative to learn of the client’s citizenship and status to accurately plan and determine if any treaties apply.

  1. If the surviving non-citizen spouse becomes a citizen prior to the filing of the estate tax return, there will be no need for a QDOT.
  2. If the surviving spouse becomes a citizen after the assets are transferred to the QDOT, distribution of property from the QDOT will not be taxed if:
    • the surviving spouse either was a U.S. resident from the date of death of the decedent or no taxable distributions were made from the QDOT prior to the surviving spouse becoming a citizen; and
    • the United States trustee notifies the IRS that the surviving spouse has become a U.S. citizen.
    • Note: Special rules apply if the QDOT had already made taxable distributions. See Treas. Reg. § 20.2056A-10

As a practical matter, we strongly encourage surviving non-citizen spouses to consider becoming a US citizen to minimize the tax and administrative complexities.

Tax Consequences

  1. The assets transferred into the QDOT are eligible for the unlimited marital deduction.
  2. The QDOT is generally taxed as a simple trust for income tax purposes. This means that when the trust earns income, it MUST be distributed to the surviving spouse. The surviving spouse is then required to pay the income tax on that income based upon the surviving spouses own tax rates.
  3. Each distribution of PRINCIPAL from the QDOT triggers the federal estate tax. (This may be waived if the surviving non-citizen spouse can prove a hardship.)
  4. Income distributions from a QDOT are not subject to the estate tax.
  5. The Trustee must file Form 706-QDT annually. Form 706-QDT reports the amount in the trust as well as the distributions made from the trust.
  6. A non-citizen spouse cannot use the applicable exclusion amount to shelter any distributions of principal from a QDOT. Assets in a QDOT assets are never considered part of the non-citizen spouse’s gross estate. They are part of the deceased spouse’s estate for estate tax purposes.

Portability

In 2012, President Obama signed a law allowing a surviving spouse to port the unused estate tax exemption of a deceased spouse. The unused estate tax exemption is officially known as DSUE (Deceased Spouse’s Unused Exemption). While a surviving non-citizen spouse is entitled to port the DSUE of their deceased spouse, complex recapture rules potentially make this an effectively useless benefit. (See Treasury Regulation 2.2010-2(c)(4) and Example 3 under (c)(5).)

Same Sex Spouse Issues

Since 2013, the IRS has treated same sex spouses the same as heterosexual spouses. If the marriage is legally recognized in the US, there should not be a difference when it comes to this topic. However, those who have entered into a registered domestic partnership, civil union, or other similar formal relationship recognized under state law that is not denominated as a marriage will NOT qualify to set up a QDOT.

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