Estate planning for a married couple becomes more complex when one spouse is not a citizen of the US. This is because the unlimited estate tax deduction for transfers between spouses – “the marital deduction”, a cornerstone of estate planning – is unavailable or limited in the case of non-citizen spouses. Somewhat equivalent results can often be achieved, but will require maneuvering through twisted loopholes.
What Kind of Alien Are You?
In the context of estate planning, people are divided into different categories. The first distinction is between Citizens, Resident Aliens (“RA”), and Non-Resident Aliens (“NA”). Some rules regarding estate tax apply to each group differently, as will be seen in this article. What a “citizen” is requires little explanation: you were either one at birth, or went through a process of naturalization. “Resident Aliens” are citizens of another country, but are “domiciled” in the U.S., i.e., live here with the intention of remaining here. There is a sophisticated test for whether ones qualifies as an RA (which is beyond the scope of this article); the clearest factor is whether the person has a green card, which will usually mean that the person is an RA, unless that person has moved back to the home country for a prolonged period. Non-Resident Aliens are those that are not domiciled in the US. They live in their home country and intend to have their domicile there.
Some other rules distinguish between “US persons” and “Non-US persons.” Generally, “US persons” includes citizens and RAs, while “Non-US persons” is largely synonymous with Non-Resident Aliens (for purposes of this discussion). The estate tax of U.S. persons (citizens and RAs) will be collected by the US, and determined based on U.S. law. The estate tax of Non-US persons will largely be collected by the home country, based on its law, except as to property located in the US – which the US will tax. However, in some cases so much of the NRAs property is located in the U.S. that the U.S. feels entitled to control taxation of the entire estate, despite the lack of domicile.
Estate Taxation of Resident Aliens
While there will be some exposition of the rules for Non-US persons later in this article, the bulk of it will be dedicated to the situation of the Resident Alien. Fortunately, in one major regard the RA and the citizen are treated the same: each is entitled to utilize the unified credit estate tax exemption to shield transfers from their estate. The amount of the exemption is currently $5.45M in 2016, which is adequate to protect most estates.
However, the next line of defense against taxation is the marital deduction which is not available to Resident Aliens. The marital deduction allows one spouse to freely transfer an unlimited amount of assets to the other spouse with no estate tax or gift tax being levied. In many estates this is used to transfer all of the deceased spouse’s property to the surviving spouse at the first death, for use during the surviving spouse’s lifetime. Then, at the surviving spouse’s death, using “portability”, both spouse’s entire exemption (a total of $10.9M) can be used to shield assets when they are passed to the next generation. Unfortunately, since the RA cannot benefit from the marital deduction, this plan will not work. When a citizen spouse leaves assets to an RA – those assets may be subject to taxation.
Let’s say “Citizen Spouse” has a $7M estate, and leaves it all to his wife, “RA”. His $5.45M exemption will apply, but there will remain $1.545M in his estate. Estate tax is 40%, and 40% of $1.6M = $640,000 tax due.
Furthermore, having received this money, RA’s estate will probably also exceed the exemption amount, so that more tax will be due at her death. Assuming she retained $7M at her death, another $640,000 would be due.
If both were citizens, the $7M would have transferred to RA with no tax (because of the unlimited marital deduction), and then on her death, portability would have allowed both spouse’s exemption –totaling $10.9M – to shelter the transfer of the $7M to the next generation.
One way to allow this happy result would be for the RA to become a citizen before the time to file the estate tax return on the decedent spouse’s estate. But, there are often many reasons the people prefer to hold onto their green cards instead of becoming citizens, and for some people that is not an option. Fortunately, there is another option. This is known as the Qualified Domestic Trust, often referred to as the “QDOT”.
The QDOT allows RA’s to create a trust which will grant them the right to a “marital deduction” similar to the citizen spouse. The QDOT would be included in estate plan of the citizen spouse, or the estate plan of the couple. The QDOT imposes limitations on the use of the assets to ensure that IRS requirement to qualify for the marital deduction are met. It is often used in conjunction with another trust, known as a Qualified Terminable Interest Trust (”QTIP”), which is a trust utilized to make sure that additional rules regarding the marital deduction – whether Citizen or RA – are followed.
The problem with the QDOT is that it contains some inconvenient restrictions, aimed generally at ensuring that the RA surviving spouse does not leave the U.S. with the property, and so avoid taxation. The big limitation is that at least one of the QDOT’s Trustees must be a U.S. citizen. In most “couple” trusts, the surviving spouse is the sole trustee during his or her lifetime; but this is not allowed where the RA is the surviving spouse; and so the QDOT forbids it. Further, the U.S. Trustee must have the right to withhold tax from the trust. In fact, if the estate is in excess of $2M, the trustee must be a bank or institution, and not an individual. As if that were not enough protection, the IRS is given a security interest in the trust assets.
Additionally, QDOT treatment must be elected by the surviving spouse or trustee in a timely-filed IRS estate tax form shortly after the death of the first spouse. Finally, there is a quirk in the QDOT law, such that an RA surviving spouse is not entitled to take advantage of portability. (For a more complete discussion of portability, see “Has Portability Rendered the Bypass Trust Extinct?) Despite these restrictions, a QDOT is often the best that can be done.
So, let’s say that “Citizen” and “RA” had a QDOT in their trust. How would that work out? On the first death, the marital deduction allowed by the QDOT would shelter the $7M going to the surviving spouse. Unfortunately, because portability would not apply, only the surviving spouse’s exemption would be available at death, which would shelter only $5.45M and not the entire $7M. Fortunately, another type of trust can be used with the QDOT (called a “Bypass” or “Credit Shelter” Trust) which would solve the problem. That Bypass trust is uses some of the decedent spouse’s exemption at the time of his or her death by passing some of the property to the next generation – while still keeping it in trust for limited use by the surviving spouse. So, with a combination of trusts, the RA can duplicate the same result as if both spouses were citizens.
One group of RA’s may obtain the protections of the QDOT without actually using one. The U.S. has entered into estate tax treaties with numerous countries which provide their own form of marital deduction without using a QDOT. (In fact, one must elect either treatment under the treaty or under a QDOT. These have their own rules and limitations depending on the treaty language, but they are often more lenient than using a QDOT.1
One other important limitation regarding the marital deduction for RA’s is that the QDOT or treaty rules apply only to transfers at death. For lifetime (inter-vivos) gifts to non-citizen spouses, the marital deduction is not available at all, even with a QDOT or treaty. Instead, gifts to non-citizen spouses are eligible for an annual exclusion similar to the normal annual exclusion for citizens who give gifts to people other than their spouse: an inflation adjusted amount, currently $14,000 annually. (When gifting their spouse a citizen can use the unlimited exclusion). Instead of only $14,000, however, the annual exclusion for gifts to noncitizen spouses (whether RA or NRA) is an inflation adjusted figure currently at $147,000. That may seem ample, but consider a situation such as wishing to put your spouse on title to your home. Interests in real property can far exceed that amount.
Estate tax treatment of the RA is also different since the normal rules for joint tenancy property do not apply to them. With a joint tenancy, the property transfers automatically to the survivor spouse. For citizens, at death of a joint tenant, only half of the property is considered to be transferred at death, so that only 50% of the property needs to be sheltered from tax. But this rule does not apply to the RA. Hence, if a citizen and RA have a joint property, and the citizen dies, 100% of the property will be considered to have transferred to the RA, and the entire amount will be included in the estate of the citizen, and 100% of the transfer will need to be sheltered form tax. This will use up a large part of the decedent’s exemption. One way to limit the consequence of this law is that- to the extent the RA can prove the Joint Tenancy property was theirs to begin with- by “tracing” – then it will not be considered to have been transferred.
Estate Taxation of Non- Resident Aliens
In contrast to citizens and RAs, the estates of NRAs are subject to U.S. taxation only as to transfers of property that have a U.S. “situs” – i.e., assets that are physically or legally in the U.S. Although the bulk of the NRAs estate will be taxed by, and under the laws of, their home country, there may be portions of the estate which will have to be administered in the US upon death, to ensure that US tax is paid. This may be an inconvenience for the estate executor or trustee, as well as a possible tax burden. And, more property may be considered to have U.S. situs than you might think.
Obviously, real property located in the U.S. will be subject to U.S. estate tax. It frequently happens that a nonresident alien will purchase a second home in the U.S. without realizing that it will be subject to estate tax in the U.S. Tangible personal property in that home – or elsewhere in the U.S.- is likewise subject to taxation.
What is less obvious is that shares of stock issued by a U.S. corporation have U.S. situs, even if the stock certificate is located elsewhere. Interests in U.S. partnerships and LLCs will probably be similarly treated, particularly if the company does business in the U.S. or owns property here. Debt obligations owed to the NRA by a “US person” (which includes government or corporate bonds) are subject to U.S. estate tax. The proceeds of a life insurance policy owned by a U.S. citizen or resident, or on the life of a citizen or resident, are subject to U.S. estate tax when paid to an NRA. Whether bank deposits in a U.S. bank will be taxed is subject to complex rules which and must be reviewed specifically. A beneficial interest in a trust holding U.S. situs assets is subject to U.S. estate tax. So, consider carefully your estate and investment decisions when dealing with US assets.
Although much property may be subject to U.S. estate taxation, there are fewer U.S. deductions and exemptions available to the NRA to offset any tax. For example, instead of the $5.45M estate tax exemption available to US Persons (citizens and RAs), the NRA is entitled to only a $13,000 credit against estate tax due – which effectively shelters only $60,000 in US situs property. If property owned is above that amount, then an estate tax return must be filed, and estate tax will be due.
For purposes of the marital deduction, the NRA is treated similarly to an RA: the marital deduction is only available if there is a QDOT or treaty allowing it. The NRA is also treated the same as the RA in two other respects: for purposes of joint tenancy and gift tax. Joint property will be considered 100% transferred, unless proven otherwise by “tracing”; and, there is no marital deduction for lifetime gifts, only the $147,000 annual exemption.
When planning the estate of an NRA, or even financial planning in general, it is wise to plan carefully in light of all of the difference in tax treatment that they are subject to.
1 Accordingly, if the RA is a citizen of any of the following countries, it is strongly urged that they refer to the treaty in effect before making any estate planning decisions: Australia, Austria, Belgium, Canada, Denmark, Finland, France, Germany, Greece, Ireland, Italy, Japan, The Netherlands, Norway, South Africa, Switzerland and the United Kingdom