Estate and Gift Tax Planning For Non-Citizen Spouses
Article Date: Monday, October 22, 2012
Written By: Gregory Herman-Giddens
This article provides an overview of the federal gift and estate tax laws affecting transfers to non-citizen spouses, common inter vivos property transfers between spouses that can inadvertently trigger negative tax results when the recipient spouse is not a U.S. citizen, and a review of planning techniques that can be used to reduce or defer such taxes.
Gift and Estate Tax: General Rules for U.S. Citizen Spouses
United States gift and estate tax laws apply to all property of U.S. citizens and residents, wherever that property is located worldwide. See generally 26 U.S.C. § 2001; 26 U.S.C. § 2501. U.S. citizens and permanent residents generally receive the benefit of the federal gift and estate exemption of $5.12 million (2012). However, the application of transfer tax laws to property given to a spouse differs depending upon the citizenship of the spouse receiving the property. Where the donee spouse is a U.S. citizen, property passing to the spouse normally qualifies for the unlimited marital deduction, so that the transfer is free of estate or gift taxes. When the spouse receiving the property is not a U.S. citizen, the same marital deduction rules do not apply. Consequently, property received by a noncitizen spouse during the life of the U.S. citizen spouse or at the U.S. citizen spouse’s death may be subject to substantial taxes that U.S. citizen couples do not have to face.
Congress Changes the Rules for Noncitizen Spouses
The Economic Recovery Tax Act of 1981 (ERTA) provided for an unlimited marital deduction for property passing to a surviving spouse regardless of citizenship, deferring payment of all estate taxes until the death of the surviving spouse. Within a decade of ERTA’s passing, however, Congress discovered that as an unintended result of this unlimited marital deduction, noncitizen spouses were able to return to their native country after a citizen spouse’s death and thereby avoid paying U.S. estate taxes on what was the citizen spouse’s property. In response, Congress passed the Technical and Miscellaneous Revenue Act of 1988 (Act), which repealed the estate tax marital deduction for property passing to noncitizen spouses. The Act also repealed the gift tax marital deduction for lifetime transfers to a noncitizen spouse. After the Act’s passage, couples in which one or both spouses were noncitizens suddenly faced the possibility of having to pay estate taxes upon the first spouse’s death, as well as gift taxes for unintentional gifts when spouses purchased real property as joint tenants or tenants by the entirety.
Federal Gift Tax Rules for Noncitizen Spouses – No Marital Deduction
In contrast to the unlimited gift tax marital deduction available to couples in which both spouses are U.S. citizens, there is no marital deduction for gifts to noncitizen spouses. Instead, Congress addressed the potential for imposition of significant gift tax on transfers to noncitizen spouses by increasing the gift tax annual exclusion amount for gifts to noncitizen spouses to $100,000, indexed for inflation pursuant to 26 U.S.C. Section 2503(b)(2). In 2012, the “super” annual exclusion amount is $139,000. Only a present interest gift, or the portion of a gift consisting of a present interest, qualifies for the exclusion.
Federal Estate Tax Rules for Noncitizen Spouses
Marital Deduction Is Not Available Unless Property Passes to QDT.
While a U.S. citizen spouse can benefit from the unlimited marital deduction to receive tax-free assets from a decedent spouse, the marital deduction is not available for property passing from a decedent spouse to a noncitizen spouse unless the property is paid to a Qualified Domestic Trust (QDT). 26 U.S.C. § 2056(d). At death, a citizen spouse can transfer to a noncitizen spouse property worth up to the estate tax exemption amount free of tax, either outright or in trust. The estate tax exemption for 2012 is $5,120,000 with a 35% tax rate, but on January 1, 2013, barring congressional action, this exemption will decrease to $1,000,000, with a 55% top rate. Property passing to a noncitizen spouse that exceeds this amount must be transferred to a QDT in order to qualify for the marital deduction, and unlike a standard marital trust, a QDT simply defers estate tax rather than possibly eliminating it altogether.
QDT Qualification Requirements. In order to qualify for the marital deduction, the transfer of property to a QDT must meet several requirements. First, a decedent’s estate plan must transfer property directly to a trust for the benefit of the surviving spouse that qualifies for the marital deduction and QDT election, with the decedent’s executor making a timely QDT election. For a QDT to qualify for the marital deduction, it must also satisfy the requirements of IRC Section 2056(b)(5) (life-estate power of appointment trust) or Section 2056(b)(7) (QTIP trust). Alternatively, the surviving noncitizen spouse could transfer some or all of the assets he or she receives from the decedent at death into a QDT established after the decedent spouse’s death. However, in this case the surviving noncitizen spouse must irrevocably assign this property to the QDT before the due date for the decedent’s federal estate tax return, and timely election by the executor is required. Regardless of whether the decedent spouse or the surviving noncitizen spouse forms the QDT, at least one trustee must be an individual U.S. citizen or domestic corporation; but the rules do not prohibit the surviving spouse from serving as co-trustee.
Finally, estate tax is payable on taxable events, including principal distributions from the QDT to the surviving noncitizen spouse, with the balance of the trust value being taxed upon the noncitizen spouse’s death. The trust instrument must require that the U.S. trustee have the power to withhold estate tax from principal distributions to the surviving spouse. Exceptions are recognized for distributions of “income” and on account of “hardship.” For large QDT’s (generally in excess of $2 million at the time of the decedent’s death), additional measures must be taken to ensure the collection of Section 2056A estate taxes. One way to satisfy this security requirement is to structure the trust to require that a U.S. bank always serve as trustee, while allowing the surviving spouse the power to remove or replace the bank as well as serve as co-trustee. See M. Read Moore, “Practical Estate Planning Techniques for Noncitizen Spouses,” 26 Est. Plan. 205, 208 (1999).
Jointly-Owned Property in Non-Community Property States
Gift Tax Treatment. Generally, the creation of a joint tenancy or tenancy by the entirety between spouses is not a taxable gift. However, the establishment of a property interest held jointly with a noncitizen spouse is treated differently. With personal property, the general contribution rule applies. Under the general contribution rule for personal property, there is a taxable gift to the extent that one spouse provides consideration in excess of the value of the right retained by that spouse. Gift tax is due on the share that the noncitizen spouse receives in excess of the amount that spouse proportionally contributed at the creation of the joint ownership. For example, a citizen spouse who purchases a car with his or her own funds and includes both spouses’ names on the title has made a gift of one-half the value of the car. For most couples, the super annual gift tax exclusion should cover the majority of personal property transactions.
With regard to joint ownership in real property, creation is a taxable gift subject to potential relief through the super annual exclusion (if 26 U.S.C. Section 2515 and its principles were in effect at the time of creation). For joint ownership established in 2012 where a present non-terminable interest gift is made to the noncitizen spouse, the donor spouse is allowed a $139,000 exclusion. For joint interests in real property created when Section 2515 was not in effect, and for gifts in excess of the annual exclusion, the general contribution rule applies. Thus, a citizen spouse who purchases a $500,000 home with his or her own funds and then adds a noncitizen spouse’s name on the deed might unintentionally make a taxable gift of $111,000 (one-half of the value of the house less the $139,000 annual exclusion).
If the joint interest was created between 1955 and 1981, Section 2515 provided that such creation was not a transfer for gift tax purposes, and deferred taxation until termination of the interest. A gift upon termination occurs if the proceeds received by the noncitizen spouse upon termination of the joint interest exceed the proceeds that spouse contributed upon the creation of the interest. Termination of joint ownership can result from the conveyance of property from the spouses as joint tenants or tenants by the entirety to the noncitizen spouse alone or to both spouses as tenants in common. The same result occurs if both spouses sell the property to a third party and use the proceeds of the sale to purchase another house in joint names.
In these circumstances, the termination will result in a gift by the citizen spouse receiving a smaller share of the proceeds than that attributable to the consideration that spouse gave. For example, the transfer of a house owned as joint tenants or tenants by the entirety (purchased with funds belonging only to the citizen spouse) to both spouses as tenants in common results in a gift of one-half of the value of the house to the noncitizen spouse. In contrast, where each spouse contributes one-half of the purchase price of a house owned as joint tenants or tenants by the entirety, then a subsequent transfer to both spouses as tenants in common does not result in a taxable gift; transfer to the noncitizen spouse in his or her sole name results in a gift of one-half the value of the house.
Even where creation of the joint ownership in real property is treated as a taxable transfer, it is still possible for termination to result in a taxable gift. This occurs where one spouse receives proportionately more as a result of the termination than the value of the interest that he or she surrenders at termination.
Estate Tax Treatment. Generally, where property is held with a spouse jointly with rights of survivorship, one-half of the value of the property is included in the estate of the first spouse to die, regardless of how much the surviving spouse contributed when the joint interest was created. However, where the surviving spouse is a noncitizen, the contribution rule dictates that the decedent U.S. citizen spouse’s gross estate includes the entire value of the property owned jointly with the noncitizen spouse, except to the extent that the surviving spouse furnished consideration for the property. 26 U.S.C. § 2056(d)(1)(B); Treas. Reg. § 20.2056A-8(a)(1). The practical effect of such a rule is that the full value of the property is taxed twice: first at the death of the decedent U.S. citizen spouse, then at the noncitizen spouse’s death. The surviving noncitizen spouse can avoid this double taxation for transfers that take place by operation of law, such as through right of survivorship provisions, by transferring the property to a QDT before the deadline for the decedent spouse’s federal estate tax return.
Post-Mortem Relief under Gift Tax Rules. Notwithstanding the unfavorable estate tax treatment of property held jointly with a noncitizen spouse, surviving noncitizen spouses might find some post-mortem relief through the gift tax rules. Depending on how the decedent U.S. citizen spouse treated his or her consideration toward the creation of the joint property interest, it is possible that the surviving noncitizen spouse could lessen the amount of estate taxes due on the jointly-owned property. For deceased citizen spouses who furnished consideration for jointly-owned property prior to July 14, 1988, the consideration will be attributed to the noncitizen surviving spouse to the extent that such consideration was treated by the decedent spouse as a gift under 26 U.S.C. Section 2511, or to the extent that the decedent elected to treat it as a gift under 26 U.S.C. Section 2515 at the time the joint tenancy was created. A donor citizen spouse will be considered to have treated consideration toward jointly-owned property as a gift under 26 U.S.C. Section 2511 if the donor retained no dominion or control over the transferred interest, thus making it a complete gift, and if the recipient furnished no consideration. Thus, in either situation, only the value of the joint tenancy property that was treated as having been retained by the donor spouse will be included in his or her estate for estate tax purposes.
Estate Planning Strategies
No Special Planning. For some couples, taking no additional steps beyond the typical techniques used to create estate plans for married couples might be the preferred option. In this case, the surviving noncitizen spouse will have to pay death taxes on all the property he or she receives from the decedent U.S. citizen spouse in excess of the exemption amount. Requiring the surviving noncitizen spouse to pay estate tax will impose an additional burden on the surviving noncitizen spouse not faced by surviving U.S. citizen spouses, and it could significantly deplete the pool of assets available to the surviving noncitizen spouse for living expenses.
Yet, by receiving the estate assets directly rather than in trust, the noncitizen spouse maintains greater flexibility, including the freedom to leave the U.S. with all the assets upon the citizen spouse’s death. If a noncitizen spouse stays in the U.S. following the decedent spouse’s death and thus remains subject to the U.S. transfer tax system, these assets will most likely be taxed on his or her death as well. Some relief may be obtained by the credit provisions of 26 U.S.C. Section 2013 - if the surviving noncitizen spouse dies within ten years of the decedent spouse, the credit for tax on prior transfers under Section 2013 may reduce taxes owed upon the noncitizen spouse’s death.
When a couple opts not to engage in special estate planning, it is imperative to fully consider the tax ramifications, particularly if the decedent’s estate lacks liquid assets. Practitioners should make sure that clients are aware that the proceeds of life insurance owned by the citizen spouse will be included in his or her taxable estate and can substantially increase the amount of estate tax owed. The source of payment of tax becomes an important consideration; it may make sense to apportion tax among the various assets rather than paying it all from the residuary, as doing so could exhaust the estate’s residue. See M. Read Moore, “Estate Planning in Depth: Answers to Your Questions About International Estate Planning,” American Law Institute, American Bar Association Continuing Legal Education 125, 231(June 12-17, 2011).
Lifetime Transfers. For couples whose total assets do not significantly exceed twice the amount of the estate tax exemption, equalizing assets between spouses can help to avoid wasting either spouse’s federal estate tax exemption. In contrast, couples with larger estates might want to rearrange assets to give the noncitizen spouse more than one-half of the property; doing so will ensure that there will be less property subject to estate taxes and QDT rules upon the citizen spouse’s death. Effectuating this property division requires careful planning due to the lack of the gift tax marital deduction for transfers to noncitizen spouses.
By taking advantage of annual exclusion gifting, a couple can increase the noncitizen spouse’s assets and thus minimize the estate taxes that the noncitizen spouse will have to pay upon the citizen spouse’s death. However, in order to pass large tax-free sums to his or her noncitizen spouse, this strategy requires the U.S. citizen spouse to make annual gifts over a long time period. See Michael J. Stegman, “The Noncitizen Spouse: Implications for Estate Planning and Administration,” 19 Ohio Probate L. J. 127 (2009).
An annual gifting strategy is most easily accomplished where the U.S. citizen spouse owns significant assets in his or her sole name that can be divided and valued easily, such as publically traded securities. With real estate, transferring the property to a limited liability company and making percentage interests gifts may be most expedient. For the transfers to qualify for the annual exclusion, however, the LLC operating agreement must mandate income distributions to the members or otherwise provide present interest rights.
Instead of outright gifts, couples should consider funding a lifetime qualified terminable interest property (QTIP) trust for the benefit of the noncitizen spouse which includes a Crummey withdrawal power for the noncitizen spouse. This will qualify transfers up to the annual exclusion amount as a present interest, thus satisfying the condition in 26 U.S.C. Section 2503(b) that gifts of future interests are not eligible for the annual exclusion. A lifetime QTIP trust also provides protection against creditors and allows the donor citizen spouse to exercise control over the ultimate disposition of the assets.
In addition to an annual gifting strategy, couples might make the noncitizen spouse the owner of any life insurance policies on the citizen spouse, as this will enable the noncitizen spouse to receive the death benefits free of estate taxes. The same result can be achieved through the use of an irrevocable life insurance trust; upon the citizen spouse’s death, the trust will receive tax-free cash that will be available to the noncitizen spouse free of QDT rules. This technique also avoids possible estate tax at the surviving spouse’s death. Alternatively, the citizen spouse could keep the noncitizen spouse as primary beneficiary of the policy with a provision that the death benefits will pass to the citizen spouse’s estate or trust upon death in the event that the noncitizen spouse predeceases the insured. If the noncitizen spouse survives the insured citizen spouse, the surviving spouse will be able to decide how he or she wishes to receive the death benefits: outright with payment of estate taxes, disclaimed and passing to an established QDT, or outright and transferred to a QDT created post-mortem with terms of the surviving spouse’s choosing.
For the citizen spouse’s insurance policies, qualified plans, and IRAs, naming the QDT as beneficiary will ensure receiving the benefit of the marital deduction. Alternatively, the noncitizen spouse could take a lump-sum distribution and pay death taxes on the distribution, or disclaim and allow the contingent beneficiary to receive the death benefits. For IRAs, the surviving noncitizen spouse could also assign the death benefits to a spousal IRA in a QDT-qualifying trust. For non-assignable annuities, pensions and other accounts, the noncitizen surviving spouse must take extra steps to obtain a marital deduction. This includes making an agreement with the IRS either to (1) pay Section 2053A estate tax on the corpus portion of each payment, subject to the hardship exception, or (2) transfer the corpus portion of each payment to a QDT, subject to the hardship exception.
For certain assets like real property and business interests, there are clear advantages to a transfer to the noncitizen spouse during the citizen spouse’s life. Rearranging ownership of these interests through lifetime transfers, as opposed to waiting to assign them to a QDT after death, will allow the noncitizen spouse to retain greater control over these assets. Likewise, foreign situs property that cannot be transferred to a trust or held by a U.S. trustee under the laws of the situs country should be transferred to the noncitizen spouse during the citizen spouse’s life.
Gift Splitting. For couples who wish to benefit children or other family members, gift splitting provides another means of limiting the amount of gift and estate taxes that the noncitizen surviving spouse will have to pay upon the citizen spouse’s death. Under 26 U.S.C. Section 2513, a citizen spouse can elect to have inter-vivos gifts to third parties treated as being made one-half by each spouse. This strategy effectively utilizes the noncitizen spouse’s unified credit as well as the generation-skipping transfer tax exemption. Significant gifts can be made to third parties, including children, thereby removing the property from the citizen spouse’s taxable estate. However, gift splitting is not available where one spouse is a non-resident alien unless a gift tax treaty provides otherwise.
Transfers Subject to Valuation with Reference to Actuarial Tables. Citizen spouses can also reduce the value of property subject to tax by utilizing gift tax provisions that allow for a gift of the future right to receive property. These rules base the gift tax values for these transfers on the present actuarial value of the noncitizen spouse’s future right to receive the property, which can be significantly less than the current value of the property itself. The qualified personal residence trust (QPRT) is a common method of actuarial-based gift, allowing the donor to make a gift of the family residence while continuing to live in the house past the end of the QPRT term. The donor spouse’s estate will not incur any tax under Section 2036 as long as the donor retained no legal right to possession of the residence at the time of his or her death.
Testamentary Disposition: Outright versus QDT. In addition to lifetime transfers, couples must also decide how the surviving noncitizen spouse will receive any property remaining in the decedent citizen spouse’s estate. Leaving assets to the surviving noncitizen spouse in a QDT provides the gift and estate tax advantages discussed above, yet it also subjects the surviving spouse to limitations on the use of assets transferred into the trust. While transferring assets to a surviving noncitizen spouse outright may trigger estate tax, it also allows greater control for the survivor. The surviving spouse could opt to pay the estate tax and avoid the limitations that would otherwise be imposed by a QDT established by the citizen spouse prior to death, or else could transfer the assets to a post-mortem QDT or a reformed QDT with terms that the surviving spouse prefers. This option easily provides for the possibility that the estate tax laws will change prior to the citizen spouse’s death, offering more favorable treatment for transfers to noncitizen spouses. A plan that provides for an outright distribution to the non-citizen spouse, but also contains a QDT to be funded by disclaimer allows for post-mortem planning flexibility without placing the burden on the surviving spouse to engage in complex trust formation in a time of grief.
Post-Death QDT Election. Even if the citizen spouse fails to establish a QDT before his or her death, the surviving spouse can still obtain a marital deduction through post-death QDT election as long as such election is made on the last estate tax return filed before the due date or on the first return filed within one year after the due date if a timely return is not filed. To establish a QDT post-death, the surviving spouse must make sure that the trust satisfies the requirements to qualify as a QDT as well as irrevocably assign his or her right to receive the property prior to the due date for the decedent spouse’s federal estate tax return.
In addition to establishing a QDT after the decedent citizen spouse’s death, the surviving noncitizen spouse can also reform a marital trust that is not a QDT to meet QDT qualification requirements and thereby obtain the marital deduction. If reformation is pursued under the terms of the governing instrument, it must be completed by the due date for filing the decedent’s federal estate tax return; reformation pursuant to a court order must be commenced, but not completed, by this date.
Couples in which one or both spouses are noncitizens are subject to more restrictive federal gift and estate laws. Avoiding adverse tax consequences requires vigilance in structuring lifetime transfers and additional pre-or-post-mortem planning for ensuring optimum use of annual exclusion gifting, estate tax exemptions of both spouses, the estate tax marital deduction. Practitioners must be aware of the citizenship status of all their clients, as even seemingly simple matters like re-titling brokerage accounts or adding a spouse to a deed after marriage can have significant tax consequences when the recipient spouse is not a citizen. •
Gregory Herman-Giddens, JD, LLM, TEP, CFP is president of the Chapel Hill-based firm TrustCounsel, which also has offices in New York City and Miami. He expresses his appreciation to Samantha Reichle, a 3L at Duke Law School, for her substantial assistance in the preparation of this article.
Views and opinions expressed in articles published herein are the authors' only and are not to be attributed to this newsletter, the section, or the NCBA unless expressly stated. Authors are responsible for the accuracy of all citations and quotations.