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Wednesday, March 21, 2007

QDOTs

Qualified Domestic Trust (QDOT) – A QDOT is a statutorily created trust designed to allow a non-citizen widow or widower qualify for the unlimited marital deduction. See I.R.C. §2056A.

1. Other than the citizenship requirements:
a. A QDOT must qualify for the marital deduction as provided for in §2056.
1) Although I.R.C. §2056A does not expressly mandate the distribution of trust income to the spouse, the IRS has stated in letter rulings that a QDOT must also meet the general marital deduction requirements of Sec. 2056. Accordingly, a QDOT should provide that all income is distributable to the surviving non-citizen spouse.
b. The trustee of the QDOT must be a citizen of the United States and possibly even a corporate trustee depending upon the size and types of assets involved.
1) A “large QDOT” is a QDOT with assets in excess of $2,000,000.
i At least one of the trustees must be a U.S. bank or a trust company; or
ii 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.
2) A “small QDOT” is a QDOT with assets less than $2,000,000.
i There must be either a U.S. bank or a trust company as the trustee; or
ii No more than 35 percent of the trust assets can be real property located outside the United States.
c. As funds are paid out from the trust, the estate tax must be paid on each distribution and the trustee must have the right to withhold the taxable amount.
1) Income distributions from a QDOT are not subject to the estate tax;
2) A surviving non-citizen spouse may also be eligible for a hardship exemption.

2. Planning Considerations
a. To avoid the difficulties associated with QDOTs, it is advisable for clients to make use of the $100,000 gift tax exemption (indexed for inflation, making it over $134,000 in 2010) available for transfers to a non-citizen spouse. Other planning tools such as ILITs should be considered.
b. A QDOT need not be created in the decedent’s Will (or in a revocable living trust); it may be created by the surviving non-citizen spouse provided it is funded prior to the due date for the federal estate tax return.
c. Citizenship – 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:
i 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
ii the United States trustee notifies the IRS that the surviving spouse has become a U.S. citizen.
iii Note: Special rules apply if the QDOT had already made taxable distributions. See Treas. Reg. § 20.2056A-10
d. 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. See also Treas. Reg. §20.2056A-4(c) for alternatives on handling non-assignable annuities and other such assets.
e. Joint property owned by the decedent and the non-citizen spouse will follow the rules established under I.R.C. §2040(a), which basically states that the asset will be includible in the gross estate of the person who paid for the asset. I.R.C. §2040(b), which provides an exception to married couples, does not apply.
f. The QDOT should only be funded with assets in excess of the federal estate tax limit, not in excess of the New Jersey estate tax limit (unless the spouse decides to become a citizen before any distributions are made from the trust).

3. Tax Consequences
a. The QDOT should be taxed as a simple trust for income tax purposes.
b. The assets transferred into the QDOT are eligible for the unlimited marital deduction.
c. Each distribution from the QDOT triggers the federal estate tax.
d. Form 706-QDT must be filed annually to report the amount in the trust as well as the distributions made from the trust.
e. A non-citizen spouse cannot use the applicable exclusion amount to shelter any distributions of principal from a QDOT, because 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.
f. A non-citizen spouse cannot use the applicable exclusion amount to shelter assets in a QDOT from estate taxes upon his or her death. However, the surviving non-citizen spouse may use the applicable exclusion amount ($2 million in 2006) to shelter his or her own assets from federal estate taxes.
f. The 2001 tax act (known as "EGTRRA") now provides that even though the Federal Estate Tax may be abolished, if assets pass to a QDOT as a result of a death before the phase-out is complete, the assets in the QDOT will be taxable upon withdrawal until December 31, 2020.

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Minor updates made on December 14, 2010.

23 comments:

Expat One said...

I was of the understanding that a QDOT was only necessary for estates over $2M and that a U.S. citizen could transfer up to $2M (current estate tax exemption) to his/her non-citizen spouse tax free. Is that not correct? Thank you.

Kevin A. Pollock, J.D., LL.M. said...

You are correct Expat One. I think you ask the question because I discuss small and large QDOTs. It comes into play as follows:

1) If a decedent has $3,500,000, the first $2,000,000 can go to the non-citizen spouse tax free. The remaining $1,500,000 may be placed in a small QDOT.
2) If a decedent has $5,000,000, the first $2,000,000 can go to the non-citizen spouse tax free, but the remaining $3,000,000 must go in a large QDOT.

Hope this helps.

Need2know said...

My nonresident alien spouse and I jointly own a house and other assets like joint bank accounts. I was the $ source of some assets. Your wrote "Joint property owned by the decedent and the non-citizen spouse will follow the rules established under I.R.C. §2040(a)" saying my estate will include these items. Can I give $100,000 worth of assets each year to my spouse? For a $300,000+ house, how can I do this?

Kevin A. Pollock, J.D., LL.M. said...

Need2know:

Did you mean nonresident alien spouse or resident alien spouse? If he/she is not living in America, then he/she is a nonresident alien. Immigration permission is irrelevant to the IRS.

For calendar year 2008, you may gift up to $128,000 to a non-citizen spouse. Again, it is irrelevant if the spouse is a resident or non-resident alien. For threshold limits, see: http://www.irs.gov/pub/irs-drop/rp-07-66.pdf

For a house, the easiest way to accomplish this is to redo the deed putting your spouse on the deed and then file a Form 709 federal gift tax return. The Form says that you do not have to file if you give less than the annual exclusion amount, but you should still file it if you want to prove the gift was made.

If you stay under the annual exclusion amount, there will be no federal tax consequences. Unless you are in a state that taxes gifts, there will be no cost for the transaction other than hiring someone to do the deed or return for you.

Anonymous said...

Your January 6 example is very interesting.

Where is the legal support for this?

Kevin A. Pollock, J.D., LL.M. said...
This comment has been removed by the author.
Kevin A. Pollock, J.D., LL.M. said...

In the IRS Treasury Regulations Section 20.2056A-2(d).

Walsh McGuire said...

What about life insurance and Life Insurance Trusts? Should life insurance still be placed in a LIT, and then a QDOT be established w/in 12 months of the US citizen spouse's passing, or should life insurance be placed directly in a QDOT, which would require a QDOT being established and maintained for the US citizen spouse's lifetime?
Thanx!

Kevin A. Pollock, J.D., LL.M. said...

Dear Walsh,

Sorry for the slow feedback - it got lost in the Thanksgiving shuffle.

The ILIT and QDOT are two totally separate and distinct animals. If a person has a taxable estate that includes life insurance, an ILIT is the first thing to do. After that, if the estate still is taxable, then a separate QDOT can be created for the amount over the federal estate tax.

I don't think I need to say this - but if a spouse has already died, it is too late to do an ILIT...

If you are telling me that a US spouse died within 3 years of a policy being transferred into a ILIT, making it includible in the decedent's taxable estate, then the amount of the QDOT would certainly go up as a result.

Anonymous said...

Would my non-citizen spouse have to pay any taxes (including income tax) if she inherited about $2Million from my IRA?

Anonymous said...

According to the fed gift tax form #709, I do not need to file it for my planned gift of $100,000; but you recommend filing the form anyway to prove gift was made? If I give gift in January 2009 before filing 2008 tax forms, can I claim the gift for tax year 2008? Thank you.

Kevin A. Pollock, J.D., LL.M. said...

Dear Anonymous,

The gift tax return should not be filed for 2008 if the the gift was made in the 2009 the calendar year. It should be filed on a 2009 gift tax return.

Kevin A. Pollock, J.D., LL.M. said...

Anonymous said...

Would my non-citizen spouse have to pay any taxes (including income tax) if she inherited about $2Million from my IRA?
-----------------

Dear Anonymous,

I get to answer this with a lawyer's favorite answer... it depends:

1) It depends on whether the IRA is rolled over into your spouse's name or withdrawn (income tax);
2) It depends when the spouse dies or died (the estate tax is constantly changing - the exemption amount just went up to $3.5 million from $2 Million);
3) It depends what state you are in (there may be state estate taxes).

taxedtodeath said...

I'm a U.S. citizen with a non-resident alien spouse. She is "beneficiary upon death" of my Roth IRA. If I die first, is she subject to federal estate tax on the Roth, or to federal income tax on qualifying Roth distributions?

Thanks

Kevin A. Pollock, J.D., LL.M. said...

Dear TaxedToDeath,

I assume that you live in a country other than the United States, otherwise you would have a Resident alien spouse rather than a non-resident alien spouse.

If you do not live in the US, the answer is really quite tricky because it depends upon where you live and whether there is an estate tax treaty with the country in which you reside.

If you live in the US, then yes, the US can tax the ROTH as part of your estate (assuming the federal estate tax comes back into existence).

The good new is that since you have already paid income tax on the ROTH, there would not be an additional federal income tax on the withdrawals, regardless of who withdraws from it.

Anonymous said...

In New York and New Jersey- With respect to a QDOT, is it possible to pay the Trustee Commissions out of the trust's principal rather than property distributed to the spouse to avoid the additional tax?

Kevin A. Pollock, J.D., LL.M. said...

Dear Anonymous,

Trustee commissions are charged on both income and principal and they must be allocated accordingly.

So yes, it would be a deduction, but whoever receives the commission would have to report it as income.

Anonymous said...

Can a resident alien spouse serve as trustee of an ILIT

Kevin A. Pollock, J.D., LL.M. said...

There are very few restrictions on who can be trustee of a properly drafted ILIT. The trustee needs to have capacity and be at least 18 years of age. There is no residency or citizenship requirement.

Anonymous said...

I would like to include a provision in the QDOT whereby a small portion of the net income can be distributed to our children, the rest to my non-resident alien spouse. Will that affect anything?

Kevin A. Pollock, J.D., LL.M. said...

Dear Anonymous,

You can NOT name the children as an income beneficiary of a QDOT because then it will not be entitled to the marital deduction. Remember, the way an estate plan works is that a person's estate is divided into two portions, the bypass portion (currently $5,000,000) and then anything in excess of the bypass portion, known as the marital share. For citizens spouses, this can simply be put into a marital trust. For non-citizen spouses, you must set up the QDOT. Since it is for the benefit of spouses only, naming a child as a partial beneficiary will ruin the tax benefits. The children can have all or a part of the first $5,000,000.

PRTaxFrustration said...

I am a US Citizen but was born in Puerto Rico. This is also true for my spouse. I believe that although I am a US Citizen while alive, that the moment I pass away I'm considered a Foreign National by the United States and am therefore subject to estate tax on every asset I own in the US. I have considered using a QDOT to pass assets to my spouse in order to get the marital deduction.

1) Would the QDOT have to be funded prior to my death?

2) Is there a certain amount of estate exempted from estate tax for a foreign national?

3) Would the transfer of assets through a QDOT to my spouse circumvent Puerto Rico Civil Code requirements to distribute 50% of my estate at death?

Thanks!!

Kevin A. Pollock, J.D., LL.M. said...

Dear PRTaxFrustration,

I'm sorry, but unfortunately I am not licensed in Puerto Rico and I have very little knowledge of the laws with respect to it. I strongly recommend that you find a local attorney with an advanced tax degree. Good luck.