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Tuesday, December 14, 2010

The New Jersey QDOT Trap - Revised

When a person dies, the surviving spouse can receive all of the decedent's money free of tax, but only if the surviving spouse is a citizen of America. If the surviving spouse is not a U.S. citizen, anything over the estate tax exemption amount is subject to an estate tax. One way to avoid paying a tax on money going to the benefit of a surviving non-citizen spouse is to set up a Qualified Domestic Trust (QDOT).

With the ever increasing federal estate tax exemption, and the fact that we do not have a federal estate tax in 2010, most practitioners are not giving much thought to the use of QDOTs. This is because many practitioners are trying to avoid the large federal estate tax and not the smaller NJ Estate tax. If the estate is not going to be subject to the federal estate tax, the thinking is that there is no need to set up a QDOT for the surviving spouse.

Unfortunately, New Jersey has a little known rule that subjects the estate of a decedent to the New Jersey Estate tax if assets in are being left to a non-citizen spouse. This could create a significant tax on the death of the first spouse and another tax when the surviving spouse dies as well.

To avoid the NJ Estate tax, a QDOT can be set up for the surviving non-citizen spouse to deal with assets passing to him or her. Normally, if a QDOT is set up, almost all distributions other than income distributions and distributions for hardship will be subject to the federal estate tax. However, it appears that according to Treasury Regulation 20.2056a-6, the federal estate tax would not kick in until after the original decedent's exemptions are used up.

If the surviving spouse intends on becoming a citizen shortly after the first spouse passes, the QDOT can be dissolved with no tax consequences provided no disqualifying distributions were made.

The New Jersey QDOT trap only applies to decedents who own more than $675,000 at the time of their death and who were married to non-citizen spouses. However, when calculating the size of a decedent's estate, New Jersey will look at all of the decedent's assets, including retirement accounts, life insurance homes, stocks, bonds, etc.

(Note: it does not matter if the decedent is a citizen or a permanent resident alien. What is important is the citizenship of the surviving spouse.)

REVISION NOTE: This posting was revised on October 19, 2011 to correct errors and make clarifications.


K. Birkhead, Esq. said...

Interesting post, thank you for writing on a little-covered topic.

One comment/question: under the scenario you lay out, wouldn't the estate tax payable at the federal rates apply only to the amount not covered by the unified credit? (or, for a dedecent dying in 2010, not at all?) The code refers to the tax which would have been imposed had the estate been increased by the amount of the improper distribution.

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

Dear K. Birkhead,

My reading is that there would be a federal estate tax due for everything in the trust when the surviving spouse dies or when principal distributions are made.

Think of it this way, when it goes into the QDOT, you MUST claim the benefit of the marital deduction and the unified credit is lost (just as if it were an outright gift to a surviving spouse prior to portability).

If you claim the federal unified credit, you have to pay the NJ estate tax because you cannot put it into the QDOT. Hence, the trap.

K. Birkhead, Esq. said...

Thank you for your response. I think you're right. The outstanding question, then, is what happens to a QDOT established by the spouse of a decedent passing away in 2010? There's no federal estate tax to go back to upon a taxable event. It seems to me that the transfer would be essentially free of federal and NJ tax.

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

Theoretically, I think if you set up a QDOT in 2010 it would be subject to the federal estate tax on all distributions other than income. I don't see why it wouldn't.

K. Birkhead, Esq. said...

Under section 2056A, the tax on QDOT distributions is the additional estate tax that would have been due if the distribution amount was added to the first decedent's estate. If the first spouse to die died in 2010, there was no tax on the decedent’s estate. The code makes reference to the rates in section 2001, which section was effectively repealed for 2010. Based on this, to me there would be no way to tax distributions from a QDOT established under the estate of a decedent dying in 2010. Am I missing something?

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

Dear K. Birkhead,

I want you to know that I've been avoiding my blog because of questions like your last one:)

I agree that there is certainly an excellent argument to be made that the rate would be 0% - but only for the year 2010.

I honestly don't know if there is a clear answer to your question and luckily I do not have to personally deal with it.

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

K. Birkhead,

I don't know if you are still following this, but this topic came up with another attorney and I discovered Treasury Regulation 20.2056A-6. This appears to directly contradict my earlier interpretation that you have to choose between the applicable exclusion amount and the marital deduction.

It appears that there is only an estate tax after all credits of the decedent are used up. Look at example 1 (ii). Accordingly, it seems to make even more sense to set up QDOT for a surviving non-citizen spouse in NJ as future distributions can be shielded from the federal estate tax up the the applicable exclusion amount.

I will be revising the post in its entirety.

Patricio Suarez, JD LLM said...

Can I argue that it is unconstitutional for NJ to tax a citizen and non-citizen differently, i.e. to allow a marital deduction to one but not the other? The Federal government has a rational basis to require a QDOT, since the non-US person can leave the country, but what rational basis does NJ have to force a QDOT if the estate is less than 5M? Citizen or not, NJ cannot tax a resident who changes domicile? At first blush, we all look to the Federal return to determine the proper state estate tax, but are we overlooking something here?

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

Dear Patricio,

Thank you for your post. You can certainly try to make that argument, but I don't know if non-citizens are entitled to equal protection under the law.

As a practical matter, none of my clients have wanted to spend the money on a challenge. It is cheaper to set up a QDOT, become a citizen, and then dissolve the QDOT.

Heitor David Pinto said...

Everyone physically in the United States, including citizens, legal immigrants, tourists, students and even illegal immigrants, are entitled to equal protection. The only exception is foreign diplomats, who have immunity and thus are not under US jurisdiction.

Patricio's argument is valid and supported by precedent. See Graham v. Richardson (1971). States can't even deny welfare benefits to legal residents based on citizenship, so a tax, which involves a basic right (property) rather than a privilege (welfare), can't be based on citizenship either. In fact, I argue that it's unconstitutional even for the federal government to tax citizens and aliens differently. According to Graham v. Richardson and other cases, fiscal integrity can't justify creating invidious distinctions. Since citizens can leave the country as well, the rational basis is not valid.

As Kevin suggested, no one has ever challenged this for practical reasons. But if a client happens to prefer a judicial route rather than a QDOT, I believe the argument is valid.