As estate planning professionals, it’s our job to analyze our clients’ needs and objectives, and based on this “fact finding” to offer guidance, advice, solutions and planning opportunities. Often times, however, it is the question we don’t ask, and what the client doesn’t tell us, that leads to unintended results.
One such question for estateplanners concerns each client’s citizenship. The results of drafting a plan without knowing a client’s country of citizenship can be drastic. Current estate tax law imposes an immediate tax on assets passing to a spouse who is not a United States citizen. This estate tax can create substantial hardship for this surviving spouse and his or her children.
In drafting an estate plan for a married couple, our focus is on preserving and protecting the assets for the surviving spouse and children. Traditional planning for a family with assets above the estate-tax-free, unified-credit amount (a $1,000,000 exemption beginning in 2002) entails trust planning that uses the unified credit of the first spouse to pass away. All assets in excess of the unified credit amount are typically passed outright to the surviving spouse or to a "marital type" trust. It is this excess of assets, above the unified credit amount, that is subject to tax when the spouse is not a U.S. citizen and is residing in the U.S. as a resident alien.
The citizenship issue
In 1988 Congress took steps to close what was perceived to be an inequity in the existing estate tax laws as they applied to non-U.S. citizens. Prior to 1988, the federal estate tax laws allowed an unlimited marital deduction, and accordingly the deferral of all estate taxes, when a spouse passed away leaving property to the surviving spouse. This unlimited marital transfer rule applied to all taxpayers, whether or not they were U.S. citizens. What Congress sought to eliminate was the tax avoidance that resulted when the surviving spouse was not a U.S. citizen, who, after inheriting the assets, would return to his or her country of origin. Since the property would no longer be in the U.S., upon the subsequent death of the surviving non-U.S. citizen spouse, the marital property that received the estate tax deferral would not be taxed in the U.S.
Congress’ solution was to eliminate the unlimited marital deduction when property passed from a U.S. citizen spouse to a noncitizen surviving spouse. This poses a dilemma for those leaving assets to a spouse who does not have U.S. citizenship because the federal estate tax rates are substantial.
When the marital transfer rules were changed for noncitizens, they were replaced with a rule which allows a spouse to transfer no more than $100,000 directly to a noncitizen spouse each year without incurring any tax.
To clarify, consider the following case study:
- For U.S. citizens: The husband and wife are both citizens and total assets consist of a marital home (owned jointly, with an equity value of $400,000) and husband’s retirement plan of $200,000. If the husband were to pass away, the wife can receive the home (by virtue of the joint ownership) and the retirement plan (by virtue of the beneficiary designation) as well as all assets (a total transfer from husband to wife of $400,000) free of any estate tax.
- For non-U.S. citizens: We will use the same assets, but in this case, the wife is not a U.S. citizen. When the husband dies, the wife will pay an immediate estate tax on the $400,000 transfer from the husband, less the $100,000 allowable deduction. Given that the two assets being inherited by the wife are real estate and a retirement plan, there is no ready cash with which to pay the estate tax on the $300,000 taxable transfer. This problem increases substantially if the husband also owned his own life insurance at the time of his death (i.e., the very common group-term life insurance from an employer). These insurance proceeds will be treated as a taxable transfer from husband to wife at the time of his death, thereby causing a substantial estate tax.
A key first step is to institute a gift-giving program in which the U.S. citizen spouse gifts property to the resident alien spouse. Tax law now allows a $100,000 per year gift tax-free transfer when property passes from a U.S. citizen spouse to a spouse who is not a citizen. By making these gifts, you can structure the estate in an effort to minimize the amount of assets passing to a spouse who is not a U.S. citizen. By “beefing” up the noncitizen’s assets, you minimize the eventual tax problem. Of course, increasing one spouse’s assets can raise issues in the event of a divorce or creditor problem.
- A second opportunity is to make sure assets are owned in a manner that will not create a taxable event upon death. For example, the noncitizen should own the life insurance on the spouse so that upon the spouse’s death, the owner of the policy is the non-citizen, who can then receive the death benefits free of any estate tax. This result can also be achieved by utilizing an irrevocable life insurance trust. Real estate and retirement plans may require the creative use of trusts and alternative forms of ownership to prevent an automatic inheritance by the noncitizen spouse, which would create a taxable event.
- The third opportunity is to implement an estate plan that includes the use of a qualified domestic trust (QDOT) that will, if all technical requirements are met, enable the surviving noncitizen spouse to use the otherwise unavailable unlimited marital deduction. A QDOT allows for assets to be held in trust for the noncitizen spouse without incurring an estate tax, thereby deferring the tax until the spouse’s death or the assets are withdrawn. The trust specifically requires that there be a U.S. citizen trustee and that a certain amount of the trust’s assets be subject to U.S. jurisdiction. While assets are held in the trust for the spouse, the trustee has the authority to use the assets for the spouse’s benefit. As funds are withdrawn from the trust, the estate tax that was deferred must be paid on the portion withdrawn. Recent tax law legislation (the 2001 tax act known as "EGTRRA") now provides that even though the estate tax may be phased out completely, 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.
Careful planning is required when advising families when one or both spouses’ are not U.S. citizens. We must navigate carefully using a combination of trusts, properly thought-out beneficiary designations and possible retitling of the family assets. By integrating these techniques, we can minimize the negative impact an immediate estate tax can have on a surviving spouse and family.
Richard Feigenbaum, Esq. is an estate planning attorney, has authored a book on probate law and is a consultant and lecturer on estate planning topics. He can be reached at 781-237-9900 or via email at Raf@elderlaw.com.