For couples of mixed citizenship—where one partner is a U.S. citizen and the other a citizen of another country—their tax burden can get complicated and expensive without the right planning.
U.S. citizens and domiciliaries are subject to U.S. transfer taxes on their worldwide assets. U.S. gift taxes apply to the gratuitous transfer of property during life, and U.S. estate taxes apply to the transfer of property at death (i.e., bequests). Currently, the U.S. transfer tax rate is 40%.
Although annual exclusions and lifetime credits can help reduce the transfer tax burden, they are limited in their application. Once the threshold is exceeded, a transfer tax becomes due.
The only exception to this is the unlimited marital deduction. This deduction permits U.S. citizens’ spouses to transfer unlimited wealth to each other during life and upon death without triggering any transfer tax. Upon death, property owned by a surviving spouse is included in her taxable estate and subject to U.S. estate tax. The unlimited marital deduction essentially acts as a tax deferral mechanism, postponing the transfer tax until the death of the second spouse.
Unlimited marital deduction unavailable to surviving spouses who are not U.S. citizens
To qualify for the marital deduction, the recipient spouse must be a U.S. citizen. Put another way, for couples where only one spouse is a U.S. citizen, there is a fundamental lack of symmetry. While noncitizen spouses can transfer unlimited wealth to a U.S. citizen spouse, the reverse gives rise to a transfer tax liability.
Due to their focus on income taxes rather than transfer taxes, both planners and clients often overlook this asymmetry. Yet it can meaningfully affect the estate plans and financial arrangements of mixed-citizenship couples.
Fortunately, two key provisions unique to gifts and bequests made to noncitizen spouses can alleviate the potential tax burden. To explore them in further detail, let’s consider Alex and Yasmin, a mixed-citizenship couple living in the U.S. For illustration purposes, we’ll assume that Alex is a U.S. citizen and the primary wealth owner.
Gift and estate tax relief for noncitizen spouse
The couple’s first option is an annual gift tax relief that excludes the first $185,000 that Alex gifts to Yasmin. While the exclusion renews annually and is indexed for inflation, the amount involved is too low for many high-net-worth couples to move the estate planning needle. In this case, since it fails to transfer a meaningful amount of their overall wealth, the couple turn to the next option.
The second provision forestalls the immediate imposition of estate taxes upon Alex’s death by allowing Yasmin to benefit from a marital deduction. She does so through the creation of a qualified domestic trust (QDOT), which gives her access to the income generated by the QDOT assets without having to pay estate tax. Note: The term “income” here means fiduciary accounting income rather than taxable income and does not generally include capital gains.
If or when principal is paid out of the QDOT to Yasmin, U.S. estate taxes become due. In other words, the QDOT enables Yasmin to postpone the U.S. estate tax payment until one of three events occur:
- She receives a distribution of trust principal.
- The QDOT terminates upon her passing.
- The QDOT no longer qualifies as a QDOT.
In certain hardship cases, an exception to the imposition of the estate tax on principal distributions may apply if Yasmin has an urgent need and lacks alternative resources.
Here are some key QDOT requirements
- The surviving noncitizen spouse must be the sole permissible QDOT beneficiary.
- The QDOT’s trustee must be either a U.S. citizen or a U.S. bank or corporation.
- The QDOT must be established and funded by the time the estate tax return for the deceased spouse is due, either nine or 15 months after the deceased spouse’s date of death.
Putting it all together: Practical and planning considerations
If Alex has a taxable estate that exceeds the available unified credit (currently $13,610,000), the pair should consider:
- Establishing a QDOT as part of the estate plan.
- Allocating and investing QDOT assets for income generation, giving Yasmin access to wealth after Alex’s passing while postponing the imposition of estate tax.
- Including trust provisions that specifically authorize a trustee to invest with emphasis on income production.
- Yasmin becoming a U.S citizen.
If she becomes a citizen by the time the estate tax return is due for Alex’s estate, Yasmin will qualify for the unlimited marital deduction, and a QDOT will not be needed.
If Yasmin becomes a citizen after a QDOT is created and funded, estate tax will not apply to distributions from the trust after she becomes a citizen as long as either (1) Yasmin has continuously been a U.S. resident after Alex’s death and before becoming a citizen or (2) no QDOT tax had been imposed on any distributions from the trust before she becomes a citizen.
If Yasmin and Alex own property as joint tenants:
- Termination during life, such as the closing of a joint account by the couple, is a taxable gift from Alex to Yasmin if she receives more than her proportionate share of the account.
- Termination upon Alex’s death, absent community property rules, will cause the full value of property to be included in Alex’s estate. Alex’s executor can overcome that if he or she can establish that Yasmin made contributions to the property as well.
In both instances, good record-keeping is important. The couple should carefully trace contributions to assets and keep relevant supporting records in case Yasmin survives Alex.
Finally, if Alex needs to transfer an amount in excess of the annual exclusion to Yasmin, he could consider lending her funds. Later, Alex can annually forgive an amount equal to that year’s available annual exclusion.
Maximizing gift and estate tax relief for noncitizen spouses
The tax asymmetry in mixed-citizenship marriages can have a significant impact on estate plans and financial arrangements. To navigate this thorny landscape, it is essential for couples to tap into a team of experts who can advise and support them in a holistic manner. The team may include a tax attorney, wealth adviser and estate planning attorney who can work together to create a comprehensive plan that maximizes gift and estate tax relief for noncitizen spouses while ensuring that the couple’s overall financial goals are met.
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For illustrative purposes only; not an advertisement and does not constitute an endorsement of any particular wealth transfer strategy. Bernstein does not provide legal or tax advice. Consult with competent professionals in these areas before making any decisions.