A potpourri of potential pitfalls to avoid with qualified domestic trusts.

• Author: Pearson, William M.

Ever more frequently in the state of Florida we are coming to grips with planning for Florida couples where one or both are not U.S. citizens. As set forth in I.R.C. [sections] 2056(d), when the surviving spouse of the decedent is not a citizen of the United States, no marital deduction is permitted and the deemed one-half interest in joint property does not apply. However, if the property is held in or transferred to a qualified domestic trust (QDOT) as defined under I.R.C. [sections] 2056A, a marital deduction is permitted. The estate tax as calculated under the QDOT rules generally is deferred until distributions are made from the trust or upon the death of the surviving spouse. As outlined below, there are exceptions to the general rule of taxation upon distribution.

The QDOT requirement was set in place by Congress under the Technical and Miscellaneous Revenue Act of 1988 and the Revenue Reconciliation Act of 1989 in reaction to the fear that noncitizen spouses would leave the U.S. after their spouse's death, never to return and (from the government's perspective) never to be taxed. We now have had over a decade of experience with the QDOT and a review of the basics and some of the potential pitfalls probably is in order

Before discussing some of the basic requirements, it must be remembered that the QDOT requirements only apply to a decedent's estate if the surviving spouse is a noncitizen. If the surviving spouse is a U.S. citizen, these rules do not apply.

The Basics

Three basic requirements which must be met by a trust in order to qualify as a QDOT are as follows:

1) The QDOT must meet the basic requirements for any of the various marital deduction trusts under I.R.C. [sections] 2056. Under the most common example equivalent to the standard QTIP trust, the QDOT will have the same "qualifying income interest for life" as other marital deduction QTIP trusts generally have.[11] In addition, such a QDOT will be required to distribute income to the surviving spouse at least annually.[2] This distribution of income would not be subject to QDOT estate taxation, as it qualities for the income distribution exemption described more fully herein.

2) The QDOT instrument must require that at least one of the trustees be a U.S. citizen or domestic corporation and such U.S. trustee has the right to withhold the QDOT tax from any distribution.

3) The QDOT must meet the various additional requirements contained in the Treasury regulations under I.R.C. [sections] 2056A.[3]

Assuming the trust in question meets all the above requirements, in order to be considered a QDOT the personal representative must file the proper election on the decedent's estate tax return. The regulations are fairly generous, providing that the election must be made on the last federal estate tax return filed before the due date (including extensions of time to file actually granted) or, if a timely return is not filed, on the first estate tax return filed after the due date. In contrast, however, under I.R.C. [sections] 2056A(d) no QDOT election may be made on any return if such return is filed more than one year after the time prescribed by law (including extensions) for filing such return.[4] Once made, the election is irrevocable.[5]

Distributions Exempt From QDOT Estate Tax

Distributions from the QDOT generally are taxable with two major exceptions: income distributions and "hardship" distributions. For tax purposes, "income" generally is determined under the terms of the governing instrument or by applicable local law.[6] The regulations flush this out a little more to expressly provide that income does not include capital gains regardless of what the governing instrument provides. Generally, any governing instrument which expands the definition of income beyond applicable local law is ignored. Furthermore, for QDOT taxation purposes, if there is no specific...