Understanding qualified domestic trusts and portability.

• Author: Nelson, Brent W.

PREVIEW

* Learn about how transfer-tax rules for noncitizen spouses differ from the transfer-tax rules that apply to spouses who are U.S. citizens or residents.

* Find out how a transfer at death to a noncitizen spouse can qualify for the marital deduction through the use of a qualified domestic trust and how a QDOT affects portability of the deceased spouse's unused exclusion amount to a surviving noncitizen spouse.

* Examples are provided of how proper planning for the use of a QDOT in conjunction with portability can maximize the amount that a couple pass on to their heirs.

The existence of a noncitizen spouse can significantly change the landscape for federal estate tax purposes. In particular, to qualify for an estate tax marital deduction, a bequest to a noncitizen spouse must meet unique rules. Additionally, the Treasury regulations layer on specific rules that may limit a noncitizen surviving spouse's ability to benefit from portability of an estate's unused estate tax exclusion amount. This article discusses the general rules for the marital deduction in this context and how the general rules are affected by portability and then suggests planning considerations for a client seeking to take advantage of these rules.

Qualified Domestic Trusts

Generally, under Sec. 2056(a), the marital deduction provides a 100% deduction against estate tax for property passing to a decedent's surviving spouse. Each individual also has an estate tax exclusion amount of $5,450,000 ($10,900,000 for a married couple) in 2016. If either spouse is a noncitizen, however, the rules can be turned on their heads. The marital deduction does not typically apply to property passing to a surviving spouse who is not a U.S. citizen. (1)

A nonresident noncitizen (NRNC), absent a treaty provision to the contrary, has a non-inflation-adjusted estate tax credit of $13,000 (equivalent to an exclusion of $60,000) that applies against any estate tax on his or her property situated in the United States. (2) Finally, a noncitizen spouse may not be able to use the deceased spouse's unused exemption amount (DSUE amount), colloquially referred to as "portability," or the portability rules may limit the use of the DSUE amount.

In the context of the marital deduction, estate plans involving a noncitizen (3) spouse must carefully consider the following concepts. First, property passing to a trust that qualifies as a qualified domestic trust (QDOT) for the benefit of the noncitizen surviving spouse, or passing directly to the noncitizen surviving spouse who then irrevocably assigns the property to a QDOT before the deceased spouse's estate tax return is due (including extensions), does qualify for the marital deduction. (4) Second, if the noncitizen surviving spouse becomes a U.S. citizen before the time required to file the deceased spouse's estate tax return, and at all times after the deceased spouse's death and before becoming a citizen the surviving spouse was a resident of the United States, then the transfer of property from the deceased spouse to the noncitizen surviving spouse does qualify for the marital deduction. (5) Third, a treaty may allow a credit in lieu of the marital deduction (6) or may allow a marital deduction. (7) Lastly, if the noncitizen surviving spouse dies and his or her estate is subject to estate tax, then estate taxes paid by the first deceased spouse on property included in the surviving spouse's gross estate may generate a credit against the surviving spouse's estate tax under Sec. 2013 (discussed below). (8)

Technical QDOT Requirements

To be a QDOT, a trust agreement (9) must:

1. Provide that the laws of a U.S. state or the District of Columbia govern its administration;

2. Qualify as an ordinary trust under Regs. Sec. 301.7701-4(a);

3. Have terms that qualify it as a power of appointment trust, a qualified terminable interest property trust (QTIP trust), a qualified charitable remainder trust (qualified CRT), or an estate trust; (10)

4. Require at least one trustee to be a U.S. citizen or a U.S. corporation (i.e., a corporation created or organized under the laws of a U.S. state or the District of Columbia); (11) and

5. Provide that no distributions (except distributions of income) may be made from the trust unless the trustee has the right to withhold the Sec. 2056A estate tax (discussed below); and

1. Provide that if the property transferred to the QDOT has a value that exceeds $2 million (based on the values finally determined for estate tax purposes and ignoring any indebtedness on the property) at least one trustee must be a U.S. bank, the trustee must post a bond with the 1RS equal to 65% of the fair market value of the property transferred to the trust, or the trustee must furnish the IRS with a letter of credit of 65% of the fair market value of the property transferred to the trust; and

2. Provide that if the property transferred to the QDOT has a value that is $2 million or less (based on the values finally determined for estate tax purposes and ignoring any indebtedness on the property), then either no more than 35% of the trust property determined annually on the last day of the trust's tax year will consist of foreign real property, or the trust will meet the bank, bond, or letter of credit rules above. (12)

In addition to these requirements, the deceased spouse's executor must make a QDOT election on the deceased spouse's timely filed estate tax return (including extensions) or, if not timely filed, on the deceased spouse's first-filed estate tax return, provided it is filed within one year of the date the estate tax return was due. (13)

Property funded into the QDOT generally must pass from the deceased spouse. However, if the property first passes from the deceased spouse to the surviving spouse and the surviving spouse transfers or irrevocably assigns the property to the QDOT, the surviving spouse's receipt of which would qualify for the marital deduction but for his or her noncitizen status, and the assignment occurs before the deceased spouse's estate tax return is filed, the transfer of those assets to the surviving spouse (and ultimately to the QDOT) does qualify for the marital deduction. (14) In that case, the trust does not have to meet the requirements of a power of appointment trust, a QTIP trust, a qualified CRT, or an estate trust. (15) Instead, the trust must meet requirements 4 and 5 above, (16) and the executor must still make the QDOT election. The surviving spouse does not need to be a beneficiary of the trust.

The surviving spouse is treated as the transferor of the property in the trust for all other purposes except the QDOT rules and the special valuation rules of Chapter 14. (17) If the surviving spouse transfers all of his or her interest in the property to the QDOT, then the surviving spouse is also not treated as the transferor if the QDOT would have received the property had the surviving spouse executed a qualified disclaimer. (18)

Other rules may save transfers that otherwise do not qualify for the marital deduction. For example, nontransferrable assets (e.g., qualified retirement plans or annuities) that would qualify for the marital deduction but for the surviving spouse being a noncitizen may be treated as assigned to and part of the QDOT property if certain requirements are met. (19) Also, a trust that does not qualify as a QDOT may be reformed under the provisions of the deceased spouse's will or trust or under a court ordered reformation, so long as the reformation of the will or trust is completed by the time the deceased spouse's estate tax return is due (including extensions), or the judicial reformation proceeding is commenced by the time the deceased spouse's estate tax return is due (determined with regard to extensions actually granted). (20) Whether a trust qualifies (or will qualify by reformation) as a QDOT is ultimately determined on the due date of the deceased spouse's estate tax return, or, if a judicial proceeding is commenced on or before the due date (determined with regard to extensions) for filing that return to change the trust into a QDOT, as of the time when the changes pursuant to that proceeding are made. (21)

Sec. 2056A Estate Tax on QDOT Distributions

The QDOT rules allow transfers from a deceased spouse to qualify for the marital deduction, but it is a deferral and not an exemption from estate tax. A QDOT is subject to the Sec...