Last week we discussed the international tax situation of John and Sue Ling, a hypothetical couple from Taiwan that has been residing in the United States for many years. John is a U.S. citizen but Sue is not, although she is a permanent U.S. resident (or green card holder.) John and Sue are working on their estate plans, and when they met with their CPA they were surprised to learn that the estate tax unlimited marital deduction would not necessarily apply should John predecease Sue, and that there might be gift tax filing requirements should John transfer assets to Sue during his lifetime. They were already thinking of setting up a brokerage account in Sue’s name and moving some of John’s recently inherited funds into that account.

The estate tax unlimited marital deduction allows a decedent spouse to leave assets to a surviving spouse free from any U.S. or state estate taxes, but only if the surviving spouse is a U.S. citizen. A U.S. citizen may also receive unlimited lifetime gifts from a spouse without any gift tax implications to the donor spouse. These options are not available when noncitizen spouses are the recipients of the inheritance or gift. The logic is that the assets of a citizen, or of a noncitizen who is resident in the United States at the time of his or her death, should at some point be subject to estate taxes. If the unlimited marital deduction were allowed for assets bequeathed to a noncitizen spouse, that spouse could return to his or her home country prior to his or her own death, effectively keeping those assets from ever being taxed for U.S. estate tax purposes. In contrast, any assets left to a citizen spouse would be subject to estate taxes when the second spouse dies.

If John died today, his gross estate, which includes a sizable life insurance policy, would be more than $7M. John and Sue are aware that the federal estate exemption has recently increased to more than $11M, but they live in New York where the exemption is currently around $5M. They also understand that the increased federal exemption expires in 2026 as it was not one of the permanent provisions of the recent Tax Cuts and Jobs Act. Thus, without the use of the marital deduction, it is likely that at John’s death his estate will be subject to estate taxes even if he leaves his entire estate to Sue.

What is the solution? Sue could become a U.S. citizen. If she obtains citizenship prior to the filing of the estate tax return for John’s estate, the unlimited marital deduction would be available. Another option is to provide for a Qualified Domestic Trust (QDOT) in John’s will. The assets that went into that trust at his death would qualify for the unlimited marital deduction. The QDOT must meet certain technical requirements, one of which is that the QDOT must have a U.S. trustee.

The QDOT trade-off is that distributions of principal out of the trust during Sue’s life and the value of the trust at Sue’s death would be subject to potential estate and gift taxes, regardless of Sue’s U.S. status at the time of distribution or death. However, like the unlimited marital deduction, the QDOT allows for the postponement of any estate tax until the second spouse dies. In addition, because Sue has limited assets of her own, John and Sue might be able to eliminate federal estate taxes on their combined estates by using the QDOT in conjunction with other estate planning techniques.

What about their wish to transfer assets into Sue’s name? Although a U.S. citizen or resident cannot make unlimited transfers of assets to their noncitizen spouse without gift tax implications, as of 2018, a spouse can make annual gifts of $152,000 to a noncitizen spouse without a gift tax filing requirement. The $152,000 is the limit applicable for 2018 and is indexed each year for inflation.

John and Sue decide to work with their attorney and CPA to make sure the appropriate provisions are in John’s will to allow for the use of a QDOT if, and to the extent, a QDOT is needed at his death, as well as explore the use of other more traditional estate planning techniques. He will also start making annual gifts to Sue not to exceed the annual limitation for transfers to noncitizen spouses.

Next week we will discuss the potential estate tax issues for Sue, should John predecease her.

By Linda Bruckner, CPA