Most financial planners are familiar with the unlimited marital deduction between spouses under Internal Revenue Code Section 2056(a); however, some are not aware that this deduction is unavailable to spouses who are not United States citizens.
IRC Section 2056(d) states that no deduction shall be allowed under Section 2056(a) (the unlimited marital deduction) if the surviving spouse is not a U.S. citizen. The reason: A surviving spouse who is a U.S. citizen will most likely remain one and therefore the U.S. government can collect estate tax upon the surviving spouse’s death. With a non-citizen spouse, there is no guarantee the individual will remain a U.S. resident and pay any estate tax.
To prevent a surviving spouse from deferring tax on assets of the deceased spouse and then avoiding the estate tax, Congress instituted IRC Section 2056(d), imposing the estate tax on any transfer to the surviving non-citizen spouse that would otherwise pass to such spouse’s estate tax-free via the marital deduction.
When a client has significant assets that will pass to the surviving spouse and will exceed the amount the individual can pass tax-free using the unified credit (currently $2 million), the estate tax impact can be significant. The top estate tax rate in 2008 is 45%. One of the largest assets many clients have is life insurance, and the client’s insurance offers us several planning options to avoid the estate tax imposition on the spouse’s death.
The easiest and cheapest way for clients to avoid the marital deduction issue is to have the non-citizen spouse own and be the beneficiary of the life insurance policy. If the policy is so structured, when the citizen spouse dies the proceeds are delivered to the non-citizen survivor and will not be included in the decedent’s taxable estate. That’s because the decedent had none of the incidents of ownership over the life insurance policy required for inclusion in the taxable estate under IRC Section 2042.
This method of avoiding the issue may not work for the couple where the non-citizen spouse has creditor and/or legal problems or where the marriage is a second marriage and the citizen spouse does not want all of the insurance proceeds to go to the non-citizen spouse. In those instances, one may want to consider having an irrevocable life insurance trust own the policy and collect the proceeds.
Irrevocable life insurance trust
Planners frequently use an ILIT to keep life insurance proceeds from being included in an insured’s estate. An ILIT may also be the best tool to avoid an estate tax upon the citizen-spouse’s death and manage the insurance proceeds for the surviving spouse and/or children of the decedent. However, some issues with respect to forming and operating ILITs may deter clients from using these vehicles.
For instance, when assets are transferred to the ILIT to pay the premiums on the life insurance policy, the trustee of the ILIT is required to give the beneficiaries “crummey letters” in order to have the transfer qualify as a gift under the annual gift tax exclusion rules. In addition, the loss of control over the policies and having to maintain a separate checking account may also deter clients from using an ILIT.
Qualified domestic trust
A final option is to create a qualified domestic trust, either as part of a revocable credit shelter trust or as a stand-alone pour-over trust.
A QDOT allows a marital deduction and defers the estate tax on the first spouse’s death while assuring that the estate tax will eventually be collected when either subsequent distributions of principal are made or when the second spouse dies. To qualify as a QDOT a trust must meet certain technical requirements.
IRC Section 2056A(a)(1) defines a QDOT as a trust instrument that requires at least one trustee of the trust be an individual citizen of the U.S. and that no distribution of principal be made from the trust unless the trustee who is the U.S. citizen or a U.S. corporation has the right to withhold the estate tax imposed from such distribution.
If the trust is funded with more than $2 million, the regulations under Section 2056A also require that at least one trustee is either a bank or a trust company, or that the citizen individual trustee be bonded or provide a letter of credit. An election must also be made with respect to the QDOT on the decedent’s estate tax return when it is filed.
By utilizing the QDOT to collect and hold the insurance proceeds, the client can defer payment of the estate tax that would otherwise have been paid. Such amount can then be held in the trust to be invested to generate income for the surviving non-citizen spouse’s benefit for his or her life. At the surviving spouse’s death the estate tax will then be imposed.
Should the trustee make any distributions of principal from the QDOT during the life of the surviving spouse, the estate tax that would otherwise have been imposed on the first spouse’s estate at his or her death must be withheld from the distributed amount. The trustee reports and pays the withheld amounts to the Internal Revenue Service on Form 706-QDT.
While a spouse who is not a U.S. citizen creates some planning challenges, there are multiple planning options available to our clients to avoid this pitfall.
Eric L. Green, LL.M., is of counsel to Convicer & Percy, LLP, of Glastonbury, Conn. He also currently serves as a vice-chair of the closely held Business Tax Committee of the American Bar Association. He can be reached via e-mail at .