THE INTERNATIONAL TAX ADVISOR by: Douglas J. Kingston, CPA/MBA • Mailing Address: 16443 N 59^th Place; Scottsdale, AZ 85254 • Telephone: +1 (602) 595-5885 (GMT-7) • E-Mail: doug@iTaxCPA.com • URL: http://www.iTaxCPA.com/
QDOT TRUST DEFERS ESTATE TAX FOR NON-U.S. CITIZEN SURVIVING SPOUSE
Background The Qualified Domestic Trust Option Requirements to Qualify as a QDOT QDOT Provided in Decedent’s Will Versus Correction after Death QDOT Unnecessary Where Surviving Spouse Becomes a U.S. Citizen Jointly Owned Property Conclusion It is important for foreign investors to plan their investment in U.S. real estate carefully because U.S. taxation varies significantly depending on the type of ownership structure.	Background Assets transferred at death to a surviving spouse who is a U.S. citizen generally benefit from an unlimited marital deduction and are thus U.S. estate tax free. In this case, the assets are taxed at the death of the surviving spouse, unless expended during the surviving spouse’s lifetime. However, if the surviving spouse is not a U.S. citizen, the marital deduction is not allowed and thus the transfer is taxed upon the first death (assuming the estate value exceeds the applicable exclusion amount, currently $1.5 million for 2004 and 2005 increasing to $3.5 million in 2009). This unfortunate result arises whether or not the decedent-spouse was a U.S. citizen. Lawmakers’ concern in enacting this seemingly harsh provision was that property transferred could otherwise easily escape U.S. estate taxation: first by reason of the unlimited marital deduction and later (upon the subsequent death of the non-citizen surviving spouse) by removal of the property from U.S. estate tax jurisdiction during the surviving spouse’s lifetime. The Qualified Domestic Trust Option Instead of incurring U.S. estate tax upon the first death, affected couples may choose to transfer the spousal bequest to a special-purpose trust known as a Qualified Domestic Trust or “QDOT” which provides the same benefit as the unlimited marital deduction. A QDOT is a trust for the benefit of the surviving spouse. QDOT income and hardship distributions to the surviving spouse are U.S. estate tax free, but distributions of trust corpus prior to death of the surviving spouse are taxed at source (i.e., the QDOT estate tax is withheld by the trustee). The property remaining in the trust upon the surviving spouse’s death is subject to U.S. estate tax at that time. Requirements to Qualify as a QDOT In order to qualify for this favorable treatment, a QDOT must satisfy several requirements: 1) the executor of the decedent's estate must make an irrevocable election to treat the trust as a QDOT on a timely filed estate tax return (or on a late return filed no later than one year after the filing deadline); 2) at least one trustee must be either a U.S. citizen or a U.S. corporation; 3) no distribution from the trust is permitted unless approved by the U.S. trustee; and 4) the trust must meet certain additional requirements intended to ensure that the QDOT estate tax will be paid (for example, a QDOT with assets over $2 million must either have a U.S. bank as trustee or post a bond or security equal to 65% of the value of assets transferred to the trust). QDOT Provided in Decedent’s Will Versus Correction after Death Assets may be transferred to a QDOT as required in the decedent’s will, or the surviving spouse or executor may decide to create a QDOT after the first death and then transfer assets to the trust. Although either method will qualify for the marital deduction,	QDOT Provided in Decedent’s Will Versus Correction after Death (cont’d) other tax consequences may dictate that one method is more favorable than the other (for example, where the QDOT is not provided for in the decedent’s will, the surviving spouse is treated as the transferor for U.S. income, gift, estate and generation skipping transfer tax purposes). Also, a trust created outside the will cannot include spendthrift provisions for the protection of the surviving spouse against creditors. Therefore, it is generally preferable to provide for the transfer of property to the QDOT in the decedent's will. QDOT Unnecessary Where Surviving Spouse Becomes a U.S. Citizen If the surviving spouse is not a U.S. citizen at the time of the decedent's death and a QDOT is not provided in the will, an unlimited marital deduction is still available without a QDOT if the surviving spouse both: 1) becomes a U.S. citizen before the estate tax return is due (normally nine months after death) and 2) was a resident of the U.S. continuously from the death of the decedent until obtaining citizenship. As a practical matter, the surviving spouse’s U.S. citizenship naturalization process should be substantially underway prior to the decedent’s death in order to meet this nine-month deadline. Even if the surviving spouse does not become a U.S. citizen until after the estate tax return is filed, the QDOT tax can be avoided for the period after attaining U.S. citizenship if certain additional requirements are satisfied. Jointly Owned Property The usual rule for property owned jointly between two spouses is that only one-half the value is included in the first decedent’s estate. However, this favorable allocation does not apply where the surviving spouse is not a U.S. citizen, and thus the full value of joint property is included in the decedent’s taxable estate (except to the extent it can be adequately demonstrated that the surviving spouse had contributed to the acquisition of the joint property). Jointly held property taxable under this exception may be transferred to a QDOT and thus deferred from estate tax. Also, if the surviving spouse becomes a U.S. citizen prior to the estate tax return deadline, the usual rule applies and the estate tax is deferred. Conclusion Based on the foregoing, it should be evident that special consideration is required for foreign investors. Foreign investor are best advised to carefully consider the significantly different tax consequences of owning U.S. real estate directly or through a legal entity prior to making the acquisition. If incurring a U.S. estate tax is inevitable, serious consideration to be given to forming a QDOT, preferably in the owner’s will. Not discussed in this article are equally important foreign country and U.S. state and local tax considerations. Planning in this area should also consider the relative costs associated with forming and maintaining a QDOT.
Douglas J. Kingston is an Arizona certified public accountant (CPA) specializing in international tax planning and compliance for U.S., Canadian, European, Latin American and Asian business and individual clients and may be reached by: • Telephone: (602) 595-5885 • E-Mail: doug@iTaxCPA.com • URL: http://www.iTaxCPA.com/