By Anthony Diosdi
U.S. federal law imposes a transfer tax upon the privilege of transferring property by gift, bequest, or inheritance. This transfer tax takes the form of an estate or gift tax.
The tax is measured against a tax base that includes not only the assets of decedent’s probate estate, but also certain gifts by the decedent during life that are deemed to be the equivalent of testamentary transfers either because the decedent retained an interest or power over the gift. Items included in a decedent’s gross estate are reduced by other items to calculate the decedent’s taxable estate. The estate tax is currently ranging from 18% to 40%. United States citizens and residents receive a credit against the estate tax in the amount of $12,060,000 for the 2022 calendar year. On the other hand, non-residents are permitted a unified credit of $13,000, equivalent to a $60,000 exemption against the estate tax, unless an applicable estate tax treaty allows a greater credit.
Typically, spouses can transfer an unrestricted amount of assets between themselves estate and gift tax-free. This is often referred to as an unlimited marital deduction. However, a marital deduction is generally not allowed for property that passes from a decedent to a surviving spouse who is not a citizen of the United States to subsequently collect tax from the noncitizen surviving spouse. However, if the property passes to noncitizen surviving spouses in a qualified domestic trust (commonly referred to as a QDOT), marital deduction is allowed. However, unlike normal marital deduction which result in the transferred property being includable in the estate of the surviving spouse, the deduction merely results in the postponement of the imposition of the estate tax on the QDOT property as a part of the estate of the transferor spouse. The QDOT property is revalued at the time of the postponed taxation, either during the surviving spouse’s life-time or at that spouse’s death.
The Passing Requirement
Property must “pass” to the surviving spouse in a QDOT to qualify for postponement of estate taxation under Internal Revenue Code Section 2056(d). Generally, the property will pass directly from the decedent’s estate to the QDOT. However, property may “pass” to the surviving spouse in a QDOT in three ways.
First, property will be treated as passing to the surviving spouse in a QDOT even though it passes from the decedent to a trust which is not initially a QDOT if, after the decedent’s death, the trust is reformed to satisfy the QDOT requirement. The trust can be reformed pursuant to the terms of the decedent’s will, the terms of the trust itself, or a judicial proceeding. If reformation occurs pursuant to the decedent’s will or the trust, the QDOT qualifications must be completed by the time prescribed (including extensions) for filing the decedent’s federal estate tax return. If there is a judicial reformation, the reformation must commence on or before the due date for the decedent’s return (including extensions granted).
Second, if a decedent’s property passes outright to a noncitizen surviving spouse through a bequest, devise, operation of law, or pursuant to an assignable annuity, a marital deduction is disallowed because the outright gift is not held in a QDOT. However, if the surviving spouse or the surviving spouse’s representative transfers or assigns the property to a QDOT, the property is treated as “passing” to the noncitizen spouse in a QDOT. The transfer or assignment of property to the QDOT must be in writing and must occur before the decedent spouse’s estate tax return is filed and during the period allowable for making a QDOT election. If there is a valid assignment, the actual transfer of the assigned property to the QDOT must occur before the administration of the decedent’s estate is completed. Only assets that are included in the decedent’s gross estate and pass to the spouse at death (or the proceeds from the sale, exchange or conversion of such assets) may be transferred or assigned to the QDOT. Finally, in certain cases, an annuity or other arrangements that are not assignable may be transferred to a QDOT.
Requirements of a QDOT
To qualify as a QDOT, trust to which the property passes must satisfy several statutory and nonstatutory requirements that principally ensure the Internal Revenue Service’s (“IRS”) ability to collect the federal estate tax on the decedent spouse’s property passing to the QDOT. The trust must be established by a document executed under the laws of a state of the United States, the District of Columbia or under a foreign jurisdiction. If executed under the laws of a foreign jurisdiction, the document must designate the laws of a particular state or the District of Columbia as governing the trust’s administration and such designation must be effective under the law of the designated jurisdiction. The trust must also be an “ordinary trust” as defined in Treas. Reg. Section 301.7701-4(a).
The trust instrument must require that at least one trustee of the trust be a United States citizen or a domestic corporation that is commonly referred to as a “United States Trustee.” See IRC Section 2056A(a)(1)(A); Treas. Reg. Section 20.2056A-2(c). All the trustees of the trust, whether United States Trustees or not, are personally liable for payment of the estate tax imposed on certain distributions from or property held in the QDOT. The QDOT instrument must provide that no corpus distribution can be made from the trust unless the United States Trustee has the right to withhold the amount of tax liability that will be imposed upon the distribution.
A QDOT must also satisfy various requirements imposed by the Income Tax Regulations. The set of regulatory requirements that are applicable depend upon the value of the assets that pass to the QDOT. The primary determinant of which set of requirements applies is whether or not the value of the QDOT assets as finally determined for estate tax purposes exceeds $2 million. In measuring the value of the QDOT assets for determining which set of regulatory requirements apply, the value employed is the fair market value as finally determined for federal estate tax purposes at the date of decedent spouse’s death or the alternative valuation date (if applicable), determined without any reduction for indebtedness with respect to the assets. If more than one QDOT is established, the value of the assets of the QDOTs is aggregated. See Treas. Reg. Section 20.2056A-2T(d)(1)(ii)(A).
If the value of the assets passing to the QDOT at the time of the decedent spouse’s death exceeds $2 million, then at all times during the term of the trust, the trust instrument must satisfy at least one of three requirements. The QDOT may vary which of the requirements is satisfied so long as, at any given time, one of them is satisfied. Under the first alternative requirement, during the trust’s entire term, the trust instrument must require either that at least one United States trustee be a domestic bank or that a United States branch of a foreign bank is a trustee with a United States trustee as a co-trustee. Under the second alternative requirement, the trust instrument must require the United States trustee to furnish a bond in favor of the IRS in an amount equal to at least 65 percent of the fair market value of the trust corpus. The bond must generally remain in effect until the termination of the QDOT and the payment of any tax liability. Under the third alternative requirement, the trust instrument must require the United States trustee to furnish security in the form of an irrevocable letter of credit in an amount equal to at least 65 percent of the fair market value of the trust corpus as determined for estate tax purposes.
If the value of the QDOT assets passing at the decedent’s death is not in excess of $2 million, the trust instrument may provide for the trust to satisfy any of the three alternative requirements above, or may require that no more than 35 percent of the fair market value of the trust assets determined annually consists of real property located outside the United States. Second, a special look-through rule applies if the QDOT owns 20 percent or more of the voting stock or valuation in a corporation with fifteen or fewer shareholders or 20 percent or more of a capital interest in a partnership with fifteen or fewer partners. The purpose of this rule is to determine whether the QDOT owns real estate located outside the United States through a corporation or partnership. In applying the 20 percent and fifteen member test, stock or partnership interests owned by or for the benefit of the surviving spouse or members of the surviving spouse’s family are treated as owned by the QDOT. Under this rule, all assets owned by the corporation or partnership are deemed to be owned directly by the QDOT to the extent of the QDOT’s pro rata share of actual ownership of the corporation or partnership. In addition, interests owned by the QDOT in other entities (such as a trust) are subject to a similarly applied look-through rule. If the 35 percent foreign realty test is not satisfied at the time of reporting, the QDOT is not disqualified if one of the three other alternative requirements applicable to a QDOT with assets in excess of $2 million (a bank trustee, a bond, or a letter of credit) is satisfied.
Making a QDOT Election
The decedent spouse’s executor must make an irrevocable QDOT election on the decedent’s federal estate tax return. See IRC Sections 2056A(a)(3), 2056A(d). The election must meet any requirements imposed by the estate tax return or the instructions applicable to the return. The election must be made on the last federal estate tax return filed before the due date (including extensions that have been granted). If no timely return is filed, the election may be made on the first return filed after the due date, but only if such election is made within one year of the time (including granted extensions) such return is required to be filed. See Estate & Gift Taxation, Warren, Gorham & Lamont, Richard B. Stephen, Guy B. Maxfied, Stephen A. Lind, and Dennis A. Calfee, (1996).
Taxation of QDOT Property
The imposition of estate tax on the property in the decedent spouse’s estate that qualified as QDOT is deferred by allowing the decedent’s estate a marital deduction for the value of such property. The decedent’s spouse’s estate tax liability on the property is generally deferred until the property is distributed from the QDOT, the surviving spouse dies, or the QDOT ceases to qualify as a QDOT. If there is a distribution of principal from the QDOT during the surviving spouse’s lifetime, the distribution is generally subject to tax when made. However, tax is not imposed if the distribution is a distribution of income, a corpus distribution to the surviving spouse on account of hardship, a distribution to reimburse the surviving spouse for federal income tax paid on an item of QDOT income that the surviving spouse is not entitled to receive under the terms of the trust, or an administrative distribution or disposition. Thus, many distributions to third persons or to the surviving spouse are taxed. The value of any property remaining in the QDOT on the date of the surviving spouse’s death is also subject to tax.
Exception if Surviving Spouse Becomes a United States Citizen
Special rules apply if the surviving spouse becomes a United States citizen. If the surviving spouse becomes a United States citizen before the decedent’s estate tax return is filed and if such spouse was a United States resident at all times after the decedent’s death until becoming a United States citizen, there is no need for a QDOT.
If the surviving spouse becomes a United States citizen after the decedent’s estate tax return is filed, a QDOT may be disregarded with respect to any subsequent distributions and at the surviving spouse’s death, if there is no subsequent need for the QDOT. A QDOT is disregarded if one of several alternative requirements is met. The requirements ensure that any prior taxable distributions from the QDOT do not escape the equivalent of taxation to the surviving spouse. A QDOT is disregarded after the surviving spouse becomes a citizen after decedent’s estate tax return is filed if either 1) the surviving spouse was a resident of the United States at all times after the decedent’s death prior to becoming a citizen or 2) regardless of residency status, no QDOT tax was imposed on any distributions before the surviving spouse became a citizen and 3) under either of these alternatives, the United States trustee notifies the IRS and certifies in writing to the IRS that the surviving spouse has become a United States citizen.
A separate alternative applies if the surviving spouse was not a resident at all times after the decedent’s death prior to becoming a citizen and if there were prior distributions upon which the estate tax was imposed. In such circumstances, a QDOT is disregarded for periods after the surviving spouse becomes a citizen if the surviving spouse elects to treat the prior taxable QDOT distributions as taxable gifts made by the surviving spouse for purposes of determining the rate of tax imposed on gifts made by the surviving spouse in the current and subsequent years on the computation of the surviving spouse’s estate tax.
Conclusion
The foregoing discussion is intended to provide a basic understanding utilizing a QDOT for estate and gift tax planning purposes. It should be evident from this article, however, that this is a relatively complex subject. As a result, it is crucial that anyone considering utilizing a QDOT review his or her circumstances with a qualified international tax attorney.
Anthony Diosdi is one of several tax attorneys and international tax attorneys at Diosdi Ching & Liu, LLP. Anthony focuses his practice on domestic and international tax planning for multinational companies, closely held businesses, and individuals. Anthony has written numerous articles on international tax planning and frequently provides continuing educational programs to other tax professionals.
He has assisted companies with a number of international tax issues, including Subpart F, GILTI, and FDII planning, foreign tax credit planning, and tax-efficient cash repatriation strategies. Anthony also regularly advises foreign individuals on tax efficient mechanisms for doing business in the United States, investing in U.S. real estate, and pre-immigration planning. Anthony is a member of the California and Florida bars. He can be reached at 415-318-3990 or adiosdi@sftaxcounsel.com.
This article is not legal or tax advice. If you are in need of legal or tax advice, you should immediately consult a licensed attorney.