Estate Tax Planning for Non-Citizen Spouses
The good news, if your spouse or anyone you want to include in your estate plan is not a United States citizen, is that for the most part that won’t affect your estate plan. The probate laws of the various states do not distinguish between citizens and non-citizens, or even between legal and undocumented immigrants. In short, property rights are blind as to nationality as well as to the location of the owner. So, you can also include residents of other countries, whether or not they are U.S. citizens, in your estate plan. Of course, as a practical matter, locating and communicating with them may prove difficult and costly for your personal representative or trustee.
The bad news, however, is that while probate and property laws do not distinguish between citizens and non-citizens or between residents and nonresidents, the federal estate tax laws do and they are much tougher on non-citizens. The first major difference is that the unlimited marital deduction does not apply to transfers to a non-citizen spouse, whether at death or as a gift during life. To address the gifting issue, as you may know, if you make gifts above $15,000 to an individual other than your spouse during a calendar year, you are supposed to file a gift tax return reporting the gift. The excess over $15,000 is then deducted from the $11.7 million (in 2021) that you can give away tax free, reducing that amount. So, if you gave someone $1.58 million this year, you could only give away $10 million estate tax free at death. If you gave away more than $11.7 million of cumulative excess gifts, you would have to pay a gift tax. Since few people have more than $11.7 million to give away either during life or at death, this affects very few people.
For American citizens, there’s no reporting requirement for gifts of any amount between spouses. However, this is not true of gifts to non-citizen spouses living in the United States. They must report gifts to one another in excess of $157,000 (in 2020) in any calendar year. So, if your spouse is not a U.S. citizen, you can avoid the reporting requirement by keeping your transfers to him below this threshold each year. If you exceed it, you’ll have to file a gift tax return. But, again, you’re unlikely to have to pay a tax since you can still give away up to $11.7 million tax free during life and at death.
Matters can also get a bit more complicated at your death if your surviving spouse is a non-citizen since the marital deduction does not apply here either. Gifts to your spouse will be taxable just like gifts to anyone else. Again, unless your estate is over $11.7 million, this should be of little concern. If, however, you want to make sure that what you leave your spouse does not end up in his taxable estate, potentially putting it over $11.7 million, you can shelter it through a special trust, known as a qualified domestic trust (or QDOT). When determining whether this makes sense for you, be aware that even non-citizens are taxed on their worldwide assets if they are domiciled in the United States when they pass away. So, consider your non-U.S. property as well as your U.S. holdings. Also, be aware that all of these rules only apply if the recipient of the gift or inheritance is a non-citizen. If you are not a U.S. citizen, but your spouse is, he will qualify for the marital deduction like all other U.S. citizens.
In addition to the QDOT, there are three other potential ways to avoid the effect of no marital deduction available to non-citizen surviving spouses. The first is for the surviving spouse to become a U.S. citizen, which he must do before the estate tax return is due, nine month after the death of his spouse.
The second strategy would be to take advantage of portability, which Congress enacted in 2013 to permit surviving spouses, in effect, to inherit the unused estate exemption of the first spouse to pass away. In other words, if you were to pass away with an $8 million estate, your spouse could add the unused $3.58 million of your exemption to her $11.7 million exemption to give away $14.8 million tax free at death. To take advantage of this option, she would have to file an estate tax return at your death even though your estate would not be taxable and otherwise no return would have to be filed. The good news is that portability is available to U.S. residents whether or not the decedent or the surviving spouse is a U.S. citizen. But to complicate things a bit further, portability is generally not available if a QDOT is used.
Leaving the US
The third planning option would be for the surviving spouse to move out of the United States. This won’t help if the estate of the first spouse to die is over $11.7 million when she passes away, but could if the couple’s combined estates exceed this limit. However, the change of residence and severing of ties with the United States have to be very clear. The IRS has a lot of rules about how domicile is defined for tax purposes.
Further, if you or your spouse or both are considering moving out of the United States, you need to be aware of the nonresident estate tax rules. Yes, even nonresident, non-citizens (known as “aliens” to the IRS) may be subject to the U.S. estate tax, but only on their U.S. property. If you have property – including real estate, tangible personal property such as artwork, and stock in U.S. corporations situated in the United States that’s worth more than $60,000, your estate will have to file an estate tax return at your death. The federal estate tax rules will then apply, meaning that your estate will only be subject to tax if your worldwide assets exceed $11.7 million. And, even in that case, your tax will be reduced proportionally to the amount of your estate in the United States. So, for instance, if your $20 million estate includes a $4 million condominium on Miami Beach, your estate will be 20% of the normal estate tax on a $20 million estate. In addition, most countries have tax treaties with the United States which provide offsets. So if your estate would also be paying a tax in your home country on the condominium, the U.S. tax may be reduced or eliminated.
The bottom line is that all of this is very complicated. You are best advised to consult with a U.S. tax attorney or accountant if either of two situations apply to you. First, if you are a nonresident alien with property in the United States. Second, if you are a U.S. resident, but you or your spouse (or both) is not a U.S. citizen and either of you or both of you together have more than $11.7 million, or could at some point in the future. If you’re not at risk of having that much money, then simply make sure you don’t give each other more than $155,000 each year.
But What About State Estate Taxes?
If you live in a state with its own estate taxes and thresholds significantly lower than those for federal estate taxes, having or being a non-citizen spouse can have bad tax consequences at significantly lower amounts of wealth. Massachusetts practitioner Matthew E. Sullivan writes the following:
I am currently helping a couple where the husband, a U.S. citizen, and the wife, a U.S. lawful permanent resident and Japanese citizen, have combined assets of approximately $4 million. Because the non-U.S.-citizen spouse is not entitled to the unlimited marital deduction, tax will be due on her husband’s estate to the extent if exceeds $1 million and he dies first. The QDOT is available to the wife in this situation, but she would be entitled only to the income from the QDOT trust unless she were destitute or paid the estate tax. We are evaluating life insurance as a source of funds for the Massachusetts estate tax. We are also seeking to balance the assets between the spouses.
While it may not be possible, I would suggest moving $3 million of the $4 million over the wife, at the rate of $157,000 a year, so there would be no tax upon the death of the first spouse, whomever that might be, without the need to create a QDOT.