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FINAL REGULATIONS ON QUALIFIED DOMESTIC TRUSTS
By Eric M. Kramer, Esq., CPA and Gregory C. Fornasar, Esq., Farrell, Fritz, Caemmerer, Cleary, Barnosky & Armentano, P.C.
In general, property passing from a decedent to a surviving spouse will qualify for the estate tax marital deduction under IRC section 2056. However, where the surviving spouse is not a citizen of the U.S., property passing to the spouse will not qualify for the marital deduction unless the property is distributed to a qualified domestic trust (QDOT) [IRC sections 2056(d) and 2056A]. This special rule was enacted to reduce the possibility of a decedent's estate qualifying for the marital deduction and then being removed from the U.S. by the non-U.S. citizen surviving spouse prior to death, thereby entirely avoiding any estate tax on such property.
To qualify as a QDOT under IRC section 2056A, the following requirements must be satisfied:
* The trust agreement must require that at least one trustee be a citizen of the U.S. or a domestic corporation.
* The trust agreement must require that no distribution of principal be made to the non-U.S. citizen surviving spouse unless the trustee who is a U.S. citizen or a domestic corporation has the right to withhold any estate tax imposed on the distribution.
* The trust satisfies the requirements of the regulations to ensure the collection of any estate tax imposed on the QDOT.
* The executor of the decedent's estate must make an election on the Federal estate tax return to qualify the trust as a QDOT.
If the decedent's estate passes to a trust which would otherwise qualify for the marital deduction except that it does not satisfy all of the requirements of a QDOT, the trust will still qualify as a QDOT if it is judicially reformed prior to the date that the decedent's Federal estate tax return is required to be filed.
It is not necessary that the decedent's will (or an inter vivos trust) create the QDOT. If the decedent's estate passes outright to the surviving spouse, the property will nevertheless qualify for the marital deduction if the spouse transfers or irrevocably assigns the property to a QDOT prior to the filing of the Federal estate tax return and prior to the date that the QDOT election must be made (one year after the date the Federal estate tax return is required to be filed, including extensions). In such case, the QDOT may be created by either the surviving spouse or the executor of the decedent's estate. Property passing outright to the surviving spouse upon the decedent's death may also qualify for the marital deduction if the spouse becomes a citizen of the U.S. before the Federal estate tax return is required to be filed.
IRC section 2056A provides that an estate tax is imposed on any distribution of trust principal to the surviving spouse from a QDOT prior to the surviving spouse's death and on the remaining trust assets in the QDOT on the date of the surviving spouse's death. No tax will be imposed on distributions of income to the surviving spouse from the QDOT or on any distributions of trust principal to the spouse on "account of hardship." The regulations under IRC section 2056A provide that a distribution of trust principal is treated as a hardship distribution if it is made to the surviving spouse in response to an immediate and substantial financial need relating to the health, maintenance, education, or support of the spouse or of any person whom the spouse is legally obligated to support. A distribution of trust principal is not treated as a hardship distribution if the amount distributed to the surviving spouse could be obtained from other reasonably available sources, such as the sale of a publicly traded stock.
Assets that may be difficult to liquidate, such as closely held business interests, real estate, and tangible personal property, are not considered as sources that are reasonably available to the surviving spouse.
Final regulations [Regulations section 20.2056A-2(d)] have been issued which include various provisions and procedures that are required to ensure the collection of the estate tax liability imposed on a QDOT. The following is a summary of the key provisions of the final regulations.
DOTs with Assets of $2 Million or Greater. If the fair market value of the assets passing to the QDOT exceed $2 million, then the trust agreement must provide that at least one of the following three security arrangements be in effect at all times: 1) A U.S. bank is a trustee, 2) the U.S. trustee furnishes a bond to the IRS in an amount equal to 65% of the fair market value of the trust assets as of the date of the decedent's death, or 3) the U.S. trustee furnishes an irrevocable letter of credit issued by a bank equal to 65% of the fair market value of the trust assets as of the date of the decedent's death. For the purpose of determining if the $2 million threshold has been exceeded, if more than one QDOT is established for the surviving spouse, the fair market value of all the QDOTs are aggregated. At least one of the three security arrangements must be in effect at all times, although the QDOT may alternate between any of them. The regulations do not require that the trust agreement include strict rules regarding the use of the security arrangements. The QDOT may provide that the trustee has the discretion to use any one of the three security arrangements or that the trustee is required to use a specific security arrangement. The QDOT can satisfy the regulations by specifically stating that the trust must be administered in accordance with the applicable regulations.
DOTs with Assets of $2 Million or Less. If the fair market value of the assets passing to the QDOT are less than $2 million, the trust does not have to satisfy any of the security arrangements described above, if no more than 35% of the fair market value of the trust assets (as determined on the last day of each taxable year) consists of real property located outside the U.S. If the value of the real property located outside the U.S. exceeds the 35% threshold on the last day of any taxable year as a result of 1) principal distributions from the trust, 2) fluctuations in the fair market value of the trust assets, or 3) fluctuations in the value of the foreign real property due to changes in value of the currency in the country where the property is located, then the trustee has a one-year grace period to bring the trust into compliance with the 35% threshold.
Personal Residence Exclusion. For the purpose of determining if the value of the trust assets exceed the $2 million threshold, up to $600,000 in the value of real property (including furnishings) which passes to the QDOT and is used by the surviving spouse as a personal residence can be excluded. The personal residence exclusion applies to both a principal residence and a second residence as long as it is not being rented to another individual. If the personal residence ceases to be used by the surviving spouse as a personal residence at any time during the term of the QDOT (i.e., it is rented to another individual) or is sold, the personal residence exclusion will no longer apply. However, the personal residence exclusion will continue to apply if a personal residence is sold, but within a 12-month period from the date of the sale, the sale proceeds are used to buy a new personal residence for the surviving spouse that is held in either the same QDOT or another QDOT. If the purchase price of the new residence is less than the proceeds from the sale of the original residence, then only the amount reinvested in the new residence will qualify for the personal residence exclusion. The application of the personal residence exclusion can be illustrated by the following examples.
Example 1: A decedent dies with an estate of $2,500,000 which passes to a QDOT for the benefit of a non-U.S. citizen surviving spouse. The decedent's estate includes a principal residence with a value of $400,000 and a vacation home with a value of $200,000. For the purpose of determining if the $2 million threshold is exceeded, $600,000 can be excluded as a result of the personal residence exclusion. Consequently, the value of the assets in the QDOT will be treated as only $1,900,000. If the vacation home is rented to another party at any time during the term of the QDOT, the value of the vacation home will not qualify for the personal residence exclusion. In such case, the value of the assets in the QDOT will be treated as $2,100,000.
Example 2: Same facts as in example 1, except the principal residence is sold for $400,000 during the term of the QDOT, and within 12 months after the sale, is replaced with a new residence with a purchase price of $250,000. In such case, only the amount reinvested in the new residence ($250,000), plus the value of the vacation home ($200,000), can be excluded for purposes of determining if the $2 million threshold is exceeded, and thus, the value of the assets in the QDOT will be treated as $2,050,000. If the purchase price of the new house is $400,000, then $600,000 can be excluded as a result of the personal residence exclusion and the value of the QDOT will be treated as $1,900,000.
Bond or Letter of Credit Requirements. Unless an alternate security arrangement is being used, the bond or letter of credit must remain in effect until the trust ceases to function as a QDOT and any estate tax liability imposed on the QDOT is paid. The bond or letter of credit must have a term of at least one year and must be automatically renewable at the end of the term and each year thereafter, unless notice of failure to renew the bond or letter of credit is mailed to the IRS and to the U.S. trustee of the QDOT at least 60 days prior to the end of the term (or periods of automatic renewals). If the fair market value of the trust assets as finally determined for Federal estate tax purposes exceeds the value of the trust assets as originally reported on the estate tax return, the U.S. trustee has a reasonable period of time (not exceeding 60 days after the final determination of the value of the trust assets) to adjust the amount of the bond or letter of credit.
Effective Date. The final regulations are effective for estates of decedents dying after February 19, 1996.
Editors:
Eric M. Kramer, JD, CPA
Contributing Editors:
Richard H. Sonet, JD, CPA
Lawrence M. Lipoff, CEBS, CPA
Frank G. Colella, LLM, CPA
Jerome Landau, JD, CPA
Nathan H. Szerlip, CPA
Lenore J. Jones, CPA
James B. McEvoy, CPA
©2009 The New York State Society of CPAs. Legal Notices | ||||
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