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Oct 1989

Marital deduction for a non-U.S. citizen surviving spouse. (Estate Planning)

by Wolosky, Gabe M.

    Abstract- Under the provisions of the Technical and Miscellaneous Revenue Act (TAMRA) of 1988, surviving spouses who are non-US citizens will not be allowed a marital deduction for property passed to them from the estates of decedents dying before TAMRA's effective date, 10 November 1988. Additionally, under TAMRA, a surviving spouse who is a non-US citizen may not be eligible a marital deduction for a qualified terminable interest trust. Accountants should carefully review existing wills for new tax problems caused by TAMRA's limitation of marital deductions.

As a result of TAMRA, a marital deduction for property passing to a surviving spouse who is not a U.S. citizen will not be allowed to estates of decedents dying after November 10, 1988 (the effective date of TAMRA). Furthermore, after TAMRA, a qualified terminable interest trust for the benefit of a surviving spouse who is not a U.S. citizen may no longer secure a marital deduction for a decedent's estate.

IRA Sec. 2056(d)(1) sets forth the general rule that no estate tax marital deduction will be allowed if property passes to a surviving spouse who is not a U.S. citizen.

If the estate of a U.S. citizen is subject to tax, a credit for prior transfers is permitted on the subsequent death of the non-U. S. citizen surviving spouse. This credit is computed without regard to when the first decedent died. The availability of the credit will depend on several factors, one of which is whether the second decedent's estate is subject to a U.S. estate tax. Additionally, there is a lien against the property giving rise to a tax for 10 years after the taxable event.

Moreover, IRC Sec. 2040(b), which excludes one-half of property owned by husband and wife as tenants by the entirety or joint tenants with right of survivorship, is inapplicable where the surviving spouse is not a U.S. citizen. In such case the general rule of IRC Sec. 2040(a) would apply. As a result, if the decedent furnished all the consideration, the entire value of the property is included in his or her estate. Marital Deduction for QDT

IRC Sec. 2056(d)(2) permits a marital deduction for property passing in trust to the surviving non-U.S. citizen spouse, provided the trust is a qualified domestic trust (QDT). As defined in Sec.2056(A), a QDT must meet four conditions:

1. The trust requires that all trustees of the trust be individual U.S. citizens or domestic corporations;

2.The surviving spouse must be entitled to all the income of the trust, paid at least annually;

3.The trust must meet the requirements imposed by regulations concerning the collection of tax on the distribution other than income or upon the death of the surviving spouse; and

4.The executors of the decedent's estate must elect to treat the trust as a QDT. The election must be made on the decedent's estate tax return and is irrevocable. Estate Tax Triggered

An estate tax is imposed if either of the following taxable events occur: 1) the distribution of trust principal; or 2) the death of the surviving spouse. In the former, tax is imposed on the value of the distribution; and in the latter case, tax is imposed on the value of the property remaining in the QDT on the date of death of the surviving spouse.

In essence, the estate tax imposed is equal to the amount that would have been imposed if the property subject to tax had been taxed in the estate of the first spouse to die. Technically, the tax on the U.S. citizen spouse's estate is the tax on the estate increased by the amount involved in the taxable event plus prior taxable events reduced by the tax previously paid. The tax on each subsequent event is, therefore, computed at the highest applicable rate.

The tax is due on the 15th day of the fourth month following the year in which the taxable event occurs. Special rules govern the determination of the tax where a taxable event occurs before the U.S. citizen spouse's tax is finally determined.

If property passes outside the will, such as proceeds of a life insurance policy owned by the decedent of which the non-U.S. citizen surviving spouse is the beneficiary, the property can be treated as property passing under a QDT. Qualification can be obtained if the property is transferred to the trust before the date for filing the decedent spouse's estate tax return. IRS Wants the Taxes

The overall import of Sec. 2056(d) is aimed at ensuring that an estate tax is collected at least once. In the case of a transfer to the non-U.S. citizen spouse on the death of the U.S. citizen spouse, allowing a marital deduction on outright bequests on the first death would eliminate the tax that may not be collected on the second death. Presumably for such reason, the third condition for a trust to qualify as a QDT was imposed (i.e., that the QDT complies with regulations ensuring collection). The Conference Agreement suggests that the regulations might provide that sufficient trust property be kept in the U. S. to provide a vehicle for collection of the tax. Use Lifetime Transfers

TAMRA also significantly restricted the marital deduction for lifetime transfers to spouses who are non-U.S. citizens. Effective July 14, 1988, only the first $100,000 per annum of transfers to a non-U.S. citizen spouse qualifies for a marital deduction. Transfers in excess of that amount are subject to tax.

Tax-free transfers must apparently be outright. The creation of a joint tenancy with right of survivorship or tenancy by the entirety between a U.S. citizen and a non-U.S. citizen spouse will not be a transfer subject to gift tax; but the termination of such interest can create a tax.

The first step in planning for clients who are married to non-U.S. citizen spouses is to make a thorough review of the existing estate plan. At the outset, the consideration of application for U.S. citizenship by the non- U.S. citizen spouse should be discussed. However, the input of client's counsel should be sought. Consideration might also be given to beginning a program of outright transfers by the U.S. citizen spouse to his non-U.S. citizen counterpart. This practice, with the $100,000 per annum exclusion, can cause potentially significant amounts to be excluded from the U.S. estate tax on the death of the non- U.S. citizen spouse. Carefully Draft Trust Language

Care should be taken to thoroughly review existing wills. At first blush, a QTIP trust and a QDT may appear similar; however, a QDT is more limited. Trustees who qualify as QTIP trustees may not necessarily qualify as QDT trustees.

Certain powers given to spouses in non-QTIP trusts established for their benefit may present problems. While the author is not aware of any specific discussion on this point, as yet it may well be that a Power of Appointment, or right to demand principal, could taint a QDT. Without regulations, it may be prudent to avoid such provisions in a trust intended to qualify as a QDT.

Tax clauses and clauses governing survivorship of a spouse in the case of a common disaster, including abatement clauses, in such instance should be reconsidered. For instance, abatement clauses equalize taxes in the event of a common disaster involving both spouses. Since the non- citizen spouse's estate is taxed at the citizen spouse's bracket, assuming all assets are in the name of the citizen spouse, equalization may not be appropriate.

Additionally, powers clauses in wills should be considered in light of probable regulations concerning maintaining property in the U.S. to guarantee payment of taxes on the second death. A power to maintain or invest property abroad should be reexamined.

In summary, TAMRA, by limiting the availability of marital deductions, has created potential new tax problems that certainly require restructuring the existing estate plan for U.S. citizen clients married to non-U.S. citizens.

Gabe M. Wolosky

Victory for a Joint Tenant

In McDonald v. Commissioner, 88-2 USTC 13,778, the U.S. Court of Appeals for the Eighth Circuit reversed the Tax Court and held that a surviving spouse's disclaimer of her survivorship interest in real property, which she and her husband held as joint tenants, was valid when made within nine months of his death even though the joint tenancy was created several years earlier.

IRC Sec. 2518 relates to disclaimers of interests transferred after 1976, and provides that a person who makes a qualified disclaimer," as defined therein, is not treated as having made a gift to the person to whom the disclaimed interest passes. Rather, the disclaimed interest passes as if the person making the disclaimer predeceased the transferor of the property. Qualified Disclaimer at issue

One of the requirements of a qualified disclaimer is that it be in writing and received by the transferor, his legal representative, or the holder of legal title no more than nine months after the later of the date on which the transfer creating the interest in the person desiring to make the disclaimer is made or the day on which such person attains the age of 21 years. For purposes of jointly held property, Treas. Reg. 25.2518-2(c)(4) provides that the transfer for purposes of making a disclaimer is at the time that the joint interest is created. Therefore, the IRS takes the position that any disclaimer, to be effective, must be made within nine months of the creation of the joint tenancy.

In McDonald, the taxpayer/wife and her deceased husband had owned land under joint tenancies created before 1977. Within nine months following the husband's death, the taxpayer/ wife disclaimed her survivorship interest in the jointly held property (i. e., her interest in the undivided one-half interest owned by her husband). The Tax Court, relying primarily on Jewett v. Commissioner, 82-1 USTC 13,453, adopted the Commissioner's position that transfer," as used in the disclaimer provisions, refers to the transfer upon the creation of the joint tenancy. Since the joint tenancies in question were created prior to 1977 and the disclaimer was not made until 1981, the Court concluded that the disclaimer of the taxpayer/wife was not timely made. The Court noted that even though Sec. 2518 and the Regs. thereunder were not applicable since the interests were transferred before 1977, the relevant statute in effect, Treas. Reg. Sec. 25.2511-1(c)(2), also imposed a time limit for an effective disclaimer of a reasonable time after knowledge of the existence of the transfer. Court of Appeals Makes Careful Analysis

In reversing the Tax Court, the Court of Appeals agreed with the taxpayer/wife that the relevant transfer had occurred at the decedent's death and not upon creation of the joint tenancies. The Court of Appeals, relying on Kennedy v. Commissioner (86-2 USTC 13,699) a case decided by the Court of Appeals for the Seventh Circuit, analogized the survivorship interest in jointly held property which was disclaimed to the lapse of a general power of appointment and found that the relevant time to disclaim was upon the death of the joint tenant. Whereas Jewett, on which the Tax Court relied, dealt with the disclaimer by a remainderman of a trust 33 years after its creation, Kennedy specifically considered the appropriate treatment of disclaimed interests held through joint tenancies.

The Court in McDonald, as in Kennedy, reasoned that since each joint tenant possessed a right of partition, which would destroy the survivorship interest (i.e., change the joint tenancy to a tenancy in common), each joint tenant could, by partitioning the property, dispose of his or her interest in the property by will or otherwise. Therefore, the Court stated that a joint tenant's survivorship interest in jointly owned property is similar to a general power of appointment in that the surviving joint tenant may not receive the survivorship interest in the joint property. Since the IRS, pursuant to Treas. Reg. Sec. 25.1518-2 (c)(3), provides that a person to whom any interest in property passes by reason of the exercise or lapse of a general power of appointment may disclaim such interest within nine months of such exercise or lapse, the Court found that the relevant transfer for purposes of the disclaimer provisions occurs at the death of the joint tenant and not at the creation of the joint tenancy. Thus, the period in which the taxpayer/wife of the decedent could disclaim the survivorship interest in the joint tenancies began to run in 1981 when the decedent died and not when the joint tenancies were created in 1977.

Robert L. Ecker

Planning for State inheritance Taxes-Could Avoid Reduction to Marital Deduction

In Letter Ruling 8922001, the IRS interpreted the intent of the testator as to require allocation of inheritance taxes against the marital share of an estate which in turn reduced the marital deduction. The issue was whether the language of an inter-vivos trust and the decedent's will require that the portion of the estate which qualified for the marital deduction bear its share of state inheritance taxes. Ambiguity of the tax allocation clauses in the testator's will and inter-vivos trust required the trustees to seek the IRS's advice. Language in both the trust and the decedent's will required that property passing for which no marital deduction was taken should bear its share of taxes. The trust agreement contained a clause that the grantor intended to preserve and maximize the marital deduction. Neither the will nor the trust provided for the allocation of taxes if the marital trust were to become subject to state taxes.

In most states, if the instrument is silent regarding tax apportionment, taxes are allocated to the distributive shares and legacies which caused the tax. In this case, could state law override a weak saving provision in the trust? Many States Do Not Recognize QTIP

Unlike the federal estate tax, many states do not allow a marital deduction for Qualified Terminable Interest Property. Some states will assess a tax based on the expected remainder interest of the property while others assess on value passing based on relationship to the decedent. In substantial estates, state taxes can cause a federal estate tax even where all the property is passing to the spouse. This would occur if the decedent uses up the unified credit with taxable gifts or bequests or if state taxes exceed the unified credit amount. If taxes are charged to marital deduction property, the net amount passing to the surviving spouse is reduced. As you reduce the marital deduction, the tax increases. In essence, an interrelated calculation is required. IRS Publication 904 explains and illustrates methods of calculating and arriving at the proper deduction and tax. The IRSs Opinion

The representatives of the estate wanted the taxes to be borne by the non-marital property, thereby maximizing the marital deduction. The IRS's opinion was that the decedent wanted each portion of the estate to bear its share of taxes. Therefore, the marital property was reduced and a larger taxable estate created.

Accordingly, proper planning by fiduciaries for death taxes and apportionment could have avoided this letter ruling request and possibly maximized the property passing to the surviving spouse. In substantial estates, state taxes can cause a federal estate tax even where all the property is passing to the spouse.

Joseph V. Falanga

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