QDoT Basics

TAMRA 88 disqualifies the marital deduction to an estate of a decedent whose surviving spouse is not a U.S. citizen IRC Sec. 2056(d).

Using the QDoT (IRC Sec. 2056A) will temporarily (until the death of the non-citizen surviving spouse) secure the marital deduction for the estate of an individual whose surviving spouse is not a U.S. citizen. The purpose of the QDoT is to make sure that a non-citizen surviving spouse would not escape estate tax on his or her death by residing outside the U.S. QDoT was created by TAMRA as a vehicle by which the marital deduction could be allowed for property passing to the non- citizen surviving spouse and at the same time, provide the government with some assurance that the property will eventually be taxed in the estate of the non-citizen surviving spouse. The QDoT in effect is an exception to the rules created by TAMRA. The QDoT provisions are effective for estates of decedents dying after November 10, 1988.

The QDoT provisions do not apply to certain estates of decedents (dying before December 19, 1992) who are residents or citizens of the U.S. and also are residents of foreign countries engaged in a tax treaty with the U.S. with respect to estate, inheritance and gift tax. These treaties are designed to prevent double estate and gift taxation of the same property. A listing of the many countries included in the treaties can be found in Pub. L. No. 101-239, Sec. 7815(d)(14), 12/19/89.

The marital deduction will be allowed if the non-citizen surviving spouse becomes a U.S. citizen before the estate tax return is filed and resided in the U.S. from date of the decedent's death to date of U.S. citizenship IRC Sec. 2056(d)(4). However, obtaining citizenship after the decedent spouse's death may not be the most practical solution in light of the time and bureaucratic delays and also considering the surviving spouse's state of mind. The best and most simple solution is advance planning, i.e., to obtain U.S. citizenship before the death of the citizen-spouse, if possible. This will alleviate the need to comply with the stringent QDoT requirements.

QDoT Specifics

The QDoT operates as follows:

QDoT Election. The QDot must be elected by the executor on Form 706, Schedule "M," line 3. The election is to be timely made on either the last estate tax return filed before the due date (including extensions) or, if no timely return is filed, on the first return filed after the due date. Elections made on or after May 5, 1991, must be made within one year after the due date of the estate tax return (including extensions) IRC sec. 2056A(d). The election once made is irrevocable.

Trustees. At least one trustee of the QDoT must be a U. S. citizen or a domestic corporation IRC sec. 2056A(a)(1)(A).

Approval of Distributions. No distributions of trust corpus may be made unless the U.S. citizen or domestic corporation trustee has the right to withhold estate tax (imposed on QDoT) from the distribution, i.e., no distributions can be made without the approval of such trustee IRC sec. 2056A(a)(1)(B). Each trustee is personally liable for the tax imposed.

Assurance of Collection of Estate Taxes. The QDoT must meet the requirements of forthcoming regulations that will "ensure the collection" IRC sec. 2056A(a)(2) of estate taxes. According to congressional intent, the regulations will probably require the U.S. trustee (whether individual or corporate) to hold sufficient U.S. assets to pay the QDoT estate tax, including possibly posting a bond or prohibiting investments outside the U.S.

Estate Tax Traps

Inadequate transitional rules present problems for decedents (with non-U.S. citizen spouses) dying without having a chance to conform their wills in accordance with new QDoT provisions. There are no grandfathering provisions as such, which has caused the need for many wills and trusts to be reformed or updated (where possible). The Code does provide for such reformations to "change such trust(s) into a trust which is a qualified domestic trust" IRC Sec. 2056(d)(5). The judicial proceeding must be commenced on or before the due date of the estate tax return (including extensions). The reformation rules, however, are only effective where the trust in all other respects (expect for the QDoT flaw) would qualify for the marital deduction.

PLR 9043070 provided relief by permitting the estate of a decedent dying in April 1989, who was survived by a non-citizen spouse, to reform the trust to become a qualified domestic trust. The ruling required certain provisions to be made to the trust so as to qualify it as a QDoT. The required qualifying provisions were an expanded version of the QDoT requirements as set forth in the Code.

In an unrelated matter, the New York County Surrogate reformed a will to create a QDoT where all property passed to the non-citizen surviving spouse (Estate of Nangle, NYLJ, 8/15/89, p.15).

Transitional rules provide that the marital deduction will be allowed if property is transferred or irrevocably assigned to a QDoT before the due date of the estate tax return. The initial transfer date was extended to December 19, 1990, for estates of decedents dying before December 19, 1989.

Similar to QTIP

The underlying concept of the QDoT is similar to the Qualified Terminable Interest Property (QTIP) trust in that the allowance of the marital deduction is conditioned upon the inclusion of the subject property in the estate of the surviving spouse. At the date of death of the non-citizen surviving spouse, the value of the QDoT property is includable in the estate of the surviving spouse IRC Sec. 2056A(b)(1)(B) (similar to QTIP provisions under IRC Sec. 2044). Under TAMRA, certain distributions which may upset this underlying concept of estate inclusion have been identified as "taxable events" which constitute another estate tax trap. A "taxable event" IRC Sec. 2056A(b) occurs when a distribution is made before the date of death of the surviving spouse. A taxable event also occurs if the trust loses its qualification as a QDoT. For example, a taxable event will occur if the U.S. trustee is removed or the trust fails to maintain sufficient U.S. assets to pay estate taxes imposed on QDoTs. If the trust ceases to qualify as a QDoT the taxable event provisions "shall apply as if the surviving spouse died on the date of such cessation" IRC Sec. 2056A(b)(4). The death of the non-citizen surviving spouse is also a taxable event. Exempt from the taxable event provisions are distributions to the surviving spouse of income or "on account of hardship" IRC Sec. 2056A(b)(3). The Code does not define hardship, causing additional problems in drafting documents to include specific hardship distribution provisions.

The major problem is the estate tax imposed on "taxable events." The tax is figured as if it would have been imposed on and added to the first decedent spouse's estate, thereby causing an additional estate tax at the first decedent spouse's highest marginal rate.

More Suffering

The unified credit is also lost for the surviving spouse since only one unified credit can be taken on the decedent's estate tax return. To add additional suffering to the situation, if the tax imposed (on taxable events) is paid out of the QDoT property (principal), the tax paid will be considered an additional distribution that will be subject to an additional estate tax at the highest marginal rate of the first decedent spouse. In effect, the estate could be paying tax on tax indefinitely. These provisions could have been avoided by including amendments to existing law covering similar situations in the QTIP area, IRC sec. 2044, for example. QTIP property is includable and taxed in the surviving spouse's estate as opposed to QDoT property which is includable in the estate of the surviving spouse but is effectively taxed back in the estate of the first decedent spouse without the benefit of the (surviving spouse's) additional unified credit. To date there is no relief in sight, thereby creating a need for some very careful advance planning.

Paying the Tax

The estate tax imposed due to a taxable event is due April 15 of the year following the calendar year of the distribution. The tax is reported and paid with the new Form 706-QDT, "U.S. Estate Tax Return for Qualified Domestic Trusts" issued March 1991. For all taxable events occurring after November 10, 1988, and before January 1, 1991, the due date of Form 706-QDT was extended to September 16, 1991. All future returns will be due by the regular April 15 date prescribed. Where the surviving spouse dies during a yearof distributions causing taxable events, the tax may be due earlier than April 15 of the following year since the tax is due within nine months of the date of death of the surviving spouse.

IRC Sec. 2056A(b)(8) provides for a 10-year estate tax lien on the distributed property beginning on the date of the taxable event. The 10-year lien can be suspended if at the time of death of the surviving spouse, he or she is subject to U.S. estate tax. In this case the surviving spouse will be able to treat tax paid (on taxable events) as prior estate tax paid "without regard to when the first decedent died" IRC sec. 2056(d)(3) and be entitled to a credit for such on the filing of the estate tax return of the surviving spouse. The credit will be lost though if the surviving spouse has no taxable estate. This waiver of the statutory 10-year period (IRC sec. 2013) was meant to provide relief to a surviving spouse who continued to be subject to U.S. estate tax regardless of the existence of a QDoT.

Another tax trap lies in the transfer of jointly held property that passes to a non-U.S. citizen surviving spouse from the estate of the decedent spouse dying after November 10, 1988. If the property does not pass in a QDoT, it will be includable at full value in the estate of the decedent spouse and not qualify for the marital deduction.

Planning Considerations for

QDoTs

The best solution is for the non-citizen spouse to become a U.S. citizen. But that may not always be possible or practical, in which case other alternatives should be considered.

The estate of the citizen spouse should be separated into marital and nonmarital (unified credit) trusts to receive the full benefit of the unified credit. The marital trust would qualify as a QDoT (and possibly a QTIP trust, if applicable) holding assets in excess of $600,000. This is basic planning in any estate where assets exceed $600,000.

Since final regulations have not been issued, it would be prudent to make sure that any wills or trusts drafted are flexible enough to give the executor authority to conform to the forthcoming regulations in order to salvage the marital deduction with respect to QDoT property. This can be done with a saving provision in the will citing the tax rules in effect now and in the future. The executor should also be made aware of the testator's intent to elect the QDoT and should not make distributions that would disqualify the QDoT election and possibly cause the disallowance of the marital deduction.

Annual exclusion gifts to the surviving spouse may be used to reduce the estate of the citizen spouse and provide the non-citizen spouse with the means to secure the unified credit in his or her own estate as well, thus sheltering more of the combined estate from estate tax. IRC Sec. 2523(i) allows a $100,000 annual exclusion for gifts to non-citizen spouses, effective for gifts made on or after July 14, 1988. This generous allowance should be taken advantage of to reduce the estate of the citizen spouse.

New York State has no corresponding provision for the increased annual exclusion for gifts to non-citizen spouses (still limited to $10,000) but does not require a QDoT in order to qualify for the marital deduction if the surviving non-citizen spouse agrees to be considered a citizen of the U.S. for purposes of determining New York State residency status.

Similar to QTIP treatment and marital trusts, a qualified disclaimer (under IRC Sec. 2518) may be an effective estate planning tool to keep property out of the estate of a non-citizen spouse. The disclaimer can be used to cure drafting defects due to the QDoT changes enacted with TAMRA 1988. The non-citizen surviving spouse may disclaim even if he or she ultimately becomes an income beneficiary of a trust to which the bequest passes as a result of the disclaimer.

Strategic drafting may provide a partial solution to avoid the devastating effect of paying the tax on distributions (taxable events) from the QDoT corpus. The trust may be drafted to treat the distributions used to pay the tax as allocable to the income account of the QDoT which is allowed to be withdrawn without creating a taxable event, threby eliminating the problem of paying tax on tax indefinitely.

Clients' files should be reviewed to locate potential problems for non-citizen spouses whose wills have not been updated since November 10, 1988, the effective date of the QDoT provisions.

A Necessary Evil

In light of the restrictions TAMRA has placed on the marital deduction for property passing to a non-citizen surviving spouse, the QDoT is necessary evil. It is the second-best solution next to obtaining U.S. citizenship for the surviving non-citizen spouse. However, in its present state, the QDoT sets forth a minefield of estate tax traps for those who are unaware or who cannot effectively comply with the rigid requirements. Executors and trustees should be made aware of all applicable restrictions and be on the alert for new interpretations that may affect planning.

It is understandable that the government is concerned about the possibility of losing the estate tax on an estate that it previously granted a full marital deduction. Until final regulations or some relieving amendments are issued that both the treasury and the taxpayers can live with, practitioners and planners must remain acutely aware of the QDoT provisions and be able to use them effectively in advising the non-citizen on estate planning.