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This Memorandum is designed to be of general interest. The specific techniques and information discussed may not apply to you. Before acting on any matter contained herein, you should consult with your personal adviser.
[First Spouse to die = Deceased Spouse. Second spouse to die = Surviving Spouse]
Non-citizen residents can leave $5,000,000. tax free. [Special rules apply to Non-Resident Aliens.]
Foreign citizenship of the Surviving Spouse potentially may cause a problem if assets left for the Survivor exceed $1,000,000 (equity). If your assets are less than $1,000,000, this concept does not apply.
These special rules apply only to that portion of the Deceased Spouse's share of assets in excess of $1,000,000; the first $1,000,000 of assets of the Deceased Spouse (and all of the survivor's assets) are not subject to these rules.
The government's goal is to tax assets once at each generation. Therefore, an unlimited marital deduction generally exists, allowing all tax to be deferred at the death of the first spouse, regardless of the size of the estate. (With proper planning, at the later death of the Surviving Spouse, assets are potentially taxed to the extent they exceed $2.* million.)
Foreign citizenship causes a problem, in the opinion of the government. If a non-citizen spouse inherits, the U.S. government is concerned that the Surviving Spouse may "go back to the old country" with the assets, thus avoiding the opportunity of the government to tax those assets at her subsequent death (which assets were originally exempted from taxation on the first spouse's death).
Therefore, if the Surviving Spouse is a non-citizen, even a long time resident alien, the marital deduction applies differently.
Thus, as long as the taxable estate is less than $2* million (combined), citizenship is not in issue.
With a U.S. citizen Surviving Spouse, the QTIP Trust works perfectly. The only requirement to defer taxation of a QTIP bequest (on the death of the first spouse) is U.S. Citizenship of the Surviving Spouse.
If Surviving Spouse is a U.S. citizen, no complications arise.
There are two easy solutions to the problem of non-citizenship:
The slightly more complex solution is to have a different kind of trust (a QDOT, rather than the QTIP trust) with another person [a U.S. citizen] as trustee in charge of making distributions.
The U.S. Congress decided that if a U.S. citizen is appointed Co-Trustee with sole authority to determine the size of principal distributions to the foreign citizen surviving spouse, there will be no opportunity to avoid U.S. taxation at the Surviving Spouse's eventual death. Any tax would be the legal responsibility of the U.S. citizen Co-Trustee.
With the QDOT (as with a QTIP), all of the income will be paid to the Surviving Spouse, during her life.
At her death (or upon the earlier withdrawal of principal) the assets will be taxed in the first spouse's estate, not the Surviving Spouse's as would occur with a standard QTIP Trust.
[In a QDOT, the Surviving Spouse may be the sole trustee for all purposes other than making distributions; thus the Surviving Spouse may be the sole decision maker regarding investments, liquidity, and all factors other than distributions of principal to that spouse.]
The sole job of the U.S. citizen Co-Trustee is to determine the size of principal distributions to the Surviving Spouse.
This Co-Trustee may be a friendly person; in fact it should be. Any U.S. citizen adult may serve.
IF THE SURVIVING SPOUSE SHOULD BECOME A U.S. CITIZEN before the death of the first spouse, a regular QTIP will automatically be in place; the QDOT takes effect only if the Surviving Spouse is not a U.S. citizen at the time of death of the first spouse.
Remember, there are three separate trusts (for accounting purposes, although the assets may be all commingled). If your community property joint assets are $5,000,000 at the time of the first spouse's death, the first spouse owns $2,500,000 and the Surviving Spouse owns $2,500,000. The Surviving Spouse's (previously owned) $2,500,000 is put into the Surviving Spouse's Trust. She has full powers over this and the first spouse's death has no impact on these assets, since they were previously owned by the surviving spouse.
The Deceased Spouse's $2,500,000 is split in two: $1,000,000 in the Bypass Trust, managed by the surviving spouse during her life, used by the surviving spouse during her life as needed, and given to the children at the Surviving Spouse's death. Since the Surviving Spouse has only a life estate in this portion, it is not taxed at her later death.
The excess over the maximum $1,000,000 which may be left tax-free ($1,500,000) may be left to a U.S. citizen spouse for her life, but any amount remaining at her death (as well as the Surviving Spouse's Trust) is subject to tax at her death in her estate.
Since the Bypass Trust is entirely tax-free at both deaths, that portion should be allowed to accumulate and grow, while the spouse would consume the other two (subsequently taxable) portions.
If the Surviving Spouse is not a U.S. Citizen, assuming the QDOT trust is used with a U.S. Citizen as its manager, tax is delayed until principal is removed or her subsequent death, when any remaining principal will be taxed in the first spouse's estate, not the Surviving Spouse's.
Thus, the ability to spend those assets (and to avoid taxation later, since they have been spent) is lost.
In summary, the easy solution is for both spouses to become naturalized. However, if they do not wish to, we can work this other, slightly less advantageous, option.
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