As world economies become increasingly interwoven, the number of families tied to multiple countries is growing. Multinational families often face a complex web of tax rules and regulations with far-reaching wealth management implications.
This is the first of a three-part series of articles that will provide an overview of the opportunities and challenges of gift and estate tax planning for multinational families from a U.S. perspective. In this piece, we explore some of the tax rules that can complicate estate planning for married couples when one spouse is not a U.S. citizen (a “non-citizen"). We'll also review some common estate and tax planning strategies that are designed to address those challenges.
The Federal Tax Landscape
U.S. federal gift and estate tax rules govern the taxation of asset transfers both during life and after death when a U.S. citizen or resident alien owns or has an interest in the asset.
Unified Estate and Gift Tax Exemption
For U.S. citizens and resident aliens, the unified gift and estate tax rules allow for the transfer of up to $5.49 million in 2017, free of federal estate and gift taxes. Married couples can effectively transfer twice that amount — $10.98 million in 2017 — by electing portability of the unified exemption.
Non-resident aliens who own property in the U.S. and who are married to U.S. citizens or residents are much more limited; only $60,000 of their U.S.-based assets bequeathed at death are exempt from taxation, and there is no lifetime gift exclusion.
Transfers between spouses who are both U.S. citizens don't incur any gift or estate tax, thanks to the unlimited marital deduction. This applies to lifetime transfers as well as bequests after one spouse's death.
In contrast, there is no marital deduction available for lifetime gifts to a non-citizen spouse. Those gifts are limited to an annual exclusion amount, indexed for inflation. In 2017, that amount is $149,000. Making matters even worse, bequests to a non-citizen spouse also do not qualify for the marital deduction, with the exception of transfers made through a qualified domestic trust (QDOT). A QDOT is designed to defer federal estate tax when a U.S. citizen dies and leaves a large number of assets to a spouse who is a non-citizen.
Because of these differences in the tax rules, a non-citizen spouse could face federal and state estate tax obligations at the death of a spouse. With proper planning, estate and tax strategies can help multinational families avoid that scenario.
Common Planning Strategies
Qualified Domestic Trusts
Qualified domestic trusts (QDOT) are designed to allow assets to pass from the deceased U.S. spouse's estate to a non-citizen spouse. Transfers made through a QDOT qualify for the marital deduction at the first spouse's death. Withdrawal rights for the non-citizen spouse are limited, so QDOTs essentially defer estate taxes until the second spouse's death.
Usually, income generated by a QDOT is distributed estate tax free to the surviving non-citizen spouse. When the surviving non-citizen spouse dies, assets are subject to estate tax as though they had been included in the estate of the first spouse to die.
Because the laws governing QDOTs are designed to allow for the deferral of estate taxation, and not eliminate it, QDOT provisions do not allow for trust principal to be distributed to the non-citizen surviving spouse unless estate taxes are withheld for the distribution. While there is an exception for hardship distributions, the threshold to qualify for those distributions is high and all other assets must be exhausted prior to taking them.
A QDOT, which must meet very specific legal requirements, can be created either during the lifetimes of both spouses or after the death of the U.S. citizen spouse. But QDOT treatment is not automatic; the executor must formally elect QDOT treatment and qualified terminal interest property (QTIP) treatment, if appropriate, no later than nine months after the death of the U.S. citizen spouse. At least one trustee must be a U.S. citizen or domestic corporation.
Although the rules governing QDOTs are complex, they provide the means to defer the estate tax obligation that would have otherwise been present at the U.S. citizen spouse's death.
Exemption trusts are another common strategy that multinational families can use when planning for a non-citizen spouse.
Exemption trusts are designed to split assets into two shares when the first spouse passes away. The first, the exemption trust share, is funded with assets equal to the current estate tax exemption amount ($5.49 million in 2017); the second, the marital or family trust share, is funded with remaining assets.
Since principal distributions from a QDOT are subject to estate tax, the exemption trust share becomes an even more valuable planning tool for multinational families. Principal distributions from an exemption trust aren't subject to the same penalties as those from a QDOT.
Therefore, depending on the circumstances, it may make sense to fund the exemption trust up to the federal exemption level rather than limit exemption trust assets to the state exemption, even though doing so may incur a modest state estate tax.
QDOTs offer estate tax deferral, but they also come with restrictions and limitations on the non-citizen spouse. While exemption trusts do not carry the same limitations as QDOTs, they are limited to the amount of the deceased spouse's remaining exemption. Therefore, there may still be estate tax obligations due after the citizen spouse's death. Life insurance can be an effective means of providing additional or alternative support for a non-citizen surviving spouse and other family members without limitations.
Generally, using life insurance as a planning tool for multinational families is most effective when an irrevocable life insurance trust (ILIT) is created and funded by one or more life insurance policies. Then, at the death of the insured, insurance proceeds will pass free from estate taxes. An ILIT funded by a single life policy on the life of the U.S. citizen spouse can be very helpful in providing flexibility for the non-citizen spouse. A second-to-die policy may be more appropriate for transferring funds to non-spouse family members.
With an ILIT, a trustee purchases an insurance policy on the lives of one or both spouses and pays the premiums from funds which are either already in the ILIT, or are gifted into the trust specifically to cover the premiums. These gifts are often tied to the annual exclusion amounts, in which case the trust beneficiaries have a lite window during which they may withdraw their portion of the gifted funds.
An ILIT must be structured, funded and administered appropriately to take advantage of the annual exclusion gift and to ensure that death benefit proceeds are excluded from the insurers' estates after their deaths.
While U.S. residents married to non-citizens cannot automatically take advantage of the unlimited marital deduction for lifetime gifts and transfers at death, advanced planning using QDOTs, exemption trusts, ILITs or a combination of all three can help multinational families protect as much as possible from federal estate taxation.
Of course, the decision to choose one estate or tax strategy over another should be made only after carefully considering the family's goals and reviewing all available alternatives.
When professionals advising multinational families understand their clients' complex planning needs, they can help adopt effective wealth transfer strategies. With professional planning advice from advisors with global experience, multinational families have unique opportunities for wealth preservation and generational wealth transfers. Multinational families may also be subject to the jurisdiction of foreign countries' tax authorities, so clients should be advised to obtain competent advice from professionals experienced in such international matters.