QDOT: Estate planning for non-U.S. citizen spouse

In Canada as in the United States, the transfer of property from one spouse to the other at death is typically not subject to taxation. The tax rules differ between countries however.

In Canada, the Income Tax Act allows spouses to roll assets over to one another, on a tax-deferred basis. In the U.S., the Internal Revenue Code allows the surviving spouse to use what is called the “unlimited marital deduction” to avoid paying an estate tax on the assets held by the decedent.

This unlimited marital deduction allows the surviving spouse, in effect, to delay the payment of the estate tax on the assets received from his/her deceased spouse. There is a catch though. This deduction is only available to United States citizens. Uncle Sam wants to make sure that that a non-U.S. citizen surviving spouse (U.S. resident or not) will not avoid taxation in the United States. That is why the Qualified Domestic Trust (QDOT) has been created: to provide a vehicle where property can be transferred to a non-U.S. citizen spouse while deferring the payment of the U.S. estate tax.

The Internal Revenue Code imposes an estate tax on the estate of every decedent who is a citizen or resident of the United States. It also imposes estate tax on U.S. assets in excess of US$60,000 held by a non-U.S. resident who is not a U.S. citizen.

For 2012, there is an effective exemption limit of US$5.12 million dollars on assets held by a decedent; meaning that no U.S. estate tax will be payable if the value of worldwide assets held at death is less than US$5.12 million. However, that exemption level will expire on December 31^st, 2012.

We do not know, as of today, what the exemption level will be for 2013 and beyond. If Congress cannot come to an agreement on the subject before the end of the year, the exemption will revert to its 2001 level (US$1 million).

What is a QDOT?

The QDOT is a statutory defined trust allowing married couples, with a surviving non-U.S. citizen spouse, to take advantage of the marital deduction available to U.S. citizens.

The QDOT, in effect, postpones the estate tax until a subsequent taxable event occurs (such as distribution to a non-U.S. citizen spouse or the death of the non-U.S. citizen spouse). The estate tax rate will always remain the one that would have been applicable upon the death of the first decedent spouse. Furthermore, the amount subject to tax is the fair market value of the trust assets on the date of the surviving spouse’s death or the occurrence of a taxable event.

The QDOT is usually created in a will, but it doesn’t have to be. It may be created by the deceased spouse’s executor, post mortem, if the will does not provide for one; the executor will be able to transfer the inherited assets into it as long as an irrevocable QDOT election is made within 9 months of the date of death.

Note that if the QDOT is created after death (as opposed to at death by way of will), it will not qualify as a testamentary trust according to the Canadian Income Tax Act. Finally, even if a trust set up in a will does not qualify as a QDOT, it can be “amended” to meet the necessary requirements.

A QDOT is a flexible tool that can hold a large spectrum of assets: real estate, stocks, life insurance policies, annuities, pensions—the QDOT can even be named the beneficiary of an IRA or 401(k).

In order for a trust to qualify as a QDOT, at least one of the trustees must be a U.S. citizen, a U.S. corporation or a U.S. bank.

Also, if the QDOT contains assets equal to or less than $2 million, then no more than 35% of the value can be in real property located outside the United States; if that is the case, one of the trustees will need to be a U.S. bank, or, if the trustee is an individual or corporation, will need to post a bond equivalent to 65% of the value of the assets held in the QDOT.

If the QDOT holds assets in excess of $2 million, one of the trustees will need to be a U.S. bank, or, if an individual or corporation, the trustee will have to post a bond or a letter of credit equivalent to 65% of the value of the assets held in the QDOT.

Income generated by the investments held inside the QDOT can be distributed to the surviving spouse. This type of distribution will be taxed as income; but if the principal is distributed to the surviving spouse, he/she will be subject to the applicable estate tax payable on the distribution.

The trustee will have to withhold funds equal to the amount of the tax. There are, however, exceptions made for principal distribution in case of financial hardship, if the terms of the trust provides for such a possibility. After the death of the surviving spouse, the assets remaining in the QDOT will be subject to the estate tax.

A QDOT may not be recommended if the surviving spouse wants to cut ties with the United States after the death of the first spouse. In this case, the value of direct ownership of the assets may outweigh the estate tax costs of such a transfer.

Paying the estate tax upon the death of the first spouse might even be advantageous in some situations. If the estate assets are anticipated to achieve significant growth in the following years, it might be better to pay estate taxes at the first death, thereby reducing the estate tax exposure upon the surviving spouse’s death. However, while paying taxes at the first death may be financially advantageous in some situations, this approach is generally not followed.

Using the marital deduction is an integral component of most estate planning for U.S. citizens. However, this benefit is not available to Canadians if the surviving spouse is not a U.S. citizen, unless the plan includes a QDOT. An understanding of the QDOT rules and requirements and the ability to apply these rules to a client’s particular situation is essential when planning for your clients who have ties to the United States.

Francois Bernier is Mackenzie Investments’ Director, Tax & Estate Planning. He can be reached at: fbernier@mackenzieinvestments.com.