A Qualified Domestic Trust (QDOT) is designed to achieve a very particular goal: deferring federal estate tax when a U.S. citizen dies and leaves a large amount of money to a spouse who is not a U.S. citizen. If your family circumstances include both a lot of money—we’re talking at least several million—and a noncitizen who might inherit it, you’ll probably want to look into a QDOT.
Why do you need a special kind of trust if you’re married to a noncitizen? The answer is that for federal estate tax purposes, citizens get a big tax break that noncitizens don’t. When both members of a married couple are U.S. citizens, the first spouse to die can leave any amount of money to the survivor, completely free of estate tax. This is called the unlimited marital deduction.
The marital deduction does not apply, however, if the surviving spouse is not a citizen. A noncitizen survivor must pay estate tax just like anyone else who inherits. If the taxable estate is very large—more than $5.45 million, for deaths in 2016—then federal estate tax may be due. (See ”Estate Tax: Will Your Estate Have to Pay?”)
To avoid paying estate tax at the death of the first spouse, couples have two main options: get U.S. citizenship for the noncitizen spouse or create a QDOT trust.
With a QDOT, at the first spouse’s death, assets go to the trust instead of to the surviving noncitizen spouse. The survivor receives benefits (such as interest generated by trust bank accounts) from the trust assets, but doesn’t own them. When the second spouse dies, assets pass to other beneficiaries named in the trust document—typically, the couple’s children. If the estate is valuable enough, estate tax is paid then, as if the assets were in the estate of the first spouse to die. Trust assets are not included in the estate of the second spouse to die.
To get this tax break, detailed IRS rules must be followed when the trust is set up. For example, the trustee, who is has control over the trust assets, must be a U.S. citizen. If the amount of trust assets exceeds $2 million, one of the trustees must be a U.S. bank. (If it isn’t, the trustee must put up bonds for much of the trust’s value.) And after the first spouse dies, the executor must choose, on the federal estate tax return filed for the deceased spouse’s estate, to qualify for the marital deduction. This is called “making a QDOT election” and is irrevocable. The return must be filed nine months after the death.
The surviving spouse is entitled to receive any income earned by trust assets, and typically, all income is distributed to the survivor at least annually. These distributions are subject to income tax, but not estate tax.
If the trustee gives the surviving spouse any of the trust principal—the assets that were put in trust—estate tax may be due. No estate tax will be due, however, if money is distributed in circumstances that fall under the IRS hardship exemption. If the spouse has an “immediate and substantial” need for money relating to “heath, maintenance, education or support”—either his or her own, or that of someone he or she is legally obligated to support—a distribution of trust funds may qualify for a hardship exemption if the surviving spouse doesn’t have other reasonably available liquid assets. (26 CFR § 20.2056A-5(c)(1).)
Creating a QDOT involves millions of dollars and complicated IRS rules. Obviously, you’ll need advice from an expert about the advisability and mechanics of setting up this kind of trust.