Gift and estate taxation: noncitizen spouse issues.

U.S. gift and estate taxes constitute a unified transfer tax on accumulated wealth. Special considerations are necessary when a noncitizen is involved in an estate and gift tax plan. Specifically, when a spouse is not a U.S. citizen, the availability of a marital deduction for both gift and estate tax purposes may be limited. When developing a gift and estate tax plan, citizenship and residency information is critical.

Gift taxes

Gifts of property by U.S. citizens and resident aliens are subject to gift tax. Under Sec. 2523(a), a marital deduction equal to the property's value is allowed for gifts of property between spouses. However, under Sec. 2523(i), the marital deduction is not available where the donee spouse is not a U.S. citizen. Sec. 2523 provides some relief, via a $100,000 annual exclusion for gifts to the alien spouse (instead of the usual $10,000 annual exclusion). Accordingly, gifts made to a non-U.S. citizen spouse must be monitored to ensure they remain within the $100,000 annual exclusion. Gifts in excess of $100,000 to a non-U.S. citizen spouse will be considered taxable gifts.

Estate taxes

Sec. 2001(a) imposes estate tax on U.S. citizens and residents. Similar to the gift tax marital deduction, Sec. 2056(a) provides for an unlimited marital deduction in computing the taxable estate of an individual when property passes to the surviving spouse. This deduction is allowed on the theory that the property received by the surviving spouse will be included in the spouse's estate at death. In this way the couple is treated as a single entity for estate tax, similar to the treatment for income tax purposes under Sec. 1041.

Like the gift tax rules, under Sec. 2056(d)(1) the estate tax marital deduction is not allowed when property passes to a surviving spouse who is not a U.S. citizen. This is intended to ensure that property passing to a non-U.S. citizen will eventually be subject to the Federal estate tax. Absent this provision, a decedent's estate could use the marital deduction and the non-U.S. citizen surviving spouse could remove the assets from the U.S. before death. This would avoid the U.S. estate tax at the spouse's death.

Sec. 2056(d)(2) provides a way to obtain the marital deduction for property passing to a non-U.S. citizen surviving spouse through the use of a qualified domestic trust (QDT). Under Sec. 2056A(a), a QDT has the following characteristics:

* The trust instrument must require at least one trustee to be either an individual U.S. citizen or a domestic corporation.

* Any nonincome distributions from the trust must have the approval of this trustee, who has the right to withhold from the distribution the applicable estate tax computed under Sec. 2056A.

* The trust must comply with IRS regulations to ensure collection of the estate tax imposed on "taxable events."

* The executor must make an irrevocable election on the decedent's estate tax return to have the trust treated as a QDT.

Proper formation of a QDT will qualify transfers to the trust for a marital deduction in the decedent's estate. As a consequence, Sec. 2056A(b)(1) imposes an estate tax on certain taxable events, including (1) distributions of principal to the surviving spouse; (2) the value of property remaining in the trust at the surviving spouse's death; and (3) the value of property remaining in the trust when the QDT fails to meet any of the Sec. 2056A(a) characteristics. Proper use of a QDT will yield an interest-free deferral of the decedent's estate tax until the occurrence of a taxable event.

Sec. 2056A(b)(12) provides an additional special rule when the noncitizen spouse becomes a U.S. citizen. In this case, a marital deduction will be allowed if the surviving spouse becomes a U.S. citizen before the estate tax return is filed, and was a U.S. resident at all times after the decedent's death and before becoming a U.S. citizen. Given that the process of becoming a U.S. citizen may not be completed by the estate tax return's extended due date, this should be considered an opportunity of last resort.

Planning considerations

Gift and estate tax planners need to be cognizant of situations involving (1) resident alien spouses, such as a Canadian citizen couple living in the U.S., or (2) a U.S. citizen married to a non-U.S. citizen, both of whom are living either in the U.S. or abroad. In these situations, the unlimited marital deduction for lifetime transfers is not available and use of the $100,000 annual exclusion should be considered. In addition, formation of a QDT should be contemplated for transfers to the non-U.S. citizen spouse from the estate. If the couple is residing in the U.S., another possibility would involve the non-U.S. citizen spouse becoming a U.S. citizen. As a resident alien, the noncitizen spouse is already subject to U.S. income, gift and estate tax. Becoming a U.S. citizen would allow the estate to take the unlimited marital deduction for property passing to the surviving spouse, and would allow the surviving spouse to make annual exclusion gifts or unified credit gifts to others of property that would otherwise be trapped in the QDT.

Absent the spouse becoming a citizen, the donor spouse must be very careful as to gifts made during his lifetime. Present interest gifts to the noncitizen spouse in excess of $100,000 each year are taxable. This will make inter vivos funding of an irrevocable qualified terminable interest property trust difficult. It also may affect the availability of a spousal interest in a qualified personal residence trust. If a grantor-retained annuity trust is used, and there is a spousal interest in the event the grantor dies during the trust term, this will presumably have to meet the QDT rules to accomplish the desired result. All of this requires great care in marital planning. Because many Americans are married to non-U.S. citizens, these considerations are very important.