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Marital deduction planning: for the non-citizen spouse.

In recent years, Congress has voiced increasing concern over whether the United States tax laws adequately prevent the large-scale avoidance of United States income and excise taxes by foreign taxpayers.(1) This fear is evident in recently enacted provisions regarding gratuitous transfers made by a United States citizen spouse to a noncitizen spouse.(2) In essence these provisions greatly restrict the availability of the marital deduction for such interspousal transfers; and prescribe that, where such transfers do qualify for the marital deduction, potentially severe tax consequences may ensue. Since originally being placed into law, the Technical and Miscellaneous Revenue Act of 1988 (TAMRA) the rules pertinent to citizen-noncitizen interspousal transfers have undergone steady - and fortunately liberalizing evolution - with changes being made in both the Omnibus Budget Reconciliation Act of 1989 and the Revenue Reconciliation Act of 1990. In this article an examination will be made of the current tax law governing the treatment of these transfers as well as planning techniques by which the potentially harsh impact of this law can be mitigated.

Estate Tax Consequences

Pursuant to IRC Section 2056(d)(1) as a general rule, an estate tax marital deduction is denied for property passing to a surviving spouse who is not a United States citizen. A major exception to this disallowance rule is provided for property passing from the decedent to a qualified domestic trust (QDT) on behalf of the surviving spouse. According to Section 2056(d)(2), in order for property or an interest therein to be considered to pass to a QDT such must: 1. Be transferred to the QDT before the date the estate tax return is filed; or 2. Be irrevocably assigned to the

QDT on or before the date the

estate tax return is filed pursuant

to an arrangement enforceable

under local law.((3)

A QDT: What Is It?

In order to be considered a QDT, a trust must satisfy the following three criteria. 1. Have at least one trustee who is a

United States citizen or a domestic

corporation, the consent of

which is required for there to be

a distribution from the trust.

Although generally to qualify as

a QDT, transfers to the trust

must have been eligible for the

marital deduction, but for the

fact that the surviving spouse is

a noncitizen. However, the trust

will be considered a QDT and

potentially qualify for the marital

deduction if the trust is permitted

to withhold income.(4)

This rule exists even if the trust's

right to withhold would neither

qualify for the marital deduction

as a QTIP or life estate with

general power of appointment.(5)

It should be noted that the requisite

that at least one of the

trustees be a United States citizen

or domestic corporation exists

to help protect the

government's ability to collect

any tax attributable to a QDT

distribution. This protection lies

in that the Code provides that

each trustee is personally liable

for the amount of any tax due to

a QDT distribution. 2. The trust must satisfy any regulations

prescribed to ensure the

collection of any tax to which the

trust is subject.(6) 3. The executor of the estate must

make an election required by

Section 2056A with regard to

the trust. See Section 7805 and

the regulations thereto for guidance

concerning the making of

the election.(7)

Determination of whether a trust qualifies as a QDT is to be made on either: 1. The date the estate tax return is

to be filed; or 2. The date reformation of the trust

is made so that the trust conforms

to the QDT requirements

if a judicial proceeding to have

such reformation is initiated before

the estate return is due.(8)

Tax Consequences

While property passing to a QDT can avert a transfer tax due to the marital deduction special tax consequences can result form distributions from a QDT. According to Section 2056A(b)(1) and 2056A(b)(2), the distribution of property, other than income, from a QDT prior to the date of the surviving spouse's death will give rise to an estate tax. The estate tax is computed through a kind of gross up rule which pushes the applicable tax rate used for this purpose up to the maximum extent possible. The return for reporting this tax is due on the 15th day of the 4th calendar month following the end of the calendar year in which the sanctioned distribution occurs.(9) A similar type tax is also imposed on the value of any property remaining in the QDT on the date the surviving spouse dies. Such tax is computed pursuant to the following steps: 1. Calculate the tax pursuant to the

rates of IRC Section 2001 that

would arise based upon the aggregate

of.

a) The decedent's taxable

estate; plus

b) The amount of the property

distribution (or amount

situated in the QDT at the

surviving spouse s death if

such is applicable); plus

c) The total amount of

property previously

distributed from the QDT. 2. Subtract from the above tax figure

the tax that would have arisen

under Section 2001 if the taxable

amounts previously distributed

under Section 2001 were included

in the decedent's taxable

estate.(10)

Should the decedent citizen spouse's estate not yet be resolved when the taxable event occurs, the tax on such distribution will be based upon the highest estate tax rate provided for under Section 2001 as of the date the decedent died. Should it be later determined this tax is higher than appropriate when the estate is determined, a refund or credit may be claimed.

When the trust ceases to qualify, a tax will also be imposed. In this regard, the tax will be computed as described above treating the surviving spouse as having died upon the date of cessation.

Example: J. a U.S. citizen, dies leaving a $2 million gross estate. Of this amount he leaves $1.4 million to his surviving spouse K, a noncitizen spouse, in a QDT. The remaining $500,000 is to pass to other relatives of J and will avoid estate tax due the unified credit. Subsequently, $200,000 is distributed out of the QDT of which $50,000 is income of the trust. The distribution produces a tax of $55,500. This tax is derived by taking the tax on the taxable estate of the decedent increased by the aggregate of the QDT taxable events, here $750,000 ($600,000 + $150,000), and subtracting from it the tax that would have been imposed on the taxable estate excluding the taxable event, here $600,000 ($750,000 - $150,000). Thus, the tax is computed by subtracting $192,800 (the tax on $600,000) from $248,300 (the tax on a taxable estate of $750,000). Note the taxable event in this case is the distribution of property from the QDT and that the income distributed from the QDT is not considered a taxable event.

A surviving noncitizen spouse will obtain a carryover basis from the trust pursuant to the basis rules governing gifts set forth in IRC Section 1015. In a similar fashion to a gift, the basis to the surviving spouse of property distributed from the QDT is adjusted upward where taxes are paid due to the distribution and the value of the asset distributed on the date of the distribution exceeds the QDT's basis in it.

Example: M, a citizen of the United States leaves property valued at $500,000 to his wife T, a noncitizen, in a QDT. The QDT obtains a basis in the property from M of $500,000. Later the property is distributed from the QDT to T, at which time the property has a value of $1 million. The distribution gives rise to a $450,000 tax. As a result of the distribution M obtains a basis in the property of $675,000 ($500,000 carryover basis plus $450,000 gift tax paid, multiplied by $1 million fair market value, minus $500,000 basis, divided by $1 million fair market value).

In addition to restricting qualifications for the marital deduction of assets passing from a decedent citizen spouse to a noncitizen spouse other tax laws have been revised. These include a provision denying qualification for the normal tax treatment of joint tenancies held between husband and wife. Under the general tax rules such joint tenancies are treated as if each spouse provided 50% of the consideration, with 50% of the value of the asset being included in the estate of the first of the spouses to die and automatically passing to the survivor.(11) This treatment normally applies regardless of the amount of consideration provided by either spouse.

In contrast where a joint tenancy is held between a citizen and noncitizen spouse, the value going through the estate of the citizen spouse and over to the noncitizen spouse survivor is determined as if such parties were not married. Thus, all consideration is presumed provided by the first spouse to die absent proof (the ability to trace) of the independent consideration provided by the survivor.(12)

Planning Techniques

Despite the ominous outlook reflected by the previously stated general rules, opportunities exist to limit the possible financial detriment of transferring assets to one's noncitizen spouse. Tactics worth considering in this regard include the following.

Engaging in a Plan of Systematic

Lifetime Giving to One's Spouse

Although IRC Section 2523(i) disallows the marital deduction gifts to the donor's noncitizen spouse, the Code provides for an annual exclusion of $100,000 for gifts made to one's noncitizen spouse. In order to qualify for this $ 100,000 annual exclusion the transfer must have met the criteria set forth in IRC Section 2523 for the marital deduction and thus potentially been entitled to such, except the donee spouse was not a United States citizen.

Make Hardship Distributions

While the distribution of property other than income from a QDT will normally give rise to a tax relief from such tax is accorded to distributions made to a spouse on account of hardship.(13) At present, caution is advisable when attempting to meet this exception as no standard for determining hardship for this purpose has been issued in the Code or appears in the legislative history.

Becoming a Citizen

The special tax on QDT distributions or upon the surviving spouse's death will be avoided, should the surviving spouse become a United States citizen, on all distributions made subsequent to gaining such citizenship if any of the following three criteria is met: 1. The noncitizen souse was a resident

of the United States at all

times following the death of the

citizen spouse and before becoming

a citizen. 2. No tax was imposed due to a

distribution from a QDT prior

to the spouse becoming a citizen. 3. The noncitizen spouse elects to

treat any distribution from the

QDT that was taxable as a gift by

such spouse for gift and estate

purposes.(14)

Utilizing the Credit on Prior

Transfers if Available

Where a transfer to a surviving noncitizen spouse does not qualify for the marital deduction, relief from subjection to double estate taxation on the same value of an asset can be obtained under the Section 2013 credit for tax on prior transfers should the surviving spouse die within 10 years of the citizen spouse.(15)

Careful Retention of Records Concerning

Joint Tenancies

Pursuant to IRC Section 2040(b) joint tenancies between husband and wife are treated as if equally contributed to by both spouses. Consequently, 50% of the value of property held in joint tenancy between husband and wife will generally be included in the estate of the first spouse to die and automatically pass to the survivor, resulting in the survivor having an adjustment to his/her basis in the asset and 100% ownership.(16)

Pursuant to IRC section 2056(d), this 50/50 treatment is not extended to property held in joint tenancy between a citizen and noncitizen spouse. Instead, under the general rules pertaining to joint tenancies between other than husband and wife, 100% of the consideration for the joint tenancy will be presumed provided by the first to die, absent proof (tracing) of independent consideration provided by the survivor. Since the percentage of the value of the property held in joint tenancy between other than husband and wife includible in the estate of the first to die is based upon the percentage of consideration provided by such party, if 100% of the consideration is deemed provided by the first of the spouses to die, 100% of the relevant value of the property will be includible in the estate of the first to die. To avoid this consequence, records and supporting documentation should be maintained corroborating the independent consideration provided by the surviving spouse.

Conclusion

In plugging a perceived loophole, Congress has established obstacles to having transfers of property from a United States citizen spouse to a noncitizen spouse be accorded a marital deduction. While having property pass from a decedent citizen spouse to a QDT holds promise as a means of acquiring the marital deduction, its utility is impaired by tax rules regarding the taxation of distributions by the QDT, and property remaining in the QDT upon the death of the surviving spouse.

Tax planning opportunities and options exist, however, to avoid being unduly financially harmed by these rules. Such opportunities include a carefully implemented program of gift giving and the noncitizen spouse taking appropriate and timely steps to become a United States citizen. By taking these opportunities into account, practitioners can minimize their clients' vulnerability to transfer taxes.

Footnotes

(1) In this regard, see IRC [Section] 1031 which denies like kind exchange treatment to exchanges involving foreign real property, and the recent amendement of IRC [Section] 163 which limits the deductibility of interest paid or owed to foreign entities. (2) IRC Sections 2056(d) and 2056A. (3) See PLR 9043070. (4) IRC [Section] 2056A(a)(1). (5) Revenue Reconciliation Act of 1990 Section 1700. (6) IRC [Section] 2056A(a)(2). (7) IRC [Section] 2056A(a)(3). (8) IRC [Section] 2056A(d)(5). See PLR 9017015 regarding qualifying for the marital deduction through reformation. (9) IRC [Section] 2056A(b)(5). (10) IRC [Section] 2056A(b)(2). (11) IRC [Section] 2040(b). (12) IRC [Section] 2040(a). (13) IRC [Section] 2056A(3)(B). (14) IRC [Section] 2056A(b)(12). (15) See IRC Sections 2056(d)(3)and 2013. (16) IRC [Section] 2040(a).

Mark A. Segal, LLM, CPA, is an associate professor of accounting at the University of South Alabama. He is the author of numerous articles published in accounting and legal journals.
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Title Annotation:provisions on the Technical and Miscellaneous Revenue Act on income and excise taxation of foreign spouses
Author:Segal, Mark A.
Publication:The National Public Accountant
Date:Aug 1, 1992
Words:2441
Previous Article:Caution: not all taxes are discharged in bankruptcy.
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