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A potpourri of potential pitfalls to avoid with qualified domestic trusts.

Ever more frequently in the state of Florida we are coming to grips with planning for Florida couples where one or both are not U.S. citizens. As set forth in I.R.C. [sections] 2056(d), when the surviving spouse of the decedent is not a citizen of the United States, no marital deduction is permitted and the deemed one-half interest in joint property does not apply. However, if the property is held in or transferred to a qualified domestic trust (QDOT) as defined under I.R.C. [sections] 2056A, a marital deduction is permitted. The estate tax as calculated under the QDOT rules generally is deferred until distributions are made from the trust or upon the death of the surviving spouse. As outlined below, there are exceptions to the general rule of taxation upon distribution.

The QDOT requirement was set in place by Congress under the Technical and Miscellaneous Revenue Act of 1988 and the Revenue Reconciliation Act of 1989 in reaction to the fear that noncitizen spouses would leave the U.S. after their spouse's death, never to return and (from the government's perspective) never to be taxed. We now have had over a decade of experience with the QDOT and a review of the basics and some of the potential pitfalls probably is in order

Before discussing some of the basic requirements, it must be remembered that the QDOT requirements only apply to a decedent's estate if the surviving spouse is a noncitizen. If the surviving spouse is a U.S. citizen, these rules do not apply.

The Basics

Three basic requirements which must be met by a trust in order to qualify as a QDOT are as follows:

1) The QDOT must meet the basic requirements for any of the various marital deduction trusts under I.R.C. [sections] 2056. Under the most common example equivalent to the standard QTIP trust, the QDOT will have the same "qualifying income interest for life" as other marital deduction QTIP trusts generally have.[11] In addition, such a QDOT will be required to distribute income to the surviving spouse at least annually.[2] This distribution of income would not be subject to QDOT estate taxation, as it qualities for the income distribution exemption described more fully herein.

2) The QDOT instrument must require that at least one of the trustees be a U.S. citizen or domestic corporation and such U.S. trustee has the right to withhold the QDOT tax from any distribution.

3) The QDOT must meet the various additional requirements contained in the Treasury regulations under I.R.C. [sections] 2056A.[3]

Assuming the trust in question meets all the above requirements, in order to be considered a QDOT the personal representative must file the proper election on the decedent's estate tax return. The regulations are fairly generous, providing that the election must be made on the last federal estate tax return filed before the due date (including extensions of time to file actually granted) or, if a timely return is not filed, on the first estate tax return filed after the due date. In contrast, however, under I.R.C. [sections] 2056A(d) no QDOT election may be made on any return if such return is filed more than one year after the time prescribed by law (including extensions) for filing such return.[4] Once made, the election is irrevocable.[5]

Distributions Exempt From QDOT Estate Tax

Distributions from the QDOT generally are taxable with two major exceptions: income distributions and "hardship" distributions. For tax purposes, "income" generally is determined under the terms of the governing instrument or by applicable local law.[6] The regulations flush this out a little more to expressly provide that income does not include capital gains regardless of what the governing instrument provides. Generally, any governing instrument which expands the definition of income beyond applicable local law is ignored. Furthermore, for QDOT taxation purposes, if there is no specific case law or statute on the topic, the allocation is made by "general principals of law" (such as the Uniform Principal and Income Act or Restatements of applicable law).

"Hardship" distributions are those made to a spouse in response to an immediate and substantial financial need related to the spouse's health, maintenance, education, or support. This exemption also includes such distributions to another person whom the spouse is obligated to support. A distribution is not treated as being made for hardship purposes if the amount distributed may be obtained from other sources that are "reasonably available" to the surviving spouse.[7]

The Treasury regulations provide some examples of assets which are reasonably available and some which are not.[8] "Personally owned" assets such as marketable securities or certificates of deposit are available assets which would have to be used before a distribution from a QDOT could qualify as a hardship distribution. Such assets held in a revocable living trust similarly should be available. On the other hand, such assets held in a credit shelter or family trust created by the decedent for the benefit of the surviving noncitizen spouse should not be. Assets such as closely held business interests, real estate, and tangible personal property are not considered sources that are reasonably available to the surviving spouse. Regardless of whether all distributions are made for hardship purposes, a Form 706-QDT must still be filed.

"Certain miscellaneous distributions and dispositions" also may be exempt from the QDOT estate tax, including but not limited to:

1) Payments for ordinary and recurring expenses for the QDOT (including bond premiums and letter of credit fees) are exempt. Making the payment directly to the source rather than the spouse would help clarify that the distribution meets this exemption.

2) Payments to applicable governmental authorities, including income taxes and Florida intangible taxes imposed on the QDOT (other than the QDOT estate tax), are exempt. Such distributions should be made directly to the governmental authority rather than to the spouse. This express exclusion of the QDOT estate taxes under the regulations means that if a taxable distribution is made from the QDOT and the trustee pays the QDOT estate taxes from other assets remaining in the trust, the distribution of this tax payment would itself be subject to the QDOT estate tax. The QDOT estate taxes should be paid out of the taxable QDOT property distributed (similar to a withholding tax).

3) Transfers of assets for full and adequate consideration in money or monies worth are exempt. As one possible example, a spouse might be able to purchase discounted limited partnership interests from the QDOT on an installment note basis.

4) Amounts paid to reimburse the surviving spouse for any item of income imposed on the spouse to which the spouse is not entitled under the terms of the QDOT.

It is unclear what other distributions are meant to be included as exempt miscellaneous distributions[9] to be exempt under the regulations.

Computing the Tax

Assets in a QDOT are deferred from estate taxation until distribution (other than under the income, hardship, or certain miscellaneous distributions exemptions) or the death of the surviving spouse.[10] Assuming a taxable event has occurred and no further exemptions or deductions are available, the property is taxed as if the property had originally been taxed in the first spouse's estate. Thus, it gets added back into the decedent's taxable estate (including adjusted gifts) and is taxed at such marginal rates. Moreover, the property is included at its fair market value at the time of the distribution and not at the decedent's date of death value. If the estate's tax liability has not been irrevocably fixed (for example, by the continued running of the applicable statute of limitation or by a pending legal determination), the QDOT estate tax is applied at the highest marginal rate.

The trustee of the QDOT is personally liable for the QDOT tax if it is not paid out of the QDOT property. The trustee may secure an early discharge for this personal liability for the QDOT tax by requesting the IRS, in writing, for a determination of QDOT tax liability and a discharge as outlined in I.R.C. [sections] 2204. Of course, the discharge will require payment of the tax or, under certain circumstances, the furnishing of a bond.

The $2 Million QDOT

If the assets of a QDOT are in excess of $2 million (determined without regard to any indebtedness), the QDOT must meet one of the following additional requirements at all times during the term of the QDOT:

1) At least one trustee must be a U.S. bank;

2) The U.S. trustee must provide a bond in an amount equal to 65 percent of the fair market value of the trust assets (determined without regard to any indebtedness); or

3) The U.S. trustee must provide an irrevocable letter of credit in an amount equal to 65 percent of the fair market of the trust assets (determined without regard to any indebtedness).[11]

If the value of the assets as finally determined are adjusted to a different amount, the U.S. trustee must adjust the value of the bond or letter of credit accordingly within 60 days.[12] The above additional requirements also can apply to a QDOT having $2 million or less if more than 35 percent of the QDOT consists of real property located outside the United States. This is tested by the fair market value of the assets determined annually as of the last day of the taxable year of the trust. There is also a look-through rule for foreign real property held in certain business entities.

For purposes of determining the $2 million threshold, the personal representative may exclude up to $600,000 in value attributable to real property (and related furnishings) owned directly by the QDOT used by the surviving spouse as a personal or second residence. This $600,000 exclusion does not appear to have been changed in response to any of the recent indexing legislation.[13] This special election must be made by written statement attached to the estate tax return on which the QDOT election is made. The statement must identify the address and location for such property or properties. For purposes of the bond or letter of credit, the election may be made on the federal estate tax return, or prospectively, at any time, by attaching a written statement to the Form 706-QDT. These special election rules do not apply to the 35 percent foreign real property limitation. In addition, multiple QDOTs are aggregated for purposes of these tests.

Reforming the Nonqualifying Trust

Property passing to a noncitizen spouse either outright or in a nonqualifying trust does not have to be subject to the QDOT estate tax. Property will be treated as passing to a properly created QDOT if the property is irrevocably transferred or assigned to the QDOT by the spouse before the date on which the estate tax return is filed (and the QDOT election is made).[14] Property irrevocably assigned but not actually transferred to the QDOT before the estate tax return is filed must be conveyed and transferred to the QDOT under Florida law before the administration of the decedent's estate is completed. If there is no administration, the conveyance must be made on or before the date that is one year after the due date (including extensions) for filing the decedent's estate tax return.[15] Thus, having a formal administration opened when dealing with issues involving a QDOT may be advisable. If the actual transfer is not timely made, the marital deduction is not allowed.[16]

Multiple QDOTs

A personal representative or trustee might desire to create multiple QDOTs in order to take advantage of GST planning. The Treasury regulations recognize that multiple QDOTs are permitted. However, when creating multiple QDOTs, it is important to select a "designated filer" as set forth in the Treasury Form 706-QDT and reporting all of the distributions from all the QDOTs. The designation must be made on the decedent's federal estate tax return, or on the first Form 706-QDT that is due and is filed by its prescribed date, including extensions.[17] Failure to make a proper designated filer election results in a loss of the hardship exemption. Thus, the only nontaxable distributions the QDOT could make would be limited to distributions of the income and the miscellaneous other distributions previously mentioned.

Interplay With Tax Treaties

In the case of a noncitizen who is a citizen of another country with which the United States has a tax treaty with respect to estate, inheritance, or gift taxes, the QDOT rules do not apply to the extent they are inconsistent with the provisions of such treaty relating to estate, inheritance, or gift tax marital deductions. As one example, see the U.S.-German Estate Tax Convention Art. 10(4) which contains some marital exclusions available regardless of the surviving spouse's citizenship. Treasury regulations permit the estate to choose either the QDOT rules or the treaty provisions. However, the estate cannot cobble together parts of the QDOT and parts of the treaty provisions so as to use the QDOT provisions for whatever marital property the treaty may not cover.[18]

Family-Owned Business Exclusion

The exclusion for a qualified family-owned business exclusion may be subject to recapture if the qualified heir loses U.S. citizenship. A qualified heir may avoid such recapture by placing the qualified family-owned business assets into a trust meeting requirements similar to a QDOT (or through certain other security arrangements).[19]

The Charitable QDOT

One interesting approach when planning for a noncitizen spouse is to combine a QDOT with a charitable remainder trust (CRT). Under I.R.C. [sections] 2056A(b)(10), a charitable deduction may be taken into account when computing the QDOT estate tax. Assuming the QDOT is structured as a CRT, the surviving spouse can receive the unitrust or annuity amount currently and the remainder will pass to the charity (and receive a charitable deduction). This approach can simplify the administration of the trust--removing thorny issues for the trustee to judge whether distributions are for hardship purposes, for example. The IRS has approved the combination of a QDOT and a CRT in Private Letter Ruling 9224013 (July 30, 1982).[20] The ruling provides that to the extent any unitrust payment consists of trust corpus, that part of the distribution shall be subject to the additional QDOT estate tax and the trustee must withhold from such payment the QDOT estate tax imposed. Upon the death of the surviving spouse, no additional QDOT estate tax will be owed as the distribution to charitable organizations will qualify as a charitable deduction under I.R.C. [sections] 2055.

Conclusion

In conclusion, the QDOT is apt to be an ever more common estate planning technique used by Florida attorneys. With QDOTs, the devil is in the details as failure to follow the regulations can result in loss of the marital deduction or disqualification of certain exemptions from the QDOT estate tax. The practitioner must be aware of the potential pitfalls hidden in the details of the QDOT regulations.

[1] I.R.C. [sections] 2056(b)(7)(B)(i) and (ii) set forth the basic requirements for the common Qualified Terminable Interest Property (QTIP) trust.

[2] Under I.R.C. [sections] 2056(b)(7)(B)(ii)(I) a usufruct interest for life is also permitted.

[3] Treas. Reg. [sections] 20.2056A-2. See Rev. Proc. 96-54 (1996-50 I.R.B. 9) for sample paragraphs which may be used to satisfy the governing instrument requirements.

[4] I.R.C. [sections] 2056A(d); see PLR 9843030 (July 24, 1998) (IRS denied extension as CPA preparing return failed to elect QDOT status on timely filed federal estate tax return and, in fact, still had not filed election at time IRS issued letter ruling). Moral: File the election when you file for the extension.

[5] Treas. Reg. [sections] 20.2056A-3.

[6] Treas. Reg. [sections] 20.2056A-5(c).

[7] Id.

[8] Id. Further guidance may be available by analogy for hardship distributions described in I.R.C. [sections] 401(k)(2)(B)(i)(IV).

[9] Treas. Reg. [sections] 20-2056A-5(c)(3).

[10] Treas. Reg. [sections] 20.2056A-6.

[11] Treas. Reg. [sections]20.2056A-2(d)(1).

[12] Id. The Treasury regulations define what events are to be treated as "finally determined."

[13] Congress has apparently ignored those provisions dealing with aliens as the $60,000 applicable exclusion amount for a nonresident alien has not been indexed for inflation under I.R.C. [sections] 2107(c).

[14] I.R.C. [sections] 2056(d)(2).

[15] Treas. Reg. [sections] 20.2056A-4(b)(6).

[16] Id. The regulations further provide that an extension of time for completing the conveyance, or a waiver of the actual conveyance, may be requested under specified circumstances under [sections] 301.9100-1(a). An example of this request for waiver may be where the spouse is in the process of applying for U.S. citizenship and obtains same. See, e.g., PLR 9834013 (August 21, 1998).

[17] Treas. Reg. [sections] 20.2056A-9.

[18] Treas. Reg. [sections] 20.2056A-1(c).

[19] Letter from Linda L. Robertson, assistant secretary (legislative affairs and public liaison), Department of Treasury to Rep. Christopher Shays, U.S. House of Representatives, May 11, 1998, Tax Analysts Document No. 98-15807.

[20] See also Treas. Reg. [sections] 20.2056A-6(b)(3).

William M. Pearson is a shareholder in the Naples firm of Grant, Fridkin, Pearson, Athan & Crown, P.A., and chair of its trusts and estates department. Mr. Pearson is board certified in wills, trusts and estates by The Florida Bar. He obtained his J.D. from South Texas College of Law.

Todd L. Bradley is a member of the Naples firm of Grant, Fridkin, Pearson, Athan & Crown, P.A., and concentrates his practice in estate planning and probate administration. Mr. Bradley earned his LL.M. in taxation from New York University and his J.D., with honors, from the University of Florida College of Law.

This article is submitted on behalf of the Tax Law Section, J. Bob Humphries, chair, and Michael D. Miller and Lester B. Law, editors.
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Author:Pearson, William M.; Bradley, Todd L.
Publication:Florida Bar Journal
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Date:May 1, 1999
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