April 14, 2011

Qualified Domestic Trust

The following are some questions that relate to a qualified domestic trust. 

1. What is a qualified domestic trust?

A qualified domestic trust, or QDOT, is a type of marital deduction trust.

2. What is a marital deduction trust?

A marital deduction trust is an instrument used by married couples to eliminate or decrease the amount of estate taxes that will be owed on their deaths. Couples who are U.S. citizens are able to avoid the imposition of the estate tax on the first spouse to die because a spouse may transfer an unlimited amount of assets to the surviving spouse. IRC §2056(a). An A/B trust is an example of a marital deduction trust.

3. Who would write a QDOT?

A QDOT is the only type of marital deduction trust in which a deceased spouse’ estate can claim a marital deduction if the surviving spouse is not a U.S. citizen. IRC §2056(d)(1). For instance, Harry and Wendy, a wealthy married couple who were Ugandan citizens but resided in the U.S., could not take advantage of the estate tax loophole, namely marital deduction, granted to U.S. citizens who were married unless they drafted a QDOT.

4. What is the purpose behind a QDOT?

The U.S. imposes an estate tax on the worldwide assets of each citizen. IRC §§2001(a), 2511(a). Hence, the fact you live abroad but hold U.S. citizenship will not prevent the taxman from knocking on your estate’s doorstep when you pass away. Conversely, the assets of nonresident noncitizens are subject only to the U.S. estate tax if the assets are located in the U.S. IRC §2101(a). The intent of the QDOT then is to prevent the situation whereby a U.S. citizen's property escapes estate taxation by first qualifying for the marital deduction and then having the noncitizen surviving spouse move to a foreign country and die.

5. What are the requirements to create a QDOT?

A QDOT requires the following elements:

At least one trustee of the trust is a U.S. citizen or a domestic corporation. Treas Reg §20.2056A-2(d)(1)(i)(A).

The trust document must state that no distribution, aside from income, may be made from the trust unless the trustee who is a U.S. citizen or a domestic corporation has the right to withhold from the distribution the estate tax imposed under IRC §2056A.

The trust must comply with regulations issued by the Secretary of the Treasury to ensure the collection of any tax. See Treas Reg §§20.2056A-1—20.2056A-13.

A QDOT election must be made on the last estate tax return filed before the due date or, if a timely return is not filed, on the first return filed within 1 year after the due date. Treas Reg §20.2056A-3(a); IRS Letter Ruling 200352005.

The surviving spouse must agree to pay the estate tax due on the corpus portion of the trust under IRC §2056A(b)(1) and the executor must file the agreement to pay tax and a prescribed information statement with the estate tax return. See Treas Reg §20.2056A-4(c)(4)-(6); Temp Treas Reg §20.2056A-4T(c)(4)(ii)(B).

The executor must make an irrevocable election on the estate tax return to treat the trust as a QDOT. IRC §2056A(d).

6. What are some advantages of a QDOT?

The principal reason why a QDOT is drafted is to delay the imposition of the estate tax.

7. What are the disadvantages of a QDOT?

First, there is the expense of establishing the QDOT. Second, there is the annual expense of administering the QDOT given the tax implications. For example, an annual tax return will need to be filed with the state of California and the IRS. Third, the fact that a U.S. based-trustee will be involved, dilutes the power of the surviving spouse to make distributions from the QDOT to themselves.

8. What are taxable distributions from a QDOT?

Generally speaking, distributions of principal from the QDOT to the surviving spouse are considered taxable distributions. IRC §2056A. For example, if the QDOT owned a rental property and the rental property was sold and the proceeds were distributed to the surviving spouse, this would be considered a taxable distribution.

9. What are not considered taxable distributions from a QDOT?

An income distribution is not considered a taxable distribution. IRC §2056A(b)(3)(A). For instance, if the QDOT owned a rental property and the rents were distributed to the surviving spouse, this would not be considered a taxable event. Moreover, a distributions of principal to the surviving spouse on the account of hardship is not considered a taxable distribution. IRC §2056A(b)(3)(B). Examples of hardship distributions relate to situations involving the surviving spouse's health, maintenance or support, or the health, maintenance or support of any person the surviving spouse is legally obligated to support, unless the amount distributed may be obtained from other reasonably available sources. Treas Reg §20.2056A-5(c)(1).

10. What happens if a noncitizen spouse later becomes a citizen?

If a noncitizen spouse becomes a U.S. citizen before the estate tax return is filed and was a resident of the U.S. at all times after the decedent's death and before becoming a citizen, then the spouse will be entitled to the marital deduction. IRC §2056(d)(4); Treas Reg §20.2056A-1(b).

For example, assume that Horace was a U.S. citizen who married Wilhemina, a citizen of Germany. Horace was a multi-millionaire who owned vast tracts of farmland in the San Joaquin Valley. The couple resided in California until Horace’s passing in 2011. Since Wilhemina was not a U.S. citizen, Horace’s estate would be subject to the federal estate tax (there is no CA estate tax) and thus Wilhemina was required to file an estate tax return. Wilhemina applied for and was granted the automatic 6-month extension to file Horace’s estate tax return. Treas Reg §20.6081-1(b). This extension allowed for Wilhemina to obtain U.S. citizenship. Thereby Wilhemina could take advantage of the marital deduction for estate tax purposes because she was an eligible recipient, namely a surviving spouse who was a U.S. citizen.