U.S. citizens married to non-U.S. citizens often want to know how much they can give to their spouse without incurring U.S. gift tax. Gifts to non-U.S. citizens are subject to different rules than spouses who are U.S. citizens, and there is a hidden income tax consequence that many fail to consider.
From a U.S. estate and gift tax perspective, couples who are American citizens enjoy an unlimited marital deduction; spouses can give unlimited amounts of assets to each other without any estate or gift tax implications. After all, any assets in excess of the couple’s estate tax exemption ($11.4M per person in 2019; $11.58M in 2020) will be taxed at the death of the surviving spouse. Transferring assets to the survivor only defers the tax that the Internal Revenue Service (IRS) will eventually collect. Since a non-U.S. citizen spouse may not be subject to U.S. estate tax, the U.S. tax code does not allow a U.S. citizen spouse to transfer unlimited assets to a non-U.S. citizen spouse, as the transferred wealth could avoid U.S. estate taxation upon death. Thus, when the recipient spouse is not a U.S. citizen—regardless of whether the non-U.S. citizen spouse is a resident or nonresident of the U.S. —the amount of tax-free gifts is limited to an annual exclusion amount: $155,000 for 2019 and increased to $157,000 for 2020. For 2019, any gift in excess of the $155,000 exclusion amount will subject the transferring spouse to gift taxation.
To avoid gift taxation, the couple usually should consider at least these two alternatives:
1. Obtaining U.S citizenship
The first strategy is for the recipient spouse to become a U.S. citizen before the transferring of the deceased spouse’s U.S. federal estate tax return is due. If the surviving spouse becomes a U.S. citizen, he or she will qualify for the unlimited marital deduction and no estate tax will be due at the date of gift or date of death of the first spouse. The overall consequences of becoming a U.S. citizen are obviously very significant, even from a tax perspective, so this decision should only be made after extensive consultation with experienced professional advisors.
2. Utilizing a qualified domestic trust (QDOT)
The second method is to use a qualified domestic trust (QDOT), which does not avoid estate tax, but postpones it until after the surviving non-U.S. citizen spouse passes away. A QDOT is created by the U.S. citizen spouse, either before or at death. Instead of leaving assets to his/her spouse, the U.S. citizen leaves them to the trust. The surviving spouse is the sole beneficiary of the trust and receives all income generated by the trust’s assets. All other distributions from the trust, except for “hardship distributions,” will be subject to estate tax. After the surviving spouse’s death, the remaining assets in the trust will be subject to U.S. estate tax. At least one of the QDOT’s trustees must be a U.S. citizen (must be at least one U.S. bank if value over $2M) and the QDOT election must be made.
While American citizenship solves gift and estate tax issues if the spouse is becoming a U.S. citizen for other reasons, a QDOT is a more flexible estate planning option for those spouses who will not obtain their U.S. citizenship.
If you have questions relating to gifts to non-U.S. citizens or estate planning, please call John Ure or one of our experienced estate tax advisors today at 301.231.6200.