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By: S. Mark Mathews, J.D., LL.M.
This article identifies common gift and estate tax issues faced by married couples when one or both are not United States (hereinafter “U.S.”) Citizens. The information listed in this article may or may not apply to you. Before acting on any technique discussed herein you should contact a legal advisor well versed in non-citizen planning.
THE TAX LANGUAGE
Resident Aliens – Non-citizens who live in the United States. A non-citizen lives in the U.S. if they live here and have no present intention to leave. A facts and circumstances test is used to determine a present intent to stay. Intent is derived from visa applications, tax returns, wills, drivers license, church affiliations, length of stay, green cards, citizenship aspirations, business interests and various other factors.
Resident Aliens benefit from the same unified gift and estate tax credit as citizens, but the unlimited marital deduction is not available unless the surviving spouse is a United States citizen.
The residency test for income tax and gift and estate tax is different so you could be considered a resident for one but not for the other. For income tax purposes to be a resident you must pass the “green card test” or the “substantial presence test”. For more information on the income tax test for residency please refer to Internal Revenue Service Publication 519 U.S. Tax Guide for Aliens.
Non-Resident Aliens – Legal aliens who plan any contact with the U.S. either by spending time in the U.S. or by investing in assets situated in the U.S. will be considered non-resident aliens. You are considered a nonresident alien for any period that you are neither a U. S. citizen nor a U. S. resident alien which means you live in the U.S. but do not pass the facts and circumstances test mentioned above.
Regardless of whether a non-resident alien is in the U.S. for an indefinite period of time or for a short stay their death in the U.S. may have negative U.S. estate tax consequences. Similarly, lifetime transfers by non-resident aliens may be subject to U.S. gift tax.
THE FEDERAL ESTATE TAX EXEMPTION HAS A CRITICAL IMPACT ON ESTATE AND GIFT TAXES FOR NON-CITIZENS
The amount of the federal estate tax exemption is crucial for non-citizen alien spouses because couples with assets under the estate exemption can just transfer the assets utilizing the estate exemption without needing the marital deduction which is limited for non-citizen spouses. The federal estate tax is and has been in a state of flux for some time. The estate tax exemption was $600,000 in 1987, it was optionally unlimited for 2010, and it is $5 million in 2012. Furthermore, it is scheduled to go back down to $1 million in 2013. The problem is we can only guess as to whether the exemption will be reduced as currently scheduled or if it will be increased by later congressional action as expected by many legal experts (President Obama’s planned tax proposal for 2013 and after is to lock in the exemption at $3.5 million but the problem with this is that it requires congressional action and that term has largely become an oxymoron in recent years). The status of the estate tax exemption is important to all citizens but has its greatest effect on planning for non-citizen spouses because non-citizen resident aliens get the unfettered benefit of the estate exemption but are not entitled to the unfettered benefit of the marital deduction.
The unlimited marital deduction allows the transfer of an unlimited amount of assets to a surviving U.S. citizen spouse free of any estate tax (some exceptions apply to decedents passing before 1982). If, however, one of the citizens is not a resident alien, taxation at death depends on which spouse dies first, the U.S. citizen spouse or the non-citizen resident alien spouse. If the resident alien spouse dies first then the marital exemption remains available to the surviving U.S. citizen spouse on all of the worldwide assets owned by the predeceased non-citizen spouse. If, on the other hand, the U.S. citizen spouse dies first then only a Restricted Marital Deduction is available to the surviving resident alien spouse on the worldwide assets owned by the predeceased citizen spouse. The first decision that must be made where you have a surviving non-citizen spouse is whether to shelter assets from tax using the available Restricted Marital Deduction or by ignoring it altogether and using the federal estate tax exemption to shelter assets, going to a non-citizen alien spouse. The size of the estate is the greatest factor in making this determination. The smaller the estate the more likely it is that you will NOT need the Restricted Marital Deduction. The gross estate of a decedent is calculated by adding together all the decedents worldwide assets then subtracting the value of the property going to the U.S. citizen surviving spouse, among other items, to determine the net taxable estate. The remaining net taxable estate is sheltered up to the decedents remaining estate tax exemption. For example, in 2012 a U.S. citizen spouse with $10 million could transfer $5 million to his citizen spouse and $5 million to his children estate tax free. This is because the $5 million going to his spouse is exempt by the unlimited marital deduction and the $5 million going to his kids is exempt due to the federal estate tax exemption. Unfortunately, the unlimited marital deduction does not apply to non-citizen spouses except on a restricted basis. This is because the U.S. is concerned that a non-citizen surviving spouse could return to his or her country of origin and avoid later federal taxation of assets held outside the U.S. so the U.S. restricts those assets to guarantee the later taxation of those assets. With larger estates the use of the Restricted Marital Deduction may be necessary depending on the size of the estate and the goals and objectives of the couple. This would require the use of a Qualified Domestic Trust (hereinafter “QDOT”) explained later in this article.
Non-resident aliens like resident aliens are subject to the Restricted Marital Deduction but they are not entitled to the federal estate tax exemption like resident aliens. Non-resident aliens are limited to a federal estate tax exemption in the amount of $60,000 compared to the $5 million exemption available for resident aliens in 2012. Non-resident aliens are taxed on that portion of the decedents gross estate which at the time of death is located in the U.S. including but not limited to real property, stock, collectibles, furniture and other items of tangible personal property. Certain deductions may also be available to reduce the taxes dues (debts and expenses) but only in an amount proportionate to the value of the U.S. situs assets divided by the value of the decedents worldwide assets. Charitable deductions and credit for estate taxes paid under a gift and estate tax treaty between the countries may also reduce the estate tax due. Any non-resident with assets located in the U.S. should seek the advice of competent estate planning counsel to avoid potentially serious and unexpected taxes.
ELIMINATE ESTATE AND GIFT TAXES BY BECOMING A CITIZEN
Another way to deal with the Restricted Marital Deduction is to become a citizen. If the non-citizen surviving spouse becomes a citizen prior to the filing of the Estate tax return (due 9 months after death) and has lived in the U.S. since their deceased spouse’s death then they can qualify for the normal marital deduction. This solution has to be identified extremely early as it can take some time to become a citizen. If there is not enough time to complete the process before the estate tax return is filed you can create a QDOT that will defer the taxes normally outstanding until a later specific triggering event occurs (discussed later) causing the tax to become due. If citizenship is timely completed then the new citizen spouse qualifies for the normal unlimited marital exemption and as such can withdraw any portion including the entire amount of the assets held in the QDOT without triggering any tax. For this to be effective the non-citizen must remain a resident alien throughout the entire citizenship process.
USING A QDOT TO DEFER TAXES
Where the couple’s combined gross estate is more than the federal estate tax exemption or where the non-citizen spouse does not wish to become a citizen a good estate plan will require the use of the marital deduction. For example, if a husband and wife have combined assets of $10 million dollars and the exemption is $5 million then traditional estate planning would require the use of a tax exemption shelter trust or A/B trust to capture both exemptions and eliminate the federal estate tax. This is done by capturing the deceased spouses $5 million dollar exemption in trust and sheltering the rest with the marital deduction. For the non-citizen resident alien any amount beyond the $5 million going into trust would be taxed because there is no marital exemption. The only way a non-citizen can take advantage of the marital deduction is to create a QDOT which will act to grant a Restricted Marital Deduction. A QDOT allows the surviving U.S. non-citizen resident alien spouse to defer (without interest) estate taxes until one of three triggering events occur that will require the estate taxes to be paid at the rate in place at the predeceased citizen spouses death. The triggering events are: (1) distributions of principal to the non-citizen spouse (except for hardship) and only up to the amount distributed, (2) the trust ceasing to meet QDOT requirements or (3) the surviving non-citizen spouse’s death. When the triggering event occurs the Trustee must withhold assets equal to the amount of the tax due. Distributions of income do not trigger the estate tax nor do distributions of principal if done because of a hardship. Hardship is defined as an immediate and substantial financial need relating to the spouse’s health, maintenance, education or support or the health, maintenance, education or support of any person that the spouse is legally obligated to support. A hardship does not exist if funds are reasonably available from other sources such as stocks or securities.
Could there be double taxation in more than one country upon the death of a non-citizen? Yes. Every country applies their own different and distinct domicile standards so it is possible that more than one country may consider you domiciled there. Further you may owe tax based on where certain assets are physically located. This situation should be examined before death to see what planning opportunities may be available.
LIFETIME GIFTS BETWEEN SPOUSES AND NON-CITIZEN SPOUSES
Both U.S. citizens and non-resident aliens can gift up to $13,000 (indexed for inflation) per person per year in accordance with the annual gift exclusion. This means you can gift $13,000 each year to as many people as you want without reducing your estate exemption. U.S. citizens and non-resident aliens can also gift split meaning they can together gift $26,000 each year to as many persons as they want each year. U.S. citizen spouses can gift an unlimited amount of assets tax free between themselves during life. Additionally, U.S. citizen spouses can normally transfer as many assets between them as they deem best due to the marital exemption. Unfortunately, the transfer from citizen spouses to non-citizen spouses is limited to $139,000 per year in 2012 and is in place of and not in addition to the normal $13,000 per person per year. If the lifetime exemption is not adequate to shelter your assets you might want to make a series of annual gifts during life to more evenly divide the assets owned by each spouse. Gift tax returns are due annually on the same date that your annual income tax returns are due. Gifting could be desirable for many tax and non-tax reasons.
In summary, a married couple, whether both or either is a resident alien, does not need to worry about owing gift tax or estate tax as long as their combined assets worldwide do not exceed the unified gift and estate tax exemption amount ($5 million in 2012 but scheduled to go down to $1 million on January 1, 2013). Any person or any married couple, whose assets exceed the unified gift and estate tax exemption amount may be exposed to significant tax at death (the rate is currently scheduled to be up to 55% of exposed assets as of January 1, 2013) and would be well advised to review their situation with a tax planner. Even without a tax issue, non-citizens just like citizens should, at least, have a last will and testament in place and other lifetime planning documents necessary in the event of death or incompetency respectively.
Additionally, all individuals regardless of tax exposure would benefit from creating documents to protect themselves against the other kinds of things that can go wrong while they are alive, specifically stroke, heart attack or other illness which may prevent them from being able to act. Non-citizens, just like citizens should have in place a business power of attorney, health care power of attorney, living will and Health Insurance Portability and Accountability Act release form. These documents can prevent expensive legal procedures which are necessary to take care of your business if you have not acted to protect your family while you are able.
ABOUT THE AUTHOR
S. Mark Mathews received a Bachelor of Science in Business Administration from Ohio Northern University in 1992. He received a Juris Doctor from Thomas Cooley Law School in 1998 and he earned a Master of Laws (LL.M.) Degree in Business and Taxation from Capital University in 2002. He was admitted to practice law in Ohio in 1999 and in Kentucky in 2004. He was appointed special counsel to the Ohio Attorney General in 2007 and continues in that capacity today. He is a member of the Cincinnati Estate Planning Council and is also a member of the American, Ohio, Cincinnati and Kentucky Bar Associations. He is admitted to practice before the United States Supreme Court and all Ohio and Kentucky state courts and agencies.
The law firm of Mathews & Mathews began in 1946 when S. Paul Mathews and Carl Lore Meier formed a law partnership in Norwood under the name of Meier & Mathews. They were later joined by Carl G. Werner, Lawrence Collins, Judge Paul J. George (Domestic Relations Judge – retired) and Louis J. Hendricks, Jr. In 1968 Stanley A. Mathews joined the firm when it became the present firm of Mathews & Mathews Co., L.P.A. In 1998 S. Mark Mathews joined the firm.
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