Qualified Domestic Trusts

A qualified domestic trust enables a non-U.S. citizen married to a U.S. citizen to be eligible for an unlimited marital deduction to keep the deceased person’s estate from being subject to federal taxes at death.

The Internal Revenue Code’s marital deduction enables a spouse to give his or her estate to a surviving spouse and avoid the assets being taxed at the first spouse’s death. Instead, the tax is enforced when the second spouse dies. The Internal Revenue Service (IRS) changed the law so that the deduction does not apply to non-citizen spouses, since they are concerned that this spouse may take the money to his or her native country, leaving the IRS unable to gather the taxes. Currently the federal estate tax exemption is $5 million, adjusted for inflation, and every dollar over that amount is taxed at 40%.

According to Title 26 of the U.S. Code, a qualified domestic trust must fulfill certain requirements:

  • At least one trustee must be a U.S. citizen or domestic corporation;
  • The trust must not enable a distribution of principal unless the U.S. citizen trustee can rightfully withhold estate tax on the distribution;
  • The trustee must keep an adequate amount of trust assets inside the U.S. to guarantee payment of federal taxes; and
  • The executor of the citizen spouse’s estate must elect to have the marital deduction apply to the trust.

If the qualified domestic trust assets surpass $2 million, one trustee is required to be a domestic bank, and if there is an individual trustee, he or she must post a bond or letter of credit to the IRS valued at 65% of the trust assets to safeguard the tax’s payment. If the trust assets are under $2 million, no bond need be posted and a bank need not be a trustee, if no more than 35% of the trust assets consist of non-domestic real estate.  

If an individual with a non-citizen spouse does not form a qualified domestic trust, everything in his or her estate after the sum of the estate tax exemption will face estate taxes. With a qualified domestic trust, by contrast, assets transferred to the trust are not taxed with the event of the first death, so the entire estate is available to provide for the living spouse. The trust retains the assets, but the spouse can receive income from the trust and, with the trustee’s authorization, also can collect principal. The income collected from the qualified domestic trust is taxed as regular income in the year it is received, unless the distribution results from IRS-defined “hardship.” Assets remaining in the QDOT at the second death will be taxed as if they were part of the citizen spouse’s estate, or at the highest tax rate.

Without a qualified domestic trust, the estate taxes would have to be paid at the citizen’s death. But with a qualified domestic trust, the taxes are delayed until the surviving spouse dies, meaning increased assets are available to provide for the spouse.

To help the non-citizen spouse get the tax deferral if the deceased spouse did not create a QDOT, the non-citizen spouse can create his or her own QDOT after the death of the spouse. The non-citizen spouse also could eliminate the problem by becoming a citizen prior to filing the federal estate tax return.