If you’re a U.S. citizen married to a non-U.S. citizen, it’s essential to understand the estate tax implications that may arise in the event of your passing. Estate taxes are taxes imposed on the transfer of property after someone passes away, and they can be levied by both the federal government and the state of New York.
The rules and regulations surrounding estate tax for a non-U.S. citizen spouse are more complex than planning for a citizen spouse – making it essential for both spouses to understand the potential pitfalls and available tax strategies that can be employed to mitigate estate tax liability.
Unlimited Marital Deduction
The federal gift and estate tax exemption for each spouse is $12.92 million in 2023 if the spouse is either a U.S. citizen or a U.S. resident. In addition, married couples have the option to combine their exemption which means it is possible to pass $25.84 million without incurring estate tax liability.
The New York state rules are separate and different from the federal rules. The New York exemption is $6.58 million per person for a U.S. citizen or U.S. resident regardless of marital status in 2023. However, the exemption is lost, and the estate will be subject to estate tax on dollar one if the value of the estate is 105% above the exemption. This quirky rule is often referred to as the New York tax “cliff” and is another reason why New York married couples may need to implement tax strategies to reduce estate tax liability. In addition, New York does not allow a non-U.S. spouse the unlimited marital deduction, and it does not offer portability for married couples regardless of their citizenship status.
How to Determine Domicile for Estate Tax Purposes
For the purpose of determining potential estate tax liability, it is important to establish the domicile rather than establishing the residency of the married couple. The concept of residency is tied to income tax and the number of days the taxpayer is physically residing in the United States within a given year. While domicile is determined by the person’s present intent to remain in the United States without the intention of leaving in the future.
Once Domicile is established it is usually not severed unless there is an actual move outside the U.S. with the intention not to return. For example, a permanent resident alien (green card) status usually is enough to establish a domicile for estate tax purposes.
Gifting Assets to Non-U.S. Citizen Spouse
Married U.S. citizens can gift an unlimited amount of assets to each other during their lifetime without incurring a tax liability, whereas gifts to a non-US citizen spouse are limited to an annual exclusion. The federal annual exclusion for gifts to non-US citizen spouses is $175,000 for 2023.
Taking advantage of the annual exclusion to systematically transfer wealth from the U.S. citizen spouse to the non-U.S. citizen while the spouses are alive may be an appropriate tax planning strategy for couples that anticipate having a number of years together and need to mitigate potential estate tax liability upon the passing of the U.S. citizen spouse.
Another option is the non-U.S. citizen spouse can transfer unlimited wealth to their U.S. citizen spouse, tax-free, which means the property’s value assigned to the surviving spouse is not subject to estate taxes, regardless of the amount.
Qualified Domestic Trusts (QDOTs)
If the surviving spouse is not a U.S. citizen, a Qualified Domestic Trust (QDOT) can be created to reduce estate tax liability. A properly structured QDOT is a trust that allows a non-citizen spouse of a deceased U.S. citizen to take advantage of the marital deduction on estate tax. Any assets that would have qualified for the federal estate tax marital deduction if both spouses were citizens can be left in this trust.
A properly structured QDOT needs to comply with certain IRS rules that are complicated to navigate. Some of the most important rules include a QDOT’s trustee must be a U.S. citizen or a U.S.-based corporation, such as a bank. If trust assets exceed $2 million in value, or more than 35% of the trust is funded with foreign real estate, the trustee must be a bank or an individual able to post a bond or a letter of credit to the Internal Revenue Service equal to 65% of the trust assets’ value at the deceased’s date of death.
In addition, the trust must require that the trustee cannot distribute any principal from the trust unless the trustee has the right to withhold the QDOT tax imposed on the distribution. These are not the only requirements, but they are among the most important.
Other Planning Options
In addition to annual gifting options, by creating a QDOT a non-U.S. citizen spouse can apply for citizenship to that they will qualify for the unlimited marital deduction upon the death of the U.S. citizen spouse. However, this would need to be done in advance of the death of their spouse because the unlimited marital deduction must be elected on an estate tax return that must be filed within nine months after the death of the U.S. citizen spouse -subject to a six-month extension. Therefore, the timing may be an issue if they wait to apply.
The other option is to establish an irrevocable life insurance trust (ILIT) which can provide liquidity to an individual’s estate and ensure that the surviving spouse has sufficient funds to pay any estate taxes that may be owed. A life insurance trust can be beneficial when the value of an individual’s estate is primarily tied up in illiquid assets such as real estate or closely held business interests.
Estate tax planning for non-citizens who are married to U.S. citizens is a complicated roadmap to navigate. There are several tax strategies that can be implemented to help minimize estate liability for the non-U.S. citizen spouse. But it is important to work with an experienced estate and tax planning attorney who is familiar with the IRS rules, can properly structure a tax plan, and help the couple understand the rules that will apply upon the passing of the U.S. citizen in order to reduce estate liability for the non-U.S. citizen spouse.
Amato Law, PLLC, assists clients with estate tax matters in New York, NY. Call 212-355-5255 or contact us online.
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