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Spouse’s Citizenship Is Critical in Estate Plans

September 1, 1995

Who you marry is a very personal decision, and it’s nobody’s citizen or a citizen of, let’s say, Germany, Taiwan, Egypt or Brazil.

But even in these days of global markets and globe-trotting executives, your spouse’s citizenship is a critical factor in at least one important area: estate planning.

Lots of lawyers don’t ask about nationality, and many clients forget to mention it. It can be a costly oversight. That’s because the unlimited marital deduction _ which allows you to leave everything to your husband or wife without paying any estate taxes _ doesn’t apply to spouses who aren’t U.S. citizens.

As a result, any resident of the U.S. with a noncitizen spouse who writes a standard U.S. will may end up giving Uncle Sam a bundle upon death. ``It is forgotten, and it is overlooked,″ says New York attorney Martin M. Shenkman. ``It is a real trap for the unwary.″

The intent of the law _ passed in 1988 _ is to keep surviving spouses from simply returning to their home countries, taking their untaxed inheritance money with them. But the law is so restrictive that many noncitizen spouses opt to become U.S. citizens rather than comply with its onerous requirements.

Keep in mind that uets of the deceased, be they U.S. citizens or simply U.S. residents. Moreover, for estate-tax purposes, assets held jointly by a couple are considered to be 100 percent in the first-to-die spouse’s estate unless the noncitizen spouse can prove that he or she contributed.

Folks with less than $600,000 in assets need take no special steps. Any U.S. resident can pass that amount tax free to anyone they want, no matter what their citizenship. But anything over $600,000 passed to a spouse who isn’t a citizen is subject to estate taxes unless it is put into a qualified domestic trust, or QDOT.

But even that doesn’t solve the estate-tax problem if the surviving spouse needs to get at the principal. Any principal taken out of the trust is taxed as though it had been part of the estate of the first-to-die spouse. And the estate-tax rate is calculated to include all prior distributions, thus potentially pushing successive withdrawals into higher estate-tax brackets.

That’s a big penalty to pay, says Gideon Rothschild, a New York attorney. A husband with a $1.2 million estate could leave his noncitizen wife $600,000 tax-free and put the remaining $600,000 in a QDOT. But as she withdrew that QDOT principal, Mr. Rothschild estimates, the government would collect $235,000 in taxes on money that a citizen spouse would have inherited tax free.

``She is left with substantially less dollars,″ he says.

In addition, there are restrictions on the management of a QDOT. At least one of the trustees must be either a U.S. citizen or corporation. QDOTs also may be restricted in the amount of assets invested in real property located outside of the U.S.

To avoid the constraints of a QDOT, many couples opt to transfer assets to the noncitizen spouse. For couples with assets of as much as $1.2 million, simply dividing the assets equally between the two partners can effectively solve the problem, since each can leave the other as much as $600,000 free of estate taxes.

Couples with more than $1.2 million may want to shift most of the assets to the noncitizen spouse as the unlimited marital deduction remains intact when it is the U.S. citizen who inherits. ``In some respects, the gift technique can be just as effective, if not more effective, than utilization of the QDOT,″ says Kenneth Freshman, tax director for Pannell Kerr Forster PC in Boston.

But such transfers are yet another trap for the unwary because any gifts above $100,000 a year to a noncitizen spouse trigger the gift tax. Mr. Shenkman cites the case of one man who was unaware of the gift-tax limits until after he made some very large transfers to his wife.

``Technically, he had some substantial gift tax due as a result of that,″ says Mr. Shenkman. ``His spouse has since become a citizen, but he was one unhappy camper.″

Indeed, becoming a citizen is the easiest answer for many. That’s why estate attorneys typically recommend documents be worded in such a way that a QDOT is effective only if the spouse remains a noncitizen.

Timing of that citizenship, however, is important. If obtained before or within nine months of the spouse’s death, there is no need for the QDOT at all, says Mr. Rothschild. After that time, estate taxes become due unless a QDOT is established. Even then, the surviving spouse can avoid paying QDOT taxes by remaining a resident and leaving all trust principal untouched until obtaining U.S. citizenship.

If your spouse was oblivious to the problem and never took any estate planning steps, there is still a way to avoid estate taxes if you aren’t a U.S. citizen. If you initiate proceedings within nine months of your spouse’s death, you can ask the court for permission to set up your own QDOT. This limits estate taxes to any principal money withdrawn from the trust.

Then, if you wish, you can begin the process of becoming a citizen to avoid the estate taxes altogether, Mr. Rothschild says.

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