ON THE LITTLE cul-de-sac where I live in Colorado, three couples face an unusual estate tax problem. So does my brother. And it's all because of love. Seriously. My brother, like my friends down the street, married a noncitizen. And that prevents him from leaving unlimited assets to his wife estate-tax free -- a privilege every other American enjoys. Fortunately, there's a solution.
Estate Tax Basics
For those who are unaware, estate taxes, which are levied after a death, start at 37% and quickly rise to 55% on large estates. American citizens and resident aliens (basically, permanent U.S. residents who are not citizens) are both allowed an exemption on assets up to $675,000 (rising to $1 million by 2006). Beware: Your estate will owe tax even on assets outside the U.S. (To assess your liability, use our estate tax calculator.)
But there is another estate-tax bonus that those married to noncitizens do not enjoy. That's the so-called "unlimited marital deduction." Under this rule, spouses can leave any amount of assets to each other free of estate taxes. But that's only as long as your spouse is an American citizen. The rule also allows you to give an unlimited amount to your spouse while you're still living, free of federal gift taxes. But again, that's provided your spouse is a citizen. This problem exists whether or not you are an American citizen.
Obviously, this is all very bad news if you've been (wrongly) assuming you qualify for the unlimited marital deduction.
So What Can You Do?
There are several ways to get around the noncitizen spouse estate-tax dilemma. Depending on your circumstances, some are more feasible than others. Here's the list.
First, you can marry a citizen. This is a potential solution if you're currently unmarried, but obviously not very practical if you are already hitched to a noncitizen. In fact, if you get divorced from a noncitizen, you may owe income and capital gains taxes on assets transferred to your spouse under your divorce property settlement. (This is another little-known disadvantage of being married to a noncitizen.)
Second, your spouse can become a citizen. This can occur even after you are dead, but no later than the due date for filing the estate tax return (generally nine months after your death). As long as your spouse attains citizen status before the deadline, the unlimited marital deduction is available -- meaning he or she can be left an unlimited amount free of any federal estate taxes. However, your spouse may not want to become a U.S. citizen for various reasons. (For example, becoming an American citizen may require renouncing one's home country citizenship, which could affect the right to own property in that country.)
The third solution involves setting up a qualified domestic trust, or QDOT. The QDOT can be formed under the terms of your will, by your estate's executor after your death or by your spouse after your death. Basically the assets inherited by your spouse go into the QDOT. Then the federal estate tax on the value of those assets is deferred until your spouse takes money out of the QDOT or dies. At that point, the QDOT assets are added back to your estate, and the deferred taxes become due -- often at rates well above 37%. The bottom line: The QDOT arrangement only defers the federal estate tax, it doesn't reduce the amount that ultimately must be paid. However, if your surviving spouse becomes a citizen, he or she can then take all the assets in the QDOT, and the deferred tax bill will go up in smoke. In effect, your spouse is treated as if he or she had been a citizen all along.