Beware US Estate Tax When Your Spouse Is Not A US Citizen

Are you a US taxpayer married to a non US citizen spouse?

If yes, then you’ll want to be aware of the US estate tax rules that can result in a sizable tax bill absent the right cross border estate planning.

Recently, we started working with an American client, let’s call him Gary, with a significant estate that lives in the US and works in Los Angeles. His wife, let’s call her Julia, is a Canadian citizen only, and continues to live and work in Toronto. The couple does not have any kids.

The majority of people leave the bulk of their estate to their surviving spouse because most of the property can be transferred with no income tax consequences. In particular, under the “unlimited marital deduction,” if a married person leaves his or her estate to a spouse, there is no estate tax on the transferred property, regardless of the size of the estate. The IRS, for purpose of the estate tax, is willing to wait until the second of two spouses dies before levying an estate tax. Similarly, married couples are free to make unlimited inter-spousal gifts without incurring gift taxes.

In a recent tax planning session, our client, Gary, was shocked to learn that because his wife is a non-citizen, any lifetime gifts between spouses and inheritances received by a foreign citizen surviving spouse are potentially subject to tax at rates up to 40%. Better yet, the same rules would apply should Julia become a green card holder.

With the recent Supreme Court decision on DOMA, there’s been a lot of news lately on how same sex couples can now take advantage of transferring as much of their estate as they like to their spouse free of gift or estate taxes.

Unfortunately, the same can’t be said for transfers between couples of any sex where one or both of the spouses are not a U.S. Citizen. Why the different treatment? Simply put, the “unlimited marital deduction” does not apply to a foreign citizen spouse because the IRS is afraid the non-citizen spouse will move to another country and thus avoid US gift and estate taxes all together.

Without the availability of the marital deduction, current law permits the first $5,250,000 (adjusted for inflation) of assets to be transferred tax free.

In other words, an inheritance left to a Non-Citizen Spouse is subject to a 40% estate tax after the $5,250,000 lifetime exemption is used up.

But the problem is that the US assets left to a surviving non-citizen spouse using the estate tax exemption will be subject to estate taxes when the non-citizen spouse dies.

Why? Because non-citizen spouse’s who are not “domiciled” in the U.S. have only a $60,000 lifetime exemption, as opposed to the $5,250,000 exclusion.

So what should you do if you are married to a non-citizen spouse and your estate is larger than the applicable exemption amount?

Well, to start, in our clients’ case, Gary and Julia could take the steps to have Julia become a US citizen prior to Gary’s death. Another option is to establish a Qualified Domestic Trust (QDOT). A QDOT actually allows for a deferral of the estate tax until the surviving foreign citizen spouse’s death and for an annual income stream to be paid to the surviving spouse. Moreover, it can buy time for the surviving spouse to acquire US citizenship. Also, properly structuring the QDOT can have it meet the tests of a spousal trust under the Canadian Income Tax Act.

Alternatively, if certain conditions are met, our clients can take advantage of the marital credit under the Canada US tax treaty. This option, however, cant be used in conjunction with the QDOT deferral.

As our client Gary learned, there are certain planning strategies and legal structures that, if set up in advance, can help cross-border couples avoid having unnecessary taxes reduce their wealth by up to 40%.

If you would like more information about this topic or to discuss your own unique situation, please contact us today for a confidential consultation.

*This content is for general information purposes only and is not legal or tax advice. Materials on this website should not be used as a substitute for consultation with professional advisers. Transmission of the information is not intended to create, and receipt does not form a client relationship between the sender and receiver. Online readers should not act upon this information without seeking professional counsel. Do not send us confidential information until you speak with one of our staff and get authorization to send that information to us. No client relationship will be formed with our firm absent a written retainer agreement that is signed by the firm and the prospective client and that defines the scope of the representation.


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