by Bob Rywick
The executor of an estate and his advisors must determine to what extent, if any, it is desirable to qualify assets for the marital deduction.
In estates that don’t exceed the applicable exclusion amount of the unified credit ($1 million in 2002 and 2003), it is not necessary to use the marital deduction, and, if possible, should not be used in order to avoid having the property taxed in the estate of the surviving spouse.
For larger estates, it will usually be advantageous to qualify all or part of the estate for the marital deduction. However, if the surviving spouse is not a U.S. citizen, the marital deduction will be available only if:
• The spouse becomes a U.S. citizen before the estate tax return is filed and was a U.S. resident continuously from the decedent’s death until becoming a U.S. citizen, or,
• The property passing to the spouse passes in a qualified domestic trust.
In addition, to qualify for the marital deduction, property that passes in a QDOT must also satisfy the general marital deduction requirements, e.g., the terminable interest requirements must be met. Thus, a QTIP trust could also qualify as a QDOT.
QDOT defined. For a trust to qualify as a QDOT, the following requirements must be met.
(1) The trust instrument must require that at least one trustee (the "U.S. trustee") of the trust be an individual citizen of the United States or a domestic corporation. For this purpose, a domestic corporation is defined as a corporation that is created or organized under the laws of the United States or under the laws of any state or the District of Columbia.
(2) Only income may be distributed unless the trust instrument provides that a trustee who is an individual citizen of the United States or a domestic corporation has the right to withhold from distributions other than income (and certain hardship distributions, see below) the estate tax imposed on the distribution. The estate tax equals the additional tax that would have been imposed on the decedent’s death if the distributed property had been included in the taxable estate.
In making this computation, you also have to take into account any property that had previously been distributed from the QDOT that was subject to estate tax as a result of the distribution. The additional tax is imposed for distributions during the surviving spouse’s life or at his death, and will also be imposed on the principal of the trust if the trust ceases being a QDOT. However, the tax will not be imposed on a distribution to the surviving spouse if he became a U.S. citizen before the distribution and is a U.S. citizen at the time of the distribution.
Generally, income means income of the trust for the tax year determined under the terms of the governing instrument and applicable local law, except that income does not include capital gains.
(3) The trust must meet the requirements of any Treasury Department regulations that may be issued to ensure the collection of any estate tax imposed on the trust. Regulations provide that the trust instrument must provide for one of three security arrangements if the fair market value of the assets passing, or considered to have passed, to a QDOT exceeds $2 million, as finally determined for federal estate tax purposes.
The determination is made as of the date of the decedent’s death or as of the alternate valuation date, if applicable, and is determined without any reduction for any indebtedness with respect to the assets. However, an adjustment is made for the personal residence exclusion (see below).
One of the following security arrangements must be used, but the QDOT may alternate among any of the three as long as, at any given time, one of the arrangements is in effect.
(a) The "bank trustee security arrangement." Under this method, at least one U.S. trustee must be a domestic bank. Alternatively, at least one trustee generally must be a U.S. branch of a foreign bank and, in such cases, during the entire term of the QDOT, a U.S. trustee must act as a trustee with the foreign bank trustee.
(b) The "bond security arrangement." Under this method, the U.S. trustee must furnish a bond in favor of the Internal Revenue Service in an amount equal to 65 percent of the fair market value of the trust assets. Again, this value is determined (without regard to any indebtedness with respect to the assets), as of the applicable valuation date for federal estate tax purposes, but is adjusted for the personal residence exclusion.
(c) The "letter of credit security arrangement." Under this method, the U.S. trustee must furnish an irrevocable letter of credit issued by:
• A domestic bank;
• A U.S. branch of a foreign bank; or,
• A foreign bank with a confirmation by a domestic bank.
The letter of credit must be for an amount equal to 65 percent of the fair market value of the trust assets as determined in (2), above.
(4) The executor must elect to have the trust treated as a QDOT. The election must be made on the last federal estate tax return filed by the executor before the due date of the return, or if a timely return isn’t filed by the executor, on the first estate tax return filed by the executor after the due date.
The election is made by listing the QDOT or the entire value of the trust property on Schedule M (Bequests, etc., to Surviving Spouse) of the return, and deducting its value. The executor is presumed to have made the election if he lists the trust or trust property and deducts its value on Schedule M. Once made, the election is irrevocable.
When the QDOT must be created. While the QDOT often will be created either in a trust made during the life of the citizen or resident alien spouse, or in his will, this is not a requirement. A QDOT can be created after the decedent’s death by the executor or by the surviving spouse. A trust also can be reformed to comply with the QDOT requirements by the date the decedent’s estate tax return is filed or under a judicial proceeding begun before that date.
Personal residence exclusion. In determining whether:
• The $2 million threshold QDOT security requirement has been exceeded; and,
• In determining the amount of the bond or letter of credit required when the bond security arrangement or the letter of credit security arrangement applies, the executor may elect to exclude up to $600,000 in value attributable to real property (and related furnishings) owned directly by the QDOT that is used by, or held for the use of, the surviving spouse as a personal residence. The election may be made regardless of whether the real property is situated within or outside the United States.
If the exclusion is elected by the executor of the estate and the personal residence is later sold or ceases to be used, or be held for use, as a personal residence, the exclusion (except as noted below) no longer applies. If this happens, the U.S. trustee must file a written statement with the Internal Revenue Service.
The written statement must be filed for the tax year of the QDOT (calendar year if the QDOT does not have a tax year) for which the residence is sold or ceased being used as the surviving spouse’s personal residence. The written statement should be sent to the IRS by filing a Form 706-QDT, with the statement attached, no later than April 15 of the calendar year following the calendar year in which, or with which, the tax year of the QDOT ends.
If the residence is sold, the exclusion will continue to apply if, within 12 months of the date of sale, the amount of the adjusted sales price is reinvested to purchase a new personal residence for the spouse. If less than the amount of the adjusted sales price is reinvested, the amount of the exclusion equals the amount reinvested in the new residence.
Distributions to the surviving spouse on account of hardship are exempt from the estate tax on distributions from a QDOT before the surviving spouse’s death. A distribution of principal is treated as made on account of hardship if the distribution is made to the spouse from the QDOT in response to an immediate and substantial financial need. This need must relate to the spouse’s health, maintenance, education or support, or the health, maintenance, education or support of any person that the surviving spouse is legally obligated to support.
A distribution isn’t treated as having been made on account of hardship if the amount distributed may be obtained from other sources that are reasonably available to the surviving spouse. Such sources would include the sale by the surviving spouse of personally owned, publicly traded stock or the cashing in of a certificate of deposit owned by the surviving spouse.
Assets such as closely held business interests, real estate and tangible personal property (e.g., jewelry, furniture, automobiles, etc.) aren’t considered sources that are reasonably available to the surviving spouse. Although a hardship distribution of principal is exempt from the QDOT estate tax, it must be reported on Form 706-QDT even if it is the only distribution that occurred during the filing period.
Observation: In effect, the hardship exception allows a reduction in the amount that is subject to estate tax for amounts that the surviving spouse would be expected to have consumed in his life.
Effect of termination clause
The IRS held in Private Letter Ruling 9808022 that a termination clause contained in a QDOT instrument that became operative only if the surviving spouse became a U.S. citizen did not prevent the trust from meeting the QDOT requirements. A clause in the trust instrument provided that if, at any time after the creation of the trust, the surviving spouse became a U.S. citizen, the trust would terminate and all of the trust property would be distributed to the surviving spouse free of the trust. Noting that if the surviving spouse is a U.S. citizen at the time of a distribution, no estate tax is owed on the distribution, the IRS ruled that such a clause did not prevent the trust from meeting the QDOT requirements.
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