from BORDERS: Thoughts of a Cross-Border Advisor (03 Dec 2012) -- "Qualified Domestic Trusts - No Silver Bullet Solution for Cross-Border Estate Planning"

By John Flecke, JD, CFP® posted 06-19-2013 09:16


The Qualified Domestic Trust or QDOT has for years been an essential tool of cross-border estate planning. However, US non-citizen married couples and estate planning practitioners alike may be lulled into a false sense of security with the QDOT.

The QDOT is great as far as it goes. It grants a non-citizen spouse a privilege akin to the unlimited marital deduction under Section 2056 of the Internal Revenue Code. Without a QDOT, assets transferred from the decedent to the surviving spouse may be subject to estate tax. After December 31, 2012, a surviving spouse could find her retirement assets (and her heirs could find their inheritance) reduced by more than half (maximum tax rate: 55%). A QDOT, properly drafted and properly utilized at death, should avoid that estate tax nightmare. However, the QDOT has some noteworthy deficiencies.

IRD. The QDOT does not cover everything that a non-citizen surviving spouse receives from the decedent. For example, income: there may be a deduction available for Income in Respect of a Decedent or IRD (IRC Section 691) but the deduction must be elected; it is not automatic via the QDOT.

Life insurance. The noncitizen surviving spouse gets some protection by immediately transferring life insurance proceeds received to the QDOT. However, properly invested, the growth of that nest egg over time in the QDOT is subject to deferred estate tax upon transfer or withdrawal. Instead, placing the insurance policy in an irrevocable life insurance trust (simpler than it sounds) while both spouses are alive removes the life insurance death benefit from the decedent’s estate and thereby avoids estate tax/deferred estate tax at the first death.

Assets with potential for high appreciation. As with life insurance proceeds, any increase in asset value is subject to deferred estate tax at the decedent’s rate. Consider keeping such assets out of the QDOT and pay the estate tax. Just paying the estate tax, however, is not always the best approach. Would a surviving spouse be better off

  • paying 55% estate tax now and 20% capital gains tax much later when the asset is sold, or
  • avoiding 55% estate tax now but paying 55% tax (deferred estate) on the gain upon eventual sale?

The right choice is not so obvious. Issues such as life expectancy must be considered. Other options include placing high-potential growth assets in the QDOT initially and later converting the QDOT or a portion of the QDOT into a unitrust. Or take arms-length loans from the QDOT instead of distributions—such loans are tax free and in essence defer taxation until the death of the surviving spouse, better assuring her lifestyle throughout retirement (though the heirs might not be so happy).

Continuing payments from decedent’s Canadian defined benefit pension. Tread carefully here. The rules are tricky. As part of the estate planning process, explore the pros and cons of entering a pension rollover agreement with IRS; . As long as no more than 25% of each payment is classified as income (75% as corpus), pension payments avoid deferred estate tax but the corpus must be rolled over to the QDT within 60 days of receipt by the surviving spouse. Failure to follow the rollover requirements can trigger estate tax on the value of decedent’s pension as determined under IRS Reg. 20.2031-7(d)(2)(iv).

Non-US real estate. In some jurisdictions, real estate cannot be held in a trust or cannot be held in a foreign (US) trust. Or holding local real estate in a US trust makes the US trust a domestic trust for income tax purposes. Placing Canadian real estate in a QDOT at the first death is probably a bad idea. Consider placing real estate in a Canadian trust or corporation or simply selling the property at the first death and placing the cash proceeds in the QDOT. There are pros and cons to each approach. One size does not fit all.

The Intersection of Estate and Immigration Planning. Clearly, the QDOT does not give a non-citizen the rights of a US citizen. In view of the many limitations associated with the QDOT and the burdens of meeting and monitoring QDOT requirements, non-citizen couples may wish to think of the QDOT as an interim solution to an estate planning problem. The permanent solution actually lies at the intersection of estate planning and immigration planning. Specifically, non-citizen spouses should explore the pros and cons of dual citizenship. For a spouse who is already a US Lawful Permanent Resident (aka, a green card holder), there are few if any cons associated with naturalization (the process of acquiring citizenship after birth), except for exposure to US expatriation tax if the individual ever gives up US citizenship, under current rules.

Non-citizen spouses are eligible to apply for US naturalization once they have been in Lawful Permanent Resident status for two years and nine months (four years and nine months if the green card was acquired by some method other than by marriage to a US citizen). Candidates also must have been physically present in the United States for the previous 3 or 5 years, respectively. 

Note that a very small percentage of green card holders should never apply for US naturalization because of irregularities in their immigration or criminal histories—when in doubt, consult with a US immigration attorney who is well-versed in naturalization issues.

Once both spouses are dual citizens, the QDOT provisions are no longer needed. While the QDOT provisions will be ignored, new citizens should consider re-drafting their estate documents to omit the QDOT provisions to avoid the possibility of confusion when the estate plan is carried out after death.

Estate Planning: An Integrated Approach. Estate planning ought to be a multidisciplinary effort. Why? Because estate planning decisions can impact numerous other areas of a person's life. Estate planning affects income tax, retirement, risk management, investment planning, immigration... While only an attorney can prepare legal documents, a financial planner (and perhaps other professionals such as an accountant, risk management specialist, and an immigration attorney) ought to have roles in designing the estate plan. 

A financial planner, better than anyone, appreciates the interdependence of various aspects of an individual’s financial life—and knows how easy it is for plans to fail when no professional looks at the client's financial life holistically and coordinates the work of professionals working on a client's behalf in disparate disciplines. 

There is nothing quite like a orchestra led by a skilled conductor—and there is nothing quite like an orchestra that plays without one.