The term “QDOT” is an acronym for “Qualified Domestic Trust.” Some people prefer to use the acronym “QDT,” but we’ll refer to this type of trust as a QDOT. Qualified Domestic Trusts were created under the Technical & Miscellaneous Revenue Act of 1988 (TAMRA), effective for decedents dying after November 10, 1988. Prior to TAMRA, the unlimited marital deduction was not allowed when property passed to a surviving spouse who was not a United States citizen. The creation of QDOTs was designed to provide a mechanism whereby property could pass to a non-U.S. citizen spouse and still qualify for the unlimited marital deduction.
That’s what QDOTs are all about. Now, let’s take a closer look at the requirements for a QDOT and some of the reasons for these requirements.
Historically, the transfer of property from one spouse to another has not been subject to either a gift tax or an estate tax. The reason is simply because most married couples depend upon their combined assets for their financial security. If a gift or estate tax is levied every time one spouse transfers property to the other, their combined assets would be seriously depleted in short order and their financial security may well be placed in jeopardy. And, that is particularly true when one of the spouses dies. Remember, the gift and estate tax rates can be as high as 45% of the value of the property transferred.
Think of a married couple as one economic unit. As long as property remains within that economic unit, the federal government keeps its hands off the property. Married couples can transfer property from one spouse to the other as often as they’d like, either during lifetime or upon death. It is only when property is transferred outside the economic unit (i.e., to someone other than the surviving spouse) that the federal government puts its hand out.
That’s not to say that the federal government exempts inter-spousal transfers from the gift and estate tax. On the contrary, it subjects these transfers to the gift and estate tax, but then gives a corresponding deduction equal to the full value of the property transferred. This deduction is called a marital deduction because it only applies to transfers from one spouse to another. Furthermore, it is called an “unlimited marital deduction” because there is no limit on the amount of property that qualifies for the marital deduction. The use of an unlimited marital deduction, rather than an outright exemption, effectively defers the tax until the death of the surviving spouse.
Keep in mind that the federal government is not as benevolent as you might think. Although it is willing to defer the estate tax until the death of the surviving spouse, it is not willing to forgive the tax entirely. In fact, the federal government won’t even allow the tax to be deferred upon the first spouse’s death unless there is a reasonable certainty that the property will be subject to tax upon the surviving spouse’s death. How does the federal government determine whether there is a reasonable certainty that the property will be subject to tax upon the surviving spouse’s death? It does so by imposing a three-prong test at the time of the first spouse’s death. If all three-prongs are satisfied, then property passing to the surviving spouse qualifies for the unlimited marital deduction. The three-prongs of this test are: (1) that the property is being transferred to a bona fide spouse of the decedent; (2) that the spouse of the decedent is a U.S. citizen; and, (3) that the spouse of the decedent is not given a terminable interest in the property.
If all three-prongs of the test are met, then the unlimited marital deduction applies and the estate tax is deferred until the death of the surviving spouse. It is important to note that there is no requirement that the surviving spouse actually keep the property until he or she dies. In fact, it’s entirely feasible that some or all of the property will be consumed by the surviving spouse during his or her lifetime. That is the whole idea behind the so-called “economic unit” theory that drives the unlimited marital deduction in the first place.
Now, let’s take a closer look at this three-prong test to qualify for the unlimited marital deduction. The first prong requires that the property be transferred to a bona fide spouse. Historically, only valid marital relationships between a man and a woman were considered worthy of protection against a potentially devastating gift or estate tax. Today, those historic beliefs have come under attack and at least two states have now authorized same-sex marriages. Presumably, same-sex marriages will be tested soon against the “bona fide” spouse requirement for the unlimited marital deduction. That, however, is the subject of another day.
The second prong requires the surviving spouse to receive the entire rights to the property transferred. In other words, the property given to the surviving spouse must not be terminable. Generally speaking, a terminable interest is akin to having certain strings attached to the property, which makes it doubtful that the property will be taxed in the surviving spouse’s estate. For example, if the surviving spouse is given a life use of the property and cannot designate who will receive the property upon his or her death, then that property is deemed to be terminable interest property. As such, it would not be subject to tax in the surviving spouse’s estate and, therefore, it does not qualify for the unlimited marital deduction. There is, however, an exception for terminable interest property placed in a “Qualified Terminable Interest Property Trust,” or “QTIP Trust,” Again, however, that is the subject of another day.
The third prong of the test requires that the surviving spouse be a U.S. citizen. Again, the federal government wants to be reasonably certain that the property will be taxed in the surviving spouse’s estate. If the surviving spouse isn’t a U.S. citizen at the time of the first spouse’s death, then there is a good possibility that the estate tax will not be collected when the surviving subsequently dies, simply because the federal government doesn’t have the power or authority to tax property owned by a non-resident, non-U.S. citizen, unless the property is physically located in the United States. So, if a U.S. citizen dies and leaves all of his property to his wife who is a not a U.S. citizen, then there is nothing to stop the surviving wife from returning to her native country and taking all the property with her. In that case, none of the property would be subject to tax by the federal government when she subsequently dies. To prevent this from happening, the unlimited marital deduction is denied for any property given to a surviving spouse who isn’t a U.S. citizen.
While the citizenship requirement is easy to justify, it’s application can be very harsh – especially for those who have resided in the United States for years and years without obtaining citizenship, but with no intention of ever returning to their native country. For this reason, the federal government created an alternative way to qualify for the unlimited marital deduction when property is given to a non-U.S. citizen spouse. The alternative is to transfer the property to a Qualified Domestic Trust (QDOT) instead of giving it directly to the surviving spouse.
In order to qualify as a Qualified Domestic Trust (QDOT), the federal government imposes the following requirements:
- At least one trustee must be a U.S. citizen or a U.S. bank. If the QDOT holds more than $2 million dollars in cash or property, the trustee must be a U.S. bank.
- The executor of the decedent’s estate must make an irrevocable QDOT election to qualify for the marital deduction on the federal estate tax return within 9 months from the date of death.
- If the QDOT has assets equal to or less than $2,000,000, then no more than 35% of the value can be in real property outside of the United States or else: (1) the U.S. trustee must be a bank, (2) the individual U.S. trustee must furnish a bond for 65% of the value of the QDOT assets at the transferor’s demise, or (3) the individual U.S. trustee must furnish an irrevocable letter of credit to the U.S. government for 65% of the value.
- If the QDOT has assets exceeding $2,000,000 either: (1) the U.S. trustee must be a bank, (2) the individual U.S. trustee must furnish a bond for 65% of the value of the QDOT assets at the transferor’s demise, or (3) the individual U.S. trustee must furnish an irrevocable letter of credit to the U.S. government for 65% of the value.
In addition to the above requirements, any distributions of principal to the surviving spouse will be subject to estate taxes, and the trustee is required to withhold funds equal to the tax. However, exceptions are made for principal distributions for the health, education or support of the surviving spouse or a child or other person whom the spouse is legally obligated to support, as long as substantial financial need exists. Any property that the deceased spouse transfers to the surviving spouse outside of the QDOT (i.e., directly as a result of jointly-owned property, or through a will or some other means) may be transferred to the QDOT without being subject to the estate tax if the property is transferred prior to the estate tax return’s due date. If the deceased spouse’s will does not provide for a QDOT, the executor or the surviving spouse may elect to establish a QDOT and transfer the assets to the trust before the date on which the tax return is due.
It should be noted, however, that the best way to insure the availability of the marital deduction is to have the non-U.S. citizen spouse establish citizenship beforehand. If that is not possible, then the U.S. citizen spouse should take the necessary steps to insure that a QDOT is established in his or her will and/or living trust so that the QDOT is established automatically upon his or her death.
