Before we look into the value of qualified domestic trusts, we should examine the federal estate tax, because this type of trust would be used by some people who are exposed to it.
The estate tax can pose a significant threat to your financial legacy, because it carries a very hefty 40 percent maximum rate. Everyone does not pay the tax, because there is a relatively large credit or exclusion. During the current calendar year, the exact amount of the federal estate tax exclusion is $11.58 million.
This can sound like a rather arbitrary number, but there is a rationale behind it. The exclusion was set at $11.18 million for 2018, and there have been ongoing adjustments to account for inflation ever since then.
The exclusion is the amount that you can transfer to others tax-free before the estate tax would become a factor.
We should point out the fact that there is also a gift tax that is unified with the estate tax. This tax exists to stop people from giving gifts to avoid the estate tax. The gift tax and the estate tax are unified, and as a result, the exclusion is a unified exclusion. It applies to taxable gifts that you give while you are living along with the value of your estate.
Federal Estate Tax Marital Deduction
You would be using a portion of your unified exclusion to transfer assets tax-free to anyone other than your spouse. Transfers to your spouse are not taxable, whether you are transferring the assets while you are alive or after you pass away, as long as your spouse is an American citizen.
Why would this citizenship requirement be in place? The answer is that the tax man wants to get his money eventually. Imagine the scenario that would exist if you leave everything to your citizen spouse tax-free after your passing. Granted, there would be no taxes due at that time, but your surviving spouse would be in possession of a taxable estate. The death tax would still be looming large.
On the other hand, if the unlimited marital transfer tax deduction was extended to a spouse who is not a citizen of the United States, the tax man could be out of luck. The surviving spouse could return to his or her country of citizenship after receiving a tax-free inheritance.
This person could live out his or her life in this country, and the United States Internal Revenue Service may never see a penny. This is why the unlimited marital deduction is not allotted to non-citizen spouses.
Qualified Domestic Trusts
Now that we have provided the necessary background information, we can explain the value of qualified domestic trusts. When you fund this type of trust, you would make your non-citizen spouse the beneficiary, and you would name a trustee to administer the trust after your passing. You would also name secondary beneficiaries to inherit the remainder that is left in the trust after the death of your spouse. These beneficiaries would presumably be your children.
The trustee would be able to distribute the earnings from the trust to your spouse throughout his or her life without distributing the principal. These distributions would not be subject to the estate tax, but regular income taxes would be applicable.
It would be possible for the trustee to distribute portions of the principal under some circumstances, but distributions of the principal would be subject to the estate tax unless there was a hardship exemption granted by the IRS.
After the passing of your surviving spouse, the secondary beneficiaries would assume ownership of the remaining assets in the trust. The estate tax would potentially be applicable at that time.
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It should be noted that here in New York where we practice law, there is a state-level estate tax that has an exclusion of just $5.85 million. As a result, you could face state-level exposure even if you are federally exempt.
If you would like to discuss potential taxation or any other estate planning matter with a knowledgeable attorney, our doors are open. You can send us a message to request a consultation appointment, and we can be reached by phone at (585) 374-5210.