Before we explain the purpose of a qualified domestic trust, we should provide some background information about the federal estate tax and the unlimited marital deduction.
Estate Tax Parameters
There is a federal estate tax that is potentially applicable on large asset transfers. During the current calendar year, the amount of the federal estate tax credit or exclusion is $5.34 million. You can leave behind as much as $5.34 million tax-free. Anything that you pass along that exceeds this amount is potentially subject to the estate tax and its 40 percent maximum rate.
You would be using a portion of your $5.34 million exclusion to leave bequests to people other than your spouse. If you are legally married in the eyes of the law, you may transfer unlimited assets to your spouse free of the federal estate tax, but there is a caveat.
If you are married to someone who is not a citizen of the United States, you cannot utilize the unlimited marital deduction. To explain why, let’s look at a hypothetical scenario.
Let’s say that the unlimited marital estate tax deduction was available to non-citizen spouses. You are married to a citizen of another country, and you have a large estate. You leave the entirety of your estate to your surviving spouse tax-free.
Your surviving spouse could then return to his or her country of citizenship with this tax-free inheritance. When your surviving spouse passes away, the United States Internal Revenue Service would have no way of collecting taxes. This is why the unlimited marital estate tax deduction is not available to spouses who are not citizens of the United States.
Qualified Domestic Trusts
There is an estate planning solution that will provide tax efficiency for high net worth individuals who are married to non-citizens. If you are in this position, you can make your spouse the beneficiary of a qualified domestic trust.
You fund the trust, and you also name a successor beneficiary who would assume ownership of assets that remain in the trust after the death of your spouse.
After you pass away, the assets that are held by the trust are not subject to the estate tax at first. Because the estate tax has not reduced the value of the trust, maximum earning power will remain in place.
Your surviving spouse can receive distributions of income that is earned by the trust throughout his or her life, and the estate tax is not applicable. Regular income taxes would be levied.
After your surviving spouse passes away, the successor beneficiary would inherit whatever remains in the trust. This transfer would be subject to the estate tax, but taxation was deferred throughout the life of your surviving spouse.