Now for the federal tax issues. The US taxes the transfer of wealth through gifts and estates. Interestingly enough, US estate and gift tax is generally much higher than similar taxes in other countries, even those who are known for astronomically high income tax rates. The US taxes approximately 45% of estates exceeding a certain amount depending on the year, usually $1 million or $2 million. However, US tax laws allow portions of the estate to be exempt for various reasons, no matter how big the estate is. One of the biggest is through marital transfers. Amounts in the estate transferred to a spouse are not taxed. This is known as the marital deduction.
However, the martial deduction is NOT available to spouses who do not have US citizenship. This is the biggest tax difference regarding non-citizens. Why don't non-citizens receive this tax benefit? We have to go back to the reason behind the marital deduction. The IRS is not granting a tax break so much as deferring when the tax is paid. Let's say that Husband dies leaving 5 mil to his citizen spouse. When she dies, she would theoretically have that 5 mil in the estate, which would then, theoretically, be taxed. However, the IRS is not as confident that they will get their money if the spouse is a non-citizen. The thinking goes that once the citizen dies, the non-citizen will go back to their home country. Without the spouse having citizenship or being domiciled in the US, the IRS has no way to tax the amount that went to the spouse.
Is there any way for a non-citizen spouse to avoid estate tax? There are two main ways. The first is through an estate tax treaty between the US and the spouse's country of citizenship. Many of these treaties allow a limited marital deduction. The US-Germany treaty, for instance, allows a martial deduction equal to the amount that is tax exempt in that year. For example, this year estates under $ 2 million are exempt from estate tax. A German spouse would also be able to receive an additional $2 million of the estate tax free under a marital deduction. Your planner should be aware of tax treaties and use the provisions in the applicable treaty to your advantage.
Second, the IRS does not tax amounts set in trust, with an American trustee, for the benefit of the spouse. These trusts are known as qualified domestic trusts, or Q-DOTs. There are some negative aspects of Q-DOTs. First, the spouse will not have control over the money and will have to go through a trustee in order to obtain funds. Second, Q-DOTs must meet certain requirements in order to be considered valid by the IRS. Make sure you are working with a planner who is familiar the the IRS rules regarding Q-DOTs.
With the right understanding of tax treaties and proper use of Q-DOTs, you can minimize or eliminate the tax burden you or your non-citizen spouse may have upon death.