Since the enactment of the Technical and Miscellaneous Revenue Act of 1988, the marital deduction for federal estate tax purposes is disallowed for property passing to a non-citizen spouse, unless that property is held in a qualified domestic trust (QDOT). The QDOT can be established under the Will of the deceased spouse, or can be created after the deceased spouse's death by the surviving alien spouse, so long as the QDOT is funded prior to the filing of the federal estate tax return. Distributions from the QDOT, other than income distributions, are subject to a special estate tax, which is levied at the time of distribution. At least one of the trustees of the QDOT must be a United States citizen or a U.S. domestic corporation, and that trustee must have the right to withhold the amount of the applicable estate tax in the event of any taxable distribution from the QDOT. Although Internal Revenue Code (IRC) Sec. 2056A does not expressly mandate the distribution of trust income to the spouse, the Internal Revenue Service (IRS) has taken the position in letter rulings that a QDOT must also meet the general marital deduction requirements of Sec. 2056. Thus, consistent with the qualified terminable interest requirements of Sec. 2056(b)(7), the QDOT should provide that all income is distributable to the spouse.
Application Problems
Although the QDOT rules seem relatively straightforward in concept, their application presents a host of practical problems. To date, no regulations have been issued in this area, and taxpayers are advised to seek private letter rulings in those situations which are not clearly addressed by Sec. 2056(d) and Sec. 2056A.
A recent IRS Letter Ruling, PLR 9235015, deals with one of the special problems which can arise when the alien spouse is the beneficiary of qualified plan benefits. In the particular situation presented in this ruling, the decedent died intestate. Among the assets passing to the spouse as a result of his death was his interest in his employer's thrift plan (which the spouse elected to take in a lump sum). The spouse proposed to create a post mortem QDOT and to contribute the thrift plan assets to the QDOT.
An initial question arises as to why the spouse did not roll the lump sum benefit over into a spousal IRA. The letter ruling does not address this question. A prior ruling, PLR 9109021, held that a surviving alien spouse could rollover the decedent's IRA and the death benefit received from the decedent's Sec. 403(b) retirement plan into what the ruling describes as a "spousal rollover individual retirement trust," but which was constructed as a qualified domestic trust. The ruling held that the benefits would qualify for the marital deduction. It is noteworthy that PLR 9109021 addresses the availability of the marital deduction, but does not discuss whether the "spousal rollover individual retirement trust" was itself qualified from an income tax perspective, or whether the contribution to the trust would be a rollover contribution within the meaning of Sec. 408(d)(3). These omissions are troubling, and it is not clear that the contribution to the described trust would qualify as a tax-free rollover. For example, the terms of the trust permitted an individual citizen to serve as trustee. Under Reg. Sec. 1.408-2(b)(2) and 1.401-12(n), an individual cannot serve as a trustee of an IRA trust. Given the limitations of the holding of PLR 9109021, an attempted rollover into a trust arrangement of the sort described in that ruling is not without income tax risks.
Assuming that a qualified IRA could be constructed as a QDOT, the required income distributions to the spouse from the IRA would generate a premature withdrawal penalty if the spouse is not yet age 59 1/2. Thus, if the spouse was significantly younger than 59 1/2, it may be to her advantage not to attempt a rollover of the lump sum benefit.
Income Taxes
As a result of her receipt of the lump sum benefit, and her subsequent contribution of those benefits to the QDOT, the spouse in PLR 9235015 was presented with a dilemma which the existing QDOT provisions do not address. Substantial income taxes would be incurred by the spouse in the year of her receipt of the lump sum distribution. If the QDOT reimbursed the spouse for those income taxes, would that reimbursement constitute a distribution from the QDOT which would give rise to an estate tax? Sec. 2056A(b) provides that distributions, other than the mandatory income distributions and distributions for "hardship", are subject to estate tax. Sec. 2056A was amended by the Revenue Reconciliation Act of 1990 to furthermore provide, in See. 2056A(b)(15), that no taxable distribution would occur if the QDOT reimbursed the surviving spouse for tax imposed on the spouse on income of the trust which was not distributable to the spouse under the terms of the QDOT. Nevertheless, the income tax payable by the spouse in PLR 9235015 would not be tax on the "income of the trust" within the literal meaning of Sec. 2056A(b)(15).
The 1990 amendment to Sec. 2056A apparently was made as a result of Congressional recognition that it was unfair to subject a spouse to an estate tax if the spouse paid income taxes on capital gains incurred by the trust. The situation presented in PLR 9235015, while not within the literal meaning of Sec. 2056A(b)(15), is surely within its intent, which was to effectively allow the QDOT to assume the income tax burden with respect to amounts properly allocable to trust capital or principal. PLR 9235015 applies an expansive reading of Sec. 2056A(b)(15) to hold that the spouse can be reimbursed for income taxes paid by her on the lump sum distribution.
Notwithstanding the generosity of the ruling, individuals with alien spouses should receive careful counseling with respect to their accumulation and disposition of qualified retirement plan benefits. The income tax benefits of accumulating wealth in these plans may be offset by the problems presented in transferring plan benefits to an alien spouse. For example, if most of an individual's wealth is concentrated in such a plan, as opposed to more freely transferable assets, it will generally be more difficult to accomplish nontaxable lifetime transfers (permitted up to $100,000 per year, without gift or estate tax consequences, under Sec. 2523(i)(2)) to the alien spouse, It is furthermore not at all clear that the surviving alien spouse can postpone the recognition of income by transferring plan benefits to a trust that can qualify as both an IRA and a QDOT. Although PLR 9235015 provides that no estate tax will be incurred as a result of the spouse's effective payment of income tax out of a lump sum distribution, it must be recognized that the IRC is not at all clear on this issue.
Better planning may consist of curtailing employee contributions to qualified plans if the employee's spouse is an alien, and using the additional available funds to make annual lifetime transfers (within the limitations of Sec. 2523(i)(2)) to the alien spouse to equalize the couple's assets between each of them. Consideration also should be given to making the employee spouse's testamentary QDOT the beneficiary of the employee plan, rather than the spouse (although this precludes any possible taxfree rollover).
PLR 9235015 is illustrative of just one of the many pitfalls which can be encountered in establishing and funding QDOTS. It also demonstrates that the estate plan of a client with an alien spouse does not consist merely of a carefully crafted QDOT. Planners also should consider the nature of the assets owned by the client, and the consequences of transferring those assets to a QDOT at his or her death. The client should be encouraged to take advantage of the $100,000 a year gift exception in order to transfer assets to the alien spouse outside of the confines of the QDOT. Thoughtful lifetime planning can help to prevent a post mortem struggle with this largely undeveloped area of federal estate tax law.
