These days, it’s fairly common for U.S. citizens who live in this country to be married to non-citizen spouses who also live here. Or two non-citizens may get married while living here. In tax lingo, non-citizens who are permanent U.S. residents are termed resident aliens.
Unfortunately, standard estate-tax planning advice that works for most married couples will not necessarily work when one or both spouses are resident aliens.
Here’s what you need to know if this is your situation:
Federal estate-tax basics
In general, American citizens and resident aliens are covered by the same set of federal estate-tax rules. If you die in 2019 with a taxable estate worth over $11.4 million, the feds want 40% of the excess. If your estate is worth $11.4 million or less, no federal estate tax is due.
If you are wealthy enough to be exposed to the federal estate tax, you can usually minimize it or even avoid it entirely with some advance planning. The most common drill is to bequeath (give away at death) some of your assets to your children and grandchildren (either directly or via trust arrangements) while bequeathing the remainder to your surviving spouse.
For example, say you are a married American citizen or a resident alien with an estate worth $15 million. You can completely avoid the federal estate tax by bequeathing $11.4 million to your children and bequeathing the remaining $3.6 million to your surviving spouse, as long as your spouse is a U.S. citizen. In fact, you can bequeath an unlimited amount to your surviving spouse federal-estate-tax-free if he or she is a citizen.
Alternatively, you can — while still living — gift an unlimited amount to your spouse, provided he or she is a U.S. citizen, without any federal gift tax bill.
This privilege of being able to make these unlimited tax-free wealth transfers to your spouse is called the unlimited marital deduction. Taking advantage of this privilege is a key element of estate and gift tax planning for most well-off couples.
The problematic issue with a non-citizen spouse
Unfortunately, when your spouse is not a U.S. citizen, the unlimited marital deduction privilege is unavailable. That’s true regardless of whether or not you yourself are an American citizen.
Going back to our example, say you pass away this year and bequeath $11.4 million to your children and the remaining $3.6 million to your non-citizen spouse. The amount going to your kids is federal-estate-tax-free thanks to your $11.4 million federal estate-tax exemption.
But there’s no shelter for the amount going to your non-citizen spouse. So the federal estate tax hit is a whopping $1.44 million (40% x $3.6 million). If you bequeath your entire $15 million estate to your non-citizen spouse, the federal estate-tax bill is the same $1.44 million, because the first $11.4 million is sheltered by your exemption while the remaining $3.6 million is unsheltered and taxed at 40%. This is bad news if you’ve been (wrongly) assuming that you qualify for the unlimited marital deduction privilege.
Here’s what to do if your spouse is a non-citizen
There are several ways to get around the non-citizen spouse estate tax dilemma.
1. Marry an American citizen (the obvious route)
This is a potential solution if you are currently single, but obviously not very practical if you’ve already married a non-citizen.
2. Your spouse can become a citizen
The event can take place after you’ve died but by no later than the due date for filing the federal estate-tax return for your estate. The deadline is generally nine months after death. As long as your spouse attains U.S. citizenship before that deadline, the unlimited marital-deduction deal is available, which means your spouse can be left an unlimited amount free of any current federal estate-tax hit.
However, your spouse may not want to become a U.S. citizen for various reasons. For example, becoming a citizen might require renouncing your spouse’s home country citizenship, which could affect his or her right to own property in that country.
3. Gradually reduce your taxable estate
Another idea is to gradually reduce your taxable estate by making substantial gifts to your non-citizen spouse while you are still alive. Such gifts are eligible for a larger-than-normal annual gift tax exclusion. For example, the exclusion for 2019 is $155,000 compared to the standard $15,000 exclusion for 2019 gifts to other folks.
By taking advantage of the larger annual exclusion, you can gradually transfer wealth to your non-citizen spouse without incurring any federal gift tax. Those gifts can whittle your taxable estate down to where it will be sheltered by your federal estate-tax exemption ($11.4 million for 2019).
4. Set up a qualified domestic trust
A fourth potential solution involves setting up a qualified domestic trust (QDOT). The QDOT can be formed under the terms of your will, by the executor of your estate after you’ve passed away, or by your surviving spouse. Basically the assets inherited by your spouse go into the QDOT. Then the federal estate tax on the value of those assets is deferred until your spouse takes money out of the QDOT or dies.
At that point, the QDOT assets are added back to your estate for tax purposes, and the deferred federal estate tax bill comes due. In other words, the QDOT arrangement only defers the federal estate tax hit. It does not reduce the amount that ultimately must be paid to the U.S. Treasury.
However, if your surviving spouse becomes a citizen, he or she can then take all the assets in the QDOT, and the deferred tax bill will go up in smoke. In effect, your spouse is treated as if he or she had been a citizen all along.
The bottom line
The non-citizen spouse estate-tax problem can potentially affect well-off couples. Thankfully, the problem can often be mostly or completely solved with advance planning. You probably need assistance from an experienced estate planning professional to get the job done right. Don’t wait.