Estate planning with a non-citizen spouse / How those married to foreign nationals can avoid the estate tax

Bill Bischoff for Marketwatch writes: These days, it is not uncommon 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 alike are covered by the same set of federal estate tax rules. If you die in 2014 with a taxable estate worth over $5.34 million, the IRS wants 40% of the excess.

Thankfully, the federal estate tax can often be minimized or avoided with 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 $7 million. You can completely avoid the federal estate tax by bequeathing $5.34 million to your children and bequeathing the remaining $1.66 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 spouse federal-estate-tax-free if he or she is a citizen.

Alternatively, you can gift away an unlimited amount to your spouse before you die—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 the key element of most estate and gift tax planning strategies.

The potential problem with a non-citizen spouse

Unfortunately when your spouse is not a U.S. citizen, the unlimited marital deduction privilege is unavailable. That is true regardless of whether or not you yourself are an American citizen. Going back to the preceding example, let’s say that you pass away this year and bequeath $5.34 million to your children and the remaining $1.66 million to your non-citizen spouse. The amount going to your kids is federal-estate-tax-free thanks to your $5.34 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 $664,000 (40% x $1.66 million). Ouch! If you bequeath your entire $7 million estate to your non-citizen spouse, the federal estate tax bill is the same $664,000, because the first $5.34 million is sheltered by your federal estate tax exemption while the remaining $1.66 million is unsheltered and taxed at 40%. Ouch again! This is bad news if you’ve been (wrongly) assuming that you qualify for the unlimited marital deduction privilege.

What to do

There are several ways to get around the non-citizen spouse estate-tax dilemma. Here are some tax-saving moves to consider.

First, you can make sure you marry an American citizen. This is a potential solution if you are currently single, but obviously not very practical if you are already married to a non-citizen.

Second, your spouse can become a citizen. That 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 your death). As long as your spouse attains citizen status before the deadline, the unlimited marital deduction deal is available, which means your spouse can be left an unlimited amount free of any federal estate tax hit. However, your spouse may not want to become a U.S. citizen for various reasons. For example becoming an American citizen might require renouncing one’s home country citizenship, which could affect the right to own property in that country.

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 exclusion. For example, the exclusion for 2014 is $145,000 (compared with the standard $14,000 exclusion for 2014 gifts to other folks). By taking advantage of the larger-than-normal annual exclusion, you can gradually transfer wealth to your non-citizen spouse without incurring any federal gift tax and at the same time whittle your taxable estate down to the point where it will be sheltered by your federal estate tax exclusion ($5.34 million for 2014).

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 have passed on, 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 doesn't 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 threat can potentially affect many well-off couples. Thankfully, the threat can often be mostly or completely disarmed with advance planning. You may need assistance from an experienced estate planning pro to get the job done right.