How to do an Asset Freeze with a Qualified Domestic Trust

Two weeks ago I talked about how to make a bad situation slightly less bad with a qualified domestic trust. A reader emailed me and asked a follow-up question, and . . . well, here we are. How It Is Done.

Qualified domestic trusts—why?

One of the features of a qualified domestic trust is that it postpones the payment of estate tax where the recipient of a bequest is a surviving spouse who is not a U.S. citizen. The marital deduction is disallowed for bequests to noncitizen spouses, but a transfer to a qualified domestic trust for the benefit of a noncitizen surviving spouse is an exception to that rule.

Eventually, of course, the estate tax chicken comes home to roost. Estate tax is due when the qualified domestic trust distributes principal during the spouse’s lifetime, and no matter what, when the surviving spouse dies.

But parking the bequest in a qualified domestic trust allows you to defer payment of the estate tax. We like deferral.

The problem with qualified domestic trusts and appreciating assets

When principal is distributed, estate tax is imposed. What happens if the qualified domestic trust was originally funded with $1 million of real estate that became worth $3 million? The trustee wants to sell the real estate and distribute the proceeds to the surviving spouse. Guess what! The estate tax bill is calculated based on principal distributions and now there's a lot more than $1 million of principal, so the estate tax bill will be a lot higher.

Qualified domestic trusts should not hold appreciating assets. Estate tax is optional for the well-prepared, and leaving appreciating assets in a qualified domestic trust means you are not well-prepared.

Qualified domestic trusts should hold nonappreciating assets (debt obligations), not appreciating assets (real estate, stock, etc.).

Let’s engineer a transaction to convert a qualified domestic trust's real estate asset into a debt obligation to freeze the principal value of the trust's assets.

Example

Let’s use this simple set of facts:

• Decedent spouse: nonresident, non-citizen of the United States.
• Surviving spouse: nonresident, non-citizen of the United States.
• Decedent’s only U.S.-situs asset: a home worth $1 million (FMV at death).
• The Decedent’s will leaves everything to the surviving spouse.
• House is transferred into a qualified domestic trust (QDOT) via ancillary probate; IRC § 2056A election made.
• Surviving spouse buys the house from the QDOT for $1 million cash.
• QDOT invests the cash in registered-form Treasury notes.
• Each year the QDOT distributes all of its income to the surviving spouse.

Why the sale is safe from estate tax

Trusts generally can engage in transactions with their beneficiaries. As long as the transactions are at arm’s length, normal commercial terms, they will be respected for what they are and not be treated as distributions from the trust to the beneficiary.

A distribution of principal to the beneficiary triggers an estate tax liability. IRC §2056A(b)(1)(A). An asset sale to a beneficiary is not a distribution.

“[D]ispositions of trust assets by the trustees (such as sales, exchanges, or pledging as collateral) for full and adequate consideration in money or money's worth . . .” will not trigger the IRC §2056A estate tax. Reg. §20.2056A-5(c)(3)(iii).

QDOT’s capital gain on sale of the house

Remember the transaction: the surviving spouse bought the house from the QDOT at fair market value of $1,000,000, for $1,000,000 cash.

The QDOT’s basis in the house its its fair market value on the date of the decedent. IRC §1014. If the QDOT sells the house to the surviving spouse reasonably soon after the date of death, the asset value on Form 706-NA = basis = (in my example) $1,000,000.

Sale of the house at fair market value will result in $0 capital gain for the QDOT.

QDOT’s income taxation

The QDOT will take its $1,000,000 and invest in (for the sake of this example) Treasuries. Again for the sake of this example, assume the interest rate is 4%.

That means the QDOT is earning $40,000 of interest income every year from the Treasury Notes it holds.

The QDOT has $40,000 of DNI, which it distributes to the beneficiary—the surviving spouse. It takes a distribution deduction, resulting in taxable income of $0 for the QDOT.

No income tax liability for the QDOT.

Surviving spouse’s income taxation

The surviving spouse receives a distribution of income from the QDOT.

The distribution of income does not trigger an estate tax liability. IRC §2056A(b)(3)(A).

Surviving spouse does not have any U.S. income tax liability, either. Items distributed by a trust to a beneficiary carry their character with them. IRC §§ 652(b), 662(b); Regs. §§1.652(b)-1, 1.662(b)-1.

Interest earned on Treasuries is portfolio interest. IRC §871(h). Treasury bills and notes are registered debt obligations that satisfy the requirements to be classified as portfolio debt instruments.

The interest paid on such portfolio debt obligations to a nonresident holder is exempt from U.S. income tax. IRC §871(h)(1).

This means that when the surviving spouse receives a distribution of interest income generated by Treasuries, she is receiving portfolio interest.

No income tax liability for the surviving spouse.

Sweet.

What we accomplished

By initially putting the house into the QDOT, the surviving spouse postponed an immediate estate tax liability that would have been payable 9 months after the date of death of the decedent spouse.

By selling the house to surviving spouse, the trust swapped an appreciating asset for a debt obligation that by definition will not appreciate in value (not counting swings in interest rates that can change the value of a debt obligation for better or worse).

By investing in the right kind of debt obligation (one that generates “portfolio interest”), we have ensured that the surviving spouse will receive all of the interest income free of U.S. income tax.

“Yeah, but . . .”

I can hear you now.

“But the surviving spouse is a nonresident alien and she owns U.S. real estate. She is exposed to estate tax risks on that asset!”

True. So make the buyer be an irrevocable trust. Now the U.S. real estate is owned by a nongrantor trust and you have eliminated the estate tax exposure when the surviving spouse dies.

“But who has a million bucks cash lying around for such frivolity?”

A lot of people actually. But let’s say your client doesn’t. Here’s an alternate strategy.

Have the QDOT sell the house to a new foreign nongrantor trust for a promissory note with adequate interest (meet or beat the AFR). Interest due annually, balloon payment of principal in 25 years. That buys you enough time for anything.

Here’s how interest payments work.

• The surviving spouse lends the foreign grantor trust $40,000 to pay interest on the promissory note held by the QDOT.
• The foreign nongrantor trust pays $40,000 interest to the QDOT.
• The QDOT has foreign source interest income. (Source of interest income derives from the residence of the debtor making the interest payments).
• The foreign nongrantor trust distributes $40,000 to its beneficiary—surviving spouse.
• Character of income, when distributed, follows through to the beneficiary. That means surviving spouse gets a distribution of foreign source interest income.
• Nonresident aliens are only subject to income tax on U.S. income.

Result: no U.S. income tax paid by the surviving spouse.

Take aways

For the reader who emailed me about this type of transaction, I hope I addressed your curiosity.

A warning. My involvement with QDOTs is usually because someone set them up and then neglected them terribly, resulting in tax calamities. Usually these calamities come when the QDOT wants to sell its (usually real estate) asset.

Therefore, if you do the QDOT game, do it well. This is a picky, technical area of tax law, where foot-faults are easy and catastrophic. Translation: be prepared for fairly high annual maintenance costs in terms of trustee fees, tax compliance and regular legal review.