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How to Make a Bad Estate Tax Situation Slightly Less Bad with a Qualified Domestic Trust

Portrait of Phil Hodgen

Phil Hodgen

Attorney, Principal

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Estate tax problems

Nonresident-noncitizens of the United States invest in U.S. assets. And sometimes, in a moment of poor judgment, they die. This means an estate tax problem faces the surviving family.

This problem can sometimes be managed (not eliminated) by using a “qualified domestic trust.” I will call it a QDT here. This strategy allows use the unlimited marital deduction if the decedent’s U.S. assets pass to a surviving spouse.

The strategy postpones the time for payment of estate tax until assets are actually distributed to the surviving spouse, eliminating the need for liquidity to pay estate tax nine months after death.

Typical scenario

Husband, a nonresident and noncitizen of the United States, owns U.S. rental property worth $2,000,000, free and clear. It is titled solely in his name.

Husband dies. His will leaves “everything to my wife”; she is also a nonresident and noncitizen of the United States.

What happens if you do nothing?

The default outcome for the surviving spouse is an estate tax bill of $732,800, due nine months after Husband’s date of death.

Here is how the estate tax calculation works:

  • Gross estate. Only U.S.–situs property is included in Husband’s gross estate. IRC§ 2103. The rental real estate is U.S. situs property. Husband’s gross estate is $2,000,000.
  • Administrative Expenses, Debts. The gross estate is reduced by allowable deductions to compute the taxable estate. IRC§ 2106(a)(1). I ignore administration expenses and debts to keep this example simple. $0.
  • Marital deduction. The gross estate is reduced by a deduction for assets transferred at death to a surviving spouse. IRC §2106(a)(3) tells you to use IRC §2056 to do this. However, the marital deduction is disallowed for transfers to a noncitizen spouse. IRC§ 2056(d)(1)). Marital deduction = $0.
  • Taxable estate. Husband’s taxable estate is therefore $2,000,000- $0 - $0 = $2,000,000. Form 706-NA, Part II, line 1.
  • Tentative tax. IRC §2101(b) tells you to use the IRC §2001(c) tax computation methodology to compute the tentative tax. The estate tax on the first $1,000,000 of the taxable estate is $345,800. The estate tax on the second $1,000,000 of Husband’s taxable estate is $400,000. The total tentative tax is $745,800. Form 706-NA, Part II, line 4.
  • Credit against tentative tax. The estate is entitled to a $13,000 credit against the tentative tax. IRC §2102(b)(1), Form 706-NA, Part II, line 5.
  • Estate tax. The estate tax liability is the tentative tax minus the unified credit. Therefore, the surviving spouse will need to come up with $745,800 - $13,000 = $732,800. Form 706-NA, Part II, line 6.

This creates a liquidity problem for the surviving spouse: $732,800 is payable nine months after Husband’s date of death.

She may not have that much cash available, forcing a sale of an illiquid asset. That might cause a forced sale, or the surviving spouse will need to use other liquid assets to pay the estate tax.

Postpone estate tax payment with a qualified domestic trust

The reason the surviving spouse must pay $732,800 in estate tax is because the marital deduction is not allowed when the surviving spouse is not a U.S. citizen.

There is a way around this: a qualified domestic trust.

Instead of the decedent’s assets passing to the surviving spouse at death, they are instead transferred to a trust for the benefit of the surviving spouse.

  • The estate tax is imposed when capital distributions are made from the trust. Reg. § 20.2056A-5(b).
  • Income distributions are taxed on a current basis to the surviving spouse. Reg. § 20.2056A-5(c)(2).

This defers estate tax payments until capital distributions are made from the qualified domestic trust—and the timing of the estate tax payment due date is controlled by the trustee of the qualified domestic trust.

There are a lot of technical details to satisfy when setting up a qualified domestic trust. They are fussy.

But you can create the trust after the date of death.

You have a deadline of the filing deadline for the estate tax return (including extensions) so get on it. IRC §2056(d)(2)(B), Reg. §20.2056A-2(a), (b). You will need an ancillary probate proceeding to get this all done (set up the trust, get the property transferred to the trust).

As I said, get on it. Courts are slow.

Estate freeze: prevent the estate tax from increasing

Estate tax is imposed on capital distributions from the trust. What happens if the trust’s assets appreciate in value? Simple answer: more estate tax.

This is bad.

Example. Our qualified domestic trust has U.S. real estate with fair market value of $2,000,000 in it. If the real estate is distributed to the surviving spouse, estate tax is due on the $2,000,000 value

Let’s say the qualified domestic trust holds the real estate until the surviving spouse’s death. That is a deemed distribution. IRC §2056A(b)(1)(B).

If the real estate is then worth $3,000,000, the deemed distribution of the real estate will trigger estate tax on the $3,000,000 amount distributed.

Holding appreciating assets in a qualified domestic trust is dumb.

Sale for an installment note

What I do is have the qualified domestic trust sell its appreciating assets for an installment note.

This sale does not create a capital gain tax problem, because the qualified domestic trust’s tax basis in its assets is equal to date of death value which of course is equal to fair market value. IRC §1014. So, if you can execute this sale quickly after the date of death, capital gain is zero or tiny.

I usually have the buyer be an irrevocable trust that I create. This protects the appreciating asset from a second estate tax if the wrong person dies at the wrong time.

Now look at the situation:

  • The qualified domestic trust holds a debt obligation as its only asset. Interest income received is distributable to the surviving spouse, subject to tax (at worst) of 30%.
  • Estate tax is payable when the promissory note is paid off and the cash subsequently distributed to the surviving spouse.
  • Estate tax cannot increase, because the value of the promissory note is fixed.
  • The U.S. real estate asset is still held by the family, now in an efficient (for estate tax) trust structure.

Some years later, when the time is right, the irrevocable trust that I created will sell the real estate at a time chosen by the trustee—not forced upon it for liquidity needs triggered by a looming estate tax payment deadline.

The irrevocable trust I created will then pay off the promissory note. The qualified domestic trust has cash. It distributes the cash to the surviving spouse.

Benefits recap

We have made it possible to defer estate taxation. Pay $732,800 now or many years from now? That’s an easy question to answer. Yes, I understand present value/future value games.

We have matched the time for payment to the time when cash becomes available to pay the tax. Liquidity crunches eliminated.

We have also prevented estate tax on future appreciation of the U.S. real estate. Double taxation eliminated.

Possible tax savings on rental income

There is also an interesting game to play with shifting taxable rental income to a potentially lower income tax rate.

With care, the interest expense incurred by the purchasing irrevocable trust will create a tax deduction and reduce its taxable income from rental activities. Maybe to zero.

Interest income received by the qualified domestic trust is subject to income tax at normal Federal and State graduated tax rates. But if the qualified domestic trust distributes the income to the surviving spouse, the qualified domestic trust has zero taxable income using the distribution deduction.

The surviving spouse, as a nonresident alien, pays U.S. income tax under IRC §871 at a maximum 30% tax rate on the distribution received of income from the qualified domestic trust.

Can you set up this income received by a nonresident alien to be not subject to State tax? If so, you have converted rental income (subject to Federal and State income tax) into interest income (subject to Federal income tax only). And the effective tax rate (maximum 30%) might be lower than the combined Federal and State income tax the surviving spouse would have otherwise paid on net rental income.

Conclusion

What I have described is a way to make a bad situation less bad.

If you have a decedent, and the estate tax liability is big enough to matter, consider the qualified domestic trust idea as a way to postpone the day of reckoning for the estate tax liability.