Regardless of your profession, you likely don’t want to pay any more taxes to Uncle Sam than necessary. Also, like most people, you probably want as much of what you earned in your lifetime to go to your spouse or children when you die. If this describes you, and you are in a marriage where only one spouse is an American citizen, you may be in for a terrible tax surprise when the first spouse dies. Without the proper planning, the tax costs could be in the hundreds of thousands of dollars if not millions, and the funds remaining may be vulnerable to lawsuits and creditor claims.
This potential financial disaster was created by the IRS in 1989, when it radically altered how non-citizen surviving spouses would be treated for estate tax purposes. For couples where both spouses are U.S. citizens, the “unlimited marital deduction” allows any property left to a surviving spouse to be exempt from estate taxes when the first spouse dies. In 1989, the IRS took away this deduction for couples where the surviving spouse is not an American citizen.
By eliminating this deduction, the IRS now taxes any property left to the non-U.S. citizen surviving spouse. After an estate exclusion amount of $60,000 for Non-Resident Aliens and $5.49 million for Citizens and Resident Aliens (‘green card holders”), this estate tax quickly rises to 40%. For someone leaving a large estate, the taxes can easily reduce a family’s estate in half. Let’s see how this tax works for the unprepared couple and what type of planning strategy makes sense.
Let us take the example of a businessman here (the occupation of the taxpayer is totally irrelevant). Juan Vargas is an American citizen, while Juan’s wife, Valerie, is a Peruvian citizen and their children are U.S. citizens. Juan and Valerie will have amassed an estate of approximately $10 million, mostly consisting of $4.0 million in real estate $4.0 million in a family business, and almost $2,000,000 in stocks and equities. The $8 million in property and the family business stock is entirely titled in Juan’s name because he has been the U.S. citizen, and almost all of the $2,000,000 in equities are titled to him as well. Assume that Juan dies at age 75 and that he leaves all of his nearly $10 million of assets in his Will to Valerie, and that the Unified Tax Credit exempts the first $5,450,000 of Juan’s estate from estate tax.
Because Juan and Valerie are not familiar with the special tax rules for non-U.S. citizens, they wrongly assumed that the marital deduction would cover them, so there would be no tax due on Juan’s death. In reality, Valerie will owe tax on approximately $4,510,000 of Juan’s estate in cash 9 months after Juan dies, or approximately $1.804,000 in estate taxes (40% x $4,550,000).
How will Valerie pay this tax $1.8 million bill? She may have to sell their best piece of real estate at a fire-sale price just to raise the money. Even worse, she might have to exhaust all of their equities, upon which she may have to sell all of the $2 million worth because those sales may be subject to capital gains taxes as well.
To avoid this “1st death disaster” tax hit, and to protect their assets from lawsuits as well, Juan and Valerie should establish three trusts: (1) a credit shelter or “Bypass” trust, (2) a Qualified Domestic Trust (QDOT) and (3) an Irrevocable Trust.
The Bypass Trust is a common estate planning trust. It assures that Juan will be able to pass his lifetime exemption amount — $5,490,000 as of today – estate tax free to Juan’s children. Valerie would also be able to collect income on the $5,490,000 during her life without paying estate taxes (Note: she would still be subject income taxes on this income).
The QDOT is a trust with certain special provisions for non-citizen surviving spouses. These provisions allow any property left to the trust for the benefit of the non-citizen spouse to qualify for the unlimited marital deduction. However, the QDOT can only pay income to the surviving spouse estate tax-free, distributions of principal will be subject to estate tax.
If Juan and Valerie properly create the Bypass trust for their children, $5,490,000 will go to their children estate tax free. Moreover, if Juan leaves the rest of his estate to Valerie through the QDOT trust, the balance of $4,510,000 million in Juan’s estate will be covered by the marital deduction and there will be no estate tax due on his death! This is a total estate tax-savings of $1.8 million at the time of Juan’s death. (Note: upon Valeries death, the principal of $4,510,000 in the QDOT will pass to Juan and Valerie’s children but will be subject to the 40% estate tax unless Valerie is a US Resident and they are able to take advantage of other planning strategies outside the scope of this discussion).
This planning will keep Valerie from having to sell stocks or real estate to come up with the cash for the IRS. Further, the $4.5 million in the QDOT will be protected from all types of lawsuits– extremely important when the surviving spouse is in an occupation that is a high-risk lawsuit target, such as a physician, financial advisor, entrepreneur, or real estate development and management.
While a Bypass Trust and QDOT are always needed in this situation, more planning may be required. Because the surviving spouse cannot invade the principal without incurring estate taxes, he/she may have to live off income alone. For Valerie, this is not a concern because the estate is so large, but for families with smaller estates, this can be difficult for the surviving spouse.
To combat this problem, the couple should establish an Irrevocable Trust to purchase a 1st-to-die life insurance policy on the U.S. citizen spouse. In Juan and Valerie’s case, they could use part of the $2.0 million in stocks to purchase a policy that would pay off when Juan dies. If they buy the policy when Juan is 60, it would pay off about 5 to 1 upon Juan’s death if Juan is in good health (about 2.5 to 1 if Juan is 70). Assuming they use $1,000,000 from the stocks to purchase the policy, this trust will pay out approximately $5 million to Valerie at Juan’s death. Moreover, because the policy is owned by the irrevocable trust, Valerie will owe $0 in estate taxes on the entire $5 million death benefit … and that $5 million is asset-protected as well. As an alternative, Juan is also allowed to gift his non-citizen spouse $149,000 per year without any tax consequence, and Valerie could simply use this gifted money to purchase a policy on Juan’s Life that she owns, and the death benefit would be entirely hers income tax free and without being subject to estate tax at Juan’s death.
In doing this, Juan and Valerie are able to (1) reduce their present estate tax liability by $1.8 million; (2) prevent a fire-sale of their valuable assets; (3) pass $5.49 million to their children estate tax free; (4) provide Valerie with an additional $5 million of death benefits on Juan’s death, and (5) pass an additional $2.7-4.5 million in assets to their children from their QDOT.
The costs of this planning are the insurance policy, any capital gains taxes on any stocks sold to pay for the policy, and the legal fees to institute the plan. In total, such costs will be slightly more than $1,000,000 if they implement this plan when Juan is 60 – approximately 10% of their assets at the time we start the planning process, and approximately 6.6-7.6-% of the value of the plan’s benefit of $13-15 million in assets that are in the estate when we are finished with the planning process.
The main challenge is creating this type of strategy is finding the experienced advisors who can implement it. To create a strategy that works for you, these advisors must have a powerful financial modeling program that can forecast your financial condition under all circumstances, taking into account your retirement and estate planning goals. This is where many attorneys will fail.
Still, though, attorneys are important to this planning and your advisors should have experienced legal counsel at their disposal. In the end, then, the ideal advisors have both financial expertise and quality legal counsel. These are the ingredients of a sound retirement and estate plan.