Federal Estate and Gift Taxes -- Trusts for the Non-Citizen Spouse

As mentioned in the last installment of this series, the unlimited marital deduction is only available if your spouse is a U.S. citizen.  If your spouse is not a U.S. citizen, transfers to that spouse at death will be subject to the estate tax unless you use a "qualified domestic trust," or "QDOT."

A QDOT trust must pay all of its income to the surviving spouse, and can have no other beneficiaries while the spouse is living.  So far, this looks a lot like a QTIP marital deduction trust, but a QDOT is subject to additional restrictions intended to prevent the non-citizen spouse from leaving the country with the assets and thereby escaping estate taxation:

• At least one of the trustees must be an individual U.S. citizen or a U.S. trust company.
• No more than 35% of the assets of the trust may be foreign real estate.
• The U.S. trustee has the power to withhold taxes from any distribution of principal.

That last power is very important, because the principal of the QDOT trust (but not the income) is subject to an estate tax if it is distributed while the spouse is living (other than for reasons of "hardship"), and any principal remaining in the trust is taxed at death.

How do you prevent taxation of principal distributions?  If the spouse becomes a U.S. citizen, the special QDOT restrictions and the tax on lifetime principal distributions no longer apply.