Trusts can be a useful tool for estate planning in order to preserve assets for loved ones while minimizing estate taxes. A qualified domestic trust (QDOT) is a specific type of trust that can offer tax benefits for married couples. With a QDOT, a surviving spouse can qualify for the marital deduction on estate taxes for assets included in the trust. This type of arrangement can be particularly helpful when a surviving spouse is not a U.S. citizen. This article explains how these trusts work, the benefits and limitations of having one and how to establish a QDOT as part of your estate plan.
Qualified Domestic Trust (QDOT), Explained
A trust is a legal arrangement in which you transfer assets to the control of a trustee. This can be yourself or someone else you name and it’s the trustee’s duty to manage assets in the trust on behalf of the trust’s beneficiaries.
A QDOT is a specific type of trust arrangement that’s designed to benefit married couples, specifically when one spouse is not a U.S. citizen. This type of trust extends the marital tax deduction to non-citizen spouses, who would otherwise not be eligible to claim the deduction on estate taxes.
If you’re married to someone who is not a U.S. citizen, then setting up this type of trust could make sense if you’d like to minimize any tax burden your spouse may assume if the U.S Citizen spouse passes away first. A QDOT can essentially create a tax shelter for non-citizen spouses as part of an estate plan.
How a QDOT Works
To understand how a QDOT can benefit a non-citizen spouse, it’s helpful to understand the marital deduction and how that applies to estate taxes. Ordinarily, the Internal Revenue Code allows surviving spouses to claim a 100% marital deduction for estate taxes that may be due on assets they inherit when their spouse passes away. This is a significant tax break, as it enables surviving spouses to assume control of marital assets without getting hit with a sizable tax bill.
When a married couple consists of one spouse who’s a U.S. citizen and one who is not, the marital deduction does not apply. That means a surviving spouse could face substantial estate taxes on any assets they assume control of after their spouse passes away. Creating a QDOT and transferring assets to it with the non-citizen spouse named as beneficiary solves this problem.
Assets held in the trust would go to the surviving non-citizen spouse, allowing them the benefit of using those assets as well as any income they generate. They would pay no estate tax on assets in the trust. The surviving spouse could then pass those assets on to their children or another named beneficiary when they pass away. If applicable, the estate tax would be due on those assets at that time.
The main advantage of including a QDOT in your estate plan is to extend tax benefits to your spouse if they’re not a U.S. citizen and don’t plan to apply for citizenship. A surviving spouse would be able to enjoy the marital tax deduction on estate taxes. They’d also be able to receive income distributions from the trust. Those would be subject to income tax but not estate tax. If you have a sizable estate then setting up a QDOT in your Will could be worth it to ensure that you’re passing on as much of your wealth as possible to your spouse.
Limitations of a QDOT
While there are some advantages to QDOT, there are some potential downsides to keep in mind.
First, it’s important to note that the IRS is specific about how these types of trusts are set up. The trustee must be a U.S. citizen and if the assets in the trust exceed $2 million, a secondary trustee, who is a US Bank, will be required.
Once the spouse who created the trust in their Will passes away, their executor must make a QDOT election when filing a federal estate tax return. This is necessary to qualify for the marital deduction. The IRS specifies that the estate tax return with the QDOT election must be filed no later than nine months after the U.S. citizen spouse passes away.
Estate tax may be due if a surviving non-U.S. Citizen spouse receives principal from the trust, rather than income. There are, however, some exceptions to this rule. For instance, if a surviving spouse is experiencing financial hardship and has no other assets to tap into it may be possible to receive principal from the trust without being required to pay estate tax.
How to Set Up a QDOT
A QDOT can be set up prior to a person passing or through a person’s Will. The biggest considerations to keep in mind are who will be the trustee, what assets will be available to transfer and how those will be managed on behalf of your spouse once you pass away.