Estate planning allows you to determine who will receive your assets when you are no longer able to make financial decisions. By planning and organizing, you can take advantage of laws that help reduce the tax burden associated with passing assets to your beneficiaries. The marital deduction, in particular, allows you to transfer unlimited assets to your spouse upon death without triggering any estate taxes.

However, this deduction is generally only available to U.S. citizens. Surviving spouses who are not U.S. citizens may consequently owe considerable estate taxes upon inheritance. The good news is that it is possible to preserve the marital deduction for noncitizen surviving spouses by setting up a qualified domestic trust (QDOT).

Learn about qualified domestic trusts in this video.

What Is a Qualified Domestic Trust (QDOT)?

A qualified domestic trust (QDOT) is a specialized trust that allows non-U.S. citizen spouses to defer any estate taxes owing upon the death of their U.S. citizen spouse. By postponing any estate taxes that would otherwise be owing, a QDOT can provide the noncitizen surviving spouse with the type of financial security typically offered by the marital deduction.

How Does a QDOT Work?

Rather than transferring the deceased spouse’s assets to the noncitizen surviving spouse outright, a QDOT holds those assets in trust. This legal arrangement gives the noncitizen surviving spouse access to income generated by the trust’s assets during their lifetime without triggering estate taxes.

That said, QDOTs only defer taxes to a later date. Those taxes become due upon the death of the noncitizen surviving spouse unless the survivor later becomes a US citizen. Estate taxes also apply to any distributions made from the trust’s principal assets, although there are some exceptions to this rule. For instance, if the surviving spouse is experiencing financial hardship, they could potentially receive principal distributions without paying estate taxes.

By deferring estate taxes until the surviving spouse’s death, a QDOT makes it easier for the surviving spouse to maintain their standard of living while avoiding the premature depletion of the family’s wealth. Any assets that remain in the trust can then be passed to the next generation or to other named beneficiaries, although those assets will be subject to estate taxes at that time.

While QDOTs are generally set up by the U.S. citizen spouse -within their own estate documents, the non-U.S. citizen spouse may also set up a QDOT on their own behalf by irrevocably transferring all the assets they receive upon their spouse’s death to the trust before the deceased spouse’s estate tax return becomes due. This second option leaves less time to structure the QDOT, however, which is why many married couples choose to create a qualified domestic trust in advance.

QDOT Eligibility Requirements

For a trust to qualify as a QDOT, it must meet specific criteria established by the Internal Revenue Service. For instance:

• The primary beneficiary of the QDOT must be a noncitizen who is legally married to a U.S. citizen at the time of the citizen spouse’s death
• At least one of the trustees managing the QDOT must be a U.S. citizen or U.S. corporation
• The executor of the deceased spouse’s estate must elect to treat the trust as a QDOT when they file the estate’s federal tax return
• The trust documents must explicitly indicate that the arrangement qualifies as a QDOT and there are strict regulations on how the assets within the trust can be handled

Given the complexity of these rules and the need to draft compliant trust documents, it is important to consult with an estate tax attorney when setting up a QDOT.

Tax Implications of a Qualified Domestic Trust

One of the primary reasons to establish a QDOT is to take advantage of its favorable tax treatment. Without this trust, the estate of a deceased U.S. citizen could face taxes of up to 40% on any assets left to a noncitizen spouse. Creating a QDOT defers estate taxes until principal distributions are made from the trust or until the surviving spouse passes away.

However, QDOTs are not tax-exempt. This means that any income generated by the trust will be subject to income tax. Similarly, any income distributions made by the trust to the surviving spouse would trigger income tax liabilities at that spouse’s prevailing income tax rate.

Pros and Cons of a QDOT

Establishing a QDOT comes with both benefits and potential drawbacks. On the plus side, QDOTs allow for the deferral of estate taxes, which can help to preserve marital assets. This deferral can provide essential financial stability, allowing the noncitizen spouse to access income from the trust without depleting the principal. Additionally, QDOTs allow wealth to be preserved and managed over time, which can work to the benefit of future generations.

On the flip side, QDOTs can be complex to establish and administer, which is why many people opt to work with a professional trustee who understands the tax consequences associated with different types of distributions. They are also subject to specific restrictions on the types of assets and investments they may hold, which could affect the trust’s overall performance. For this reason, it makes sense to work with a financial advisor who understands the intricacies associated with QDOT investment strategies.

The Bottom Line

If you or your spouse is a non-U.S. citizen, adding a qualified domestic trust to your estate plan can help defer estate taxes, protect your hard-earned assets and provide financial stability to the noncitizen surviving spouse. As just one tool in your estate planning arsenal, a QDOT can help you structure a financial plan uniquely tailored to your specific needs and goals.

To unlock the benefits of a QDOT, however, careful planning is important. To discuss some of the steps associated with establishing a QDOT and determine how this type of trust might fit into your estate plan, reach out to your financial advisor today.

This information is not intended to be a substitute for specific individualized tax advice. We suggest that you discuss your specific tax issues with a qualified tax advisor. 

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