Marital Deduction Trusts and Expatriates – More Questions Than Answers

If an expatriate dies and leaves property to a U.S. citizen or resident spouse, can a marital trust be used to defer or avoid the transfer tax imposed under Section 2801? Both the Code and the Regulations seem to say yes, but a closer reading suggests that absent further regulatory relief, the answer is uncertain. And will the surviving spouse be taxable on the marital trust assets at his or her later death?

FACTS: Code Section 2801 imposes a transfer tax at the highest estate tax rate of estate tax on a covered gift or bequest to a U.S. citizen or resident. In the circumstances of death of an individual, a covered bequest is any property acquired directly or indirectly by reason of the death of an individual who, immediately before such death, was a covered expatriate. Code Section 2801(e)(1)(B). A covered expatriate is an individual who expatriated from the U.S. and met or exceeded certain asset or income thresholds at the time of expatriation. This tax is not a Chapter 11 estate tax (nor a Chapter 12 gift tax) – this will be an important fact.

Code Section 2801 should only apply to decedents who are nonresidents of the U.S. and noncitizens, since it does not apply to Chapter 11 gross estate assets of a decedent. Expatriates who nonetheless are U.S. residents or citizens at the time of death will have all of their assets included in their Chapter 11 gross estate, and thus will not be subject to Code Section 2801. Further, Code Section 2801 should only apply to non-U.S. situs assets of an expatriate decedent. This is because under Code Section 2101, U.S. situs assets of nonresident/noncitizen are included in his or her Chapter 11 gross estate – as noted Code Section 2801 does not apply to Chapter 11 gross estate assets.

So assume we have a nonresident/noncitizen qualified expatriate who owns $20 million of common stock in a non-U.S. corporation, and at his death he leaves it to a trust meeting the QTIP requirements of Code Section 2056(b)(7). As a threshold matter, this a transfer of non-Chapter 11 gross estate property from a qualified expatriate to a U.S. citizen – this is a covered bequest and is subject to Code Section 2801 tax. Can the tax be deferred or avoided under the estate tax marital deduction?

Code Section 2081(e)(3) provides: “[A covered bequest] shall not include any property with respect to which a deduction would be allowed under section 2055, 2056, 2522, or 2523, whichever is appropriate, if the decedent… were a United States person.” If our decedent is a U.S. person, then the estate tax marital deduction is available under Code Section 2056, so it would seem to allow the marital deduction. The proposed regulations expand upon this and provide: “A transfer from a covered expatriate to the covered expatriate's spouse is not a… covered bequest to the extent a marital deduction under section… 2056 would have been allowed if the covered expatriate had been a U.S. citizen or resident at the time of the transfer. To the extent that a… bequest to a trust (or to a separate share of the trust) would qualify for the marital deduction, the gift or bequest is not a… covered bequest. For purposes of this paragraph (c)(4), a marital deduction is deemed not to be allowed for qualified terminable interest property (QTIP) or for property in a qualified domestic trust (QDOT) unless a valid QTIP and/or QDOT election is made.” (emphasis added) Prop. Regs. Section 28.2801-3(c)(4).

COMMENTS: Let’s examine the proposed regulations first. They require a valid QTIP election, on a Form 706 or Form 706-NA. A Form 706 QTIP election is not possible, since the estate of our decedent will file a Form 706-NA per the decedent’s nonresident/noncitizen status.

The Form 706-NA and its instructions require the inclusion of a Schedule M from the Form 706 to obtain a marital deduction. That Schedule M by default imposes a QTIP election on assets described thereon in the QTIP section. The instructions to Schedule M provide that you can only include property interests that are included in the decedent’s gross estate – non-gross estate assets do not belong on the schedule. So how does one make a “valid QTIP” election for non-U.S. situs assets that are not included in the decedent expatriate’s estate? It would appear that requiring a “valid QTIP election” prevents the estate from meeting the requirements of the proposed regulation.

Does Section 2801(e)(3) allow for the deduction? Likely yes, but maybe no. To get the deduction under Code Section 2056 if we treat our expatriate as a U.S. person, a valid QTIP election on an estate tax return is needed – we now circle back to the question of how one can make a QTIP election on an estate tax return if the assets are not actually included in the gross estate of the decedent. Perhaps a constructive inclusion of the subject assets in the decedent’s gross estate, along with a constructive election with the completion of a Schedule M that includes the foreign situs assets, will suffice. One would suppose that this is the proper result, per the inclusion of Section 2801(e)(3) in the Code. That being the case, at a minimum, the proposed regulations when finalized should remove the requirements for a “valid” QTIP election and allow for a constructive QTIP election that includes the non-U.S. situs assets for which a deduction is sought – otherwise the requirements of the regulation cannot be satisfied.

Here is perhaps a more interesting question – if the marital deduction is allowed, what happens at the subsequent death of the surviving spouse? Will the assets be subject to estate tax in the surviving spouse’s estate under Code Section 2044? That would be a stretch – Code Section 2044 by its terms applies only if there was a deduction taken at the first spouse’s death under Section 2056(b)(7) – “… [t]his section applies to any property if… a deduction was allowed with respect to the transfer of such property to the decedent… under section 2056 by reason of subsection (b)(7). At best, there is no deduction that occurs, only an exclusion of assets from property subject to tax under Code Section 2081. See Code Section 2081(e)(3). Alternatively, can Code Section 2081(e)(3) be read expansively to impose an estate tax on the surviving spouse under Code Section 2044? That, too, would be quite a stretch since all Code Section 2081(e)(3) says is to exclude certain property from a covered bequest – it says nothing about imposing estate taxes on the surviving spouse.

So where are we? Here are the main possibilities:

1. A QTIP election may be allowable, however inartfully allowed under the Code and proposed regulations. An informal discussion with the draftpersons of the proposed regulations indicates this is what was intended. If that is the case, then the next question is whether the surviving spouse will be subject to having the QTIP trust assets included in his or her gross estate at death under Code Section 2044. If not, this strongly suggests the use of QTIP trusts in lieu of outright transfers to U.S. person spouses by expatriates when future estate taxes are an issue! Even if the regulations are issued in final form to provide for such taxation though, one has to question whether the IRS has regulatory authority to impose such a tax.
2. The election may not be allowable, at least until revised proposed or final regulations or a Form 708 are issued that address these issues. In that situation, draftspersons will have to give consideration to an outright bequest to a U.S. person surviving spouse in lieu of a QTIP transfer.

When the surviving spouse is a resident of the U.S. but not a citizen, similar considerations should apply in regard to a QDOT trust..