Local QDOTs – US Qualified Domestic Trusts Need Not be Domestic

The conventional wisdom is that trusts qualifying for the US estate tax marital deduction should be US domestic trusts for US income tax purposes. Typically, when the settlor/testator dies, if the surviving spouse is not a US citizen, the assets subject to US estate tax are figuratively whisked away to Delaware or some other US state where they are placed in the care of a US bank trustee. Families resident in the United States may accept this post-mortem re-engineering of family planning in their stride.

However, additional complexities may arise when a qualified domestic trust (QDOT) is required by an international family. The US trustee may have never spoken to, or even speak the same language as, the surviving spouse. That new trustee (however lovely) is now explaining to the spouse that assets the family may have controlled prior to the settlor/decedent’s death are now subject to US income tax and the QDOT regime.  

But what if the Singapore trustees who have known the family since the children were born could continue to serve as trustee? If the Cayman or Channel Islands trustees who have been with an entrepreneur through the growth and eventual sale of two start-ups could continue when a beloved spouse and business partner dies? Or if the solicitors in England who have acted for the family for three generations could continue to act as trustees of the QDOTs created in connection a certain family member’s will.  

Not only is it possible, in many cases it is preferable.

All QDOTs must have at least one “US Trustee” (defined as a US citizen or US domestic corporation). However, nothing in the QDOT rules requires a client’s interest in a family business or any other assets to be held in a US domestic trust.

If a US Trustee is appointed to act as co-trustee alongside an existing non- US trustee, surviving spouse or some other non-US taxpayer, the QDOT will be a foreign trust. Alternatively, powers can be given to the surviving spouse or another non-US person that will cause the trust to be a foreign trust for US income tax purposes because it will fail the “control test” set out in the regulations. See Treas. Reg. §301.7701-7(d).

Bequests to surviving spouses who are not US citizens are eligible for the US estate tax marital deduction if they “pass” (a defined term) to a qualified domestic trust or QDOT.

The unlimited US estate tax marital deduction only applies to bequests to US citizen spouses, bequests to green card holders and domiciliaries who are not US citizens do not qualify for the deduction.

Nuanced rules govern the structure and administration of a QDOT. See IRC §2056A; Treas. Reg. §20.2056A-1 et seq. Broadly, the trust must be governed by the law of a US state and the surviving spouse must be the sole beneficiary of the QDOT during the spouse’s lifetime. The surviving spouse is entitled to receive the ordinary income earned by the trust each year free from US estate tax.

The US Trustee takes responsibility for the QDOT’s payment of estate taxes (i) upon the distribution of capital or capital gains during the surviving spouse’s lifetime, other than due to hardship and the payment of estate taxes; and (ii) upon the death of the surviving spouse.

The QDOT balances the ability to defer tax until the death of a spouse whose estate may not be subject to US estate tax with the United States’ interest in securing the payment of tax upon the death of the surviving spouse. Certain US States (eg, New York) also have their own QDOT regimes.

Additional security options for QDOTs holding assets valued in excess of USD 2 million include the use of a:

If the QDOT’s remainder beneficiaries are US taxpayers, additional planning may be required to mitigate the impact of the throwback rules. These rules impose an additional tax and interest charge on US taxpayers who receive distributions that are deemed to include “undistributed net income” or UNI, which broadly means income and gains that have been accumulated in foreign (read non-US) trusts.