I received this question from S.G., of Portola Valley, CA., who wrote:

My friend is married to a handsome man who is not a U.S. citizen. She is concerned she won't be able to give him her assets without incurring estate or gift tax. Is her concern well founded?

Dear S.G.:

Recent tax law changes have significantly affected how much individuals may pass to their spouse who is not a U.S. citizen.

A key section in federal law denies the unlimited estate and gift tax marital deduction for assets passing to the non-citizen spouse. This negates the common estate planning device, available to U.S. citizens, that allows assets to pass to a surviving spouse tax-deferred. Individuals leaving assets to a non-citizen spouse should plan for estate tax being payable at their death.

In addition, federal law limits the ability of these spouses to give each other unlimited lifetime gifts without the imposition of gift tax. Tax-free gifts to a non-citizen spouse are restricted to an annual maximum of $100,000. However, this limited spousal gift provision remains one of the few methods to pass assets free of estate and gift tax to the non-citizen spouse.

Further, federal law now includes in the deceased spouse's estate the full value of property jointly-held with a non-citizen spouse. Only contributions provided by the non-citizen spouse can be subtracted from the value of the jointly-owned property. This is less favorable than the old rule that only counted half of such jointly-owned property.

The overall effect of these changes is to impose estate tax sooner, and to increase the amount of assets subject to estate tax rates which Federally start at 37% and quickly rise to 55%. Remember, U.S. residents (citizens or not) are subject to estate tax on their world-wide assets. State inheritance tax and other final expenses can increase total estate costs, further reducing the amount available to pass on to heirs.

There are some methods to keep the unlimited estate and gift tax marital deduction. One is to pass the assets to a Qualified Domestic Trust (QDT). The QDT would generally allow assets to pass for the benefit of the non-citizen spouse free of immediate estate tax. The spouse can receive income from the trust, but withdrawals of principal could be subject to estate taxation based on the deceased spouse's rates. To be valid, the QDT must satisfy strict requirements. Another method to avoid the estate tax is for the non-citizen spouse to become a U.S. citizen by the due date of the estate tax return and to have been a U.S. resident since the death of their spouse.

Although the preceding methods may allow for the transfer of assets without current estate tax, there is an easier method to provide for the non-citizen spouse, by using life insurance. Gifts of cash to the non-citizen spouse can be used to purchase a life insurance policy on the citizen spouse. The non-citizen spouse would own the policy, and would receive the proceeds income tax-free, without a lot of complications. Since the citizen spouse never owned the policy, the proceeds would not be included in their estate. Life insurance may provide a significant benefit, often for pennies on the dollar, at the exact time it is needed.

The magnitude and potentially adverse impact of these tax law changes make it imperative that individuals affected establish an estate plan or review their existing plan. Be sure to consult with a professional who specializes in this area and who is familiar with these laws.