To understand the value of a qualified domestic trust (QDOT), you have to digest some information about the estate tax. There is a federal estate tax in the United States, and it carries a hefty 40 percent maximum rate that can take a major toll on your legacy. We also have a state-level estate tax here in New York, but to keep things simple, we will stick to an explanation of the federal parameters here.
Fortunately, the majority of people do not have to pay the tax, because there is a credit or exclusion that is relatively high. The exclusion is the amount that can be transferred in a tax-free manner. At the time of this writing in 2018, the exclusion is $11.18 million. Next year, the amount of the exclusion will probably be adjusted slightly to account for inflation.
It would make sense to consider lifetime gift giving as a way to sidestep the estate tax. This was possible in 1916 when the estate tax was first enacted, and many wealthy people did take advantage of this loophole. In 1924, a gift tax was put into place to close it, but it was repealed in 1926. Six years later, the gift tax was reinstated, and it has been in place ever since then.
The estate tax and the gift tax are unified under the tax code, so the $11.18 million exclusion that we have this year is a unified exclusion. It encompasses lifetime gifts along with the estate that will be transferred to your heirs after you pass away.
While we are on the subject, we should touch upon the existence of the annual gift tax exclusion. This sits apart from the unified exclusion. It allows you to give up to $15,000 a year to any number of gift recipients tax-free, and there is no limit to the total as long as you do not give more than this amount to any one person. You are also allowed to pay school tuition and medical bills for others without incurring any transfer tax liability.
As long as you and your spouse are United States citizens, you would be entitled to a gift and estate tax marital deduction. You can transfer any amount of money or property to one another free of the gift tax and the estate tax. We should also point out the fact that the estate tax is portable between spouses. This means that the surviving spouse would have his or her own exclusion, and the survivor would also be allowed to use the deceased spouse’s exclusion.
Now that we have provided all the necessary background information, we can explain the value of a qualified domestic trust. If you are married to someone that is a citizen of another country, you cannot utilize the estate tax marital deduction. A solution that is commonly utilized is the qualified domestic trust.
To implement this strategy, you convey assets that comprise your estate into the qualified domestic trust. Your spouse would be the first beneficiary of the trust, and you would name secondary beneficiaries that would presumably be your children. After you pass away, the estate tax would not be applied on assets that are held by the trust. They could continue to appreciate in a tax-deferred manner.
When you establish the trust, you name a trustee to administer the vehicle after you are gone. If you do predecease your spouse, the trustee could distribute the earnings from the trust to your surviving spouse. The estate tax would not be applied on transfers, but regular income taxes would be applicable.
It would be possible for the trustee to distribute some of the principal to the beneficiary. However, if this is done, the estate tax would be a factor. This being stated, it is possible to request a hardship exemption from the Internal Revenue Service.
After the passing of your surviving spouse, the assets in the trust would be passed to the secondary beneficiaries. The estate tax would be applicable at that time if the value of the assets in the trust exceed the amount of the federal estate tax exclusion.
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