If you or your spouse (or both) are not U.S. citizens and you live in Massachusetts with a total combined estate of more than $1 million, your estate tax planning could get complicated. This is in large part because non-U.S. citizens are not eligible for the marital deduction which permits unlimited tax free gifts between spouses whether during life or at death.
While the marital deduction means that there's almost never an estate tax when the first spouse of a married U.S. citizen couple passes away, matters can get more complicated when one or both spouses is not an American citizen, at least if they live in Massachusetts. With the federal estate tax exemption set at $11.7 million in 2021, virtually all estates are exempt from the federal estate tax, so it doesn't matter whether the surviving one qualifies for the marital exemption.
Taxation of Non-U.S. Citizens in Massachusetts
But the Massachusetts estate tax exemption is just $1 million, so many couples where one or both are not U.S. citizens risk an estate tax upon the death of the first spouse. A couple of examples can show how much this may cost. In the first, the couple (couple A) together have an estate totaling $2 million, each holding $1 million. In the second, the couple (couple B) owns assets worth $4 million, each spouse holding $2 million. Let's also assume that all the individuals have estate plans giving all their assets to their surviving spouses. If everyone is a U.S. citizen, there will be no Massachusetts estate tax when the first spouse passes away in either case, due to the marital deduction. This is also true if the deceased spouse is not a U.S. citizen, but the surviving spouse is.
But if the surviving spouse is not a U.S. citizen, no matter the citizenship of the deceased spouse, there would be a Massachusetts estate tax of approximately $36,000 when the first spouse passes away in the case of couple A and of approximately $70,000 in the case of couple B. Most couples in Massachusetts are also advised to do basic estate tax planning through the use of so-called "QTIP" or "credit shelter" trusts to avoid another $100,000 more or less in estate taxes upon the death of the surviving spouse. In the case of couple A, such a plan could totally avoid estate taxes.
But what can be done when one or both spouses are not U.S. citizens? Here are some options:
Massachusetts residents can shelter up to $1 million in assets for the benefit of non-U.S. citizen spouses, postponing any tax and protecting the funds in trust from taxation at the death of the surviving spouse as is done with QTIP and credit shelter trusts through the use of Qualified Domestic Trusts or "QDOTs." Unfortunately, these trusts are more limited in how the money may be spent, more complicated to administer than typical estate tax planning trusts, and the trust assets will be subject to taxation upon the surviving spouse's death.
While the QDOT will postpone taxation, the question is whether it's worth the trouble given that it simply delays taxation rather than eliminates it entirely on the sheltered assets.
If the surviving spouse obtains U.S. citizenship within nine months of the death of her spouse, she will be treated, for estate tax purposes, just like any other U.S. citizen.
Each spouse can make efforts to make sure his assets are under $1 million through gifting. No gifts need to be reported if they are below $15,000 per recipient per year ($30,000 if both spouses make gifts). For non-U.S. citizen spouses, it's even more important than for citizen spouses to make sure that assets are balanced between them. In the case of couple A, if they can make sure that they each hold just under $1 million and create credit shelter trusts for the benefit of the surviving spouse, they can avoid the Massachusetts estate tax just like U.S. citizen couples. (They just can't use QTIIP trusts.)
However, they have to be careful in how quickly they rebalance assets. While there are no restrictions on U.S. citizen spouses transferring assets back and forth, when the recipient is a non-U.S. citizen spouse, any gifts above $159,000 (in 2021) must be reported on a gift tax return. While no gift tax will be due until $11.7 million has been transferred, this can also complicate Massachusetts estate calculations in ways that are too complex to explain in this context. It's just much easier to keep annual inter-spousal transfers below this amount.
Life Insurance Trust
One long-standing estate tax strategy is for taxpayers to purchase life insurance through specialized trusts that keep the proceeds out of the taxable estate of the decedent. The benefit of using this approach has decreased or disappeared for most taxpayers as the federal exemption amount has increased from $1 million in 2000 to $11.7 million today, meaning that very few estates are subject to the federal estate tax. The Massachusetts estate tax savings for most people is too small to justify the expense and rigmarole of setting up and administering a life insurance trust. However, the added taxes payable by non-U.S. citizen Massachusetts residents may justify its use, especially in the case of couple B who cannot avoid the Massachusetts estate tax as easily as couple A.
Don't Worry About It
Unlike the federal estate tax, which is at the rate of 40% once the threshold is met, the Massachusetts estate tax is graduated, starting at 0.8% and reaching 11.2% for estates in excess of $4 million. This is why the taxes to be paid at the death of the first spouse with no estate taxation is just $36,000 in the case of couple A and $70,000 in the case of couple B. While no one wants to pay any estate tax, these taxes are far from confiscatory. It may be easier to do no tax planning or to do the type of planning that U.S. citizen Massachusetts residents do to avoid the additional $100,000 in taxes due at the death fo the surviving spouse (assuming she remains a resident of Massachusetts).