Non-Citizen Spouse. Estate Planning Using Qualified Domestic Trusts (QDOTs) and Irrevocable Life Insurance Trusts (ILITs)

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1 Guiding you through life. SALES STRATEGY NEEDS ANALYSIS Non-Citizen Spouse Estate Planning Using Qualified Domestic Trusts (QDOTs) and Irrevocable Life Insurance Trusts (ILITs) As large numbers of people from other countries settle in the United States, the need for estate planning for non-citizens has been increasing. If you have a client that is married to a non-citizen spouse, do they realize that asset transfers between them might be limited? Have your clients looked at the tax law with regards to asset transfer, ownership of current assets, and worldwide property? How much life insurance do they need? The Concern Most married couples want to ensure that their families are taken care of in the event of their death. At death, they likely want to provide income replacement, cover debt obligations, and perhaps cover future college expenses. If your client is a U.S. citizen who is married to a non-citizen, they will have to be careful how they transfer assets because there are greater restrictions on asset transfers from a U.S. citizen spouse to a non-citizen spouse. To best understand how you can serve your clients that are married to non-citizens, it is important to first be familiar with the terminology. Non-citizens who reside in the U.S. are referred to as resident aliens (RAs). For example, you may have a client who lives in the U.S., but is a Canadian citizen. Non-citizens who permanently reside in a country outside the U.S. are referred to as non-resident aliens (NRAs). NRAs reside in another country, but have ties to the U.S. such as being married to a U.S. citizen or perhaps they own property and assets in the U.S. The IRS treats U.S. citizens, resident aliens, and non-resident aliens differently. 1 For the purpose of this piece, the focus will be on resident aliens as the non-citizen spouse. 2 Transferring Assets During Life There are many nuances related to gifting assets. The following rules help explain what is important to consider for each scenario. U.S. Citizen Spouse Gifting to a Non-Citizen Spouse Non-citizen spouses do not qualify for the unlimited gift tax marital deduction that is available to U.S. citizens. This means that a U.S. citizen is limited to the amount of money he/she can give to his/her non-citizen spouse. This is because Congress is concerned that the non-citizen spouse will receive the assets and take it back to his or her home country, effectively removing it from the reach of Congress s taxation. There are two gifting methods a U.S. citizen spouse can utilize during life to transfer assets to his/her spouse. The first is to gift his/her available lifetime gift exemption ($5M indexed for inflation. In 2017 the lifetime exemption is $5.49M.) The second method is based on an annual exclusion. In 2017, a U.S. citizen can gift $149,000 annually to his/her non-citizen spouse. It is important to note that this annual exclusion is different from the traditional annual exclusion of $14,000. LIFE /17 Page 1 of 6. Not valid without all pages.

2 Non-Citizen Spouse Gifting to Others While there are limitations on gifting from the U.S. citizen spouse to the non-citizen spouse, this limited marital gift is only applicable when making a transfer to the non-citizen spouse. A non-citizen spouse can gift an unlimited amount to his/ her U.S. citizen spouse. For example, a Canadian spouse can gift $50M to her U.S. citizen husband without any gift tax consequences. For transfers to other individuals, RAs can use the $5.49M lifetime gift exemption and $14,000 annual exclusion (using 2017 amounts) during their lives. Transferring Assets At Death When making decisions related to your clients estate, it is important to take an inventory of worldwide assets and the ownership of the assets. Once there is an understanding of the individual networth of the U.S. citizen and non-citizen, the second step is to figure out if estate taxes will be assessed. Due to the differences between U.S. citizens and RAs, the following is a breakdown of transferring assets at death: U.S. Citizens If the U.S. citizen dies first and his/her intent is to leave all his/ her assets to the non-citizen spouse and no planning has occurred the estate tax will be assessed over the exemption. The client can also delay estate taxes by setting up a Qualified Domestic Trust (QDOT). Non-Citizen Spouse (RA) At the death of the RA, they can leave their entire estate to their U.S. citizen spouse without estate taxes (they have the unlimited exemption). If the U.S. citizen spouse predeceases the RA, the RA then has the full applicable credit against U.S. estate taxes. SIMILARITIES AND DIFFERENCES BETWEEN ESTATE PLANNING FOR A U.S. CITIZEN, AS OPPOSED TO PLANNING FOR A NON U.S. CITIZEN IN 2017 Transfers to a Non-Citizen Transfers to a U.S. Citizen Annual Gifts To Spouse $149,000 Unlimited marital deduction Annual Exclusion Gifts $14,000 $14,000 Lifetime Exemption for Gifts $5M indexed for inflation $5M indexed for inflation Unlimited Marital Deduction No, unless QDOT is established Yes The Solution While estate taxes may not be applicable to all U.S. citizens married to RAs, basic estate planning and needs analysis applies to the majority of these global families. Clients should work with their financial advisor and legal counsel to create, plan, and fund a comprehensive estate plan. Clients should also work with their attorney to create the documents needed to fulfill their ultimate wishes. These documents include: y Will and/or Trust: Outlines your clients intent for distribution of assets. y Powers of Attorney: Gives your clients the ability to make financial decisions for each other. y Health Care Proxy: Gives your clients the ability to make health care decisions for each other. These documents should express your clients wishes as it pertains to distribution of property, guardianship issues of minor children, etc. Beneficiary designations should be continuously reviewed on qualified plans, insurance policies, and annuities, and updated when changes are necessary. Your client should work closely with their attorney with regards to these matters, especially when a non-citizen spouse is involved. Additional planning and consideration of world wide assets, and specific tax treaties with country of citizenship, have to be considered. In addition, trust planning might be needed for those clients who also face estate and gift tax problems. It is also important to make sure the client s family can maintain its economic position into the future should something happen to the primary income earner. For younger clients with less assets, but have a good income, mortgages and student loans, life insurance can be an especially desirable method to ensure their family s shortfall is covered. A comprehensive Needs Analysis can help determine how much life insurance is appropriate for your client. This life insurance need can also take into consideration the estate tax that may be levied on the U.S. citizens death. John Hancock Solutions has a Needs Analysis module for non-citizen spouses married to U.S. citizens to help determine the life insurance need. Below is a snapshot of this module with an example of how it could work. Page 2 of 6. Not valid without all pages.

3 CASE STUDY Robert Jackson and Anna Aristondo, both age 45, have settled in Michigan with their family and a growing business. Although Robert is a U.S. citizen, Anna is a Spanish citizen and is not planning to change her citizenship. Robert and Anna would like to provide for each other and their three children. ANALYSIS OF NEEDS FOR ROBERT JACKSON Expenses to Replace Income Replacement Needs Salary of $150,000 replaced for 20 years. indexed for inflation at 0.00% Child Support Needs Child Care Needs College Fund Needs Debt Clearance Needs Estate Administration Costs Other Expenses (Emergency funds, charitable gifts, etc.) Estate Taxes Present Value $2,298,570 $65,073 $148,916 $300,000 $25,000 $0 $1,726,314 ANALYSIS OF NEEDS FOR ANNA ARISTONDO Expenses to Replace Income Replacement Needs Salary of $82,000 replaced for 20 years. indexed for inflation at 0.00% Child Support Needs Child Care Needs College Fund Needs Debt Clearance Needs Estate Administration Costs Other Expenses (Emergency funds, charitable gifts, etc.) Present Value $1,256,552 $65,073 $148,916 $300,000 $25,000 $5,000 Total Death Benefit Needed Less Existing Insurance and Assets Set Aside for Death Needs $4,563,873 $2,500,000 Total Death Benefit Needed Less Existing Insurance and Assets Set Aside for Death Needs $1,800,540 $1,000,000 New Life Insurance Need $2,063,873 New Life Insurance Need $800,540 This is a hypothetical example provided for illustrative purposes only. Estate Planning Options for Affluent Clients Qualified Domestic Trust (QDOT) For clients who are concerned with estate taxes, a QDOT should be established to obtain the estate tax marital deduction. y QDOT Requirements: 1 The QDOT must have at least one U.S. trustee (a U.S. individual or corporation), and must also satisfy the general marital deduction requirements of U.S. estate tax law under Section 2056 of the tax code. 2 Income must be distributed annually to the non-citizen spouse. Income distributions to the surviving spouse from the QDOT trust will not be subject to estate tax, but distributions of principal to the surviving spouse will be subject to estate tax (unless the distributions are made on account of hardship). In some cases, if a non-citizen couple is preparing their estate plan and they are planning to become U.S. citizens in the near future, they may not need to have QDOT provisions in their living trusts. If they die before they actually become U.S. citizens, their executor can elect post-mortem for their marital trusts to qualify as QDOTs. It is important to remember that the citizenship of the spouse who is the beneficiary of the marital trust makes a difference for tax planning purposes, not the citizenship of the donor spouse. For example, in a situation where a husband is a U.S. citizen and a wife is not a U.S. citizen, the husband s will or living trust should contain QDOT provisions, whereas the wife s will or living trust can provide for a typical marital trust, known as Qualified Terminable Interest Property Trust, or QTIP Trust. 3 Page 3 of 6. Not valid without all pages.

4 Other Planning Considerations for Non-Citizen Spouses y Jointly Owned Property: For U.S. citizens, when the first spouse dies, the estate will generally only include 50% of jointly owned property. However, for non-citizen spouses, the entire value of a joint interest will be included in the estate of the first spouse to die, reduced by contributions which the estate can prove were supplied by the surviving spouse. As a result, it may be a good idea to undo joint ownership of assets during both spouses lives, if it is expected that they will have a taxable estate. y Retirement Assets: Since assets passing to a non-citizen surviving spouse will only receive the marital deduction if they are included in a QDOT, one of the best options for a non-citizen surviving spouse who receives qualified plan assets or IRA assets is to rollover the plan benefits into an IRA-QDOT. The IRA-QDOT will allow the surviving spouse to continue deferring income tax on the retirement assets that remain in the IRA and receive income from the IRA estate tax free. However, principal distributions to the surviving spouse will be subject to both estate and income tax, as with a standard QDOT. Why Use a QDOT? Affluent clients use QDOTs because it is an efficient way to transfer assets without gift tax consequences. They delay and postpone estate taxes for the non-citizen spouse. Even though the nature of a QDOT is restrictive, it should still be considered. In addition, an Irrevocable Life Insurance Trust (ILIT) should be considered to help minimize estate taxes. Irrevocable Life Insurance Trusts While a QDOT is one option that should be considered when planning for the non-citizen spouse, other options should also be considered, as a QDOT does not solve the estate tax problems it simply postpones the estate taxes. Due to the restrictive nature of QDOTs, clients should explore flexible planning options to balance and enhance their estate. ILITs funded with life insurance can provide additional benefits and flexibility. ILIT vs. QDOT How Do They Differ? y Funding an ILIT: An ILIT is funded during the life of the U.S. citizen spouse. The funding of the trust is typically done through gifting, and thus transfers may be limited to gifts. Compared to a QDOT, which is funded at death and can be funded with all of the U.S citizen spouse s assets. y Beneficiary Designation: An ILIT usually will name children and grandchildren as beneficiary of the trust. It also can allow for spousal access rights (referred to as a Spousal Access Trust) 4 that allow a spouse to also be a beneficiary. With a QDOT, children and grandchildren may not receive assets until after the death of the non-citizen spouse (the same is not true for an ILIT). y Income Distributions: During the life of the U.S. citizen, the non-citizen spouse could receive income distributions from the ILIT. This would still make the ILIT assets excludable from the U.S. citizen s estate, but allow for distributions to be made to his/her spouse during life. At the death of the U.S. citizen spouse distributions can be made to all beneficiaries. With a QDOT it is required that all income generated by the trust be paid out to the non-citizen spouse. y Estate Taxes: A properly drafted ILIT will not be includable in the U.S. citizen s estate. While a QDOT postpones taxes at the death of the U.S citizen spouse, those estate taxes will have to be paid when a distribution of principal is paid out or at the death of the non-citizen spouse. How Does an ILIT Work With a Non-Citizen Spouse? A U.S. citizen spouse can create an ILIT with spousal access provisions (Spousal Access Trust). He/she can gift money to the trust for the benefit of the entire family, including the spouse. The trustee can purchase a life insurance policy on his/her life. During the life of the U.S. citizen the trustee can make distributions to the non-citizen spouse. Upon the death of the individual, the death benefit can be tax free and will not be subject to estate taxes. Benefits of an ILIT y The trust will receive the death benefit free from income and estate taxes. y An irrevocable trust can protect assets from creditors and protect the family s privacy. 5 y When gifts are used to purchase life insurance, lifetime giving can increase the amount of money left for heirs. y A Spousal Access Trust allows distributions to the grantor s spouse and children during his/her lifetime, allowing access to the policy cash value. Page 4 of 6. Not valid without all pages.

5 Considerations y Transfers of assets to an ILIT are irrevocable and may only be used for the benefit of the trust beneficiaries. y Taking policy loans and withdrawals from a life insurance policy during the insured s lifetime can reduce the available death benefit and cash value, and may cause the policy to lapse. Cash value available for loans and withdrawals may be more or less than the amount originally invested, and lapse or surrender of a policy with a loan may cause the recognition of taxable income. y Policies classified as modified endowment contracts may be subject to tax when a loan or withdrawal is made. A federal tax penalty of 10% may also apply if the loan or withdrawal is taken prior to age 59½ from a modified endowment contract. y Life insurance death benefit proceeds are generally excludable from the beneficiary s gross income for income tax purposes. There are a few exceptions such as when a life insurance policy has been transferred for valuable consideration. The JH Solutions software has the capability of not only illustrating a Needs Analysis, but also includes a QDOT module to help illustrate the benefits of planning using a QDOT and an ILIT. Below is a snapshot of a sample case taken from JH Solutions. CASE STUDY: OSBORNE AND AIMEE HAMLEY Osborne and Aimee Hamley are both 65 years old and have three adult children. Osborne is a U.S. citizen who has been married to Aimee (a resident alien) for over 20 years. Osborne has en estate of $10M and wants to leave his estate to his wife and children. The chart below illustrates the benefits of creating a QDOT and an ILIT. In addition to enhancing the benefit to the heirs, the additional flexibility of the ILIT is one that cannot be quantified in numbers. COMPARISON OF VALUES IN 40 YEARS Estate of Citizen Spouse Today Insurance Premiums to Year of Death (Yr. 22) Current Scenario: QDOT Only 10,000,000 0 Current Scenario: QDOT & ILIT 10,000,000 1,848,000 Estate of Citizen Spouse at Death (Yr. 22) 19,161,034 16,518,992 QDOT at Death (Yr. 22) QDOT in Focus Year 40 Excess QDOT Earnings in Focus (Yr. 40) Estate Taxes on QDOT and Excess Earnings 13,821,034 13,821,034 2,764,541 5,528,414 11,178,992 11,178, ,008 4,471,597 Net to Heirs from QDOT 11,057,162 7,560,403 Cumulative Distributions in (Yr. 40)* Cumulative A/T Distributions in (Yr. 40)* Credit Shelter Trust in (Yr. 40) Irrevocable Life Insurance Trust in (Yr. 40) Net to Heirs from QDOT in (Yr. 40) 7,463,358 7,463,358 9,090,993 11,057,162 6,036,656 6,036,656 9,090,993 7,233,466 7,560,403 Net to Heirs in Year 40 Potential Gain Due from Planning 20,148,154 23,884,862 3,736,707 * Distributions have been taken for 18 years. The figures used in this case study are hypothetical, for discussion purposes only, are not guaranteed and may not be used to project or predict results. Actual results may be more or less favorable. Specific product and policy elements would be found in a policy illustration provided by an insurer. Page 5 of 6. Not valid without all pages.

6 SUMMARY A needs analysis that includes potential estate taxes should be completed for families with a non-citizen spouse. In addition, they should consult with their attorney about creating a QDOT and Spousal Access Trust. While the QDOT exists as an option for married couples in which one members is not a U.S. citizen, an ILIT is an additional option that can provide greater flexibility and liquidity, as well as the estate and income tax benefits. 1. U.S. gift tax (see IRC 2501(a) 1 & 2511(a)) / U.S. estate tax (see IRC Sections 2101(a) and 2106(a)). 2. Treas. Regs (b) (1), (b). Note the residency test for gift and estate tax for RAs is different than the income test for RAs, which focuses on the physical presence of the RA. This means that a non-citizen RA may be classified as a citizen for income tax purposes but not for gift and estate tax purposes. 3. The requirements for a QDOT are set forth in Internal Revenue Code Section 2056A. The election for treatment as a QDOT must be made on the decedent s estate tax return. If the value of the QDOT assets exceeds $2 million, it is considered a large QDOT and must either a) name a U.S. bank or trust company to act as trustee or b) furnish a bond or letter of credit in the amount of 65% of the QDOT. Treas. Regs See IRC Section To avoid giving the beneficiary spouse any incidents of ownership with a Survivorship Spousal Access Trust, the authority to make distributions to the surviving spouse may need to be limited to an independent trustee with absolute discretion. See PLR Consult your tax advisors. 5. Assuming the proposed initial gift was not a fraudulent conveyance meant to inhibit creditors. This material does not constitute tax, legal or accounting advice and neither John Hancock nor any of its agents, employees or registered representatives are in the business of offering such advice. It was not intended or written for use and cannot be used by any taxpayer for the purpose of avoiding any IRS penalty. It was written to support the marketing of the transactions or topics it addresses. Comments on taxation are based on John Hancock s understanding of current tax law, which is subject to change. Anyone interested in these transactions or topics should seek advice based on his or her particular circumstances from independent professional advisors. Insurance products are issued by: John Hancock Life Insurance Company (U.S.A.), Boston, MA (not INSURANCE PRODUCTS: licensed in New York) and John Hancock Life Insurance Company of New York, Valhalla, NY 10595; securities offered through John Hancock Distributors LLC through other broker/dealers that have a selling agreement with John Hancock Distributors LLC, 197 Clarendon Street, Boston, MA John Hancock. All rights reserved. Not a Deposit MLINY Scan this code to find out more. Not FDIC Insured Not Bank Guaranteed May Lose Value Not Insured by Any Government Agency Page 6 of 6. Not valid without all pages.