Connections between Canadians and the U.S. have never been as numerous or transparent as they are now: many Canadians own U.S. property, have U.S. spouses or partners, and have children and grandchildren born or living in the U.S. As of January 20, 2017, Donald Trump is President of the U.S. If he repeals or otherwise changes U.S. inheritance taxes, as he said he will, things won’t just change for Americans; they’ll change for many Canadians, too. But whether that will actually happen remains to be seen, and even if it does, it will take some time to kick in and will only affect the estates of those who die while the change is in effect. Canadians with U.S. connections should, in the meantime, be planning and can only do so based on the current rules.
Here are some tax basics and key planning strategies for three common estate planning scenarios that Canadians with U.S. connections regularly face (all amounts are USD).
THE U.S. ESTATE TAX SYSTEM
U.S. tax laws are complex. The Canada-U.S. Tax Treaty modifies some of these laws, but not all. And for tax and estate planning purposes, much depends on whether an individual is a “U.S. Person”: any of a U.S. citizen, a person born in the U.S., or a U.S. “resident” with a U.S. “domicile”. For estate (as opposed to income) tax purposes, a “resident” is an individual “domiciled” in the U.S.: physically present with the intent to stay indefinitely as determined based on a variety of factors. Though it’s presumed that a person’s domicile is their place of birth (so for Canadian Snowbirds, Canada), that presumption can be rebutted.
The biggest difference between the Canadian and U.S. tax systems is taxation at death. Canada doesn’t have estate or inheritance tax; instead we deem all assets to be sold as of date of death, with taxes payable on the gain in asset value from date of acquisition. But in the U.S., there are three key forms of taxes on the transfer of wealth:
Federal Estate Tax. U.S. estate tax (calculated at graduated rates, the top being 40%) is based on the U.S. Person’s worldwide estate (WWE) at death, less the exemption amount ($5M indexed for inflation from 2011, or $5.5M as of 2017) and applicable deductions. If the taxable WWE is less than the exemption amount, no U.S. estate tax is payable. Canadian residents who aren’t U.S. Persons are only liable for this tax on their U.S. situs property (including real estate, tangible personal property and certain U.S. securities and other assets). The Canada-U.S. Tax Treaty also allows Canadians to benefit from the same exemption U.S. residents can claim, but prorated based on the ratio of the value of U.S. situs assets to the individual’s WWE.
Gift Tax. Intended to prevent people from simply gifting away their estate before death, this tax applies to property transferred for less than full consideration at rates consistent with the estate tax regime. The giver pays the tax: it generally applies to gifts by U.S. Persons and to gifts of certain U.S.-situs property by non-U.S. Persons. But there’s a lifetime gift tax exemption amount ($5M in 2011 indexed for inflation, $5.5M as of 2017). There are also two annual gift tax exemptions not deducted from the lifetime exemption: one (currently $14,000 / recipient / year) for U.S. Persons, so U.S. Person spouses can give $28,000 to a single recipient; one ($149,000 in 2017) is for gifts by U.S. Persons to their non-U.S. Person spouse.
Generation-skipping Transfer Tax. This tax is intended to stop people from trying to skip a generation of estate tax by giving their estate directly to their grandchildren – and there is a lifetime exemption amount ($5.5M as of 2017).
KEY ESTATE PLANNING STRATEGIES
Here are three common scenarios and key estate planning strategies for each.
A non-U.S. Person can still be exposed to U.S. estate tax if they own U.S. assets valued at over $60,000 and their WWE exceeds the exemption amount. So it’s important to understand a person’s U.S. assets: a condo in Florida is obviously a U.S. asset, but there are other types of less-obvious assets that count as “U.S. assets” for the purpose of U.S. estate tax. These include the proceeds of any life insurance policies the person owns and the value of certain property held in trust.
Estate planning opportunities include keeping the non-U.S. Person’s WWE below the exemption amount or reducing U.S. situs assets to under $60,000, simply by making alternative investment decisions, selling assets or considering a different ownership structure for U.S. real property. If married, using “bypass” trusts for U.S. assets in the Will can ensure a surviving spouse won’t be subject to any U.S. estate tax on those assets.
Spouses of a “mixed” marriage (where one person is a U.S. Person and the other is not) must plan to minimize U.S. estate tax exposure and defer any U.S. estate tax payable until the death of the second spouse because they are not eligible for the same benefits and deductions as two spouses who are both U.S. citizens.
In the U.S. spouse’s Will, a special kind of spousal trust (Qualifying Domestic Trust or “QDOT”) can be used for the surviving Canadian spouse to essentially defer U.S. estate tax until the death of the Canadian spouse. In the Canadian spouse’s Will, a “bypass” trust can be used for the benefit of the U.S. surviving spouse so all trust assets wouldn’t form part of the surviving spouse’s estate for U.S. estate tax purposes. Assets in this trust aren’t included in the U.S. spouse’s WWE on death if the recipient spouse’s discretionary access to funds is limited by an “ascertainable standard” of capital distributions only for the beneficiary’s “health, education, maintenance and support”. If this trust also qualifies as a spousal trust under Canadian tax laws, there’s also no deemed disposition on the transfer to the trust for Canadian tax purposes.
There are additional planning options. One is to reduce the value of the U.S. spouse’s estate with annual gifts by the U.S. spouse to the non-U.S. spouse using the annual gift tax exclusion. A trust could also be used to keep any insurance proceeds out of the estate of the U.S. spouse. And since property held in Joint Tenancy with a right of survivorship is included at its full value in the U.S. Person spouse’s estate, the non-U.S. Person spouse can hold solely in their name any Canadian real estate and assets expected to appreciate in value.
Canadian parents with U.S. resident children (and grandchildren) will wish to plan to minimize the U.S. estate tax on any inheritance to those children. One option is a U.S. inheritance trust set up either during the parents’ lifetime or through the parents’ Wills; the U.S. children can be their own trustees, but the trust terms would limit discretionary access to the funds in such a way that the funds wouldn’t form part of their overall estate for U.S. estate tax purposes.
To discuss this or any other legal issue, contact any member of McInnes Cooper’s Estates & Trusts Team. Read more McInnes Cooper Legal Publications and subscribe to receive those relevant to your business.
McInnes Cooper prepared this article for information; it is not legal advice. Consult McInnes Cooper before acting on it. McInnes Cooper excludes all liability for anything contained in or any use of this article. © McInnes Cooper, 2017. All rights reserved.
About the author:
Sarah Dykema is an Estates & Trusts lawyer at McInnes Cooper and holds STEP Canada’s prestigious Trust and Estate Practitioner (TEP) designation. Sarah advises clients on domestic and cross-border trust and estate planning and administration, incapacity and probate planning, estate administration and drafts wills and powers of attorney geared to minimize tax implications on death. You can reach Sarah at email@example.com.