Note from Coleman Wealth: We work with a network of Canada’s best cross border experts, and are fortunate to have partnered with Altro Levy LLP, a boutique law firm providing sophisticated cross border tax, estate planning and real estate legal services with offices across Canada and the United States. This blog was co-authored by David Altro, D.D.N, J.D, L.L.L, and Jonah Speigelman, M.A, J.D, partners at Altro Levy. David has worked with a number of our clients who have cross border legal issues and is known as a thought leader in this complex area of law. We thank Altro Levy for providing us with this blog post. To set up an introduction, please email us at email@example.com.
There are over one million American citizens who currently call Canada home. It has been our pleasure to work with some of the many Americans living in Canada over the past several years, helping them achieve their estate planning goals. Such clients require specialized care as they are subject to a unique set of legal and taxation challenges since the US is the only Western nation which taxes its citizens regardless of their country of residence. Americans in Canada are therefore subject to two sets of laws: the US Internal Revenue Code (the ‘IRC’) and the Income Tax Act of Canada (the ‘ITA’).
However, the Canada-US Tax Treaty (the ‘Treaty’) affords many benefits to Americans living in Canada, such as providing foreign tax credits that can offset the impact of being subject to two different tax codes, preventing double taxation in many situations. However, without careful planning, it is possible to miss out on the Treaty’s benefits.
One area that requires particular attention is will and estate planning, which is discussed in detail in the book, Americans Living in Canada: Smile, the IRS is Watching You, by Davd A. Altro and Jonah Z. Spiegelman. Both US and Canadian tax principles need to be incorporated into the wills of US citizens living in Canada in order to ensure that assets are distributed in a tax-advantageous way on both sides of the border upon death. Canadian laws surrounding the treatment of capital gains tax upon death must be considered, as well as US estate tax laws.
US Estate Tax
Upon death, the Internal Revenue Service has jurisdiction to impose an estate tax on the fair market value (‘FMV’) of all assets owned by a US citizen, regardless of where the assets are located or where the person lived; however, not all US citizens are subject to US estate tax due to a number of available exemptions, deductions and credits. Deductions available under the IRC can reduce the amount of a US citizen’s taxable estate, thereby decreasing the portion of the estate that will be subject to tax (‘taxable estate’).
Under current law, for example, there is an unlimited deduction available for gifts made to a surviving spouse as long as he or she is a US citizen. However, gifts must be made carefully in order to ensure that the surviving spouse qualifies for this deduction. It is also important to note that if the surviving spouse is not a US citizen (a ‘mixed marriage’), this unlimited spousal deduction is not available.
The first $1 million of taxable estate is subject to graduated rates, with the remainder taxed at 40%. This results in the determination of what is called the ‘tentative tax.’ This would be the tax payable by the estate if no credits were available to offset that tax.
Fortunately, for many estates, the unified credit will offset all or a portion of this tentative tax. The unified credit can be applied against tax imposed on lifetime gifts and/or bequests in one’s estate.
For 2015, the credit amount is $2,117,800, sufficient to offset $5.43 million in taxable transfers. To the extent that unified credits are used against taxable gifts, they will be unavailable for use against that person’s estate tax liability.
In addition to a person’s own unified credits, a surviving US citizen spouse is now able to use the unused unified credits that were available to that person’s most recently deceased spouse (‘portability’). Like the unlimited spousal deduction, portability does not apply to mixed marriages.
US Estate Tax for Canadians
Canadian citizens and residents are only exposed to US estate tax if they pass away owning US assets with an FMV over $60,000 USD and their worldwide estate is valued to be greater than $5.43 million USD. (The $5.43 million USD exemption is current for 2015 and may change in coming years.) However, if a Canadian is exposed to the estate tax, the tax will only be levied on the value of the deceased’s US-situated assets, not on his or her worldwide estate, and he or she may also qualify for a credit under the Treaty. (For more information on this, please see David A. Altro’s book, Owning U.S. Property the Canadian Way, Third Edition).
Tax-Efficient Estate Planning Through Wills: Mixed Marriages
The estate planning for a married couple’s wills depends on whether one or both spouses are US citizens. In a mixed marriage, the wills of each spouse will be very different.
Consider Jerry, a US citizen married to Deanna, a non-US, Canadian citizen. Jerry and Deanna’s combined estate is $10 million, virtually all of which is held in joint names. Jerry has never made taxable gifts. The couple has three Canadian citizen children.
Jerry wants to ensure that any Canadian capital gains tax on death is deferred if he dies first, and he also wants to ensure that he pays no US estate tax whether he dies first or second.
As the first to die, to defer Canadian tax, assets with unrealized capital gains have to pass either directly to Deanna or to a spousal trust for her exclusive benefit during her life.
If Jerry’s assets are valued at $5 million, no US estate tax would be due, as his unified credit would be sufficient to cancel it out. Moreover, under the Treaty, when a US citizen is married to a Canadian citizen and the US citizen passes away first, he or she is able to use the Canadian citizen spouse’s unified credit to offset US estate tax. In this situation, if Jerry were to pass away in 2015, before Deanna, there is therefore a total of $10.86 million in unified credits available. If Jerry’s assets were valued at $8 million, then he still wouldn’t have any estate tax due because of the availability of Deanna’s credit.
However, a well drafted will must take into account the possibility that Jerry’s estate will have grown above the exemption amount available under the Treaty by the time he passes away. (It is possible that the exemption amount may be reduced by new legislation effective in the year of his death.)
To ensure that no tax is payable on Jerry’s death as first to die, the will should allow the executor the option to apply a Qualified Domestic Trust (‘QDoT’). A QDoT is similar to the Canadian concept of a spousal trust, except that any distribution of capital from the trust is subject to deferred estate taxation at the rate that would have applied had no QDoT been formed.
However, the QDoT will only be necessary if Jerry’s estate exceeds the amount of his and Deanna’s combined credits available under the Treaty. If Jerry dies in 2015 with $8 million of assets, as in the example above, it is preferable to use his $5.43 million credit and most of Deanna’s $5.43 million credit in order to cancel out the tax due rather than to defer tax using the QDoT: cancelling tax, rather than deferring it, is always the goal.
It is still good estate planning to include a requirement in Jerry’s will that the QDoT is an option. Since a QDoT is complicated, its terms and conditions should be carefully drafted into the will. Given the uncertainty surrounding whether or not estate tax will apply, and the rate at which it will apply when a will is probated, good estate plans always make the QDoT election optional. Furthermore, the executor should seek advice from a cross-border tax advisor due to the complexity of issues.
Since Deanna is not a US citizen, she does not need the same type of US estate tax planning. Unless Jerry and Deanna have US-situated assets, she will not be subject to US estate tax at all. As such, Deanna’s will has two primary objectives:
To defer Canadian capital gains tax at death if she passes away first. This will be achieved with an exclusive spousal trust for Jerry, with a remainder interest for the kids upon his subsequent death.
To shelter the assets within that spousal trust from US estate taxation upon Jerry’s passing by drafting the trust with special US tax provisions.
Tax-Efficient Estate Planning Through Wills: Two US Citizen Spouses
If both spouses are US citizens living in Canada, they will be subject to the same tax rules on death; as such, their cross border wills are likely to be mirror images of each other.
From a Canadian perspective, it remains advantageous to defer capital gains tax on death until the second spouse passes away through the use of a spousal trust, which should be drafted to ensure that it qualifies for the deduction from the taxable estate of the deceased spouse on the US side.
The objective is to defer the death tax on the same assets in both Canada and the US until the second spouse passes away. Under the Treaty, such taxes can offset each other, limiting the amount payable on second to die.
Tax-efficient estate planning for US citizens in Canada is a complex endeavor that raises a variety of issues. Each couple’s situation is unique, so each couple’s wills must be unique, too. The ultimate objective of cross-border wills is not only to save clients time and money, but to bring peace of mind to US citizens and their heirs.