In recently released proposed regulations related (see pages 49-50, 53, 70-71) to the impact of GILTI on individual US taxpayers, the IRS has surprisingly taken a taxpayer friendly position. They are...
Canadian residents who aren’t U.S. citizens may be surprised to know that U.S. estate tax can apply to them.
That’s because U.S. estate tax applies to any assets that are considered to be located in the United States. This includes U.S. real estate, stocks in U.S. corporations (such as Apple, Exxon or Walmart), and personal property located in the country.
The 2016 top U.S. estate tax rate is 40% of the value of the property. This could create a sizable tax bill when any Canadian resident who owns U.S. real estate or a large U.S. stock portfolio dies. Under domestic U.S. law, only US$60,000 of U.S. property is protected from estate tax. Note that RRSPs offer no protection from the U.S. estate tax. Canadians get an increased estate tax credit thanks to the Canada-U.S. Tax Treaty, which is more complicated than meets the eye.
Increased Exemption for Canadians
The Canada-U.S. Tax Treaty gives Canadian residents extra protection from the U.S. estate tax by increasing the tax credit for Canadian residents. A simplified version of the credit calculation is:
Value of property exempt from U.S. estate tax (2016) =
Therefore, a Canadian resident will not have estate tax payable on U.S. assets if the value of her entire estate, including her worldwide assets, doesn’t exceed US$5.45 million (in 2016). Under the Canada-U.S. Tax Treaty, the estate tax exemption for a Canadian is doubled when property is left to a surviving spouse. Claiming any credit under the treaty requires filing Form 706-NA.
Problems with Form 706-NA
Failing to file Form 706-NA can result not only in additional estate tax, but also negative consequences for beneficiaries.
Without an extension from the IRS, Canadian residents must file Form 706-NA within nine months of the date of death, or else the treaty credit will be denied. Filing the form requires disclosing detailed information about all assets around the world and providing their values according to U.S. tax principles. Obtaining proper valuations is costly and burdensome, and undervaluation can result in onerous penalties.
On the other hand, not filing Form 706-NA at all can result in the beneficiaries inheriting U.S. real property with a cost basis of zero. This means that when they later sell the property, the entire amount will be taxed as a capital gain.
In short, even though Form 706-NA provides access to an expanded treaty credit, it may have more costs than benefits.
Problems with joint tenancy
Another issue to be aware of is U.S. property should not be owned as joint tenants with rights of survivorship. U.S. tax law assumes that property owned this way is 100% included in the gross estate of the first joint tenant to die. If this presumption is not rebutted with evidence, eventually the entire property would again be included in the estate at the second death. This means twice the estate tax, and twice the cost and problems of filing Form 706-NA.
Instead, Canadians considering investing in the United States could use one of many possible legal structures to protect themselves from estate tax.
Legal structures that block the U.S. estate tax
There are a number of ways to own U.S. property that effectively prevent the application of the estate tax. The U.S. estate tax applies at the death of the owner, and since legal entities don’t die, the estate tax wouldn’t apply. The key is choosing the right entity. Some options are:
A. Specially drafted trust
U.S. property is protected from the estate tax
Assets are subject to the taxpayer’s lowest capital gains rate in Canada and the U.S.
Tax returns are fairly simple
Difficult to use with real estate if it is already owned, or if a contract to purchase it has already been entered into
Generally requires the person who gives up the property to also give up control
to achieve U.S. estate tax protection
To maintain estate tax protection, trustee’s power must be limited
It’s also unclear how much liability protection the trust provides, so it’s not ideal for ownership of rental properties.
Note that an ordinary Canadian trust will not work. The trust has to be specially drafted.
B. Canadian partnership for U.S. real estate
Provides liability protection to the owners of the property (this can be helpful with rental real estate)
Allows owners to retain control
Provides reasonably good (though not perfect) estate tax protection
Qualifies for lowest possible capital gains tax rates on sale in both Canada and the U.S.
Lets annual income be taxed in the most efficient manner possible
Following the death of the partners, an election can be made to strengthen the estate tax protection.
May not provide perfect U.S. estate tax protection (the law in this area is unclear)
Election to provide perfect estate tax protection must be made within 75 days of the death of a partner
Annual accounting fees are usually higher for a partnership than the other options
Partnership may have to withhold U.S. income tax on distributions to non-U.S. partners
C. Hybrid Canadian partnership
A Canadian partnership may elect under U.S. tax rules to be taxed as a corporation while remaining a partnership in Canada.
Partnership is protected from the U.S. estate tax without a time-sensitive election
Qualifies for lower total capital gains tax than under the corporate option
Substantially higher capital gains tax rates relative to the partnership or trust options
High set-up costs
High annual compliance costs
D. Canadian corporation
Perfect protection from the U.S. estate tax
Simple annual filings
Excellent liability protection
Useful shielding of U.S. stocks from the estate tax
Substantially higher capital gains tax relative to the other options
Inability to own property that is personally used by shareholders
Restructuring existing property ownership
Many Canadian residents directly own U.S. real estate or stocks and will want to restructure ownership to avoid the U.S. estate tax when they die. While this is a complex area, there are three options:
U.S. stocks held personally can be transferred to options A-D generally without tax.
U.S. real estate can generally be transferred to a Canadian partnership or corporation (options B-D above) without income tax. There may be local property transfer tax.
U.S. real estate owned personally can be sold to a trust at fair market value in exchange for a promissory note — a good strategy if there is no accrued gain.
In short, those taxpayers who own more than US$60,000 of U.S. property must consider the U.S. federal estate tax implications of owning that property. While there is a substantial exemption under the Canada-US Tax Treaty, taking advantage of it requires Form 706-NA, which is invasive and complex. A better option may be to use a legal entity that blocks the application of the estate tax. The best type of entity will depend on the taxpayer’s specific facts.