How far-reaching is the IRS’ power to collect taxes from Canada?
Written by Max Reed If you’re a U.S. citizen living in Canada, you might be frantic about the IRS tax crackdown and hefty fines if you haven’t been tax compliant....
Canadian residents who aren’t U.S. citizens may be surprised to know that U.S. estate tax can apply to them. Newly enacted U.S. tax rules have increased the exemption amount, but there are still pitfalls to be aware of.
The way U.S. estate tax works has not really changed. The tax applies to any assets that are considered to be located in the United States (such assets are called “U.S. situs assets”). 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 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. While Canadians get an increased estate tax credit thanks to the Canada-U.S. Tax Treaty, this is more complicated than meets the eye.
Increased Exemption for Canadians
For 2018, the value of the estate tax exemption has essentially doubled. 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 (2018) =
U.S. situs assets Worldwide assets | X | US $11.2 million |
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$11.2 million (in 2018). Furthermore, under the Canada-U.S. Tax Treaty, the estate tax exemption for a Canadian can potentially be doubled when property is left to a surviving spouse.
There are two problems with relying on that Treaty credit. First, the estate tax exemption may later be lowered by a more left-leaning administration. (Even under the new Republican tax plan, the doubled estate tax exemption expires in 2025.) Second, while these benefits appear appealing, they are burdened by certain compliance requirements that carry potential pitfalls, and the tax cost of mistakes can be tremendously high.
Claiming any credit under the Canada-U.S. 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 tax consequences for beneficiaries.
Without an extension from the IRS, Canadian residents must file Form 706-NA within nine months of the date of death; otherwise, the Treaty credit may be denied. Filing this form requires disclosing detailed information about all worldwide assets of the decedant and providing their U.S.-dollar values (determined according to U.S. tax principles). Obtaining proper valuations is costly and burdensome, and undervaluation can result in onerous penalties. Perhaps most importantly, not filing Form 706-NA at all can result in beneficiaries inheriting U.S.-situs assets with a cost basis of zero. This means that when they later sell the property, all proceeds will be taxed as a capital gain.
In short, even though Form 706-NA provides access to an expanded treaty credit, choosing to rely on it may have more costs than benefits.
Problems with Joint Tenancy
U.S. property should not be owned by non-residents 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 when the second tenant dies. 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:
1. Specially drafted trust
Advantages:
Disadvantages:
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.
2. Canadian partnership for U.S. real estate
Advantages:
Disadvantages:
3. 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.
Advantages:
Disadvantages:
4. Canadian corporation
Advantages:
Disadvantages:
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:
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. The new U.S. tax rules have doubled the exemption under the Canada-U.S. Tax Treaty. This still has some risk, as the exemption could later be lowered by a different administration and 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.