As of 2018, the U.S. estate tax applies to all assets over USD $10 million for individuals and $20 million for married couples. Thanks to those high thresholds, only about 1,800 American estates need to worry about this tax, and as these numbers are pegged to inflation, the real threshold for an American individual is likely to be about $11.2 million. But for Canadians with assets in the United States, the rules are a bit different. If you have clients with significant U.S. assets, you may want to take steps to help them understand this tax and prepare for it.
Understanding the Tax
In the past, Canadian individuals faced the U.S. estate tax on any U.S. assets worth over $60,000 but only if their worldwide assets were over the thresholds listed above. As of 2018, the rules have shifted slightly. Now, Canadians may be exempt from estate tax if their worldwide assets are under $11.2 million.
Here’s the formula: (assets in the United States / worldwide assets) x $11.2 million.
Here’s an example: assume your client has $200,000 of real estate in the United States plus $100,0000 in U.S. corporate stocks. Also assume worldwide assets come in at $11.2 million. To calculate your client’s potential credit, you take ($300,000/$11.2 million) x $11.2 million and the result is $300,000. This credit cancels any estate tax they might have owed. Of course, when your client’s assets are above the $11.2 million threshold, the specifics change, which will likely result in potential U.S. estate tax. These rules aren’t set in stone though, and the increased threshold is due to expire in 2025. In addition there are regulatory requirements that must be met to claim the credit.
Claiming the Credit
First off, you need to file Internal Revenue Service Form 706-NA within nine months of your client’s death. In addition to losing out on the credit, if you forget to file this form, the cost basis on all your client’s U.S. assets can drop to zero. Then, when your client’s heirs sell the assets, they basically have to treat the entire value as a capital gain.
Because of the inherent uncertainty and regulations regarding this new exemption, you may want to help your clients explore different ways to insulate their assets from U.S. estate taxes.
Cross Border Trust
A cross border trust is designed to hold property in more than one country, and it shields your client’s U.S. assets from estate tax. Additionally, as the trust never dies, it doesn’t have to go through probate, which saves time. Any income earned by the trust faces capital gains tax, which tends to be much lower than both income and estate taxes.
Tax returns for estates are relatively easy to file, but unfortunately, when it comes to real estate, it’s easier to set up the trust and then purchase the property. If your client already has property, you can talk with an estate planning attorney to see if you can transfer the property into a trust. If that’s not possible, you may want to consider other options.
U.S. property owned by a Canadian corporation will bypass U.S. estate taxes. In this situation, the estate generally goes through probate and that means it takes more time to settle affairs after a client’s death. Additionally, your client has to pay capital gains tax on the sale of the property. Lastly, there are also shareholder issues for personal use of the property. In other words, your client may have to pay taxes based on the reasonable rent for that property, even if it’s not rented out. You might want to crunch the numbers to see if that’s cheaper than paying estate tax.
With a Canadian partnership, your client gets more control than they do with a trust or corporation. They also face the lowest possible tax rate on capital gains in both the United States and Canada. Unfortunately, the law isn’t that clear on how the estate tax applies to partnerships so you may want to consult with an estate planning specialist.
Hybrid Canadian Partnership
With this option, your client forms a partnership but chooses to be taxed as a corporation in the United States. This gives your clients a mixture of the benefits and protections enjoyed by partnerships and corporations. On the plus side, they avoid estate tax and qualify for relatively low capital gains tax. The drawback is that it can be expensive to set up this type of entity, and the annual costs connected with reporting and compliance can also be high.
If your client is one of a lucky handful of people who have enough assets to face the estate tax, you may want to help them avoid it as much as possible. In addition to the tips presented above, remember to look at state-specific taxes. Some states have estate or inheritance taxes that may also increase your client’s tax liability. If your client decides to incorporate, form a trust, or create a partnership, you may want to check with the Canadian Competent Authority for more tips on how to avoid double taxation.