President Obama's re-election may mean higher taxes for Americans in Canada and Canadians with American property. Why?
Unless Congress and the President can come to terms with critical budget, spending and entitlement issues by the end of this year, all Bush income tax cuts enacted in 2001, as well as estate and gift tax rates and exemptions, will expire.
If that happens, the top marginal tax rate on ordinary income would revert back to 39.6%. Since President Obama increased Medicare payroll taxes by 0.9% and passed a tax of 3.8% on investment income, single people with taxable incomes above $200,000, or married couples above $250,000, would face a top U.S. tax rate of 40.5% on wages, 43.4% on interest and dividend income and 23.8% on capital gains.
As for the U.S. estate tax, if the cuts expire, the present $5,120,000 gifting and estate tax exemptions would drop to $1,000,000 on January 1, 2013. In addition, the estate tax rate, which is now only 35%, would increase to 55%.
Implications for Americans in Canada if cuts expire
If you have U.S. clients with taxable incomes exceeding $200,000 (single) or $250,000 (married or joint), it's likely they will end up paying additional U.S. income tax beyond the level of net tax they would be paying in Canada.
This is especially true if your clients have been paid in eligible dividends in Canada.
With the possible elimination of the U.S. qualified dividend rate of 15% next year, the top U.S. federal rate along with the 3.8% Obamacare surtax would top out at 43.4%. This is significantly higher than the net eligible dividend rates in the three provinces indicated in the table below.
|Jurisdiction||Ordinary Income||Dividends||LT Capital Gains|
|US Federal Only 3/||43.4%||43.4%||23.8%|
1/ Taxable income exceeds C$135,054
2/ Taxable income between C$135,054 and $509,000
3/ Taxable income exceeds US$388,350
Paying in dividends
Consider our American-in-Canada client, a physician who's been paying himself $300,000 in dividends from his professional corporation in Alberta. If the tax cuts expire, he will pay a substantial amount of additional U.S. tax on income that was never sourced in the States.
If he incurs short-term capital gains (held for less than one year) on his investment portfolio or has net rental income in Canada, he will also pay higher levels of additional tax in the U.S.
Further, American in Canada clients who hold Canadian mutual funds that are considered Passive Foreign Investment Companies (PFICs) and are required to take the Mark-to-Market election would also be subject to the highest marginal rate in the U.S.
So if your client is an American in Canada who has primarily been paid in dividends that exceed the $200K (single) or $250K (married) taxable income thresholds, revisit her compensation. She may want to earn employment income instead that could be eligible for the U.S. foreign earned income exclusion of U$97,600 (for 2013).
If these types of clients have large unrealized capital gains, it might make sense for them to realize such gains prior to the end of this year, given the potential increase in net capital gains rates in the U.S. next year.
Estate planning concerns
On the U.S. estate planning side of things, if the exemption is reduced to $1 million from $5.12 million (or possibly $3.5 million, as indicated in the President's budget last February), it will be critical for clients to revisit their estate plans in Canada.
American in Canada clients with worldwide estates exceeding US$2 million should consider the role of Spousal Rollover Trusts in Canada (that will qualify as Marital or Bypass Trusts under U.S. rules) within their wills. Using those trusts would remove the first to die's estate from that of the surviving spouse's estate.
You may also want to explore holding life insurance through an Irrevocable Life Insurance Trust to cover off exposure to U.S. estate tax.
If the American in Canada client is married to a non-U.S.-citizen spouse, then explore a Qualified Domestic Trust (QDOT) within the U.S. citizen's Canadian will. The QDOT would defer any U.S. estate tax if the estate were intended to go to the surviving spouse.
Gift tax exemption
With the U.S. lifetime gift tax exemption dropping from $5.12 million to $1 million and the tax rate increasing from 35% to 55%, the American in Canada client should consider making substantial taxable gifts below the lifetime exemption amount this tax year. Any gifts exceeding $13,000 to an individual or $139,000 to a non-US citizen spouse would be subject to a gift tax and the filing of an IRS gift tax return (Form 709).
Estate tax and real estate
Canadians who personally own U.S. real property may also be exposed to U.S. estate tax. That would depend on the size of the Canadian's worldwide estate and the value of the real property at death.
Under current rules, generally if a married couples' worldwide estate does not exceed $10,240,000 after the application of certain individual credits and additional credits available under the Canada/U.S. Tax Treaty, U.S. estate tax exposure was generally zero.
Now, with the potential for a lower estate tax exemption, people should try to reduce or eliminate U.S. estate tax exposure at their deaths. This could mean changing how real property is titled, using will planning with spousal rollover trusts provisions, using a specific Canadian trust, and using non-recourse mortgage financing and life insurance.
Terry F. Ritchie, CFP™ (U.S.), RFP (Canada), TEP, EA, is a Calgary-based cross-border financial planner with expertise in both American and Canadian tax regimes, and co-author of The Canadian Snowbird in America, The Canadian in America, and The American in Canada. Look for updated editions of these books in 2013.