For ease of reading, this article uses non-U.S. and U.S. to refer to non-U.S. persons and U.S. persons when referring to spouses.
The U.S. tax reform passed late last year will impact many Canadians with U.S. connections and requires a review of individual and family estate planning.
Here’s an overview of certain major changes. Then, we’ll get into specific scenarios.
Personal tax rates
The Tax Act reduces personal tax rates. The top bracket for people with income over US$500,000 (previously US$453,351) is now 37%, reduced from 39.6%.
By comparison, the top marginal tax rate for an Ontario taxpayer in 2018 is 53.53%, which applies to individuals with income above $220,000. There is now a huge gap between U.S and Canadian tax rates, and they seem to be on opposite trajectories.
The Tax Act doubles the tax exemption for gift, estate and generation-skipping tax (U.S. transfer taxes). In 2018 each person will have an exemption of $11.2 million; for married couples, it will be $22.4 million (all figures in USD). These figures are indexed for inflation. However, estate tax will not be permanently repealed: on Jan. 1, 2026, the personal exemption will revert to $5 million, adjusted for inflation.
U.S. citizens and persons domiciled in the U.S. (deemed U.S. persons for transfer tax purposes) are generally liable for U.S. estate tax on the gross value of their worldwide estates, subject to allowable exclusions, deductions and credits.
Gift tax and generation-skipping transfer tax
The U.S. transfer tax regime includes gift tax and generation-skipping transfer tax (GSTT). Generally, U.S. gift tax applies to gifts by U.S. persons and to gifts of certain U.S. situs property by non-U.S. persons. Gifts by U.S. persons above an annual exclusion amount may be tax-free up to the lifetime estate tax exclusion amount.
Gifts reduce the estate tax exclusion available on death. GSTT generally applies to gifts valued above the US$11.2 million exclusion amount made to people at least 37.5 years younger than the donor if the recipient is unrelated, or at least two generations younger if related.
Gift tax exclusions for U.S. persons include:
- an annual exclusion of $15,000 in 2018, increased from $14,000 in 2017;
- an annual exclusion of $152,000 in 2018 for gifts by any person to a non-U.S. spouse, increased from $149,000 in 2017; and
- unlimited exclusions for certain healthcare or tuition payments.
In addition, a gift in any amount between two U.S. spouses of what’s called a “present interest” (received immediately; as opposed to a “future interest,” which the recipient can only access at a future date) is sheltered by the unlimited marital deduction from gift tax consequences.
What this means for Canadians
Canadian tax residents who are not U.S. persons are generally liable for U.S. estate tax on their U.S. situs property, including U.S. real estate and tangible personal property, as well as certain U.S. securities and other assets.
The good news for Canadians who own U.S. assets is that only those whose worldwide estate exceeds the $11.2 million exclusion amount will have to pay U.S. estate tax.
But a worldwide estate can also include assets such as the proceeds of life insurance policies owned by a deceased person, the total value of property held in joint tenancy with right of survivorship (subject to limited exceptions and deductions), and certain property held in trust. In addition to U.S. estate tax, which is levied at the federal level, several states also levy estate or inheritance taxes on death.
In the following sections, we discuss various will and estate planning strategies in three common scenarios: where one spouse is a U.S. person and the other is not; where intended beneficiaries, including children and grandchildren, are U.S. persons; and where both spouses are U.S. persons.
Where one spouse is a U.S. person
Using a bypass trust
If a non-U.S. spouse bequeaths assets to a surviving spouse who is a U.S. person—and that surviving spouse still owns those assets at death—those assets will be included in the second-to-die spouse’s worldwide estate for U.S. estate tax purposes. As a result, it’s critical to ensure the spouse’s assets are not exposed to additional U.S. estate tax if the available exclusion amount will not eliminate the estate tax liability.
To minimize or eliminate U.S. estate tax, assets may be transferred to a bypass trust for the spouse. Assets in this type of trust are not included in the spouse’s worldwide estate on his or her death, provided the trust meets certain requirements. These include limits on the spouse’s participation in certain discretionary decisions, such as paying income or capital. Failing to meet those requirements would result in the assets of the bypass trust being included in the surviving spouse’s estate on death, and thus subject to U.S. estate tax.
For Canadian tax purposes, assets with accrued capital gains may be rolled over to the bypass trust on a tax-free basis if it is also a qualified spousal trust under the Canadian Income Tax Act. The assets in the trust would not be subject to tax until either the date they are disposed of or the spouse’s death (whichever comes first).
Using the spousal credit under the Canada-U.S. Tax Treaty
The Canada-U.S. Tax Treaty provides a spousal credit to a U.S. person to use against U.S. estate tax. The spousal credit is in addition to any unified credit or exclusion amount. To qualify for the spousal credit, the property must pass to the surviving non-U.S. spouse in a manner that would otherwise qualify for the U.S. marital deduction: either outright, or to a special trust called a QTIP trust (qualified terminable interest property).
The spousal credit is approximately equal to the lesser of the unified credit or the estate taxes imposed on the qualifying property, which, in 2018, can allow for up to approximately $22.4 million of assets to pass from a U.S. spouse to his or her non-U.S. spouse free of estate tax—approximately double the exclusion amount.
Qualified domestic trusts
Transfers from a U.S. citizen spouse to a non-U.S. citizen spouse generally do not qualify for the unlimited marital credit available to two married U.S. citizens, which would allow a deferral of U.S. estate tax. One exception allows a U.S. citizen spouse to pass assets at death to a non-U.S. citizen spouse by means of a special trust called a Qualified Domestic Trust (QDOT). Under U.S. rules, the estate tax otherwise due on the death of a U.S.-citizen spouse is paid upon distribution of any capital of the trust to the surviving non-U.S.-citizen spouse, or upon the surviving spouse’s death.
It is important to note that the QDOT only defers U.S. estate tax that otherwise would have been imposed. The deferred tax is generally imposed at the survivor’s death on the gross value of the property remaining in the QDOT. Therefore, if the value of the QDOT property increases, the tax at the survivor’s death could be higher than if the tax had been paid at the death of the first spouse.
A QDOT must meet several complex requirements, including that it must have at least one U.S. trustee and that it be governed by the law of a U.S. state.
Credit shelter trust
A credit shelter trust can be established in a U.S. person’s will, up to the exclusion amount, so that the trust assets may eventually pass to the non-U.S. spouse free of estate tax.
The non-U.S. spouse may consider purchasing life insurance on the life of the U.S. spouse in an amount sufficient to fund the expected U.S. estate tax liability. In addition, the beneficiary of that insurance could be a bypass trust for the benefit of the U.S. spouse. As well, insurance may be owned through a special trust called an irrevocable life insurance trust, as opposed to directly, to exclude the value of the proceeds from the estate.
Holding assets between spouses
Real property held in joint tenancy with right of survivorship is presumed to be included at its full value in the estate of the U.S. spouse (except when the non-U.S. spouse can establish the extent of his or her contribution to the purchase price), and the value of any mortgage is generally not deductible from the property value.
Canadian real estate could be held solely by the non-U.S. spouse so as not to be included in the estate of the U.S. spouse. Conversely, any U.S. real estate could be held in the name of the U.S. spouse. Clients could also hold assets of fixed value in the estate of the U.S. spouse, and assets expected to appreciate in the estate of the non-U.S. spouse.
Where intended beneficiaries are U.S. persons
When the intended beneficiaries of an estate are likely to become U.S. persons and may have exposure to U.S. estate tax, consider transferring assets to a testamentary bypass trust to protect their inheritance from U.S. estate tax.
As mentioned, a bypass trust must meet certain requirements, including restrictions on the beneficiary’s participation in certain discretionary decisions with respect to the trust.
Use of a trust may provide a host of other benefits, including ensuring capital succession to the next generation, minimizing probate fees, and general wealth, matrimonial and creditor protection.
Where both spouses are U.S. persons
Where both spouses are U.S. persons and the gross value of one spouse’s estate exceeds the exclusion amount, the following options may be available for the spouse who dies first.
Unlimited marital deduction
Transfers on death from a U.S. citizen to a U.S.-citizen spouse, outright or through a special marital trust under each will, allow for an unlimited marital deduction against estate tax. This provides a deferral of any U.S. estate tax until the death of the surviving spouse, or payment of capital from the spousal trust.
The unlimited marital deduction is available for assets passing from the deceased spouse, under his or her will, via a QTIP trust.
From a Canadian tax perspective, a QTIP trust may also meet the requirements of a qualifying spousal trust under Canadian tax legislation. Assets transferred on death by a deceased spouse to a qualifying spousal trust may be rolled over and are not subject to tax until the asset is disposed of by the trust or the surviving spouse dies.
Credit shelter trust
A credit shelter trust can be established under each will, generally funded up to the exclusion amount, to ensure a U.S. person’s estate tax credit is utilized so that the amount allocated to the credit shelter trust passes to the intended beneficiaries free of estate tax. This type of trust acts like, and is sometimes called, a bypass trust.
Portability of exclusion amount
The exclusion amount of approximately $11.2 million for 2018 appears to be portable. If one spouse dies, any unused exclusion can be transferred to the surviving spouse. This can allow up to approximately $22.4 million of assets to pass free of estate tax for a U.S. couple.
Purchasing sufficient life insurance to fund the expected U.S. estate tax liability is another option, since life insurance owned by a person other than the insured will not be subject to U.S. estate tax. Trusts with special terms can also own large insurance policies, which remove the value of the proceeds from the taxable estate.
Charitable donation planning
A charitable donation can reduce the amount of an estate, providing generous tax relief.
Canadians with U.S. connections should review their individual estate planning to ensure it is still appropriate.
Given that there has not been a permanent repeal of the estate tax, what the future holds is still in question. Ensuring there is flexibility in the estate plan so that it can be revised and updated as circumstances change is critical.
Tax reform: hits and misses for cross-border clients
Pleading not GILTI: tax deferral strategies for Canadian-resident U.S. citizens
4 structures to protect Canadians from the U.S. estate tax—updated
Margaret O’Sullivan is founder of O’Sullivan Estate Lawyers LLP.