Editor’s note: This is an updated version of a story first published in November 2016.
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)]*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:
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
- 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. 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.
Max Reed, LLB, BCL, is a cross-border tax lawyer at SKL Tax in Vancouver. firstname.lastname@example.org