The situation

There can be such a thing as too much money—at least when it comes to taxes.

Wendy Lee*, 64, is a Montreal- based railroad executive whose career has included multi-year stints in San Francisco and New York. Originally from Portland, Ore., she’s an American citizen.

She met her now 63-year-old husband, Hiram*, in Montreal, a few months after Canada’s passenger rail system recruited Wendy eight years ago. (Serendipitously, Wendy learned French as a child.)

Wendy keeps a home in San Francisco, which she purchased decades ago for just under US$1 million. It’s since doubled in value, and she owns it outright thanks to rental income of US$60,000 per year. Wendy has two adult children who remain in San Franciso and act as landlords. Soon after meeting, Wendy and Hiram co-purchased a condo in Montreal’s affluent Westmount suburb for $650,000, cash.

Thanks to a golden handshake from Wendy’s past employer, a NYSE-listed company, she has a 401(k) pension worth US$750,000 (untouched) and US$100,000 of the company’s shares. The couple has a $2-million life insurance policy on Wendy. Her Canadian employer has also furnished her with a defined benefit, inflation-indexed pension worth $75,000 per year; it has a generous survivorship clause. The couple has no other investments.

Wendy intends to work another five years, after which the couple will retire to a warm-weather locale—either the southern U.S. or Central America, where the cost of living might be lower.

In thinking about her future, Wendy’s concerned about how close she is to the U.S. estate tax threshold (US$5.49 million in 2017). Sure, she doesn’t plan on dying anytime soon, but what planning can she undertake now to mitigate a potential hit?[custom-html id=102]

No need to fret

Christine Perry: If she came into my office and was concerned about tax planning, I’d tell her she doesn’t need to be that concerned. Sometimes clients get worried because they’ve heard stuff from friends, but I don’t think it’s actually a concern for Wendy because she’s not way over the U.S. estate tax threshold. Still, she may want to take some measures to protect herself. You’re looking at creating a flexible plan for her.

Max Reed: I agree. To be specific, even if she’s over the estate tax threshold, she’s going to get a foreign tax credit for her Canadian tax at death against her U.S. estate tax. At her asset level, even the U.S. estate tax is not going to be the material factor—it’s going to be a wash.

CP: Yes, people tend to get caught up on the U.S. estate tax issue. But in Canada, you have a deemed disposition for capital assets. When we’re concerned about the U.S. estate tax, we’re looking at tax wastage. This means, would the U.S. estate tax exceed the tax liability that you’re going to have here on death in Canada? As Max mentioned, there’s a credit available so we’re not in a double tax situation. It would allow her to reduce her U.S. estate tax liability by the amount of capital gains tax paid in Canada. It’s offered under the income tax treaty between Canada and the U.S.

MR: Yes, there’s no extra tax by virtue of her being American. If she came into our office and said, “I’m worried about U.S. estate tax,” I’d tell her, “You’re going to pay more tax in Canada anyway.”

Forfeit life insurance to reduce the estate?

Terry Ritchie: I would put together a life insurance analysis to determine if there’s a true need for the insurance. I’d quantify what their need for life insurance is on a number of assumptions. If she predeceases Hiram, is he able to maintain the lifestyle he’s accustomed to? Also, can it be used to cover off any tax, both in Canada and the U.S.?

If there is a true need for it, then I’d determine the type of life insurance they have. If it’s a whole life or universal life policy, something that has a cash-value component in it, I’d suggest they get an in-force ledger to see what’s going on in the policy, and how it would perform in the future. If there’s enough cash value in it that they wouldn’t have to feed it for another three or four years, then why get rid of it? It can sustain itself for a period.

And if it’s a group policy, we don’t want it to form part of the estate. We can remove the life insurance as part of the gross estate for U.S. estate tax purposes. Wendy would have the right to change the beneficiary designation on her group policy because she’d have “incidents of ownership” within that policy. To remove it from the estate, she could make the beneficiary designation irrevocable, and then the three-year rule (under IRS Code Section 2305) would apply. This means that, as long as Wendy doesn’t die in the next three years, it won’t come back to the U.S. gross estate, which can solve a lot of problems on the estate side.

CP: Yes, we could set up an irrevocable insurance trust. Otherwise, when Wendy dies they’re exposing that death benefit of $2 million to U.S. estate tax. They’ll lose potentially 40% of value of the death benefit. If they use an irrevocable life insurance trust, then the trust is the owner of the policy and is the beneficiary of the policy. If properly drafted, it excludes the death benefit from the individual’s estate.

And there are no issues with this type of trust on the Canadian side, [as stated under] the Income Tax Act. The policy is non-income-producing from a Canadian perspective, so there is no concern about attribution (although we generally draft the trust to avoid attribution). There is no issue with the policy at the trust’s 21-year anniversary.

Generally, the trust will acquire the policy in the first instance. If the policy is transferred to the trust after it has been issued, however, the transferor will be considered to have disposed of the policy and may have a tax liability (to the extent that the fair-market value of the policy exceeds its adjusted cost basis).

Marital credit vs. QDOT

CP: If you have a foreign spouse, you, as a U.S. person, can leave assets to them outright. The concern would be if your estate far exceeds the amount of the worldwide estate exemption of US$5.49 million. You can transfer [up to that amount] to anyone in the world without attracting an estate tax.

The issue is any amount over that. In the U.S., if you’re transferring to a U.S. spouse, there’s an unlimited marital deduction, similar to what we have here—the spousal rollover. But because she doesn’t have a U.S. spouse, the question is, what kinds of tax are attracted by any amounts over US$5.49 million?

There are two mechanisms that allow her to deal with that.

  1. A marital credit. If she leaves the amounts outright to Hiram or in a trust that would qualify for the marital deduction in the States, she can actually double that exemption amount. So she can leave almost US$11 million without any tax issues.
  2. The Qualifying Domestic Trust (QDOT). This is essentially a deferral only. It’s a complicated trust and, instead of using the credit, she’d use this trust to defer tax on anything over the US$5.49 million.

For most people, unless they have a gigantic estate [i.e., more than US$10.98 million], the value of that dollar-for-dollar marital credit would be much more advantageous than using the QDOT deferral.

MR: All the QDOT does is punt the estate tax to the death of the spouse. It doesn’t mitigate the estate tax.

But if they moved to Costa Rica, for instance, the marital credit would not be available because it’s a U.S.-Canada treaty-based credit. To be safe, you want to draft the will so that the executor has the choice to use the QDOT or the marital credit.

Probate concerns in California

Clients with assets in California could face a slow and costly probate process, note the experts.

“Everyone I’ve met who has assets in California takes steps to avoid probate,” says Max Reed, cross-border tax lawyer at SKL Tax. “Wendy’s going to need a power of attorney in California to take care of the property there. She’ll want a separate Californian will.”

The probate fee can be high: 4% on the first $100,000 of assets. For comparison, the highest probate fee in Canada is 1.695% of estates over $100,000 in Nova Scotia.

Christine Perry, counsel at Keel Cottrelle LLP, explains the 4% is a statutory fee, charged by the lawyer. “So the lawyer doesn’t have to charge 4%. He can just charge an hourly fee. It’s about getting a reputable lawyer to assist you in the probate process.”

There may be a way for Wendy to eliminate probate: “There’s beneficiary deeds that are available,” says Terry Ritchie, director of cross-border wealth services at Cardinal Point Capital Management Inc. “These deeds, called transfer of death deeds in California, can be used before death. So she can retitle the asset, put [one or both of her kids] as beneficiary on that property and eliminate probate.”

More retirement considerations

TR: Since they want to leave Canada when they retire, that’s another tax situation. They’d be hit with a departure tax. The rate is 26.65%, which is the Quebec capital gains rate. That’ll be the net effect. It’s on the entire worldwide assets, except the 401(k), Canadian defined benefit plan and the principal residence (the condo in Montreal).

MR: You can postpone the departure tax. They can defer it until they die or their assets are sold. But since it’s a deferral and not a mitigation, they’ll eventually have to pay it. For the U.S. property, there’s a credit mechanism in the U.S.-Canada tax treaty that allows you to avoid paying tax twice—departure tax now, and on the capital gains on the property if you sell it later.

Let’s say they leave Canada. They get hit with Canadian departure tax on the U.S. house. Then, a few years later they say, “We’re going to sell the property.” They’d get hit with capital gains tax without the treaty. Right now there’s a credit mechanism, but there’s no guarantee there will be one in future. So, they may want to think about using the election in the treaty that allows them to force payment of tax in the U.S. federal system and increase their cost basis.

TR: The couple also needs to look at what type of retirement benefits they’d get in the U.S. versus Central America.

In the U.S., most people get social security benefits. But I have a lot of railroad clients and since Wendy worked for a railroad company in the U.S., instead of contributing to social security, she likely contributed to the Railroad Retirement Board. That benefit is much greater and can be paid earlier than the social security benefit.

In terms of which jurisdiction they’re better off in, many people don’t realize something about the OAS clawback. In Canada there’s a clawback, but there isn’t one in the U.S. So if they establish U.S. residency, they’d still be entitled to CPP and OAS, but would not be subject to any OAS clawback, nor would there be any withholding tax imposed on the CPP or OAS benefits.

Another question: Where’s healthcare coming from? If they retire in the U.S., Wendy would likely be able to get Medicare at age 65. And as long as she sponsored Hiram and he’s had a Green Card for at least a year, he can get Medicare as well. In Costa Rica, for instance, they’d likely have to self-insure. Since they don’t know where they want to retire yet, they should still apply for Medicare. A lot of people don’t know that if you’re entitled to Medicare and you fail to apply at age 65, and then decide you need health insurance and apply at age 67 or 68, there’s a penalty for applying late. So no matter where they live, they should apply for Medicare, whether they use it or not.

CP: First, look at where you want to live. Then, look at the tax costs and benefits. Does the place you want to retire have a tax treaty with Canada or the U.S.? In that jurisdiction you might have a lower tax rate, but if you’re receiving funds from the U.S. or Canada, you might have a higher withholding tax on those sources of income, which increases your tax rate.

TR: Overall, if they’re looking to go to Central America because they think they’re going to save some tax, that isn’t going to happen because she’s a U.S. person.”

*These are hypothetical clients. Any resemblance to real persons is coincidental.
Note: This story uses U.S. and Canadian tax law that’s current as of October 2017.

Suzanne Yar Khan, a Toronto-based business writer