Mature smiling couple sitting and discussing estate at home

Estate planning with a U.S. citizen spouse

Estate planning with a U.S. citizen spouse

Synopsis
3 Minute Read

It is not uncommon to find couples where one spouse is a U.S. citizen, but it’s key to be aware of the certain complexities that exist on the estate planning front.

Let’s dive into this example of Peter and his wife Cathy to better understand the implications and potential opportunities of estate planning for a couple where one spouse is a U.S. citizen.

Peter, a surgeon, was born and raised in Canada. He met Cathy, a U.S. citizen, 40 years ago in New York while completing his residency. Cathy moved to Canada and married Peter. Cathy and Peter have two children who reside in Canada and are dual citizens. Peter, now retired, has accumulated significant wealth from his medical practice and his net worth was estimated at $21.3M. Cathy, a retired teacher, has a net worth of $600,000. Their personal balance sheets include the following items (all amounts expressed in Canadian dollars unless denominated in U.S. dollars (US$)):

Peter 
Non-registered investments $500,000
RRSP $300,000
 Shares of a holding corporation (100%)  $18,000,000
 Florida condo (100%)  $2,000,000
 Quebec home (50%)  $500,000
 Total  $21,300,000

 

Cathy
RRSP $100,000
Quebec home (50%) $500,000
 Total  $600,000

 

As U.S. citizens, Cathy and her children are subject to U.S. income and transfer taxes (e.g., estate, gift, and generation skipping tax) even if they do not reside in the United States. As such, Cathy and the children would be subject to both the Canadian and U.S. tax systems on their worldwide income and assets.

Peter is concerned about his estate plan and reaches out to his accountant to discuss options to minimize his and Cathy’s exposure to U.S. estate tax. The following discussion points were presented:

1. Understanding the U.S. and Canadian tax implications on death

  • Assume Peter dies first. From a Canadian tax perspective, Peter will be deemed to have disposed of all his assets at fair market value. A deferral of taxes on Peter’s death can be achieved if there is a surviving spouse, Cathy. Under this scenario, Peter’s assets are transferred to Cathy at cost, effectively deferring the tax arising from the deemed disposition until Cathy’s death. In this case, the basis of the asset carries to the surviving spouse.
  • From a U.S tax perspective, U.S. citizens and domiciled individuals are subject to U.S. estate tax on the gross value of their worldwide estate, subject to a U.S. estate tax exemption, currently at US$12.92M. A person is domiciled in the United States, for U.S. estate tax purposes, if he/she has the intention to remain in the United States for an unlimited time. Individuals who are not U.S. citizens or domiciled may also be subject to U.S. estate tax if they hold "U.S.-situs” assets on death and the fair market value of their worldwide estate is greater than the U.S. estate tax exemption in effect at the time of death. Under the scenario where Peter dies first, Peter would ordinarily be subject to U.S. estate tax on the value of the Florida condo since his net worth exceeds the current US$12.92M U.S. estate tax exemption. Note that shares of U.S. corporations held by Peter in his non-registered and registered accounts would also expose Peter to U.S. estate tax. However, since Cathy is a U.S. citizen, and assuming Cathy inherits Peter’s US-situs assets, Peter’s estate could claim an unlimited marital deduction, effectively deferring U.S. estate tax until the time Cathy passes away. If Peter dies after Cathy, and Peter dies holding the Florida condo, Peter will be subject to about US$80,000 of U.S. estate tax and the amount owed for U.S. estate tax may be higher if the current exemption is reduced under the current sunset provisions.
  • Moreover, If Peter’s assets are transferred to Cathy outright pursuant to the terms of his will, Cathy’s net worth will be increased by $21.3M. As a U.S. citizen, Cathy would be subject to U.S. estate tax on the fair market value of her worldwide estate, not only on U.S.-situated assets like in the case of Peter. As a result, Cathy’s estate would be subject to about US$1.4M of U.S estate tax under current exemption and assumptions (or an estimated US$3.7M if the current exemption is reduced under the sunset clauses after 2025).

Potential solutions:

  • The main objective for Peter and Cathy is to minimize taxes on death. From a U.S. estate tax perspective, Cathy bears greater exposure if Peter dies first, and no additional estate planning is undertaken.
    • To this end, Peter could update his will to direct some or all of his estate to be distributed to Cathy outright and/or in trust to a spousal trust for Cathy’s exclusive benefit. Those assets held in trust would be excluded from Cathy’s gross estate provided that her participation in decisions to distribute trust capital are sufficiently limited. The spousal trust can provide flexibility so that Cathy is not deprived of funds for her living, while providing protection against estate tax.
    • Peter may also consider obtaining life insurance to fund the tax liability, rebalancing the investment portfolios that hold shares of U.S. corporations, sell, or restructure the ownership of the Florida condo.
      • In restructuring ownership of the U.S. real estate, careful consideration should be made to U.S. and Canadian income tax, U.S. gift tax, lender approval and land transfer/stamp taxes.
    • U.S. guardianship proceedings in the event of incapacity and probate on death should also be considered when acquiring or structuring the ownership of U.S. real property. Guardianship and probate proceedings can be a costly and lengthy processes.

2. Shares of Canadian corporations and U.S. tax

  • If Cathy inherits, outright or through the spousal trust, the shares of the Canadian corporation, Cathy would be exposed to the complex and costly U.S. Controlled Foreign Corporation (“CFC”) rules, commonly known as Subpart F and GILTI regimes. These rules require Cathy, as a U.S. citizen, to include in her personal income a portion of the earnings of the Canadian corporation, even if the corporation did not make any actual distributions. Without proper tax planning, Cathy may be subject to double taxation.
  • A risk of additional U.S. income tax for Cathy (and potentially the children) exists if traditional Canadian post-mortem tax planning (such as “pipeline” transaction) is implemented for Peter’s estate without proper U.S. tax planning.

Potential solutions:

  • Holdco could be converted to an Unlimited Liability Company (“ULC”). The corporate continuance and conversion have no Canadian tax implications. A ULC with a single owner is viewed as a “disregarded entity” for U.S. tax purposes. The CFC rules do not apply to ULCs, eliminating the risk of double taxation. However, the timing of the continuance and conversion must be carefully planned.

3. Other considerations

  • Planning should be considered for the children. For instance, if they inherit Peter’s assets through Canadian testamentary trusts, these trusts must be properly drafted to include language that avoids exposure to trust accumulation tax under U.S. income tax rules (commonly known as “throwback rules”). This accumulation tax may cause the children to be subject to punitive U.S. income tax on certain trust distributions even if this income was previously taxed in Canada.
  • Peter mentioned that he was interested in an estate freeze during his lifetime to limit his Canadian tax on death. There is an opportunity to implement such planning during Peter’s lifetime, but the implementation of the estate freeze should also include U.S. tax planning to limit U.S. income tax exposure for Cathy and the children as beneficiaries of the new family trust.
  • The estate plan could be greatly simplified if Cathy and/or the children renounce U.S. citizenship. The United States applies an “exit” tax for some individuals who renounce their U.S. citizenship, and a special gift/bequest tax on receipts from those “expatriates.”

To ensure you know all your options, and to learn more about estate planning, contact and MNP tax advisor today.

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