U.S. Estate Tax Laws: What you need to know

Beth Webel
Tax services partner

"There’s a naivety and lack of understanding about the U.S. tax regime here."

Canadians need to understand the implications U.S. tax laws can have on their estate if they have a child who is a U.S. citizen or resident

On Dec. 17, 2010, when U.S. president, Barack Obama passed a law governing tax on inherited wealth, most Canadian family business owners probably didn’t sigh with relief—but in fact many had good reason to.

“It’s remarkable how many Canadians don’t realize that if they have a child who is a U.S. citizen or resident, U.S. estate laws apply to them,” says Beth Webel, partner, tax services, PwC. “There’s a naivety and lack of understanding about the U.S. tax regime here. A U.S. citizen or a resident in the U.S. is subject to an estate tax on everything they own— their worldwide estate. In its simple form: if the person dies, the U.S. government values their estate and slaps a very high tax on it based on that.”

In a worst-case scenario, this can translate to a family-owned Canadian business being ravaged by a U.S. estate tax bill that it cannot afford to pay. “For example, if the parent owners of a family business pass away and leave shares in the business to one of their children living in the U.S., when that child dies, the value of the company is subject to U.S. estate tax,” says Webel.

Estate taxes south of the border over the years have ranged from a whopping 35 percent on the total market value to a potentially catastrophic 55 percent. “Typically, Canadian private company owners understand there’s capital gains tax at death here, so they will get life insurance to cover 25 percent of whatever the gain is,” says Webel. “But even if they realize that as a U.S. citizen or resident, they’re going to have to get insurance to cover U.S. estate taxes and even if those taxes are at a 35 percent rate, the insurance is going to be very expensive. And life insurance in the U.S. is typically taxed, so if you don’t structure your life insurance properly, you would subject that to a high tax rate as well. There are cases of family businesses with children in the U.S. who simply can’t get enough insurance. The cost of the insurance is killing them because the estate tax exposure is so significant on the assets.”

The law U.S. President Obama passed at the end of 2010 increased the estate tax exemption to $5 million from $1 million and decreased the top estate tax rate to 35 percent from 55 percent. “However, this welcome relief expires at the end of 2012,” says Webel . “This was a temporary measure negotiated between the Democrats and Republicans at the last minute. After 2012, the exemption will be $1 million and the top rate 55 percent unless new legislation is passed. While only temporary, it is helpful and it does provide an opportunity to do some planning over the next two years. But come 2013, we’re going to be back at the drawing board and if we don’t get a permanent fix, Canadian families affected by U.S. estate taxes will have to review their whole plan again.”

Webel advises Canadian families with a child who is a U.S. citizen or who resides in the U.S. ensure their tax advisor is very well informed—and up-to-date—on U.S. tax laws and that they update and revisit their estate plans regularly. “It is absolutely imperative that one, they identify U.S. family members, and two, they have frequent checks on their estate planning because the U.S. tax regimes keep changing and that might require more frequent changes to wills and plans for these families,” says Webel.

She also recommends:

• The moment one of your children goes to live in the U.S., even temporarily, inform your tax advisor. “Often, the child will go to the U.S. to pursue their studies, and then once they graduate remain there,” says Webel. “While they’re in school in the US doing their undergrad, that’s the perfect time for us to look at it and consider the options and plan ahead.”
• Don’t assume anything: often people think that because their child has dual citizenship, U.S. estate tax laws will not apply to them. They do. As well, even if the U.S. citizen lives in Canada, U.S. estate laws also apply to them as well as to Canadians living in the U.S.
• Consider alternatives to insurance for the U.S. estate tax liability. Instead of passing assets to the child outright, pass it to a trust created under your will that is specifically designed so that the children are not viewed as the owners of the assets under US estate tax law. Make sure the trust is properly structured because if the U.S. child has too much power in respect to that trust, then the U.S. government could tax all the assets of the trust.
• If you have a Canadian trust that’s facing its 21st anniversary—and is going to be distributing its assets to defer taxes under Canada’s “21-year rule”—consider making the distributions to the children living in Canada and finding other ways to equalize the amount given to the U.S.-based child.

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