Revocable trusts are a common estate planning tool in the U.S. Also referred to as living trusts and grantor trusts, they provide a method of avoiding costly probate and incapacity proceedings. A well written revocable trust will also include tax and creditor protection planning for future generations. In addition to all of these benefits, the individual setting up the trust remains in control of the trust and trust property during his or her lifetime.
A revocable trust does not provide creditor protection to the grantor, nor does it shield the grantor from U.S. estate tax liability. Rather, it is a powerful and popular tool for U.S. citizens and residents who are below the U.S. estate tax exemption amount to hold their personal residences. The revocable trust is popular among Americans, and rightly so.
Unfortunately, the benefits a Canadian may receive by using a U.S. revocable trust to avoid the issues of probate and incapacity proceedings will likely be negated by the numerous tax disadvantages a U.S. revocable trust faces in Canada.
How a U.S. Revocable Trust Works
As with any trust, a revocable trust must have a grantor (also known as a settlor), a trustee, and a beneficiary. The grantor creates and settles the trust, meaning he or she chooses the parameters of the trust agreement and donates the initial capital to the trust. The trustee is the individual or company named to manage the trust property for the benefit the beneficiary. Finally, the beneficiary is the individual who enjoys the beneficial use of the trust property, which may include income or other payments from the trust.
In the U.S., a revocable trust allows the same individual to act as grantor, trustee, and beneficiary, as long as future beneficiaries (also known as remainder beneficiaries) are named. This allows the individual to maintain complete control of the trust and trust property, and streamline the management of the trust property during his or her lifetime. Often, married couples will go a step further and create a joint revocable trust for jointly owned properties.
The U.S. Internal Revenue Service (“IRS”) disregards the existence of the U.S. revocable trust for tax purposes due to the control and reversionary rights retained by the grantor of the revocable trust. This means any income or capital gains earned on trust property is taxable in the hands of the grantor during his or her lifetime. This is normally not an issue, since the grantor of a revocable trust is almost always the initial beneficiary. It also means that property with accrued gains can be transferred to a U.S. revocable trust without triggering a tax on this capital gain.
U.S. revocable trusts do not provide protection from U.S. estate tax to the grantor, but certain planning can be included to reduce or defer this tax where a surviving spouse is inheriting the trust property.
There is no creditor protection for a property held in a U.S. revocable trust. Similar to the above-described tax treatment, the trust will be disregarded should creditors pursue the grantor.
Canadians and U.S. Revocable Trusts
Canadians who seek tax and estate planning advice from U.S. attorneys are often counseled to take title to their U.S. vacation residences through a U.S. revocable trust. These attorneys are trying to help their clients avoid the expensive and time-consuming issues of probate and incapacity, and take advantage of other tax and estate planning opportunities within the trust document. Unfortunately, a U.S. revocable trust is often not the ideal structure for a Canadian resident.
In Canada, trusts are considered separate taxpayers, meaning trusts are not normally disregarded like the U.S. revocable trust is in the U.S. There are limited exceptions to this rule, such as the Alter Ego trust available to Canadian residents over age 65.
Tax on income or capital gains earned by trust property could result in a double taxation scenario where tax is paid personally by the grantor in the U.S., but the income or gains are not attributed or distributed to the same individual as a beneficiary in Canada, therefore triggering income or capital gains tax at the trust level in Canada.
Such double taxation may be avoided by function of section 75(2) of the Canadian Income Tax Act (“ITA”). This section says that where an individual contributes property to a Canadian resident trust in which he or she is a controlling trustee and potential capital beneficiary, and he or she has the power to decide who will receive the property, then all income, capital gains, and capital losses associated with the donated property will be attributed back to that person during his or her lifetime.
Let’s say Mr. Smith, a Canadian citizen and resident, agrees with his U.S. attorney’s advice on how to avoid U.S. probate and incapacity proceedings, and has a U.S. revocable trust drawn up in which he is the grantor, trustee, and sole beneficiary during his lifetime. Section 75(2) of the ITA will cause all income, capital gains, and capital losses related to any property contributed by Mr. Smith to the trust to be attributed back to him individually. The trust will therefore essentially be disregarded for income and capital gains tax purposes on both sides of the border.
Result: During Mr. Smith’s lifetime, there should be no double taxation on income and capital gains earned on property he contributed to the trust.
The application of section 75(2) of the ITA does not protect against tax on the rollover of a property with accrued gain by a Canadian resident into a U.S. revocable trust. While not recognized for tax purposes in the U.S., such a rollover would cause an immediate disposition on the gain in Canada.
Let’s take Mr. Smith as an example again, but look at a slightly different situation. He has a condominium in Naples, Florida that he purchased 15 years ago for $150,000. His US attorney has informed him that he needs proper planning to avoid probate and incapacity issues for his family. If he continues to own the property in his name personally they could face lengthy court proceedings and high fees should he ever become incapacitated, and certainly upon his eventual death.
Mr. Smith would therefore like to put his condominium, which now has a fair market value of $250,000 into the U.S. revocable trust prepared by his U.S. attorney, since the trust would allow him to avoid these two issues. There is no tax on this rollover in the U.S. Such a rollover would trigger tax in Canada though, on the existing $100,000 in capital gain. To make matters worse, since no corresponding gain would be triggered in the U.S., if Mr. Smith then sells the same property five years later he would potentially be faced with taxation in the U.S. on the same $100,000 in gain for which he has already paid tax in Canada.
Result: Capital gains tax on the rollover of property in the U.S. revocable trust by a Canadian resident. Potential double taxation on an eventual sale of the U.S. property.
The situation gets even more complicated. Under section 104 of the ITA all Canadian trusts are subject to a 21 year deemed disposition rule. This means that the trust is treated as having sold and reacquired its property on the 21 year anniversary of the trust. Any accrued gains are taxed, even if the property is not actually sold. It does not matter if the property has not been in the trust for the full 21 years. A trust is generally considered resident in Canada when central management and control of the trust is carried out in Canada.
To continue with Mr. Smith as an example, say he purchased a condominium in Fort Lauderdale, Florida, in his U.S. revocable trust ten years after the trust was created. The property is still in the trust on the 21st anniversary of the trust. This condominium was purchased by the trust for $200,000, but is currently worth $325,000. Mr. Smith has no intention of selling the property anytime soon. Unfortunately, on the 21st anniversary of his trust he must pay tax on the gain of $125,000 in Canada. Like the last example, if Mr. Smith later sells this property he will potentially face a double taxation on the gain in the U.S., because no corresponding gain was recognized in the U.S. on the 21 year anniversary.
Result: U.S. revocable trusts are subject to Canada’s 21 year deemed disposition rule, which may also result in double taxation upon an eventual sale of the U.S. property.
Finally, Canadians who own property through a U.S. revocable trust face potential double taxation on the assets when they die owning property in the trust. Since the assets in the U.S. revocable trust are included in an individual’s estate upon death in the U.S., they may be subject to U.S. estate tax upon death. Estate tax is on the fair market value of the property at the time of death, not on the accrued gain. No credit for taxes paid by the estate in the U.S. will be available to the trust in Canada. Even if no U.S. estate tax is due, the IRS considers the value, also known as the adjusted cost basis, of the asset to have increased to its fair market value when inherited by the grantor’s heirs.
No such increase in adjusted cost basis will take place on this asset in Canada, which means that there may be tax on the total accrued gain either on the 21 year anniversary of the trust or when the deceased’s heirs eventually dispose of the trust assets. This could turn into a double taxation scenario where the deceased’s estate had to pay U.S. estate tax on the property at the time of death, since no credit is available for the tax already paid in the U.S.
As a final example, let’s say Mr. Smith dies leaving a Miami condominium in his U.S. revocable trust worth $500,000 that he originally purchased for $400,000, and a worldwide estate of $10 Million. As a Canadian citizen and resident, US estate tax only applies to his US situs assets, which include, but are not limited to real property held in a revocable trust. Should Mr. Smith pass away in 2013, his U.S. estate tax would be about $53,510.
If Mr. Smith had owned the property in his name personally at time of death, Canada would have also assessed a deemed disposition on the $100,000 in capital gain. Mr. Smith’s estate should have been able to use the U.S. estate tax paid as a foreign tax credit against the capital gains tax owed on the property in Canada, eliminating the double taxation.
Since the property is held in a U.S. revocable trust though, tax is not due in Canada until the 21 year anniversary of the trust, the sale of the property, or, in certain situations the distribution of the property to the trust beneficiaries. No foreign tax credit will be given for the U.S. estate tax paid by Mr. Smith’s estate.
Result: Potential for double taxation where U.S. estate tax is due on property held in a U.S. revocable trust.
On the rare occasion a U.S. revocable trust may be used effectively by a Canadian resident. Due to the potential for double taxation scenarios though, U.S. revocable trusts are best avoided by Canadian residents, especially when not used under the watchful eye of an informed cross border tax and estate planning attorney.
Alternatives to the U.S. revocable trust that still allow you to avoid issues of U.S. probate and incapacity proceedings do exist. Due to the revocable nature of such a trust, steps may be taken even with an existing U.S. revocable trust to implement an appropriate alternative and bring the structure into line with Canadian tax rules. You can contact Altro LLP to learn more about the various alternatives available to you as a Canadian resident owning property in the U.S.
The information contained herein is for informational purposes only, and is not legal advice or a substitute for legal counsel. It is not intended to be attorney advertising or solicitation. If you have a legal question, please consult with a licensed attorney.