Tax & Estate Planning
for US Citizens
Tax and estate planning is an important, and often neglected, topic for everyone. In order to ensure that as much of your hard-earned money is retained for the benefit of you and your family, planning is required. The laws can be complex, and for many people it involves issues that they would rather not spend time and money thinking about.
However, the consequences of inadequate planning can be severe in terms of both penalties for non-compliance with income tax rules, and unexpected challenges for those responsible for settling estates. When an individual or family has connections to both Canada and the United States, there is an added level of complexity that requires specific expertise uncommon among the professional tax and estate planning community.
The attorneys at Altro LLP specialize in such planning for US citizens in Canada and Canadian citizens with cross border issues. We understand how the US and Canadian rules apply and interact as a consequence of the Canada-US Income Tax Treaty. With the right planning, many of the adverse consequences can be avoided. We take the time to fully understand the facts and objectives of a client, and develop custom-tailored solutions to arrive at a favorable result.
US Citizens
in Canada
An estimated one million US citizens are living in Canada as permanent residents or dual citizens. These individuals face extraordinary challenges in their tax and estate planning, and deserve planning support from professionals who specialize in issues that affect them.
Many American expats are unaware that they have continuing tax obligations to the Internal Revenue Service (IRS) that do not end when they leave the US. Annual income tax returns are required throughout their lives, and there may be tax filings required on death to complete the settlement of their estates.
In recent years, the IRS has been increasingly vigilant in pursuing Americans with assets outside the US. A number of complicated rules have been put into place to ensure that US taxpayers properly report their income, and pay their fair share of US tax. In enacting these rules, Congress was hoping to address what it perceived as abusive schemes to hide assets offshore and beyond the reach of the IRS. Such rules apply to foreign financial accounts, trusts and corporations with US owners.
Of course, Canadian resident US citizens are subject to significant rates of Canadian tax as a result of Canada’s residency-based system of taxation. Therefore, it cannot be said that these individuals are being specifically targeted by these US anti-deferral rules. Nonetheless, because US tax rules apply uniformly to all citizens, compliance must be maintained to avoid significant penalties imposed by the IRS.
Fortunately, Canada and the US have a very advantageous tax treaty, which goes a long way toward avoiding double taxation for those subject to tax in both countries. This means that for many people, compliance simply requires filing returns in both countries each year.
However, there are a few instances in which the Treaty does not provide complete relief, and tax is owing to the US. Examples include selling one’s principal residence in Canada for a large capital gain, and reinvesting earnings within a holding company.
Furthermore, IRS rules on disclosing financial information often impose significant penalties for non-compliance. Therefore, even when no actual tax is due, failure to file can result in significant consequences due to the penalties that can be retroactively imposed.
Identifying and avoiding these tax traps requires detailed knowledge of tax rules in both Canada and the US, and competent advisors in just one country may lead US citizens in Canada astray due to a lack of this cross border expertise. Altro LLP specializes in advising people with tax obligations in both Canada and the US, and can help avoid problems while ensuring optimal tax treatment in both countries.
Canadian rules for taxation on death are different from those in the US in important ways. In Canada, death taxation consists of a capital gains tax imposed on all the assets owned by the deceased person (other than those qualifying for a rollover to a surviving spouse). Therefore, if a person’s assets have no unrealized gains, the Canadian tax consequences of passing away are generally not significant.
In contrast, the US rules impose estate tax on the fair market value of includible assets, regardless of whether they have increased or decreased in value. Under current rules, the federal estate tax rate applies at up to 40% on assets over $1 million. To soften the impact of this tax, each estate has an applicable exclusion amount of $5.49 million (in 2017), which can pass free of tax. This exclusion amount is reduced by prior gifts on which no gift tax was paid.
For US citizens resident in Canada, who are subject to both of these tax regimes, planning strategies are available to minimize the overall tax payable on death, and therefore preserve as much as possible for your heirs. Careful drafting of testamentary spousal trusts, based on rules found in both the Income Tax Act and the Internal Revenue Code, as modified by the Canada-US Tax Treaty, can defer or eliminate significant taxation on death.
Altro LLP attorneys regularly assist clients facing these issues, and can provide expert advice to ensure your estate plans are tailored to achieve the best results possible.
Minimizing the impact of US tax compliance obligations often involves structuring investments to avoid the anti-deferral rules around foreign corporate investments. For example, the Passive Foreign Investment Company (PFIC) rules apply where US persons own a non-controlling interest in a foreign corporation that either earns greater than 75% of its gross income from passive sources or 50% of its assets are held to generate passive income.
In such a case, the US shareholder may be subject to punitive rates of tax on abnormally large dividends earned on those shares in a given year, or on the sale of such shares for a capital gain. The effect of the PFIC rules is to reallocate some of that income or gain to prior years in which the US person owned the shares, impose income tax at the highest marginal rate for the prior year, and retroactively apply interest and penalties from back years. To avoid this harsh treatment, elections are required in the first year that PFIC shares are owned, and even then tax deferral on the unrealized gains is not possible. Alternatively, a US person might be wise to plan to avoid owning shares that qualify as PFICs.
Altro LPP can identify these and other issues to prevent such adverse tax treatment for Americans with Canadian assets.
Subpart F of the Internal Revenue Code deals with Controlled Foreign Corporations (CFCs), which are defined as any non-US corporation where more than 50% of the voting shares are held by US citizens. These rules require any US citizen owning at least 10% of the shares of a CFC to include his or her pro rata share of the corporation’s passive income in their personal tax return as income. This can lead to problems with the foreign tax credit system, which ordinarily prevents double taxation, because the timing and character of the personal tax associated with corporate earnings will not match between the two countries.
Succession planning for US citizen owners of Canadian businesses can have disastrous consequences if US tax issues are ignored. Canadian planning often involves a process called a corporate reorganization and estate freeze, whereby the current value of a closely held business is frozen to limit the capital gains tax assessed on the death of the business owner. The process generally involves exchanging common shares in the business for preferred shares, and issuing new common shares to a trust set up for the benefit of the next generation.
Estate freezes are excellent plans for Canadians, but the US has enacted tax rules that can result in an immediate gift tax on the entire value of the company when a typical Canadian freeze is implemented. For US citizens, a different procedure is required to accommodate these US rules. Our professionals can assist in this process, and help to avoid unintended consequences of otherwise good Canadian planning.
US Resident Adult Children
In today’s highly integrated and mobile world, many Canadian families may find themselves with children and grandchildren having resettled in the US. When planning for the succession of wealth to such beneficiaries, it is worth considering how these assets will be taxed in the future.
US residents are subject to tax on the transfer of wealth, either during life or on death, as explained elsewhere on this website. However, where such wealth is being passed from Canadian resident donors, unique opportunities are available to shelter these inbound inheritances from future US estate taxation.
The use of specially drafted trusts in the US, called Dynasty Trusts, to receive the inheritance destined for your US resident beneficiaries can allow them to benefit from the funds to the extent that they need to, but have those funds excluded from their taxable estates on death. Given that estate taxes can apply at up to 40%, these trusts can offer significant benefits to future generations.
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