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How California Taxes a Canadian Trust

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As we discussed in a previous article, many Canadians are shocked to learn that California taxes their RRSPs. Canadians are often also surprised and dismayed to learn that their Canadian trust could be subject, inadvertently, to the long arm of California’s tax system. Even just having a beneficiary – think trust fund baby – of a Canadian trust who lives in California is enough to subject the trust to California tax.

California taxes a trust if the trust has (a) California source income; (b) a California trustee or co-Trustee; or (c) a California beneficiary.

California’s taxation of a trust’s income that is attributable to California sources, for example rental income from property located in California, is not a strange concept. It’s California’s taxation of non-California trusts with California beneficiaries that – to borrow a line from Gowan’s song of the same name – is a “Strange Animal” and which will be the focus of this post.

In California, having just one beneficiary who resides in the state can subject the trust income to California tax in a proportion equal to the number of beneficiaries who are California residents. With California aggressively chasing trusts with a nexus to the state for failure to file income tax returns, Canadians who are beneficiaries of Canadian trusts should be aware of the tax implications that moving to California entails. The law in California subjects some or all of the income of a non-grantor trust to California income tax if any non-contingent beneficiary is a California resident. As you can see, the key distinction in the law is that a California beneficiary’s interest in the trust must be non-contingent for California to tax the trust. Hence, a non-California trust with contingent beneficiaries residing in California will not be subject to tax in California so long as there are no distributions to the beneficiary.

So, how do we determine between a contingent and non-contingent beneficiary?

Simply put, a contingent beneficiary is one whose interest is subject to a condition that must be satisfied for the beneficiary’s interest in the trust to vest. For example, most trusts are drafted whereby a trustee may make distributions for a beneficiary’s health, education, maintenance, support, care, comfort, etc. This constitutes a contingent interest in the trust property because the beneficiary’s beneficial interest is subject to the trustee’s sole and absolute discretion.

On the other hand, a beneficiary’s interest will become non-contingent if the terms of the trust agreement subsequently remove a condition to the beneficiary’s enjoyment of trust income or principal. For example, the beneficiaries of a trust that provides for the distribution of all trust income after a certain age, or provides a stipend to the beneficiary, or allows the beneficiary a withdrawal right, would be considered non-contingent. The determination of whether a beneficiary is contingent or non-contingent comes down to the distribution standards and rights of the beneficiary under the trust agreement and the trustee’s exercise of discretion in administering the trust.

Now that we’ve covered some of the basic laws applicable to California’s taxation of a trust, let’s look at this simple example.

Joe had a long and successful career playing in the NHL. To the diehard fans of one of the teams he played for, Joe is considered a legend and the second best player, after the team’s current young phenom, to ever play for the team. Over his career, Joe managed to amass a vast fortune from both playing hockey and endorsing many products. Through some good advice from his tax professionals, Joe set up a trust in Ontario to minimize his tax bill and to provide for his only child’s future. After graduating college, Madison, Joe’s only child and the sole beneficiary of Joe’s trust, decided to move to Hollywood to pursue an acting career. Madison, for lack of a better term, is a trust fund baby. The terms of Joe’s non-grantor trust provide that the Ontario based trustee shall distribute to Madison one-third of the trust income annually for her lifetime. Because the trustee is required under the terms of the trust to distribute trust income, Madison is entitled to such amounts and her interest is not subject to a condition. As a result, Madison is a non-contingent beneficiary regardless of the fact that she is entitled to just one-third of the trust income. Because Madison is the sole non-contingent beneficiary of the trust and a resident of California, the trust will be subject to California taxation. The trust would  have to report all of its income for California income tax purposes. Specifically, Madison will be taxed on the income distributed to her, while the trust will be taxed on the remaining income.

At Cardinal Point, we specialize in working with Canadians in California and we diligently work with our clients to ensure compliance with their federal, California and Canadian income tax and reporting requirements.

RRSP Withdrawal Tax Implications for Non-Residents

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From The Globe and Mail article:

Mr. Ritchie says he increasingly receives inquiries from well-to-do Canadian retirees who want to spend even more time at their homes in sunny Florida, California or Arizona than the rules allow…

Read the article here

Canadian Deductibility of 401(K) Contributions and U.S. Deductibility of RRSP Contributions

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Are Your 401(K) Contributions Deductible in Canada?

You might recognize this situation. You are a Canadian resident working in the USA on a TN visa. Your employer offers a 401(K) plan that includes a matching contribution. You know contributing to the 401(K) plan lowers your taxable income in the US. Does the same hold true for your taxable income in Canada?

Provided certain conditions are met, you may deduct, for Canadian tax purposes, the contributions you make to a 401(k) plan in the US.

For example, let’s assume you are a resident of Canada who is employed in the USA and you contribute to your employer-sponsored 401(K). Under the US-Canada tax treaty, your contribution to the plan (up to your remaining RRSP deduction room) will be deductible for Canadian tax purposes. But you need to be careful because your 401(K) deduction on your Canadian return is limited to your RRSP contribution room minus any other RRSP contributions. So if you’ve made RRSP contributions as well as 401(K) contributions, then you may have to defer some of the RRSP contributions you made and deduct them in a future year.

In addition, keep in mind that IRA contributions are NOT treated the same way as 401(K) contributions and are not deductible in Canada.

Are Your RRSP Contributions Deductible in the US?

In the above scenario, we discussed deducting 401(K) contributions for purposes of Canadian taxation. Now we turn our attention to whether or not contributions to an RRSP are deductible for purposes of US taxation.

John is a dual US-Canadian citizen who has been living and working in Canada for over 5 years. As a result, John files a Canadian tax return because he is a tax resident of Canada and he also files a 1040 return because he is a US citizen residing abroad.

If John makes a deductible contribution to a RRSP on his Canadian tax return, then will this contribution also be deductible on his US tax return? Generally, an RRSP contribution is not deductible on a US tax return.

There is, however, an exception under the Canada-US tax treaty that allows a RRSP deduction in certain situations. In particular, if the RRSP contribution is made via employee contributions to an employer sponsored group RRSP plan, then the contribution is deductible on the US tax return.

But there is a limit on how much you can contribute. Specifically, the RRSP contribution is limited to the lower of your RRSP deduction limit in Canada or your 401(K) limit (currently at $18,000 for those under the age of 50).

In addition, you will need to notify the IRS that you are lowering your taxable wages by the RRSP contribution. You do this by filing a Form 8833 with your US return and claiming an exemption under the tax treaty.

At Cardinal Point, we are here to assist residents on both sides of the border with their cross-border tax filing requirements and retirement planning scenarios.

Cross-Border Spouses: Beware of U.S. Gift-Tax Surprises

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When a U.S. citizen or U.S. resident alien is married to a Canadian spouse who is not a U.S. citizen, then property transfers between the spouses could be taxable in the United States or subject to U.S. gift-tax rules.

Most Canadians are not familiar with a gift tax or an estate tax because Canada doesn’t have such taxes. In the United States, however, gift and estate taxes exist alongside regular income tax, and can run as high as 40% of the value of a U.S. taxpayer’s wealth over a certain amount.

Inter-spousal transfers can take place via a gift, a sale or incident to a divorce. For U.S. tax purposes, a gift is treated as a transfer of property without receiving full consideration in return. For married couples where both spouses are U.S. citizens, transfers are not subject to regular income tax or gift tax. But problems arise when one or both spouses are not U.S. citizens.

Sale of property to a spouse
If both spouses are either U.S. citizens or U.S. tax residents, then an inter-spousal transfer by sale or divorce is tax-free. If, however, one spouse is a non-resident alien for tax purposes, then the transferring spouse will recognize a gain or loss for U.S. tax purposes.

Gift of property to a spouse
When one spouse is not a U.S. citizen, then U.S. gift-tax rules could apply. Unlike the unlimited marital gift tax deduction applicable to U.S. citizen spouses, a gift to a non-citizen spouse is only exempt from gift tax up to $147,000 (for 2015). This rule applies regardless of whether the receiving spouse is a green-card holder or otherwise a U.S. tax resident. As a result, care must be taken to analyze transactions between spouses to determine whether a gift tax return needs to be filed to pay any gift tax.

Let’s look at an example of when this situation would apply. Neil Youngman is an American citizen living in Malibu, Calif., and his wife, Cinnamon, is a Canadian citizen living in Toronto. Neil is a musical legend. Because Neil has a Heart of Gold, he decides to give his Canadian wife a gift of $500,000 to buy a home Down By The River in Muskoka. Unfortunately for Neil, only $147,000 of the gift is tax-free. The remaining $353,000 will need to be reported on a gift tax return, and is subject to gift tax.

As you can see, failing to plan ahead for spousal transfers could leave you afoul of complex tax rules—and subject you to unexpected tax surprises.

Marc Gedeon is a CPA (U.S), CPA (Canada) and Tax Attorney at Cardinal Point, a cross-border wealth management organization with offices in the United States and Canada.  Marc specializes in  providing Canada-U.S. cross-border financial, tax, transition, and estate planning services.  This piece is for informational purposes only and should not be considered legal or tax advice. Online readers should not act upon this information without seeking professional counsel.

Key Financial Tips for Green Card Transition

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At Cardinal Point Wealth, we come across many situations where former Canadian residents have been working in the United States on an L-1 visa. This type of visa allows a U.S. employer to transfer a manager, executive or someone with “specialized knowledge” from an affiliated Canadian office to one of its U.S. offices.

To secure this visa, the U.S. employer must be doing business in the United States and have a current business relationship with the Canadian company or affiliate. Further, the employee must have worked for the Canadian company for at least one of the past three years.

For former Canadians, the initial term of the L-1 visa is two years, and it can be renewed for a total of seven years. Unlike many other types of U.S. work visas, the L-1 provides the opportunity for a spouse and dependents to work in the United States, through an L-2 visa.

Often, after years of employment and the acceptance of their new U.S. lifestyle, individuals consider pursuing a U.S. Green Card (GC). Unlike other issued U.S. work visas, an L-1 visa holder can apply for a GC.

A GC grants “lawful permanent residence status” for the worker and his or her family. The ability to live and work in the United States for as long as you want and for whomever you want—including yourself—can be compelling. After holding your GC for five years (three years if married to a U.S. citizen), you would be entitled to apply for U.S. citizenship.

The United States determines income-tax residency based on one of three factors: U.S. citizenship, holding a Green Card, or meeting what is called the substantial presence test—a calculation of the number of days one is physically present in the country over a three-year period.

Obviously, once you receive your GC you are considered a U.S. income-tax resident, subject to tax on your worldwide income and all the requisite tax compliance requirements.

After their first year of employment in the United States, L-1 holders would generally have been considered U.S. income-tax residents, subject to the filing of U.S. tax returns and related compliance requirements of foreign accounts. So for the vast majority of individuals going from an L-1 visa to a GC, their U.S. tax situation remains virtually the same.

In unique situations, L-1 holders who filed Form 1040NRs with U.S. treaty elections tie-breaking residency back to Canada may only be subject to U.S. tax on U.S.-sourced income—but that is a subject for another time. In this case, obtaining a GC could dramatically change an individual’s U.S. tax-filing situation.

If you are living and working in the United States on an L-1 visa, you should consider U.S. gift and estate tax planning needs. U.S. gift and estate-tax residency is often based on the concept of “domicile.” Domicile in the United States can best be defined as living in the country with no present intent of leaving. Living in the United States even briefly can often satisfy this requirement, so many believe that holding a GC or renewing one’s U.S. work visa is enough to establish domicile.

If domiciled in the United States, you would be subject to U.S. estate tax on your worldwide estate (including any remaining assets in Canada). That’s after the U.S. estate tax exemption–$5.43 million for 2015 and $5.45 million for 2016.

Gift tax would also be levied on lifetime transfers after the application of the annual exclusion of $14,000 for 2015 and 2016. Non-U.S. citizen spouses could be gifted $147,000 ($148,000 for 2016). So if you are considering obtaining a Green Card, you should update your estate plan to include the transfer of wealth at death to a non-citizen spouse (through the use of a qualified domestic trust, or QDOT). Assets that might remain in Canada would need to be addressed. If you ultimately become a U.S. citizen, then the role of a QDOT, and the transfer of assets during life between spouses beyond the annual exclusion, would not create adverse U.S. gift-tax results.

Many of our clients who pursue a GC choose to return to Canada on a part or full-time basis. In such a situation, it is important to be aware of the current U.S. expatriation tax laws that could be imposed when you leave the United States and return to Canada.

The expatriation tax provisions under Internal Revenue Code (IRC) sections 877 and 877A apply to U.S. citizens who have renounced their citizenship, as well as long-term residents (as defined in IRC 877(e)) who have ended their U.S.-resident status for federal tax purposes. Under these rules, a long-term resident would be defined as someone who held a GC in at least eight of the past 15 years. So does that mean eight full calendar years? No! Under specific circumstances, you could be considered a long-term resident for less than the eight-year period. Under the rules, you count the years of long-term residency by the “moment of time” that you had your GC during a calendar year. So in some situations, long-term-resident status could actually be achieved in six years!

If you did return to Canada and voluntarily abandoned your GC by filing USCIS Form I-407 (Record of Abandonment of Lawful Permanent Resident Status) or had it taken from by an immigration officer who believed you no longer intended to reside in the Unites States, you could find yourself subject to the expatriation tax laws. In such a case you would be required to file IRS Form 8854 (Initial and Annual Expatriation Statement), where you would be required to complete a worldwide balance sheet and income statement.

Further, two types of income tax, often referred to together as the “exit tax,” would be imposed on your worldwide assets. The first is a mark-to-market tax that would be imposed on the majority of your worldwide assets. You would be deemed to have disposed of these assets at fair market value on the date prior to your date of expatriation—or, in the case of a long-term resident, on the date prior to the abandonment of your Green Card.

After an exemption of $690,000 ($693,000 for 2016), you would be subject to capital gains tax on any gains subject to the mark-to-market calculation from Form 8854. Further, there would be an additional ordinary income tax imposed on any deferred compensation, pension plans, stock options, IRAs and other tax deferred vehicles, including registered assets in Canada.

From a financial-, income- and estate-planning perspective, the implications of the U.S. expatriation tax need to be strongly considered when one is considering returning to Canada after having held a GC for a period of time and being defined as a long-term resident.

The advisors at Cardinal Point Wealth understand the unique cross-border planning need of individuals who are considering living in the United States and returning to the Canada on a full- or part-time basis. Our clients’ financial plans are customized to meet each client’s specific goals and to help them make important decisions with confidence.