If you or someone you wish to benefit in your estate plan is a US person, estate planning strategies aimed at minimizing the potential exposure to U.S. estate taxes are advised. That is especially important when the anticipated U.S. estate tax exposure exceeds the amount that can be protected by available deductions, exclusions, and treaty credits. If you are able to minimize a beneficiary’s unnecessary exposure to U.S. estate taxes, then estate planning for U.S. estate tax is certainly worthwhile. When considering any proposed plan or strategy, it is also important to factor in the associated costs and ongoing compliance requirements.
Who is a U.S. Person?
A U.S. person is anyone who meets any of the following criteria:
- They are a U.S. citizen
- They are a U.S. permanent resident (Green Card holder)
- They meet the “Substantial Presence Test,” which is a test based on the number of days they spend in the U.S. each year. Generally, they meet this criteria if they spent more than 30 days in the U.S. in the current year, and the sum of the days spent in the US as calculated below is greater than 182 days:
- Days of current year
- + 1/3 * Days of 1st previous year
- + 1/6 * Days of 2nd previous year
There are certain exemptions to the Substantial Presence Test; and below are a few of the most common:
- The Commuter Exemption – can apply to residents of Canada who regularly commute to employment in the U.S.
- The Closer Connection Exemption – can apply if they spent less than 183 days in the U.S. during the current calendar year; have a “tax home” in a country other than the U.S., and file Form 8840 – Closer Connection Exception to the Internal Revenue Service (IRS) for each applicable year, in a timely manner.
- A non-exhaustive listing of the factors used to determine where someone’s tax home is located include: location of permanent home; location of family; location of personal belongings (e.g., vehicles, artwork, jewelry, items with sentimental value, etc.); location of social, political, cultural, or religious organizations; location of routine banking activities; and location of the jurisdiction where the individual votes and holds a driver’s license
Where Both Spouses are U.S. Persons
If both spouses are U.S. persons and the gross value of one spouse’s estate, after taking into account any gift tax exclusion used prior to death, exceeds the exclusion amount ($12.92 million USD for 2023, indexed annually), they may be exposed to U.S. estate tax. In such cases, there are several planning options that may be available for the spouse who predeceases:
- Unlimited marital deduction: Transfers on death from a U.S. citizen to a U.S. citizen spouse, either outright or through a special marital trust under each Will, can take advantage of an unlimited marital deduction against U.S. estate tax. This allows for a deferral of any U.S. estate tax until the death of the surviving spouse or payment of capital from the spousal trust. The unlimited marital deduction is also available for assets passing from the deceased spouse under their Will via a QTIP trust, which must meet certain legal requirements. For Canadian tax purposes, a QTIP trust may qualify as a “qualified spousal trust” under the ITA, allowing for the tax-deferred rollover of assets from the deceased spouse to the trust. The assets in the qualified spousal trust will not be subject to Canadian tax until they are either disposed of or the death of the surviving spouse
- Credit shelter trust (bypass trust): A bypass trust can be established under each spouse’s Will, generally funded in an amount up to the exclusion amount ($12.92 million USD for 2023, indexed annually), to ensure that a U.S. person’s estate tax credit is utilized, so that the amount allocated to the bypass trust passes to their intended beneficiaries free of U.S. estate tax.
- Portability of exclusion amount: For U.S. citizen spouses, the exclusion amount of approximately $12.92 million USD (2023, indexed annually) is portable, meaning that if one spouse dies, any unused exclusion of the deceased spouse may be transferred to the surviving spouse, subject to certain terms and conditions, by making certain elections. This effectively allows for up to approximately $25.84 million USD (2023, indexed annually) of assets to pass free from U.S. estate tax for a U.S. citizen couple.
- Life insurance: Consideration can be given to purchasing life insurance on each spouse’s life in an amount sufficient to fund the expected U.S. estate tax liability. Life insurance owned by a person other than the insured person will not be subject to U.S. estate tax. Consideration can also be given to using a trust with special terms to own large insurance policies, rather than individual ownership, to remove the value of the proceeds from the taxable estate.
Where Only One Spouse is a U.S. Person
Non-U.S. person spouse’s Will: bypass trust to benefit a U.S. person spouse
If a non- U.S. person’s Will transfers assets outright to a U.S. person surviving spouse, those assets will be included in the U.S. person’s worldwide estate for U.S. estate tax purposes. To avoid additional U.S. estate taxes, it is important to transfer the assets to a “bypass trust,” which will not be included in the U.S. person’s worldwide estate on death, as long as certain requirements are met, including limits on the U.S. person’s participation in discretionary decisions. If these trust limitations are not made, the assets in the bypass trust may be subject to U.S. estate tax. For Canadian tax purposes, assets with accrued capital gains may be rolled over to a “qualified spousal trust,” which will be tax-deferred until they are disposed of or the surviving spouse dies.
U.S. person spouse’s Will: plan for utilization of spousal credit under the Canada-U.S. Tax Treaty
Under the Canada-U.S. Tax Treaty, a U.S. person spouse may take advantage of a spousal credit against U.S. estate taxes. To qualify for the spousal credit, the property must pass to the surviving non-U.S. person spouse in a manner that would otherwise qualify for the U.S. marital deduction, either outright or to a “qualified terminable interest property trust” (QTIP trust). The spousal credit is approximately equal to the lesser of: (1) the unified credit (exclusion amount up to $12.92 million USD for 2023, indexed annually) or (2) the U.S. estate taxes imposed on the qualifying property, allowing up to $25.84M USD (2023, indexed annually) of assets to pass from a U.S. person spouse to their non-U.S. person spouse, free of U.S. estate taxes.
U.S. citizen spouse’s Will: qualified domestic trust (QDOT)
A qualified domestic trust (QDOT) is a special trust that can be established in a U.S. citizen spouse’s Will. A QDOT allows the transfer of assets from a U.S. citizen spouse to a non-U.S. citizen spouse, which would not normally qualify for the U.S. spousal credit available to two U.S. citizen spouses. This allows a deferral of U.S. estate taxes until the death of the surviving U.S. citizen spouse. The U.S. estate tax that would otherwise be due on the death of a U.S. citizen spouse is instead paid upon distribution of any capital of the trust to the surviving non-U.S. citizen spouse, or upon the non-U.S. citizen surviving spouse’s death. However, the QDOT only defers U.S. estate taxes, much like the deferral of capital gains available for Canadian tax purposes for property passing between spouses. The deferred tax is generally imposed at the death of the non-U.S. citizen’s surviving spouse, based on the gross value of the property remaining in the QDOT. It is important to note that if the value of the QDOT increases, the tax at the time of the non-U.S. citizen surviving spouse’s death could be higher than if the tax had been imposed at the time when the first U.S. citizen spouse died. A QDOT must meet a number of complex requirements, including having at least one U.S. person trustee and being governed by the law of a U.S. state.
U.S. person spouse’s Will: credit shelter trust (bypass trust)
A credit shelter trust (bypass trust) can be established in a U.S. person’s Will in an amount up to the exclusion amount, in order to fully utilize the U.S. person’s estate tax exclusion. In this way, the trust assets may eventually pass to the non- U.S. person spouse free of U.S. estate taxes.
The non-U.S. person spouse may consider purchasing life insurance on the life of the U.S. person spouse, in an amount sufficient to fund the expected U.S. estate tax liability. Or life insurance on the life of the non-U.S. person spouse may be designated to a bypass trust for the benefit of the U.S. person spouse. The insurance may be owned through a special trust called an “irrevocable life insurance trust” as opposed to direct ownership, in order to exclude the value of the proceeds from the U.S. person spouse’s estate.
Holding assets between spouses
To minimize U.S. estate taxes, real property holdings between spouses should be carefully structured. Real property held in joint tenancy with right of survivorship is presumed to be included at its full value in the estate of the U.S. person spouse, except to the extent that the non-U.S. person spouse can establish the amount of their contribution to the purchase price. The value of any mortgage is generally not deductible from the property value. Canadian real estate may be held solely by the non-U.S. person spouse, so it’s not included in the estate of the U.S. person spouse − while any U.S. real estate might be held in the name of the U.S. person spouse. Assets of fixed value may be held in the name of the U.S. person spouse, while assets expected to appreciate may be held in the name of the non-U.S. person spouse. In that way, appreciating assets are excluded from assets subject to U.S. estate taxes.
When Intended Beneficiaries (including children/grandchildren) are U.S. Persons
If the intended beneficiaries of your estate are your children or grandchildren, who are now (or are likely to become in the future) U.S. persons, you may want to consider transferring assets to a bypass trust under your Will for their benefit. That will help protect these assets from U.S. estate taxes. The assets in the bypass trust will not be included in the U.S. person beneficiary’s worldwide estate upon their death, as long as the bypass trust meets certain requirements. Those requirements include restrictions on the U.S. person beneficiary’s participation in certain discretionary decisions, such as the decision to pay income or capital, so that they do not have too much ownership of the assets within the bypass trust. But if these restrictions are not in place, the value of the assets in the bypass trust could be included in the U.S. person beneficiary’s estate on their death and subject to U.S. estate tax. In addition to protecting assets from U.S. estate taxes, using a trust can also provide other benefits. Those include ensuring the preservation of wealth for future generations, minimizing probate fees, and providing protection from matrimonial claims and creditors. However, it is important to assess the differences in Canadian and U.S. taxation and compliance for these potential trusts. Please consult a qualified Canada-U.S. advisor for more insight in that regard.
If you aren’t sure whether you or one of your beneficiaries is a U.S. person, or if you would like a comprehensive review of your estate plan and financial plan, please contact Cardinal Point.