How to minimize the U.S. estate tax

If you have a client who is married to a United States (U.S.) citizen or a dual citizen, you may need to advise the person to watch out for U.S. estate tax.

U.S. estate tax is a wealth transfer tax levied upon death, on the fair market value (irrespective of any accrued gains in value) of property held by an individual. The top rate of tax can reach 45% (2009 rate).

A person who is neither a U.S. citizen nor a U.S. resident will be subject to U.S. estate tax only on assets situated in the U.S., such as U.S. real estate and shares in U.S. corporations. Even these assets may escape the U.S. estate tax net if the U.S. situs assets are not significant and can be sheltered by the Canada-U.S. Tax Treaty. The Treaty entitles Canadian residents to a credit, calculated as a fraction (U.S. situs assets/worldwide estate) of the U.S. estate tax credit amount of $1,455,800 US, against U.S. estate tax. The credit is based on the current U.S. estate tax exemption amount of $3.5 million US.

However, if your client has a spouse who is a U.S. citizen or a dual citizen, the picture changes dramatically. The U.S.-citizen spouse will be liable to pay U.S. estate tax on the fair market value of his or her worldwide assets, whether situated in the U.S. or not.

The worldwide assets include all property owned at death, and may include insurance proceeds (even proceeds of insurance owned by your client’s private company), jointly held property (100% inclusion subject to certain limits), trust interests, stock options and registered plans (RRSPs, RRIFs and pensions).

A traditional will may leave all of an individual’s assets outright to the U.S.-citizen spouse. But when the U.S.-citizen spouse dies, he or she will be subject to U.S. estate tax on all the assets held on death, which will include the property inherited from the deceased spouse. This will result in tax of 45% on the spouse’s worldwide estate to the extent it exceeds $3.5 million.

Let’s assume that your client, Carl Brown, is a Canadian citizen and resident, with a U.S.-citizen spouse, Marla. Upon Carl’s death, his will bequeaths the following items to Marla:

	Fair market value (USD)
House	$1.5 million
Investment portfolio	$2 million
Canadian recreational property	$500,000
Insurance proceeds	$1 million
Total	$5 million

Assuming that Marla owned only these assets at her death, the estate tax liability would be $675,000 — a significant proportion of the Brown family’s assets. So what are your client’s options?

Will planning

Spousal testamentary trusts are often used as part of a Canadian estate plan for the tax-effective transfer of assets on death. However, a traditional Canadian spousal testamentary trust, where assets are left in trust for the benefit of the surviving spouse, is generally not effective for U.S. estate tax purposes on the death of the surviving spouse. This is because U.S. tax law treats the surviving spouse as owning the trust assets, on account of the spouse being named as a trustee and having a degree of control over the trust assets. To effectively shelter the assets from U.S. estate tax on the surviving spouse’s death, your clients have two options:

• A spousal testamentary trust could be established by will. The surviving spouse must not be a trustee.
• A modified spousal testamentary trust could be established, structured specifically to keep the assets exempt from U.S. estate tax. This would require that the surviving spouse’s ability to participate in decisions to distribute the trust’s capital be restricted.

Spousal testamentary trust options

The first option is simple, but often not practical. In many cases, a surviving spouse wants to be a trustee so he or she can exercise some control over the trust assets.

Under the second option, the surviving spouse is made a trustee, but his or her powers are limited to an “ascertained standard.” Under this special trust, the surviving spouse is entitled to receive all income derived from the trust assets. However, his or her ability to participate in decisions to use the trust’s capital is limited to situations in which it will cover expenses related to the surviving spouse’s health, education, maintenance or support.

This special testamentary trust should also qualify for the Canadian “spousal rollover,” so that no Canadian income tax liability should arise on the death of the first spouse. Instead, the liability should be deferred until the surviving spouse’s death.

If required, the spousal testamentary trust can also be drafted to meet many other needs for your client. For instance, a migration clause could be added to allow the trust to become a U.S. trust, if the surviving spouse decides to move to the U.S. after the death of the first spouse.

The U.S. estate tax regime may apply a hefty tax on a U.S.-citizen spouse’s assets upon his or her death, which may include assets inherited from the Canadian spouse. However, with an appropriate tax plan, your clients may be able to minimize or eliminate these adverse tax consequences and protect non-U.S. assets from U.S. estate tax.

Nadja Ibrahim is a partner and Christopher Gandhu is a senior partner in the tax services practice of PricewatehouseCoopers LLP in Calgary.

(05/19/09)