Sunset, Sunrise – The Strange Rules of U.S. Estate Tax*

David Louis, J.D., C.A., Tax Partner, Minden Gross

(*This release is based on an article published in the TaxLetter, May 2004, MPL: Publishing)

Everyone knows that President Bush’s continuing debacle in Iraq could mean a change of government. But for readers with U.S. assets, there could be a more direct effect – it could cost your family money. In fact, if you are wealthy, the financial damage could be substantial.

The reason? A change of government in the U.S. could mean that the promised repeal of U.S. estate tax is off the rails. In order to understand why, you must understand the underpinnings of the repeal. These are a classic exercise in the complex and often hypocritical workings of U.S. Congress. In fact, even the name of the legislation to repeal U.S. estate taxes is hypocritical. You’d think they’d call it something like "The Estate Tax Repeal Act." Instead it’s called The Economic Growth and Tax Relief Reconciliation Act of 2001. Seems that U.S. politicians have pious-sounding names for just about everything.

For the next few years, the sun will continue to set on U.S. estate taxes, which will be an issue only to wealthy Canadians. For this year and next, an estate credit based on U.S.$1.5M of assets will apply, increasing to U.S.$2M between 2006 and 2008, and U.S.$3.5M for 2009 (with additional credits where assets are left to a spouse). These amounts refer to worldwide assets; but even so, the $1.5M credit - being in U.S. dollars - will shelter an estate of up to Cdn.$2M or so from U.S. estate tax.

But there’s a catch: there is a "sunrise" clause calling for the automatic re-enactment of estate taxes on January 1, 2011, and the reversion of the gift tax to its 2001 form, absent a positive act by U.S. Congress before that date. For Canadians with U.S. assets, this means that if the sunrise clause is operative, the U.S. estate tax will spring back to life, with a credit only for the first U.S.$1M of assets.

Besides a change to a democratic government, even if the Republicans remain in power, it’s possible that there could be a change of heart, for example, due to pressure to finance the war on terrorism. While it is too early to make any firm predictions, the farther we get into the decade, the more it seems that U.S. estate taxes may spring back to life in some form or other (e.g., maybe with a heftier credit).

The Current U.S. Estate Tax System

The following are highlights to the current U.S. estate tax regime as it applies to Canadian residents (who are not U.S. citizens), based on mid-90’s changes to the Canada-U.S. Tax Treaty:

A "unified estate tax credit" which covers up to U.S.$1.5M of an individual’s gross estate applies to Canadian residents (non-U.S. citizens) according to the following formula:

Gross U.S. Estate/Gross $1.5M exemption

Worldwide Estate x (i.e., the basic U.S. estate tax credit)

Note: see table below for exemptions and maximum rates in coming years.

$60,000 exemption. There is an exemption if U.S. property has a value of U.S.$60,000 or less. However, assets which are considered to have "U.S. situs" and are thus subject to U.S. estate taxes include stocks or securities (even held with a Canadian brokerage firm), U.S. mutual funds, debts of U.S. corporations (other than certain T-bills, bonds, and so on eligible for the so-called "portfolio exemption"), and so on.
Assets left to a spouse. To the extent that property is left to a spouse, a second estate tax credit is potentially available. However, when the surviving spouse passes away, only the normal exemption applies (unless, of course, the surviving spouse had remarried). If the estate tax credits are insufficient to eliminate U.S. estate tax, consideration should be given to using a Qualified Domestic Trust (known as a "QDOT"), which may defer estate tax until the death of the surviving spouse and, under current rules, eliminate estate tax if the spouse lives beyond 2020.

Foreign tax credits. U.S. estate tax is creditable against Canadian "death tax" on U.S. property - i.e., as a result of the Canadian rules calling for a "deemed sale" on death. (Also the U.S. will allow Canadian "death tax" as a foreign tax credit against U.S. estate tax, i.e., as a reduction of U.S. estate taxes on property located outside the U.S..)

Additional Relief for some U.S. property. If estate taxes spring back to life, or for years where the exemption is too low to cover U.S. estate taxes, you should be aware that, where a Canadian resident's gross estate is $U.S. 1.2 million or less, the U.S. may impose estate tax only on items which are gains which the U.S. can tax under the Treaty, normally U.S. real estate interests (including real estate holding companies), and personal business property. An example of a normally-exempt item would be shares in a public U.S. corporation.

Sunset Sunrise -

How U.S. estate taxes fade to black - then come back to life

Year	Estate Tax Exemption Threshold U.S. $	Maximum Estate Tax Rate
2003	1 million	49%
2004	1.5 million	48%
2005	1.5 million	47%
2006	2 million	46%
2007	2 million	45%
2008	2 million	45%
2009	3.5 million	45%
2010	N/A: Tax repealed	N/A: Tax repealed
2011(without further legislation)	1 million	55% + 5% surtax on large estates

Some Planning Ideas

Of course, one possible planning avenue is to arrange for an orderly transfer of your U.S. assets to your beneficiaries. Unless you are a U.S. citizen or resident, there is no gift tax. However, you should be aware that, for Canadian tax purposes, there is generally a deemed sale of assets at market value when they pass between generations. This means, for example, that if U.S. real estate has appreciated in value (as measured in Canadian dollars), there could be Canadian capital gains tax.

Until U.S. estate tax is completely repealed, you should consider holding U.S. assets which may attract U.S. estate tax inside a Canadian corporation. Besides the possibility of estate tax, a corporation may avoid U.S. probate, which can involve quite a bit of red tape.

Of course, one possible candidate is a U.S. vacation property. To avoid Canadian tax complications, a so-called "single-purpose corporation" is often used: the CRA imposes strict requirements on these corporations in order to avoid Canadian taxable benefit issues (the problem stems from the principle that there is a potential taxable benefit where a shareholder has the use of corporate-owned assets without paying compensation to the company). There is some possibility that the government may reconsider its policy for such corporations – even with all the strictures - although I would hope that, if this ever came to pass, pre-existing arrangements would be "grandfathered".

Also, there is at least some risk that the strategy could be attacked south of the border due to certain U.S. tax issues. Some U.S. tax advisors have warned that recent U.S. estate tax cases can be extended to cover these corporations.

In addition, because the property is held in a corporation, there could be complications if it has appreciated in value. For one thing, the single purpose corporation will not be eligible for the 15% U.S. tax rate on capital gains, which applies to individuals - but not corporations. Instead, there could be U.S. federal corporate taxes of up to 35%, plus applicable state taxes (although they would be creditable against Canadian corporate taxes). There could also be Canadian tax complications when the shares of the single-purpose corporation pass to another generation on death (or otherwise). The reason is that the shares of the corporation are treated as having been sold at their market value – which presumably reflects the appreciation of the vacation property. The result is that there is an increase of the cost base of the shares to beneficiaries; however, there is no effect on the tax cost of the underlying property, thus leading to a tax on the same appreciation if the vacation property is sold. A post-mortem reorganization might alleviate this problem, but it can get complicated.

But even with all these warts, a single-purpose corporation may give you a good shot at completely avoiding the U.S. estate tax net and should be considered if you are concerned about whether the repeal will come to pass, or if your estate exceeds the exempt limits for the second half of this decade. If the vacation property has appreciated, it cannot be transferred to a single purpose corporation on a "rollover" (tax-deferred) basis.

Alternatives to a single-purpose corporation may include a Canadian discretionary trust or family partnership arrangement. However, these alternatives involve some complexities mainly due U.S. rules. A simpler alternative may be joint ownership – but your joint ownership interest is potentially subject to U.S. estate tax and for the other interests to be exempt, the surviving joint owners must be able to demonstrate that they contributed financially to the property.