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Estate Summary- United States planning issues for Canadians

Overview

The United States imposes an Estate Tax on its citizens, permanent residents and others who are domiciled in the United States. The tax will also apply to United States assets owned by non-resident aliens. The Estate Tax was a part of a unified transfer tax system that also included transfers by gift, where similar provisions apply.

Canada abolished its estate and gift tax regimen several years ago. To replace its estate and gift tax system it imposes an income tax on the unrealized appreciation in certain assets at transferred by death, gift or many other circumstances. The Canadian income tax is imposed only on residents of Canada, and on certain Canadian assets owned by those not resident in Canada.

Estate Planning Basics

Good estate planning should involve many issues important to planners and their clients, only one of which is taxes. While this discussion focuses on tax issues, the other issues may be more important to the client and may supersede good tax planning. Similarly, good estate planning must take into account the current size and makeup of the potential estate, as well as its probable change before the client will seek to validate or update the plan. The numbers often indicate that complex planning simply is not necessary, even when the theory dictates otherwise.

One of the goals of planning for a married couple is generally to eliminate the taxes on the first death, and to minimize the taxes on the surviving spouse. This, of course, may be mitigated if the spouses are elderly or in such health that one can anticipate that one spouse will not outlive the other by a significant amount of time. These issues are the ones that present unique challenges to Canadians.

Typical Planning

The typical estate plan for most Americans of sufficient wealth is to create a trust funded with the amount of assets that can pass free of federal estate taxes. This trust is known as a bypass or credit shelter trust. The balance of the assets pass to the surviving spouse, taking of an unlimited deduction in determining the taxable estate for assets passing to the surviving spouse. This is known as the marital deduction.

The Problem

United States tax law treats permanent residents and citizens identically for income and estate tax purposes, with a couple of significant exceptions. Internal Revenue Code Sections 2056(b) specifically denies an estate tax deduction for transfers to the surviving spouse where the spouse is not a citizen of the United States.

The Generic Solution

Internal Revenue Code Section 2056(b) also provides a couple of exceptions to the general denial of the marital deduction for property left to the non-citizen spouse. The most common exception is through the use of a Qualified Domestic Trust (QDOT). The intent of the QDOT is to insure that the assets left to the non-citizen spouse are eventually subject to US tax. The QDOT provisions are beyond the scope of this memorandum, but suffice it to say that they are quite complex. A QDOT may be created by the surviving spouse where it was not created by the decedent's will, and a non-qualifying marital trust can be judicially reformulated after the first death to qualify as a QDOT.

The Canadian Alternative

Because of the different types of taxes imposed on death (Estate Tax in the US, Income Tax in Canada), the income Tax Treaty between the two countries provides some relief. The portion relevant to this discussion is Article XXIX-B of the Treaty. The treaty provides that in the case of property left by a US person to a Canadian Spouse, there shall be allowed a non-refundable credit equal to the lesser of the unified credit, or the federal estate taxes on the property left to the surviving spouse. The price of this credit is to irrevocably waive any other marital deduction provision available to the estate (the QDOT provisions and the other limited exceptions found in Section 2056(b).

Washington State Estate Taxes

The State of Washington has adopted the internal Revenue Code as the basis of its Estate Tax, although the version of the Internal Revenue Code as last adopted by the state legislature is not the most current version. lnternal Revenue Code Section 894(a)(1) provides "The provisions of this title(Title 26 United States Code, the entire Internal Revenue Code) shall be applied to any taxpayer with due regard to any treaty obligation of the United States which applies to such taxpayer." Therefore the marital credit of the Treaty should be allowed for state purposes. This provision was fully disclosed in a 2003 Washington State Estate Tax Return, with the Department of Revenue not challenging the claiming of the credit allowed under the Treaty.

Planning

It appears that giving the executor the maximum flexibility in making marital distribution decisions is advised. For the small estate, reliance solely on the unified credit seems to make sense. For the estate that is under twice the unified credit, reliance on the treaty provides for some simplicity and flexibility for the surviving spouse. For the larger estate, the QDOT provisions may still be the most appropriate solution.

The Caveats

This discussion deals with situations where both the decedent and the surviving spouse are U.S. residents and to not hold Canadian assets. The Treaty also deals with Canadian assets, as well as situations where one or both of the spouses reside in Canada.

The Caution

The US transfer tax system deals with both estate and gift taxes. The gift tax regimen also contains a denial of the marital deduction to transfers to non-citizen spouses. This means that any transfer to a non-citizen spouse beyond the annual gift tax exclusion is subject to tax. The annual exclusion for such gifts is increased by Internal Revenue Section 2523(i) to $100,000. The provisions of the Canada - United States Income Tax Treaty deals only with estate taxes and not gift taxes. There is no Treaty relief for transfers by gift. This caution would seem to apply to the most common of Washington estate planning tools, the Community Property Agreement, or to the creation of joint tenancies.