U.S. Estate Taxes Revisited

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The Fiscal Cliff Parachute

Back in April, 2012, I reported on the exposure of ordinary Canadians to the US tax net, including US estate taxes. At the time, the preponderance of opinion was that the estate tax exemption was going to drop drastically on January 1, 2013 from $5 million to $1 million. Fortunately, literally at the 11th hour as part of the ‘fiscal cliff’ legislation package, the $5 million exemption limit was maintained. Indexed for inflation this means the exemption in 2013 is set at $5.25 million. The concession given to the Democrats in the battle of political will was that the top marginal rate was raised from 35% to 40%.

While this is said to be ‘permanent’ legislation, history tells us that nothing is permanent when it comes to favorable tax legislation. All it would take is another budget crisis or, more correctly, the failure to navigate out of this budget crisis, and the fiscal lawmakers will be looking for additional sources of revenue. Estate taxes are an obvious choice in that they do not directly tax economic activity. Given how close we were to an 80% drop in the exemption limits, we must remain mindful of the possibility for change in the future and plan accordingly.

So what does all this mean? The $5.25 million exemption limit applies to US citizens and others with US connections. Under the Canada – US Tax Treaty resident Canadians are entitled to apply the exemption on a prorated basis. The prorating is based on the proportion that the value of an individual's US situs assets are to the value of the individual’s total worldwide assets. The way the exemption formula works, given the current limits, essentially there will be no estate tax liability as long as the worldwide assets are below $5.25 million. Again, while this limit is set to apply for 2013 and beyond, it is subject to change at any time.

The types of US situs assets most commonly held by Canadians are vacation properties and US stocks. The value of the assets is determined at the time of death. Given the continued depressed state of the US real estate market, particularly in many of the vacation property hotspots such as Florida, Arizona, California and Nevada, it is important to be aware of the planning options to minimize exposure in anticipation of the inevitable climb in property values back to pre-debt crisis levels.

Assuming the acquisition of a US vacation property may put you over the estate tax exemption limits, the planning strategies involve a combination of ‘how to hold title’ decisions and ‘how to transfer the property on death’ decisions. In terms of the title decisions, let's start with what not to do. Do not hold title to a recreational property in a corporation and do not hold it in joint ownership. Corporate ownership of such properties was in vogue up to about a decade ago. At that time CRA changed its administrative policy regarding the shareholder benefit issues which arise when a shareholder uses a corporately owned asset. The shareholder benefit liability is potentially very costly and weighs against this form of ownership. Joint ownership may expose the property to full estate tax on the death of each of the joint tenants resulting in double taxation. While joint ownership is in certain circumstances an effective probate planning tool for Canadian purposes, it can have ugly results in the US estate planning context.

Another strategy which may be more effective from an estate tax perspective is the use of a non-recourse mortgage which effectively reduces the value of the property. The difficulty with these is their limited availability. The most effective strategy, but one that is not without its own complications, is the use of a trust to hold title to the property. Because the trust is not an individual, the death of an individual beneficiary who is using the property does not trigger an estate tax liability. The complications lie in the critical importance of separating the funding of the trust from the administration and management of the trust. This must be carefully documented in order to preserve the effectiveness of the trust ownership as an estate tax planning strategy.

Turning now to some will planning strategies, the two provisions that I would like to highlight are the QDOT and the Bypass Trust. The QDOT is used where the death of an individual would otherwise trigger an immediate estate tax liability. This can arise either upon the death of an individual with some US connections such as citizenship or residency, or in the case of a Canadian who holds US situs assets and worldwide assets which are beyond the exemption limits. A QDOT in the will effectively defers the obligation to pay the tax until the subsequent death of the beneficiary. To effectively create a QDOT, there are some specific technical requirements, including the choice of trustees. In addition an election is required to be filed by the executor in order to choose the QDOT treatment.

A bypass trust on the other hand would typically be used when the first death would not otherwise trigger estate tax liability. For example if the deceased is a Canadian and the survivor is American or where at the time of the first death the property values are such that they are below the exemption thresholds but may be higher by the time of the second death. Again, as with the QDOT there are some technical requirements regarding the choice of trustee and the specific language regarding the allowable uses of the trust, which are referred to as "ascertainable standards".

The US vacation property market is still a hot topic for Canadians looking for gems south of the border. While there is no doubt we are in a much better place from an estate tax standpoint as of January 1, 2013 then we were expected to be, it does not mean that this issue can be ignored. The escalation of property values and revenue-generating legislation amendments in the future are both occurrences which the likelihood of which lies somewhere between probable and inevitable. Careful monitoring and planning are the only ways to avoid an unexpected estate tax hit which could take a bit of the lustre off the family’s tropical paradise.

Harold Feder is a partner with the law firm of BrazeauSeller.LLP.  He practices in the areas of tax and estate planning for individuals and business owners.  Harold can be reached at 613-237-4000 ext. 242 or at hfeder@brazeauseller.com.  For more information about Harold, please visit www.brazeauseller.com.

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