The U.S. estate tax was created to redistribute what former U.S. President Theodore Roosevelt described as "the swollen fortunes which it is certainly of no benefit to this country to perpetuate." In 2002, President Bush, who apparently harbours a greater fondness for perpetually swelling fortunes than Mr. Roosevelt, approved a bill to phase out the tax by 2010. The repeal was enacted under a peculiar political compromise whereby the tax will indeed be gone in 2010, but, like the temporarily vanquished villain in a cheesy horror flick, will lurch back to life in 2011 to terrorize villagers at the harsher pre-2002 tax rates and exemptions. This bizarre situation has led tax advisors to comment – tongue-in-cheek – that arranging one's death to occur in 2010, when the tax rate will be zero, makes for perfect tax planning.
American politicians have endured an intense public relations war over estate tax repeal. Opponents of the tax argue that family farms and private businesses are being lost to estate tax liabilities. Though these opponents have struggled to produce real-life examples, they have developed catchy negative titles to sway public opinion, such as "death tax," "pine-box tax," "grave-robber's tax" and "last-grasp tax." Pro-tax groups have adopted Paris Hilton as the poster girl for the wealthy and indolent socialites they claim will be the primary beneficiaries of a repeal. Their media tag lines include "the last thing a rich heiress needs is a $1 trillion raise in her allowance," referring to the estimated future cost of a repeal to the U.S. Treasury. The largely Democrat tax supporters have thus far carried the day; in 2006 the U.S. Senate voted 56-42 to defeat the latest bill proposing a permanent repeal.
Interestingly, America's super-rich have been divided on the issue. Many of the very wealthiest American families are reported to have quietly channeled tens of millions of dollars to organizations lobbying to repeal the tax. On the other side, financial heavyweights Bill Gates and Warren Buffet, among others, have come out publicly in favour of keeping the estate tax. They argue this will encourage philanthropy and discourage what they see as the unhealthy concentration of wealth in the hands of descendants who did little to earn it – similar arguments to those advanced by famous U.S. philanthropist Andrew Carnegie in support of inheritance taxes over 100 years ago.
But I'm Canadian – why should I care?
Canada does not have an inheritance or wealth tax per se, although our income tax system taxes capital gains and various other amounts accruing to the date of death. This leaves many Canadians blissfully unaware of the potential cost to them of U.S. estate tax – and not just for the extremely rich. Consider Joe, a single Canadian independent business owner/manager who has worldwide net assets of $5 million (all figures USD). Much of this wealth is tied up in shares of his private corporation. He owns no U.S. property other than a vacation home in Florida he just purchased for $1.2 million. Joe may be surprised to learn that if he dies in 2011 (barring legislative changes before then), Uncle Sam will collect a whopping $345,000 from his estate – 29% of the total value of his U.S. real estate!
The Canada-U.S. tax treaty now provides that Joe's estate can apply the U.S. estate tax paid to reduce Canadian income tax payable on the deemed gain at death. But that is often small relief; the amount of the estate tax, based on the gross value of the property, is often well in excess of the Canadian income tax, which is computed only on the capital gain.
If the present law remains unchanged, in 2011 the maximum estate tax rate will revert to 55%, and the basic exemption, under which an estate escapes the tax altogether, will fall back to $1 million from its highest level of $3.5 million (to be reached in 2009). U.S. assets subject to the tax include U.S. real estate, stocks and bonds of U.S. corporations, and other U.S.-situs property. Exemptions, for those who are not citizens or residents of the U.S., are pro-rated based on the proportion of U.S. assets to worldwide assets, meaning two individuals with similar U.S. assets may have varying tax bills based on their total wealth. In our example above, if Joe's worldwide estate is $10 million, the estate tax bill on his $1.2 million Florida home increases to $386,000.
Estate tax planning
There are various strategies to reduce or defer U.S. estate tax liabilities. One method is to hold U.S. property in a Canadian corporation, in which case the shares are not considered to be U.S. property for estate tax purposes. The downside is that this can worsen the U.S. tax bite on a sale of the property since corporations do not benefit from the lower long-term capital gains rates that individuals enjoy. And where the property is used personally, a Canadian tax benefit can be attributed to the shareholder.
Other options include ownership of U.S. property by a U.S. or Canadian trust, or a partnership, or structuring debt such that the net taxable U.S. estate is reduced. Some simply purchase life insurance to fund the ultimate tax liability.
The solutions are complex and will depend on your particular circumstances. Advance planning involving both Canadian and U.S. tax advisors can be critical as some strategies are effective only if carried out prior to the initial acquisition of U.S. property. Planning is particularly important for U.S. citizens living in Canada, who are taxable on their worldwide estates.
Dean Woodward is a tax partner in Collins Barrow's Calgary member firm.
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