As cross-border specialists, one of our key concerns in working with each client is the question of citizenship. This is especially true for estate planning, as developing a plan without taking into account citizenship could have dire tax consequences and create hardship for a surviving spouse.
According to current estate tax law, an immediate tax can be enforced on assets passed to a spouse who is a foreign citizen. Cross-border estate planning plays an important role in preventing a hefty tax bill due to these U.S. estate tax rules. If you’re in a similar situation, here’s what you need to know.
Estate Planning Basics
When we work with a married couple to develop an estate plan, one of our key goals is to preserve and protect assets for the surviving spouse and children. Fortunately, with advanced planning, federal estate taxes can often be reduced or avoided.
Currently, if you die with a taxable estate worth over $5.34 million, the IRS can take 40% of the excess. One common approach to avoid this federal estate tax rule is to give away some of your assets to children and grandchildren upon your death, either directly or through trusts, with the remainder going to your surviving spouse. You can bequeath an unlimited amount to your spouse free of federal estate taxes—as long as your spouse is a U.S. citizen.
You can also gift away an unlimited amount to your spouse before you die without incurring a federal gift tax if he/she is an U.S. citizen. This ability to make unlimited, tax-free wealth transfers to your spouse is known as the “unlimited marital deduction.” This privilege is an essential part of many estate and gift tax planning strategies.
The Citizenship Conundrum
Unfortunately, traditional estate tax planning strategies that work for most married couples—such as the unlimited marital deduction—are not available when one spouse is not a U.S. citizen. In 1988, the U.S. Congress eliminated the unlimited marital deduction for when a U.S. citizen spouse passed property to a surviving non-citizen spouse. This has resulted in a significant dilemma and substantial federal estate tax rates for those leaving assets to a spouse who doesn’t hold U.S. citizenship. Further, when the marital transfer rules changed, a new rule was also introduced that limits the annual transfer of assets directly to a noncitizen spouse without incurring any tax.
Let’s look at an example to see the impact this would have. Let’s say a U.S. citizen husband passes away, leaving $5.34 million to his children and the remaining $1.5 million to his non-citizen wife. Given the $5.34 million federal estate tax exemption, the amount left to the children is free from federal estate taxes; however, the $1.5 million left to the non-citizen spouse is not exempt. What’s the damage? $600,000 ($1.5 million x 40%) in federal estate taxes! Let’s say the husband leaves his entire estate worth $6.84 million to his non-citizen wife. The federal estate tax is still $600,000 because the initial $5.34 million is protected by the federal estate tax exemption.
Another problem that arises is that U.S. assets bequeathed to a surviving non-citizen spouse using the estate tax exemption may still be subject to estate taxes upon the death of that non-citizen spouse. This is because a non-citizen spouse who is not “domiciled” in the U.S. will only have a $60,000 lifetime exemption instead of the $5.34 million exemption.
What are some estate planning options if you or your spouse don’t qualify for the unlimited marital deduction? Let’s return to our example.
For starters, our married couple could take steps to have the wife become an American citizen before her husband’s death. Another alternative is to set up a Qualified Domestic Trust (QDOT), which would enable our couple to defer the estate tax until the death of the surviving non-citizen spouse. How does it work? A QDOT allows for assets to be held in trust for the noncitizen spouse without incurring an estate tax, thereby putting off taxation until the spouse’s death or assets are withdrawn. This would also provide an annual income stream for the wife and allow extra time for her American citizenship to come through. Under the Canadian Income Tax Act, a properly structured QDOT can also qualify as a spousal trust.
If certain qualifications are met, another cross-border approach we take with our clients is to look at the marital credit of the U.S./Canada Tax Treaty. It’s important to note that this route and the QDOT option cannot be used together.
Another consideration is to introduce a gifting strategy where the husband gifts property to his wife; as much as $145,000 per year would be allowable as a tax-free transfer under current tax law. Such gifts can help reduce the amount of assets passed to a non-citizen spouse and also help mitigate tax issues down the road.
In addition to these options, there are a number of cross-border planning approaches that can be established in advance as part of a total financial planning process. Life insurance, real estate and retirement plans should all be examined to look at opportunities to protect assets from taxable events upon death.
We advise families that a careful, advanced planning approach is the key to avoiding potential pitfalls when a spouse is not a U.S. citizen. After all, one of our most essential roles as an advisor is to help minimize the negative impact of estate taxes for a family and a surviving spouse dealing with the loss of a loved one.
Terry Ritchie is the Director of Cross-Border Wealth Services at the Cardinal Point, a cross-border wealth management organization with offices in the United States and Canada. Terry has been providing Canada-U.S. cross-border financial, investment, tax, transition, and estate planning services to affluent families for over 25 years. He is active as an author, speaker and educator on international tax and financial planning matters. www.cardinalpointwealth.com