It’s not uncommon for Canadians to move to the U.S. for school or work, and settle there permanently. Estate planning for the wealthy parents of these emigrants requires special attention.

Cross-border planning is complicated by the fact that inheritances are subject to both Canadian and U.S. tax rules. Plans must consider tax efficiency in settling the estate of the Canadian parents, as well as how the funds are treated in the hands (and, later, the estates) of U.S.-resident beneficiaries.

A key issue relates to assets U.S residents inherit; specifically, U.S. estate tax exposure when those beneficiaries later die.

To illustrate the issue, consider the following example. Doug and Mary are Canadian residents and citizens in their 70s. Their net worth is $6 million, consisting mostly of non-registered cash-equivalent investments supporting their retirement. Their only child, Susan, attended Harvard medical school and is now a pediatrician practicing in Boston. She’s divorced with two young children.

Susan’s built up approximately $5 million in investible assets, and has a $2 million term-life insurance policy. From a Canadian tax perspective, the estate plan is fairly straightforward.

Canada imposes a deemed disposition (and consequential capital-gains tax) on assets passing to anyone other than a surviving spouse. Because Doug and Mary only have liquid assets, there won’t be much tax.

But Susan will face a major U.S. estate tax problem when she receives that $6 million inheritance. And once she gets the funds, it’s too late to fix the problem. Planning needs to be done before her parents die.

U.S. estate tax is significantly different from Canada’s deemed disposition on death. Under U.S. law, the estate of a deceased person is taxed based on its fair market value on the date of death, regardless of where the assets are located. Tax rates are graduated through the first $1 million, after which a 40% rate applies. For U.S. citizens and permanent residents, there’s an exclusion that allows a portion of an estate to pass tax- free. In 2014, the exclusion amount is $5.34 million.

Susan is a U.S. resident for estate tax purposes. Even without the inheritance from her parents, she would have some tax to pay on death.

The reason is life insurance proceeds are included in the estate of the policy’s owner. So, setting aside the inheritance, Susan’s taxable estate would be $7 million. If she were to die this year, the estate tax bill would be about $664,000.

reduce taxes formula 1

There’s a solution to the life insurance problem. Susan’s policy could be held by an Irrevocable Life Insurance Trust (ILIT), which would prevent the policy’s proceeds from being taxed in her estate. (A detailed discussion of ILITs is beyond the scope of
this article.)

Assuming the ILIT is set up properly, Susan’s taxable estate would be $5 million before the inheritance. This leaves her below the current exclusion amount, though not by much. But when Susan inherits $6 million from her parents, it will trigger just over $2.25 million in estate tax on
her death.

reduce taxes formula 2

Susan’s earning potential and investment growth only increase her U.S. estate tax because they push her even further beyond the $5.34 million threshold.

One possible solution is a dynasty trust. It’s an irrevocable trust that can transfer family wealth from one generation to the next without U.S. estate tax consequences. But it has to be carefully drafted to avoid rules that can pull trust funds back into a trustee or beneficiary’s taxable estate.

Dynasty trusts are not used in Canadian planning because of the unfavorable tax rules that apply to Canadian trusts. These rules generally cause trusts to be wound up in 21 years or less.

But a U.S.-resident trust is limited only by the rule against perpetuities, a trust-law concept that many states have abolished or made irrelevant. There are two main ways to set up a dynasty trust.

One would be to draft it into Doug and Mary’s wills as a testamentary trust. Rather than directly naming Susan as a beneficiary, the wills would establish a trust for her and her children’s benefit.

Alternatively, before Susan’s parents pass away, she could establish a dynasty trust, which would be named beneficiary of Doug and Mary’s wills.

The trust could be formed with a nominal contribution, and lay dormant until Susan’s parents die. At that time, it would receive the inheritance, rather than Susan. Properly drafted dynasty trusts avoid U.S. estate tax for future generations, while also allowing Susan and her children to access as much of the trust income as they need in a given year. Some encroachment into trust capital is also permissible, though limitations are necessary if Susan is to serve as trustee. Finally, drafters of dynasty trusts must be mindful of U.S. and Canadian tax rules on trust residency.

To maximize benefits and avoid tax pitfalls, the trust must be considered U.S. resident and Canadian non-resident.

The Canada-U.S. tax treaty provides little relief on trust residency, so domestic rules must be applied.

Notwithstanding complexity around preparation and drafting, dynasty trusts are an extraordinary opportunity for Canadians to leave wealth to U.S. resident beneficiaries in a long-lasting and tax efficient manner.

Advisors with clients in this situation should explore this possibility before the opportunity’s lost.

David A. Altro is a Florida attorney, Canadian legal advisor and the managing partner at Altro Levy. He can be reached at 416-477-8155 or Jonah Z. Spiegelman is a partner who leads the Altro Levy Vancouver practice and specializes in cross-border tax and estate planning. He can bereached at 604-569-1445 or

Originally published in Advisor's Edge Report


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