What’s new about the U.S. estate tax

“[Most] taxpayers are not subject to the U.S. estate tax. It only targets the extremely wealthy,” notes Dean Smith, partner with Cadesky and Associates LLP in Toronto.

Under the U.S. Tax Cuts and Jobs Act, the exemption threshold for estate taxes increased to $11.4 million for 2019 from $5.49 million per person in 2017. For Canadians and other non-U.S. citizens, determining whether U.S. taxes are owed depends on the value of their worldwide assets, including their U.S. property and securities holdings. The formula used to make such a determination is complicated.

“The math is convoluted, [but] the way it always works out is that if the global estate is less than $11.4 million, you will not owe U.S. estate taxes,” says Reed.

The top U.S. estate tax rate is 40% of the value of the property. “This could create a sizable tax bill when any Canadian resident who owns U.S. real estate or a large U.S. stock portfolio dies: under domestic U.S. law, only $60,000 of U.S. property is protected from estate taxes,” Reed wrote in a column for Advisor’s Edge.

In other words, if a Canadian resident dies while owning U.S. assets – stocks, bonds, real estate, etc. – the total value of which adds up to more than $60,000, the resident’s estate must file for a treaty exemption by completing Form 706-NA. The exemption (i.e., the paperwork) notifies the U.S. government that the estate has reported its assets as required by law, but no money is owing because the estate’s assets are below the $11.4-million threshold.

Completing the form can be time- consuming, says Beth Webel, national personal tax leader with Toronto-based PwC Canada in Oakville, Ont. “The form is not a big deal to fill out, but you will need to gather a lot of information.”

Webel notes that much of that information also may have to be collected for Canadian income tax purposes. Completing both forms on behalf of your client may be easier and faster than if the client completes the forms on their own.

You also should speak with your clients about this part of the process, Reed says: “Lots of people don’t know about the filing exemption. They think because they are under the limit, they don’t have to do anything.” Such thinking could land the estate in financial hot water with U.S. tax officials.

Form 706-NA requires disclosing detailed information about all the deceased’s worldwide assets, including what’s known as U.S.-situs property (property situated in the U.S.), such as securities, real property and U.S. mutual funds. The estate must provide values in US$, as determined according to U.S. tax principles, for each asset.

“Obtaining proper valuations is costly and burdensome, and undervaluation can result in onerous penalties,” Reed wrote in his column. “Perhaps most important, not filing Form 706-NA at all can result in beneficiaries inheriting U.S.-situs assets with a cost base of zero. This means that when they later sell the property, all proceeds will be taxed as a capital gain.”

Timing is another important consideration. The form requesting an exemption is due within nine months of the property owner’s death, but many people may not think of this if the date is not around tax time, notes Webel: “Advisors need to be aware.”

There is another wrinkle related to the new estate tax exemption: it expires. Under the legislative sunset clause, if timely action is not taken, the exemption threshold will revert to $5 million, adjusted for inflation, in 2025. Even so, the threshold could change after the 2020 U.S. presidential election, cautions Reed, co-author of the book, A Tax Guide for American Citizens in Canada. He points out that historically, the Republicans have not favoured an estate tax, contending it amounts to double taxation, while the Democrats have supported such a tax as a means of getting the wealthy to contribute more to government coffers.

The uncertainty of what lies ahead means you will need to run different scenarios based on different exemption thresholds.

“Don’t assume things will be exactly the same,” cautions Webel. She recommends you have the discussion now with your clients in case they want to make changes to their worldwide assets, especially property. “It’s much harder to move U.S. real estate around,” she says. “It’s important to have a conversation.”

Even if no changes are anticipated, you need to look beyond the sunset date, Smith says: “It is prudent to do some planning for post-2025, when the limit may drop.”

One method of planning may involve a person making large gifts while alive and before 2025. In November 2018, the U.S. Internal Revenue Service (IRS) clarified that making large gifts before the sunset date “won’t harm estates.”

“People taking advantage of the increased basic exclusion amount [BEA] by making gifts during the period 2018 to 2025 will not be harmed after 2025, when this [threshold] amount is scheduled to drop,” according to an IRS Q&A document. “The regulations provide a special rule that effectively allows the estate to compute its estate tax credit using the greater of the BEA applicable to gifts made during life and the BEA applicable on the date of death.”

A POTENTIAL U.S. WEALTH TAX

With Massachusetts Senator Elizabeth Warren rising to near-frontrunner status in the race to become the U.S. Democratic presidential candidate, the possibility of a wealth tax being implemented in the U.S. has increased.

Warren is likely to impose a 2% annual tax on household net worth valued at US$50 million-US$1 billion, above which the threshold would rise to 3%.

Warren’s net-worth calculation includes residences, closely held businesses, retirement assets, assets held in trusts or held by minor children, and personal property valued at more than US$50,000.

The policy rationale is to curb growing inequality because the superrich reportedly do not pay their share of taxes. Some supporters of the rationale point to the influence of French economist Thomas Piketty, who found the rate of return on capital exceeds productivity and wage growth, thus contributing to more income and wealth for the affluent.

Warren’s platform states the richest 130,000 American families hold almost as much wealth as the poorest 117 million families. Here in Canada, a 2018 report by the Canadian Centre for Policy Alternatives notes that fewer than 100 families, each with net worth of more than $1 billion, have accumulated more wealth since 1999 than the poorest 12 million Canadians.

Warren’s proposed tax has a 10-year revenue estimate of US$2.75 trillion and includes a “significant increase” in the Internal Revenue Service’s (IRS) enforcement budget. To prevent capital flight, she would levy a 40% “exit tax” on net worth above a $50 million threshold for Americans who renounce their citizenship.

Wealth taxes abroad

A 2018 report by the OECD tracked the decline of wealth taxes among OECD-member countries – from 12 in 1990 to four in 2017. According to the report, governments repealed the taxes due to administrative concerns and because the taxes failed to redistribute wealth and generate revenue.

The OECD report states there is a case for addressing wealth inequality through taxation, as wealth inequality far exceeds income inequality. However, the report adds, taxing wealth via capital income taxes and inheritance and gift taxes may make more sense.

For countries implementing a wealth tax, the OECD report recommends:

• a high threshold to target only the very wealthy, thus avoiding an excessive burden and capital flight
• keeping the value of taxpayers’ total net wealth constant for a few years to avoid annual assessments
• limiting debt deductibility
• developing third-party reporting
• avoiding international double- taxation on wealth.

— Mark Burgess