If you have clients who are U.S. citizens, you should be aware of a variety of different U.S. income tax, gift tax and estate tax issues that can directly affect them and influence the way you construct their financial plans.

Americans living in Canada who don’t comply with their U.S. tax obligations could find themselves in hot water with the U.S. Internal Revenue Service — if not today, then at some point down the line.

“The risks of getting caught are increasing. The technology is getting better, and the tracing is getting better,” says Prashant Patel, vice president of high net-worth planning services with Royal Bank of Canada’s wealth management services in Toronto. “There are penalties for non-filing and non-reporting, and there have been cases of greater scrutiny at the border if you haven’t filed or you are delinquent on taxes payable.”

Because the U.S. tax code is based on citizenship, not just residency — unlike in Canada and most other countries — Americans fall under the U.S. tax regime no matter where they live.

“Even though these individuals may not own any assets in the U.S., spend time in the U.S. or generate income from the U.S., they still have to comply with all of the U.S. tax rules,” says Terry Ritchie, a certified financial planner and partner with Transition Financial Advisors Group Inc. , based in Calgary and Phoenix, and co-author of The American in Canada (ECW Press, 2008).

The most obvious implication of this is that Americans must file a U.S. tax return annually on all their worldwide income, no matter the country in which they reside.

Of course, if that client is also a Canadian citizen or a Canadian resident, as defined by the Canada Revenue Agency, he or she must file a Canadian tax return annually, as well.

Although preparing two tax returns each year can be an administrative nuisance, it usually does not result in double taxation. That’s because U.S. citizens in Canada will pay the greater of the two tax liabilities — usually the one assessed by Canada — and then claim a foreign tax credit on their U.S. return.

Also, if certain conditions are met, U.S. citizens can be exempted from taxation on up to US$91,400 of Canadian-source employment income under a “foreign earned income” tax exclusion. This exclusion, however, does not include investment income.

Many U.S.-citizen clients are unaware of their U.S. tax obligations. They may neglect to file a U.S. tax return or may breach other U.S. tax laws for years without hearing from the IRS. However, those clients may find themselves on the IRS’s radar screen if, among other things, they are asked about their tax obligations as they cross the border into the U.S., buy property in the U.S., sell U.S. investments or become a beneficiary of a U.S. estate or trust.

Ritchie tells of a Canada-based U.S.-citizen client who found himself the beneficiary of a U.S.-based estate after his mother, who lived in the U.S., died. “After the client, who had a social security number, sold the estate, the IRS noticed that he had received money and had sold stock,” Ritchie says. “They contacted him, asking: ‘Where are your tax returns?’ Now, he had no choice but to go ahead and get compliant.”

A U.S. citizen can get back onside with the IRS by filing an income tax return for each of the previous six tax years, which can be a hassle but not necessarily financially punitive. “In most cases, when the foreign income-tax exclusion and the foreign tax credits are factored in, the U.S. citizen should end up paying no U.S. taxes,” Ritchie says. “But if there are some U.S. taxes, there would be late-filing penalties and interest.”

If a U.S. citizen, at any time of the year, has a sum of more than US$10,000 in all of his or her non-U.S. bank or financial institution accounts, he or she must declare those assets annually to the U.S. Treasury Department using Form TDF 90-22.1 by June 30 of the following year.

“The hammer that the Treasury has for failing to file by that date is that they could assess several criminal penalties — and there can be significant fines,” says Maria Snelgrove, a senior manager with the global wealth and employer services group of Deloitte & Touche LLP in Winnipeg.

@page_break@In addition, U.S. citizens who have RRSPs in Canada must file an IRS Form 8891 annually for each RRSP, in order for the U.S. to consider the income generated within those plans as being tax-deferred.

However, the IRS does not recognize the tax benefits of RESPs or tax-free savings accounts. “U.S. citizens can contribute to these plans under Canadian tax law,” Ritchie says, “but they won’t derive any tax and estate benefits from them in the U.S.”

In addition, U.S. citizens who hold TFSAs and RESPs would have to disclose their holdings in any of these plans annually to the IRS, adding yet another layer of paperwork for the U.S. citizen. In most cases, Ritchie says, it may not be in a client’s interest to hold one of these plans. However, it’s conceivable that a U.S. citizen could, over the years, have built up enough foreign tax credits to offset U.S. taxes due on the income generated in these plans, making them worthwhile to hold.

U.S. citizens should also avoid holding Canadian mutual funds and exchange-traded funds outside of registered plans, as they are regarded as passive foreign investment companies (PFICs) by the IRS. When a Canadian mutual fund or ETF is sold, any capital gains are taxed at a rate of 35%. As well, the U.S. considers the capital gain from a fund to have been deferred over the length of the ownership of the fund. Interest is then assessed on the gain, exacerbating the tax hit.

For U.S.-citizen clients, individual stocks would be preferable for the non-registered portion of their portfolios. As well, ETFs listed on a U.S. stock exchange, says RBC’s Patel, would allow the U.S. citizen to avoid the PFIC problem.

U.S. citizens resident in Canada also need to keep in mind U.S. gift-tax rules, which would still apply to them even though they may no longer live, earn income or have assets in the U.S.

U.S. citizens have a lifetime gift-tax exemption of US$1 million. However, if the exemption is taken, the estate-tax exemption, which stands at US$3.5 million for 2009, is decreased by the same amount. U.S. citizens are limited to an annual gift-tax exclusion of US$13,000 (2009 limit) for each recipient. U.S. citizens do not have to pay taxes on gifts to a U.S.-citizen spouse but are limited to US$133,000 (2009 limit) annually if the spouse is not a U.S. citizen.

“With proper planning,” Patel says, “gifts are a way to whittle down an estate.”

U.S. citizens are also subject to U.S. estate taxes, regardless of where they live. If a U.S. citizen’s worldwide estate is worth more than US$3.5 million, estate taxes of up to 45% are levied on the value of the worldwide estate, including assets such as RRSPs and a personal residence in Canada. The value of any life insurance proceeds payable to the estate are considered in the calculation of the total value of the estate.

In addition to the U.S. estate taxes, a U.S. citizen resident in Canada is subject at death to Canadian taxes on the capital gains of the deemed disposition of all assets. However, with some proper tax and estate planning, a U.S. citizen resident in Canada can receive credit in one country for the estate taxes he or she pays in the other.

Some Canadian advisors suggest that U.S. citizens resident in Canada consider renouncing their U.S. citizenship as a way of avoiding the U.S. tax regime. This process can be financially onerous, Ritchie warns, and could affect a client’s ability to enter the U.S. in the future.

Under expatriation rules introduced in June 2008, there is a deemed disposition of worldwide assets at the time of expatriation, with a 15% tax levied on any capital gains above the basic exemption of US$626,000.

The expatriation rules apply only to “covered expatriates”— those U.S. citizens who have a net worth greater than US$2 million, had an average tax liability of more than US$145,000 for the previous five years or who have failed to certify that they have filed U.S. income tax returns for the five years prior to expatriation.

It’s important to note that if you have a Canadian client who holds a U.S. “green card,” which gives a non-U.S. citizen lawful permanent resident status in the U.S., he or she would also fall under the U.S. tax regime, even if they move back to Canada. Green-card holders would be subject to the tax obligations of a U.S. citizen until such time as the green-card status is formally revoked or abandoned. IE