Uncle Sam’s Nasty Surprise for Non-U.S. Citizen Spouses

Uncle Sam’s Nasty Surprise for Non-U.S. Citizen Spouses

Are you a U.S. citizen married to a non-U.S. citizen? Or, are you and your spouse both green card and/or U.S. visa holders living in the United States?

If so, then you’ll want to be aware of U.S. estate-tax rules that, without proper planning, can result in an outsized tax bill.

Recently, we started working with an American client who has a significant estate and lives and works in the United States. His wife is a Canadian citizen and U.S. green card holder, but not a U.S. citizen. The couple does not have kids.

In a recent tax-planning session, our American client was shocked to learn that any gifts between he and his wife may be subject to tax rates as high as 40%. The same high tax rate may apply to any inheritance left by a deceased spouse to the surviving spouse. Our client’s surprise was understandable, because the rules are very different for couples who are both U.S. citizens.

Most Americans leave the bulk of their estate to their surviving spouse, because most of it can be transferred without tax consequences. In particular, under the “unlimited marital deduction,” if a person leaves his or her estate to a spouse, there is no estate tax on the transferred property, regardless of the size of the estate.

Simply put, the IRS is willing to wait until the second spouse dies before levying an estate tax. Similarly, married couples are free to make unlimited inter-spousal gifts without incurring gift taxes.

By the way, because of the U.S. Supreme Court’s recent DOMA decision, same-sex couples can now join heterosexual couples in transferring as much of their estate as they like to their spouse, free of gift or estate taxes. The catch is that both spouses must be U.S. citizens.

The IRS sees things differently when it comes to transfers in which one spouse is not a U.S. citizen. The “unlimited marital deduction” treatment does not apply to a foreign spouse because the IRS is afraid the non-citizen spouse will move to another country, thus avoiding U.S. gift and estate taxes altogether.

Without the availability of the marital deduction, current law permits the first $5,430,000 (adjusted for inflation) of assets to be transferred tax-free. In other words, an inheritance left to a non-citizen spouse is subject to a 40% estate tax after the $5,430,000 lifetime exemption is used up.

So what should you do if you are married to a non-citizen and your estate is above the exemption threshold?

Let’s use our clients as an example. The wife could become a U.S. citizen prior to the husband’s death. Or they could establish a qualified domestic trust (QDOT). A QDOT defers the estate tax until the death of the foreign spouse, and allows for an annual income stream to be paid to her. Moreover, it can buy time for the surviving spouse to acquire U.S. citizenship.  

Gifting strategies can also be used to transfer a certain amount of assets to the non-citizen spouse each year (the 2015 limit is $147,000). This will gradually reduce the size of the U.S. citizen’s taxable estate while protecting them from federal gift-tax liability.

Alternatively, if certain conditions are met, our clients can take advantage of the marital credit under the Canada-U.S. tax treaty. This option, however, can’t be used in conjunction with the QDOT deferral.

As our clients learned, there are certain planning strategies and legal structures that, if set up in advance, can help cross-border couples avoid losing up to 40% of their wealth through unnecessary taxes.

If you would like more information about this topic, or to discuss your own unique situation, please contact us today for a confidential consultation.

www.cardinalpointwealth.com

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The US is the sole western country in the world that imposes tax on its voters no matter where they live and regardless of where income is earned. Most countries need solely residents to pay tax. If you exit Canada, for example, you don’t must file any a lot of Canadian tax returns.

The US policy is totally different. Moving faraway from the homeland doesn’t mean you are free from the Internal Revenue Service (IRS). You are needed to file your US tax returns each year, report your worldwide income to the IRS and pay any tax imposed by the US tax laws.

Since Canadian residents report worldwide income to the Canada Revenue Agency, US voters living in Canada have significant compliance necessities in order to stay up with filings in each countries on income from every supply.

US citizens should file personal income tax returns on Form 1040 every year. All worldwide employment income, interest, dividends and gains are reported. US tax rules, that often differ from Canadian rules, apply to see whether US tax is payable in an exceedingly given year.

Thankfully, there are a selection of mechanisms on the market that forestall double taxation on most of those sorts of income. As discussed below, most US citizens living in Canada will keep compliant just by filing properly. Typically there is no excess tax payable within the US.

Foreign Earned Income Exclusion

The Foreign Earned Income Exclusion (FEIE) is accessible to exclude up to $99,200 (in 2014) of employment or business income earned outside the US. As long as you are actually living and operating more often than not in Canada, the IRS can not tax even a terribly smart wage. However, unearned income, such as interest, dividends and capital gains, can't be excluded beneath the FEIE.


For those living a a lot of cross-border lifestyle, the residency limitations of the FEIE could cause problems in addition. The FEIE is only obtainable if you meet the “factual foreign resident” (BFFR) take a look at or the “physical presence check” (PPT).

To demonstrate standing as a BFFR in Canada, a personal would most typically must file a Canadian tax come back as a resident of Canada throughout the full year. There are special relieving provisions for folks who move to or from the US in a very year.

The physical presence take a look at requires the individual spend a minimum of 330 days during a twelve-month amount outside the United States.

To take the FEIE, a personal must have their “tax home” outside the United States throughout the year (for a BFFR), and for the 330-day amount (underneath the PPT). A tax home is mostly the main place that a private works, if he or she works, and the most residence, otherwise.

Foreign Tax Credits (FTCs)

Where annual income is greater than the FEIE exclusion quantity or non-wage income is received, FTCs are fundamental to ensuring that almost all kinds of income don’t get taxed twice. Generally, taxes paid to a distant country on income earned will generate a nonrefundable credit within the US, canceling out the US tax on that item of income.

Canadian personal tax rates are, for the overwhelming majority of individuals, beyond US rates, thus the FTC regime can nearly perpetually guarantee that Americans in Canada who don't have any US-supply income pay no US tax.

Those who have US income can usually find that the Canadian FTC can offset the US tax, thus there is no double taxation. In these cases, the whole tax is the same as if all the income were earned in Canada; all one is doing is allocating how a lot of goes to each revenue authority.

However, there are a number of complicated rules related to the supply, timing and character of income that may limit the number you can claim. Therefore, particularly when entities like companies or trusts are concerned, careful planning is vital to maximize the FTCs available.

Problems Remain

The biggest issues arise when an item of income is taxed in one country and not in the other. A smart example is when a US citizen sells their principal residence in Canada for a considerable gain. Beneath the Income Tax Act of Canada, the transaction is exempt from capital gains tax. The historic increase in property values, particularly in massive Canadian cities, means that that baby boomers looking to downsize their homes can receive windfalls of tax-free money.

However, beneath US law, each person can solely claim $250,000 as a capital gains exemption for a principal residence, with any excess taxed by the IRS at rates up to 23.four per cent. So, if Jane, a US citizen, sells her home for a $five hundred,000 gain, she could have to write down a cheque to the IRS for more than $fifty seven,00zero of tax without credits in Canada. If Jane co-owned the home as a joint tenant together with her husband, she would typically solely claim her half of the gains, therefore that a total capital gain of $five hundred,00zero could occur while not tax. This exclusion of capital gains tax only applies if Jane has owned the house and lived in it for at least two years within the past five year amount. Again, there are exceptions to the present rule, like for individuals who are required to maneuver for their work.

There are alternative instances where the mechanisms in place meant to forestall double taxation fall short. As discussed in later chapters, the tax treatment of sure sorts of entities will complicate tax coming up with for a US citizen living in Canada.

Furthermore, fluctuations in the relative values of the Canadian and US dollar can lead to disproportionately high capital gains in one country with tax owing as a consequence.

For the most part, maintaining compliance with US tax necessities is little more than paperwork. Nonetheless, as mentioned in the subsequent chapter, the paperwork can be quite burdensome all by itself. And then there's the estate planning that ought to be implemented to stay US tax exposure as low as legally potential. Click Here to more about americans working in canada taxes