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Estates & Trusts

US-Resident Child: Estate Planning

Originally published in Canadian Tax Highlights, Volume 15, Number 10, October 2007. Reprinted with permission.

Canadian parents face challenging tax and estate planning issues for children living in the United States. Unlike Canada, the United States taxes its permanent residents and citizens on the full FMV of assets passing at death. The estate tax credit that shields the first US$2 million of assets increases to US$3.5 million in 2009; the estate tax is then repealed for 2010, but is revived in 2011 with an exemption of US$1 million. A US generation-skipping inheritance trust may provide some relief.

Among other disadvantages, the outright disposition of property to a US-resident child may unnecessarily augment the child's own estate for US estate tax purposes. A bequest via a disposition to a testamentary trust may also create significant tax exposure because of the US foreign trust accumulation rules. The hallmarks of a properly drafted US generation-skipping inheritance trust are flexibility and control. The trust assets are not subject to US estate tax on the child's death because the assets pass directly to the grandchildren and not through the child's estate. The child may be given liberal access to the trust assets, so long as the access is defined by an ascertainable standard such as health, support, maintenance, and education. As a result, the trust's value is excluded from the child's US estate on his or her death, even if the trust grows considerably in value. Accordingly, the grandchildren inherit the trust assets undiminished by a liability for US estate tax on the child's death. The child may act as sole trustee of his or her generation-skipping trust without adverse US tax consequences, directing investments and controlling distributions to family members during his or her lifetime. The child may also determine how the trust assets pass to family members at death. The child may invest in almost any type of asset (for example, a vacation home or artwork); because the child is the trust's primary beneficiary, there is little to fetter the child's use and enjoyment of the assets. The trust assets may be used for the child's benefit (and for the benefit of his or her descendants) but are not accessible to the child's (or descendants') creditors. Thus, the child may use the trust assets to purchase, for example, a vacation home; provided that the title to the asset remains in the trust's name, claims against the child or his or her descendants will not result in a lien against the property.

A Canadian-resident and Canadian-citizen parent is not subject to US gift and estate tax and thus may transfer property of unlimited value to an inheritance trust, except for the transfer of US-situs assets, which does attract gift tax to the non-resident. The most effective inheritance trust is one structured as a US domestic trust under US income tax law; this is accomplished by designating a US trustee (typically the child) and a US jurisdiction for the trust's governing law. A US trust is preferred because a Canadian trust is subject to the 21-year deemed disposition rule, effectively limiting the benefits to 21 years. Furthermore, a non-US trust that is not properly administered may generate significant tax exposure for the US beneficiary under the US foreign trust accumulation rules. The inheritance trust is established inter vivos as an irrevocable trust, typically by a parent (or a "friendly" US grantor) and funded only nominally on creation. The trust's primary funding is derived from the Canadian parents' estates, often on the death of the surviving spouse, by means of a "pour over" provision in their wills.

Katherine E. Cauley
Hodgson Russ LLP, Buffalo