Got Heirs in the U.S.? Dynasty Trust Planning for Wealthy Families

Welcome back. The US Census Bureau says there are more than 800,000 Canadian immigrants in the US. And if one of them is your children, or a potential heir, and you have a lot of money to pass down to them, be prepared for a bit of a tax challenge.

Tax laws here and south of the border are very different. Chris Gandhu is a high net worth planner with TD Wealth. And I spoke to him earlier to ask him about some of the ways and some of the things you need to think about if you want to make sure you can pass on that money and make sure most of that money gets to who you want to give it to.

Well, in any cross-border situation, Kim, you have to worry not just about the Canadian tax implications but also the US tax implications. And they're not always the same. So that really is the crux of the issue.

Hmm. So tell us a bit about why they're not the same.

Well, two different countries, two different tax regimes. If we look at the US, they have two tax streams. There's income tax and transfer taxes.

Canada doesn't have the transfer tax regime. We just have income tax.

Huh.

That's one example.

Now let me ask you, as well, I know part of this is also dependent on how the US sees somebody-- I mean, whether you are a US citizen or not. So what qualifies as a US citizen in the eyes of the IRS?

Yeah, no, very good point. So a Canada tax is based on residency. So if you're a Canadian resident, it doesn't matter whether you're a Canadian citizen or not. You're paying taxes in Canada.

The US, however, taxes based on citizenship and permanent residency. So if you're a US citizen or a green card holder, you are paying taxes in the US on your worldwide income.

Hmm.

Right? So that's another example of how the two streams are different.

So let me ask you, if you are somebody in Canada-- again, this is a good problem to have-- and you have $5 million in cash or investments or property that you want to pass on to somebody in the States, what should you do?

Well, if you aren't going to use it, you should pass it out right away. There is a very generous exemption in place for US citizens today. It's $5.49 million, which means that once they have the property in their hands, they can gift it, transfer it to their children, for instance. But as long as their worldwide wealth is below that threshold, they will not face any additional US transfer tax.

When you say "their wealth," you mean the people who are receiving the wealth.

That's exactly right.

OK, now I do know from the little research that I have done is that if you do go over that threshold, things are different. What happens then?

Yeah, if you go over the $5.49 million threshold, then there is a tax of 40%. That's the rate effective for transfers in excess of $1 million. And the particularly nasty thing about this tax is that it's not related to income. So it doesn't matter if the property you're transferring has a gain or a loss. It's strictly a 40% haircut off the top.

Oh, wow.

Yeah, so it can substantially diminish a family's estate.

Let me ask you, because I know you've got an example that you brought with us just to illustrate this. I think if someone has a worldwide estate of $10 million, and then the exemption is about $5.49 million, the tax they would pay would be about $1.8 million. That is without any other special trust or anything else in place, right?

That's exactly right. If they happen to own that property outright, the first $5 and 1/2 million exempt. And on the remaining, they'd pay about 40% in tax.

Now the whole point of getting you to come in here and talk today was not just to talk about the problem and the big haircut people will take but how to mitigate that. And there's something called a dynasty trust that can help with that. So what exactly is a dynasty trust?

Well, what dynasty trust is-- I mean, it's a fairly sophisticated US estate-planning vehicle. But the gist is that it's an irrevocable trust that can be used to pass family wealth from one generation to another without attracting this US transfer tax that we have been talking about.

Hmm. And how does it work? Or how should it work optimally?

Sure. Well, to understand that, maybe let's step back and talk about, well, how does a US transfer tax system work? And what exactly is a US transfer tax, right?

And once you get that, you'll see how the US dynasty trust works. Yeah, so the US transfer tax system, which many Canadians might not be familiar with, is essentially a three-part tax. What you may have heard of is a US estate tax, which taxes transfers at death.

But there are two more counterparts. There is US gift tax, which taxes transfers while you're alive. And then there is a generation-skipping transfer tax, which taxes transfers when you transfer wealth to somebody who is more than one generation removed, i.e., a parent to a grandchild.

But all three work the same way. And by that I mean that they have the same tax rate associated with them. They have a unified exemption, the $5.49 million that we talked about.

And they're all a fair-value tax. So they're not related to income gains and losses. It's strictly a transfer tax, right, a haircut off the top.

And the tax applies when a US person owns property. So if you own property, and you gift it, you get taxed. If you own property, and you pass away, and you transfer it to your beneficiaries, you get taxed.

So the way a dynasty trust works is essentially by using the trust mechanism to ensure that your beneficiary can receive the benefits of the property you put in the trust. But they are deemed not to own the property for purposes of this tax.

So it sounds as though that this is a great idea for anybody who is trying to do any kind of generational planning. What's the downside to a dynasty trust?

Well, planning at this level, because it's sophisticated, is very fact-specific, which means when you're setting up this trust where your children are going to be the beneficiaries, but either they are not going to be the trustees of this trust because you have an independent trustee-- and that's how the beneficiaries end up not owning the property. Or perhaps the beneficiaries are the trustees of the trust, but they have certain conditions placed on how much control they have over the trust property.

So you must draft the trust provisions very carefully. And everybody involved-- the Canadian parents, the US child-- have to understand that the plan works. But there are limitations on control.

Well, and also--

Right, so that is--

--on the control, please, if I could, also, what can the assets in the trust be used for? I mean, is there a lot of strictness around that?

Sure. So generally, there's two ways to do this. If I was the Canadian parent, I could fund this trust, appoint a third-party trustee, in which case the third-party trustee is the one who is in control of the property. And they make the discretionary decisions as to when the beneficiary receives the property. So that's the easy way to do it.

But sometimes the beneficiaries want to be involved. And that's also quite common. So if the beneficiary wants to be the trustee of their trust, obviously, they have control over the property.

But the IRS-- and the Internal Revenue Code is very clear on this, that if your control is limited such that you can only access the trust capital for your health, education, maintenance, and support, well, in that case, for purposes of the US transfer tax, you don't have requisite control. You don't have an unfettered right to write a check to yourself and do whatever you want with that money, right? So that ascertainable standard, as it's technically called-- that health, education, maintenance, and support-- that's the restriction you have over the trust property.

I'm sure we could spend a lot of time debating this. But I would think maintenance is something that can be pretty far-reaching, though.

Yeah, maintenance and support-- I mean, they are synonymous terms. And I completely agree with you. It's very far-reaching, and you could probably justify that if I'm used to a standard of living, well, that means that this money really is for my maintenance and support.

Chris, I've only got about 30 seconds for my last question. Why not just use a Canadian trust? Is there not some way that, again, for someone who is living, or a Canadian citizen wants to bequeath to somebody in the US, a Canadian trust won't cut it?

No, you could use it. But there's a bunch of downfalls. Number one, there is a tax arbitrage. The top rate of tax for a Canadian trust, for example, if it earns income and retains income in the trust-- in Ontario, it's 53 and 1/2%. Let's compare that to jurisdictions such as Florida, where the top rate is 39.6%.

Canadian trusts are subject to the 21-year deemed disposition rule. US trusts aren't. When there is a Canadian trust with a US beneficiary, there are US foreign trust rules that are very difficult to navigate. And there's a lot of compliance headaches around that.

And finally, I guess I would say that most Canadian provinces still do follow the rule against perpetuities. So if you want the dynasty trust to last for many generations-- hence the term dynasty-- to be able to pass on wealth from parent to child to grandchild to great-grandchild, you need to find a jurisdiction where the rule against perpetuities doesn't apply or has been modified. And there's many, many such jurisdictions in the US but not in Canada.

That was Chris Gandhu. He's a high net worth planner with TD Wealth, and he joined us from Calgary.