Got heirs in the U.S.? Establish your own dynasty

Tim Cestnick is managing director at WaterStreet Family Wealth Counsel and author of 101 Tax Secrets for Canadians.

tcestnick@waterstreet.ca

You have to admire a guy like Percy Miller.

He grew up in a poor neighbourhood in New Orleans, but didn't let his circumstances keep him down. He managed to turn a $10,000 inheritance into an entertainment empire worth more than $361-million. You see, after working in the music industry as a retailer, he became an entertainer and went on to establish his own record company. He was featured in Fortune magazine in 1999 where he was listed as one of the wealthiest Americans under age 40.

If you want to maximize the value of an inheritance, there are a few things you can do. You can create an entertainment empire like Percy, or you might try some clever tax planning. Now, I can make my way around on the bag pipes, but I can't dance, I'm a mediocre singer, and certainly can't play the accordion. So, I'm opting for the tax planning route.

Today I want to share with you a strategy that can work wonders if you're planning to leave any assets to your heirs who may be U.S. citizens or residents. This is going to save them potentially significant tax dollars on that inheritance.

THE PROBLEM

Let me clarify up front that this strategy is designed for Canadian citizens (or any non-U.S. person) leaving assets to someone who is a U.S. citizen, U.S. resident or a green card holder (I'll simply refer to these people as U.S. persons). If you're a U.S. person yourself, you need different planning than what I'm talking about. Okay, we're clear on that.

Here's the problem: If you give assets to, say, your kids who are U.S. persons, either today or when you pass away, those assets could cause tax problems for them. How so? Well, the U.S. has an estate tax, a gift tax and a generation-skipping tax that could apply. These are affectionately known as "transfer taxes" south of the border.

The U.S. estate tax applies at the time of a U.S. person's death, so those assets you give to your kids who are U.S. persons could eventually be subject to this tax at rates as high as 45 per cent of the fair market value of those assets at the time of their death. A U.S. gift tax can also apply if your heirs give away some of those assets to someone else during their lifetime. A U.S. person will face taxes on gifts they make at the same rates as the estate tax. Finally, there is also a generation-skipping tax that can apply to transfers that a U.S. person might make to their grandchildren or later generations (in an attempt to skip a generation of estate and gift taxes).

To be clear, these transfer taxes won't apply when you leave your assets to your kids who are U.S. persons, but when your kids in turn give those assets to their own heirs one day, these U.S. transfer taxes can apply if proper planning isn't done. And that planning starts with you.

THE SOLUTION

If you take the proper steps today, you can effectively enable your kids or other U.S. beneficiaries to defer the nasty transfer taxes - potentially for generations. You'll be doing a big favour for those who will eventually inherit from your own heirs.

In this situation, you should consider setting up a "dynasty trust" for your heirs who are U.S. persons. This is a trust that can be established during your lifetime, or at the time of your death. The strategy involves transferring those assets earmarked for your heirs to the dynasty trust instead of transferring the assets directly to them.

The dynasty trust will be governed by written terms contained in a trust document if you create the trust during your lifetime, or your will, if created upon your death. The terms have to be worded carefully to ensure that the assets of the trust don't end up in your heirs' estate. A beneficiary can be granted what's called a "five-and-five" power to provide some flexibility around distributions from the trust. This power can allow the beneficiary to make annual withdrawals equal to 5 per cent of the trust assets, or $5,000, whichever is greater.

The dynasty trust should ideally be established as a U.S. trust that is not subject to tax in Canada. This allows your heirs to avoid annual tax in Canada on the income of the trust, avoid a rule that can create taxes in Canada on the 21st anniversary of the trust, and problems in the U.S. that often apply to foreign trusts. Visit a tax pro experienced with this type of planning for help.