Have your cake and eat it?
What is the issue? The possibility for a closely held business owner to achieve their tax and non-tax objectives using marital elections under US law or under a specific treaty.
What does it mean for me? Advisors must be aware of US law requirements that may not be modified or overruled by a treaty benefit.
What can I take away? The estate of a closely held business owner often cannot rely solely on a marital election to achieve the owner’s tax and non-tax objectives when dealing with an uninvolved spouse.
Given the proximity of Canada and the US, it is only to be expected that Canadian and US residents establish enterprises and/or engage in business in each other’s country. It is also not surprising that a closely held business owner or co-owner may want to ensure post-death continuation of the business with engaged managers and without unnecessary reduction of value by taxes related to death.
US federal estate taxation of US citizens
The value of the worldwide gross estate of a US citizen (whether residing in or outside the US at time of death), less allowable deductions, is subject to US federal estate taxation.1 The marital deduction is allowed for the value of property passing to a surviving spouse if the requirements of §2056 and/or §2056A of the Internal Revenue Code (the Code) are met.2 In computing any federal estate tax due, the Code also allows for reduction of the ‘tentative tax’ by use of an applicable credit amount, or unified credit,3 equal to the federal estate tax imposed on a basic exclusion amount, indexed for inflation.4 For estates of decedents dying in the calendar year 2014, the basic exclusion amount is USD5,430,000 (i.e. USD5,000,000 indexed for inflation),5 and the unified credit is USD2,117,800.6 The maximum estate tax rate is 40 per cent.7
Terminable interest rule
Generally, the Code disallows a marital deduction for the transfer of a ‘terminable interest’ in property to ensure that the property interest passing to the surviving spouse, if retained until their death, will be subject to federal estate taxation.8 One exception to the terminal interest rule is ‘qualified terminable interest property’ (QTIP) under §2056(b)(7). Property included in the decedent’s gross estate is QTIP if the following requirements are met: the property passes from the decedent; the surviving spouse has a ‘qualifying income interest for life’; and the executor9 of the estate timely and properly makes an irrevocable QTIP election on the US federal estate tax return.10
A ‘qualifying income interest for life’ requirement has the following two components:
- The surviving spouse is entitled to all the income from the property, payable annually or at more frequent intervals, or has a usufruct interest for life in the property, and
- no person has a power to appoint any part of the property to any person other than the surviving spouse during the spouse’s lifetime.11
In Estate of Rinaldi v US,12 the US Court of Federal Claims disallowed the marital deduction because trust terms ran foul of the second component of the ‘qualifying income interest’ requirement. Per the recited facts, the decedent, the company director, owned 52.06 per cent of closely held company stock at the execution of his will and at his death. The decedent’s will provided for the stock to pass to a trust if the decedent’s wife failed to survive his son (the company’s CEO).
In accordance with the first component of the ‘qualifying income interest’ requirement, the trust terms provided for net income payable to the surviving spouse at least annually and included a prohibition on holding unproductive property without the surviving spouse’s consent.13 Additional trust terms, however, prohibited the stock from being sold without the son’s consent and, if the son no longer managed the company on a day-to-day basis, the trust fiduciary (i.e. the son) could offer to sell the trust’s stock to himself at book value, a value determined to be below fair market value.14 Agreeing with the Internal Revenue Service, the court held the potential sale of assets at a bargain price to someone besides the surviving spouse effectively diminished the value of the corpus and, thus, was an impermissible power of appointment of the stock to a person other than the surviving spouse during her lifetime.
US citizen requirement
The Code also disallows the marital deduction if the surviving spouse is not a citizen of the US (whether or not residing in the US).15 If the surviving spouse is not a US citizen, the Code provides an exception under §2056A, allowing a marital deduction if the interspousal transfer occurs through the use of a qualified domestic trust (QDOT).16 For a trust to qualify as a QDOT under §2056A, the trust document must meet certain requirements that, in effect, ensure the collection of tax imposed by §2056A(b).17 In addition, the executor is required to make timely an irrevocable QDOT election on the federal estate tax return.18
Marital credit under US-Canada protocol
In its negotiations of bilateral tax treaties, the US typically requires a savings clause to ensure the negotiated treaty does not affect its ability to tax its current and former citizens. However, the savings clause that is part of the Convention Between the United States of America and Canada with Respect to Taxes on Income and Capital (the Convention)19 contains exceptions.20
One exception is the application of the marital credit to US citizens.21 Article XXIX B (taxes imposed by reason of death), introduced in article 19 of the 1995 protocol, provides an option for small estates of a US citizen to elect a non-refundable marital credit if the decedent and the surviving spouse meet residency and/or citizenship requirements. The executor also must make a timely election of the credit and waive the benefits of the marital deduction otherwise allowable under US law.22 With the exception of making a QTIP election, the marital credit requirements under article XXIX B, however, do not override or modify the marital deduction requirements under §2056(b)(7). For the estate of a US citizen, the amount of the credit is the lesser of the unified credit (before reduction for any gift tax credit)23 and the amount of US estate tax that would otherwise be imposed on the transfer of the property to the surviving spouse before allowable credits.24 Unlike the marital deduction under US law, the credit reduces or eliminates the estate tax instead of deferring the tax.25
Calculations one and two, above, illustrate the application of the marital deduction under US law and the treaty marital credit, respectively. The third calculation shows the implications of ignoring US law whether for purposes of the marital deduction or the credit. Each of the calculations assumes the decedent is a US citizen, the surviving spouse is a Canadian citizen and both are Canadian residents at time of the decedent’s death. No foreign tax credit is applied. All amounts are in USD.
Calculation three shows that a closely held business owner’s non-tax objectives may create unfavourable tax consequences whether proceeding under the Code or the Convention. In fact, the marital credit may have extremely limited application for a closely held business interest because the credit was designed primarily to reduce ‘the estate tax burden on transfers of personal residences and retirement annuities’.26
To achieve both non-tax and US tax objectives, the closely held business owner or their estate, in the alternative and assuming no negative tax consequences in Canada, may want to:
- employ pre-death estate-planning methods to reduce the value of the business interest for US federal estate tax purposes;
- make use of a qualified marital trust funded with assets other than business interests;
- if the bulk of the estate is the business interest, rely on life insurance proceeds to provide for the surviving spouse who is not involved in the business; or
- recapitalise the business post-mortem to pass non-voting stock to the uninvolved surviving spouse and provide voting stock to involved family members. In that way, active business managers retain control of the business.
- 1. Internal Revenue Code §2001(a); §2051; see also reg §20.0–1(b)(1)
- 2. Regulations under §2056 specifically identify the ‘deduction allowed under §2056’ as the ‘marital deduction’
- 3. In this article, ‘unified credit’ and ‘applicable credit amount’ are used interchangeably
- 4. §2010(c)(3)
- 5. Revenue Procedure 2014-61, 2014-2 CB 860 (30 October 2014)
- 6. §2010(a); §2001(c)
- 7. §2001(c)
- 8. §2056(b); §2044
- 9. Reg §20.2056(b)-7(b)(3)
- 10. §2056(b)(7)(B)(v). Also reg §20.2056(b)-7(b)(4)
- 11. §2056(b)(7)(B)(ii)
- 12. 38 Fed Cl 341 (1997), aff’d, 178 F3d 1308 (Fed Cir 1998) (without opinion), cert denied, 526 US 1006 (1999)
- 13. Reg §20.2056(b)-5(f)(5)
- 14. Reg §20.2031-1(b)
- 15. §2056(d)(1)(A). US domicile is not sufficient. See reg §20.2056A-1(a), §2056(d)(4) and reg §20.2056A(b)
- 16. §2056(d)(2)
- 17. See also §2056A(b)(1)(A); reg §20.2056A-5(b)(1) and §2056A(b)(2); reg §20.2056A-5(a)
- 18. §2056A(d); reg §20.2056A-3(a) and see further reg §20.2056A-2(b)(1)
- 19. Signed at Washington on 26 September, 1980, as amended by protocols signed on 14 June 1983, 28 March 1984, 17 March 1995, 29 July 1997 and 21 September 2007
- 20. Convention, article XXIX (miscellaneous rules), as amended
- 21. Idem. See also Internal Revenue Manual 220.127.116.11.3 (01-06-2015) (explaining how to report marital credit on page 1 of Form 706, return utilised in calculating the estate tax of the estate of a US citizen or domiciliary)
- 22. Convention, article XXIX B, paragraph 3
- 23. The current statutory term, ‘applicable credit amount’, is not used in the Convention
- 24. Convention, article XXIX B, paragraph 4
- 25. Treasury Department technical explanation (marital credit)
- 26. Joint Committee on Taxation, JCS-15-95 at 16
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