Tax issues when Canadians have U.S. executors

Tips to avoid cross-border complications

A common and problematic occurrence in cross-border families is for a Canadian to select a close relative in the U.S. as an executor. Clients considering this option should weigh the potential consequences.

To illustrate the problems, let’s use an example. Fictional couple Noah and Shayna live in Edmonton but their son, Ari, lives in Cleveland. They are currently writing their wills and, as is standard, they select the surviving spouse as executor. At the death of the second spouse, they want Ari to be the executor. That can cause problems on both sides of the border.

Canadian tax problems with non-resident executors

An executor living outside of Canada can cause the estate to depart Canada for tax purposes, making estate administration more complex.

For Canadian tax purposes, an estate is classified as a trust; therefore, the same rules that determine the residency of a trust apply to an estate. This means that the factual residency of an estate is determined based on where the estate is managed or controlled.

With Ari as executor, the estate might become a non-resident of Canada, presenting the following problems:

  • Withholding tax would apply on income earned by the estate.
  • If the estate owns real property that it would like to sell, then the buyer may be obligated to withhold funds on the sale. The withholding is generally 25%.
  • The departure of the estate from Canada might trigger more tax and make it more difficult to wind up corporations.

To put it simply, a non-resident estate makes administration of the estate more complicated and may increase the overall tax burden.

The risk of paying U.S. taxes

If Ari manages the estate from the U.S., there is a risk that not only would it be considered foreign from a Canadian tax perspective, but it might also have to file and pay U.S. taxes.

There are no clear-cut rules to determine when an estate is a U.S. resident and has to file U.S. taxes. In fact, there is frustratingly little guidance on this. The Internal Revenue Code does not define a foreign estate. It merely provides that a foreign estate is not subject to U.S. tax unless it has U.S.-source income or income from a U.S. trade or business.

To establish whether the estate is foreign or a resident of the U.S., we must refer to old U.S. case law, which demonstrates that the IRS and the courts have focused on the location of trust corpus, the nationality and residency of the trustee, and the location of the trust administration as the relevant factors to determine the trust or estate’s residency. The residency of the beneficiaries and the grantor of the trust does not factor into the determination of residency for U.S. tax purposes. No single factor is determinative; however, in later rulings, the principal focus has been placed on the location of the trustee and the situs of trustee administration.

In the example above with Ari as the executor, there is a risk that the IRS would consider the estate a U.S. taxpayer. That would mean the estate has to file a Form 1041 and report its worldwide income to the IRS.

Solutions

With proper planning and advice, these problems can be avoided. The easiest method is for Noah and Shayna to name a Canadian resident as executor instead of Ari. If that is not possible, Ari should commit to managing the estate from Canada and document this so that the estate does not leave Canada, thereby minimizing the risk that the estate becomes a U.S. tax resident.

Max Reed, LLB, BCL, is a cross-border tax lawyer at SKL Tax in Vancouver. max@skltax.com