The Biden administration has proposed a series of changes to existing American tax laws which, if passed, could have a significant impact on U.S. citizens resident in Canada, as well as Canadians who own property in the United States. While the proposals are sweeping, one aspect attracting a significant amount of attention is the treatment of inherited wealth. According to the Tax Foundation, the wealthy could face up to 61% tax on inherited wealth, the highest in nearly a century.
In this article, we will provide an overview of the proposed tax changes as they apply to estate taxes specifically, and how they could impact our clients with cross-border financial interests should the changes come into force.
A Snapshot of the new Estate Tax Proposals
Biden’s tax proposals have three major components related to inheritance, including:
- Almost double the top capital gains tax (CGT) rate to 39.6% from 20% on gains over $1 million.
- Repeal the “step-up in basis” that allows heirs to inherit assets tax-free at the appreciated value.
- Reduce the U.S. estate tax exemption to $3.5 million from the present limit of $11.7 million, while increasing the top estate tax rate to 45% from 40%.
This is just a portion of the initial proposal, and it’s unclear which, if any, aspects will pass the Senate. If all three of the above proposals were to pass as they stand, the combination of the three could result in a tax rate of up to 61%.
Estate Tax Example: Now and Under the Proposed Changes
Let us illustrate the potential impact with the help of an example:
Say that Janet bought a property for $1 million in 1995. At the time Janet dies, the property has appreciated and is now worth $10 million. She leaves the property to her son, Tony. Under the current rules, the step-up in basis would allow Tony to inherit and eventually sell the property with no capital gains taxes payable on the increased value. However, if Tony were to sell the property over and above the value at the time of his inheritance, say he were to sell the property for $12 million, he would be taxed on the $2 million in excess of the value, at a preferential rate.
If the proposals were to pass in their current form, Tony would be required to pay capital gains tax on the $9 million increase in the value of the property at the time of inheritance. In addition, he would have to pay estate taxes on the value of the property in excess of the proposed $3.5 million exemption.
Notably, the proposed capital gains and estate taxes apply to worldwide assets, so they would impact U.S. citizens living abroad, or who own foreign property, as well as Canadians who own property in the U.S.
If the changes were to go through as planned, this might prompt some property owners to gift certain assets prior to death, rather than willing them to beneficiaries. However, anonymous sources are already giving indications that the repeal of the step-up in basis will be considerably scaled back or even removed, so it seems unlikely that the plan will move ahead as initially proposed.
Impact of the Proposals on Family-Owned U.S. Businesses
The potential impact of the proposed changes on family-owned businesses is not quite known as yet. The White House has stated that the intention would be to shield family-owned businesses from additional tax obligations:
The reform will be designed with protections so that family-owned businesses and farms will not have to pay taxes when given to heirs who continue to run the business.
However, some are skeptical and worry that heirs could still find themselves paying capital gains and/or estate tax on inherited family businesses. The specific protections have not yet been laid out, and some worry that the protections might only apply to heirs who were already helping to run the business before the owner’s death, and not those who would be stepping in after the fact.
The Actual Changes Remain to be Seen
Many tax experts believe that some version of the proposed capital gains or estate tax might be implemented, but likely not both. It is a long way to legislation as the proposal will likely be disputed by many in the Senate. But as tax and financial advisors, we are preparing our clients now, and identifying ways to pass on wealth in a tax-friendly manner in case the changes come into effect.
Contact ESS CPAs LLP in Burlington for Assistance and Strategic Advice with Respect to U.S. Tax Liabilities
For assistance with filing and paying U.S. income taxes, or for questions about how these latest proposals could impact your tax obligations, please contact the tax professionals at ESS CPAs LLP by phone at 905-517-2297 or by contacting us online.