In a previous article entitled "U.S. Federal estate tax: Americans living in Canada and Canadians owning U.S. real estate", we outlined the federal estate tax rules in the United States. In short, the federal estate tax is only applicable to a minimal amount of people, as the U.S. government provides for a tax exemption if the fair market value of the worldwide assets is below USD 11.4 million. Nevertheless, Americans living in Canada and Canadians owning U.S. assets may still be subject to taxes at death, as each state has the power to enact its own legislation on taxes at death.
Estate tax versus Inheritance tax
As is stands, 18 U.S. states have some form of tax that results from death. These taxes operate independently from the U.S. federal estate tax. Twelve (12) of these states, as well as the District of Columbia, currently have their own state-level estate tax. The remaining six (6) States have an Inheritance Tax. Consequently, notwithstanding the federal estate tax exemption and barring any state-level exemptions, an American citizen or green card holder and/or a Canadian citizen and resident who owns assets in the aforementioned states and district will owe taxes at death.
Although estate and inheritance taxes are both imposed because of a person's death, there are important distinctions. The most significant difference pertains to who is responsible for payment of the tax. In the case of the estate tax, the estate itself pays an estate tax. The estate's liabilities are subtracted from the overall value of the deceased's property, thus arriving at the estate's overall net taxable value. The resulting tax bill is payable by the estate itself.
An inheritance tax is calculated on the goods received by the estate's beneficiaries instead of the net taxable value of the entire estate. In other words, the people who receive assets from the estate ("beneficiaries") will have to pay a tax based on the individual assets received. Consequently, an inheritance tax is always paid on assets free of the estate tax because the estate tax must be paid before assets can be transferred to beneficiaries. It is common for the deceased's will to provide for the payment of the inheritance taxes.
Consider the following examples highlighting the difference between the two taxes:
John died owning assets valued at USD 5 million. At his death, John has 2 mortgages totalling USD 2 million. Therefore, his total taxable estate is USD 3 million (value of assets minus liabilities).
Considering the state in which John lived does not provide for any exemptions, his estate's balance subject to state-level estate tax would be USD 3 million. Assuming John's State tax rate is 15%, the estate would have to pay USD 300,000.
It is important to note that the estate must pay this amount before any individual bequests can be made.
Consider the same facts as the previous example; however, John also had a will. In the will, John left a house worth USD 500,000 to his best friend, Robert. In this case, the estate tax would not change; however, because the State John lived in has an inheritance tax for non-relatives, Robert would now owe taxes to the state. Assuming the inheritance tax is 15%, Robert would owe USD 75,000 as an inheritance tax upon reception of the bequest (the house).
It is to be highlighted that because the house was included in the net taxable value of the estate, it is taxed twice. It is subject to estate tax and is also subject to inheritance tax because it was bequeathed to Robert.
U.S. estate tax exemptions
As mentioned above, 12 (twelve) states and the district of Columbia provide for an Estate tax. Furthermore, each of the states provides an exemption amount. The table below identifies each state with an estate tax, the exemption amount, and the tax rate.
STATE EXEMPTION AMOUNT TAX
Connecticut $5.1 million 10% - 12%
Hawaii $5.49 million 10% - 20%
Illinois $4 million 0.8% - 16%
Maine $5.8 million 8% - 12%
Maryland $5 million 0.8% - 16%
Massachusetts $1 million 0.8% - 16%
Minnesota $3 million 13% - 16%
New York $5.85 million 3.06% - 16%
Oregon $1 million 10% - 16%
Rhode Island $1.579 million 0.8% - 16%
Vermont $4.25 million 16%
Washington $2.193 million 10% - 12%
District of Columbia $5.762 million 12% - 16%
Consider the following example illustrating the application of the U.S. federal estate tax and the State estate tax:
Catherine is a Canadian citizen and resident. Her total assets are valued at USD 4 million. However, she owns two homes in Massachusetts with a combined fair market value of USD 1.2 million. Before dying, Catherine notarized a will where her two homes in Massachusetts are left for her children.
Catherine died on September 20, 2020. Upon her death, the person responsible for her estate will have to file a US Estate Tax return because his U.S. assets exceed the USD 60,000 threshold. However, because his worldwide assets do not exceed the USD 11.4 million Estate tax exemption, her estate will not owe any federal estate taxes. Nevertheless, the estate will be subject to State Estate tax because her property situated in Massachusetts exceeds the exemption amount of USD 1 million.
US State Inheritance Taxes
As mentioned above, 6 (six) states impose an inheritance tax. The table below identifies the applicable states and the tax rates corresponding to each state.
STATE TAX RATE
Iowa 0% - 15%
Kentucky 0% - 16%
Maryland 0% - 10%
Nebraska 1% - 18%
New Jersey 0% - 16%
Pennsylvania 0% - 15%
In most of the states indicated in the table above, testamentary bequests can be exempted in 3 ways:
1. Based on the amount
2. The class of beneficiary
3. The class of assets
It should be noted that even if an exemption finds application, it does not preclude the property from being subject to US estate tax and state estate tax.
(I) Exemption based on the amount received
· Exemption based on the value of the probatable estate
A probatable estate that is less than the exemption amount will be bequeathed free of inheritance
tax. A probatable estate is one where the assets forming the estate's patrimony are owned solely
by the decedent. This can include real property and personal property, amongst others.
· Exemption based on the amount received by a specific person
Other than Iowa, all the states that impose an inheritance tax provide an exemption based on a
defined amount received by defined beneficiaries. However, any amount received in excess of
the received property must pay inheritance tax.
Bob is a Canadian citizen and resident. He is the owner of a vacation home in Nebraska, valued at USD 540,000. Before dying, he bequeaths the home to his sister in his last will.
Although Nebraska has a state-level inheritance tax, it also has an exemption amount for bequests of USD 40,000 or less to siblings.
At the time of his death, his sister will deduct an amount of USD 40,000 from home as an inheritance tax exemption. However, because the home's value exceeds the exemptible amount, she will have to pay inheritance tax on the remaining potion's fair market value. Consequently, his sister will pay inheritance tax on USD 500,000 (540 000 minus 40 000).
(II) The class of beneficiary
All the states with an inheritance tax also provide an exemption for bequests made to a specific class of people. A class of exempted class of people shared amongst all the states is surviving spouses. Consequently, a bequest to a surviving spouse will be free of all inheritance tax.
(III) The Class of property
Apart from the State of Kentucky, the states in question provide an exemption for bequests of a certain type of property. Consequently, similarly to the exempt class of beneficiaries, these properties may be exempt from all inheritance taxes if the criteria are met.
This article is meant to give a brief overview of each state's legal landscape surrounding estate taxes and inheritance taxes. Americans living in Canada and Canadian's owning U.S. assets alike should be wary and remain informed of the impacts these taxes may have upon their death. The ever-changing political and legislative climate in the United States make for continuously changing tax law. It is important to note that many additional laws and rules regulate estate and inheritance taxes. At Meditax, our team of experienced lawyers and tax specialists can assist you in navigating your cross-border questions and concerns.