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On December 8th and 9th, Sanger and Manes spent a terrific weekend as sponsors at the CanadaFest at the Palm Springs Convention Center. I was amazed at how many Canadians came up and kept asking me the same question: “how many days a year can I stay in the US?” And frequently they would follow up with this supplement:”I heard if I leave the US and then return to the US in less than 30 days (like so many Canadians are doing right now as they go back to Canada for Christmas, but will soon come right back to the US in early January), then the days that I’m out of the US count in my six month computation, is that true?” Boy oh boy I thought, what is the Canadian rumor mill up to now? This is complete nonsense.

But was I right?

I Assumed They Were Asking About How Many Days a Canadian Could Stay in the US Under the US the Tax Law

Everyone (I hope) knows that a Canadian can stay in the US up to 182 days in a calendar year without being deemed a US resident for tax purposes. And if they’re here in the US between 4 to 6 months on average in a calendar year over 3 or more years, they should fill out an IRS Form 8840 (a Closer Connection Form) annually. The Form 8840 states, although you spend a lot of time in the US (but not exceeding 182 days in a calendar year), your real tax home remains Canada. Your primary residence is there, your drivers’ license was issued up there, most of your significant contacts are up there,etc. So please, United States, do not consider me a US resident for tax purposes, don’t tax me in the US on my worldwide income, and don’t subject me to the multiple US tax filings I don’t want to complete. And, if filed properly, the US will not consider you a US tax resident. It’s that simple. Finally, when you are counting days spent in the US for the purposes of determining whether you are US tax resident (and whether you have exceeded the magic threshold of 182 days in a calendar year), you only count days actually spent on US soil (even if it’s only an hour for a particular day). If you leave for a three week trip to Mexico, or back to Canada, those days do not count as days spent on US soil for the purposes of determining whether you are a US tax resident.

But Upon Reflection, What They Were Really Asking About Was The Immigration Law

In retrospect, I’m pretty sure most CanadaFest visitors were asking me about the six month stay rules under the US immigration law. Under US immigration law, Canadian visitors can stay in the US for up to six months. Now, officially, they could actually stay in the US for a six month period, say from Jan 1 to June 30, go back to Canada for a little while, and then perhaps in October (or earlier) come back and start a new six month period. As far as I know, there is no actual law which prohibits Canadians from “stacking” six month stay after six month stay (provided there is a little respite in between). Of course, that would mean you’re in the US around 9 months that year so you’d be a US tax resident (taxed in the US on your worldwide income), but “stacking six month stays” doesn’t appear to be strictly against the immigration laws. However, in practicality, it will not work.

Three Important Rules to Remember on the Immigration Issue:

1) The US Border Agents are given a lot of discretion to enforce US law. They can deny you entry because they don’t like your hat. For better or (more likely) for worse, we must follow their instructions, even when they don’t appear to have a clear legal foundation.

2) As we understand it, and although it’s not clear under the US immigration law at all, US Border Agents are basically counting six periods starting with the time your first enter (e.g., you come in October when the weather turns cold up north, the clock starts. You may now spend up to six months in US between the time you come in, and next October when you start again. If your six month period ends the following April, apparently the US border agents are unlikely to allow you re-entry until the next October…although again, every Border Agent may differ on this point in how they enforce it.).

3) Finally, the leaving the US for under 30 days rumor. Apparently, it is true!!!. The origin of the 30 day rule comes from the Instructions to the US Immigration Form I-94:

“In general, if you have been admitted to the United States under most visa classifications if you take a short trip (30 days or less) to Canada or Mexico, you may retain your I-94/I-94W, so that when you resume your visit to the United States you are readmitted for the balance of the time remaining on your I-94/I-94W.”

So the rumor, at least as its being enforced currently by (many) US Border Agents, appears to be true. If you’re here for a six month stay (as you’re allowed), and you go back to Canada for the holidays (for less than 30 days), or down to Mexico for a couple weeks, that brief visit out of the country after you’ve started your 6 month period will count in your 6 month US allowable period. So again, apparently as its being enforced currently, you enter Oct 1 of this year, you’re going to have to probably leave the US by March 30th of next year, even though you spent 3 weeks back in Canada over Christmas (i.e., you cannot add those 3 weeks back in Canada for Christmans and stay in the US until say April 21 of next year…no, you still should leave my March 30).

Call me in my office if you have questions: (760) 320-7421

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If you read my most recent post on the importance and (I think really) necessity that Canadian snowbirds obtain US individual taxpayer ID numbers an “ITINs”. Remember, Canadian snowbirds must complete an IRS Form W-7 to get a taxpayer ID number, but there’s only certain occasions when the IRS will actually comply and issue you one (such as when you fill out a US tax return or when you want to be relieved of the awful mandatory US tax withholding obligation on renting or selling US real estate). It’s now a good time to review the process for how the Canadian actually gets an ITIN.

What Documents Must the Canadian Snowbird Submit to Get an ITIN?

An original valid passport is the best document you can give. If you submit that, that’s all you need to give. If you don’t submit a passport, you’ll need multiple documents to prove both your foreign status and identity. The documents must be current, verify your identity (that is, contain your name), and support your claim of foreign status (that you’re from Canada). Among the group of documents which you may use are national I.D. cards, visas issued by U.S. Department of State, U.S. or foreign military identification card, civil birth certificates, medical and school records, U.S. state or foreign driver’s licenses, U.S. state identification card, foreign voter’s registration card and U.S. Citizenship and Immigration Services photo identification. Again, you’ll need multiple documents if you’re not using the passport.

On June 22, 2012, IRS announced interim change to its ITIN application requirements.
What are the biggest changes to the process of getting a taxpayer ID number?:

1) Notarized copies of key documents are no longer acceptable.

The IRS will continue to require original documentation or copies certified by the issuing agency with the Form W-7 and federal return attached. It will no longer accept notarized copies of documents for ITINs (although, an important note, notarized copies remain acceptable when the Canadian is just getting the withholding back from selling a home via the Form 8288…a full tax return is not necessarily required for that). Documents subject to this requirement include passports. Canadians may be able to request a certified copy of their passport or similar international identification at their local consulate’s office.

2) Taxpayer ID Numbers are Now Only Good for 5 Years- They Are No Longer Indefinite:

Newly issues ITINs will expire after five years, rather than be issued for an indefinite period. This will provide additional safeguards to the ITIN program. Taxpayers who still need an ITIN will be able to reapply at the end of the expiration period.

How Long Will the IRS Have My Passport Or Other Documents?

The documents will be returned to applicants using the mailing address on the application via postage paid standard U.S. mail within 60 days of receipt and processing of the Form W-7.

The IRS Knows Its A Hardship For Canadians to Be Without Their Passport For an Extended Period, And Has Steps To Help With That (supposedly)

The IRS has provided alternatives to mailing in passports and other original documents. Trusted outlets other than its centralized ITIN processing site need to be available to review original documentation (although they don’t appear to be available yet, so we’ll have to wait for that information). While original documents or copies certified by the issuing agency are still required for most applicants, more options and flexibility are provided for people applying for an ITIN.

Certifying Acceptance Agents (“CAAs”) and Taxpayer Assistance Centers (“TACs”) May Provide an Nice Alternative to Sending in Critical Documents to the IRS

CAAs and TACs will be able to engage in the ITIN process by reviewing original documents or copies certified by the issuing agency, but will be subject to new safeguards. But where these locations are locally that do this, I have no idea.

My Recent Trip to the Local IRS Office in Palm Springs

In the Palm Springs area, we have a local office/TAC at the following location: 556 S. Paseo Dorotea Palm Springs, CA 92264 ((760) 866-6125)). I personally visited there just last week (and waited one hour and half just to ask a question about the new procedures for obtaining taxpayer ID numbers!!!). But they don’t review documents at that office, and they don’t issue ITINs, as these TACs and CAAs supposedly do (all they do is forward them to the Austin Texas office, so it’s hard to see what is gained by going to the Palm Springs office for this purpose…you may as well just mail them in) .

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We are asked constantly by Canadians why they have to go through the pure drudgery of getting a US taxpayer ID number. And apparently, drudgery is absolutely the correct word as now the IRS wants to review either your actual passport, which is the best stand alone document you can provide (which means it may be out of your possession in the hands of the IRS for a few weeks), or a combination of a series of additional documents. We’ll talk in our next blog post about how you actually get the taxpayer ID number (via the Form W-7). But why does the Canadian snowbird need to get it? The answer is simple- it will cost you money if you don’t.

You will Need A Taxpayer ID Number to Avoid Mandatory 30% Withholding When You Rent Your US Property.

Without a taxpayer ID number, the Canadian Snowbird who rents US real estate must have the tenant or property manager withhold 30% of gross rent payments (and forward these amounts to the IRS). If the tenant or prop manager fails to withhold, the IRS will look to the Canadian for the withholding tax. However, if the Canadian snowbird completes a Form W-8ECI withholding certificate (which requires a US taxpayer ID number to get) and gives it to the tenant or property manger instructing them not to withhold, and then files the Form 1040NR tax return by June 15 of the next year, no withholding is required. This is a great option for the Canadian snowbird because it: (A) Allows the taking of deductions (e.g., property taxes, mortgage interest and depreciation) and (B) the tax rate is likely lower, much lower, than 30%.

Example. Snowbirds Suzy & Jeff purchase a house in Rancho Mirage. They personally use the house 2 months a year, and they rent it for $3,000 a month for the other 10 months. Before US taxes, Suzy & Jeff will receive $30,000 in rental income per year. What about after US taxes?

Option 1: They don’t go get a US taxpayer ID number. Tenant or property manager must withhold $900 a month from rent payments ($9,000 total for the year). Suzy & Jeff receive $21,000 per year after US taxes paid.

Option 2: First, Suzy & Jeff get a US taxpayer ID number and then complete a Form W-8ECI and then give it to the tenant or property manager and file a Form 1040NR tax return the next year. The tenant or property manager now knows he shouldn’t withhold. Suzy & Jeff deduct $400 of monthly interest from their mortgage and $200 of monthly property taxes. Their taxable US rental income for the year is $24,000. On $24,000, the US income tax rate is approximately 15% and the tax is approximately $3,600 (leaving Suzy & Jeff $26,400 for the year after US taxes paid).

You will Need A Taxpayer ID Number to Avoid Mandatory 10% Withholding on Your Gross Sales Price When You Sell Your US Property.

A similar rule exists in the sale of a house area, where, if the Canadian snowbird does not get a taxpayer ID number, the purchaser must withhold 10% and forward it directly to the IRS.

Example. Suzy & Jeff purchase a La Quinta house in 2009 for $800,000. In 2012, they sell the house to buyer for $1,000,000.

Option 1: No action taken. Buyer must withhold $100,000 for IRS (10% of the $1,000,000 sales price). Suzy & Jeff receive $900,000 after federal taxes withheld.

Option 2: Prior to the sale, Suzy & Jeff get a taxpayer ID number and then file an IRS Form 8288-B. Buyer must now only withhold $30,000 for IRS ($200,000 appreciation x 15% capital gains rate in 2012). Suzy & Jeff receive $970,000 after U.S. taxes paid.

So, unfortunately Canadians in the US, you really do have to face the drudgery of getting a taxpayer ID number.

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We continue our discussion on Canadians who had the legal requirement to annually file US tax returns and FBARs (reports of foreign bank accounts…ie, your bank accounts in Canada which had more than $10,000 (US) in them at any point in the year), but who haven’t filed a US tax return or a FBAR in many years (if ever). Again, this amnesty program offers really is peace of mind. If you haven’t been filing your US tax returns (or FBAR’s) for years, maybe you know (now) you have that obligation, but you don’t know how to “come clean”. This new amnesty program is your chance. Under the new amnesty program, for those who qualify, the IRS will not impose penalties nor conduct an audit. In order to “come clean” you must: (1) File all tax returns with appropriate related information returns required for the past three years (i.e., 2009, 2010, and 2011); (2) File Foreign Bank Account Reports (FBARs) for the past six years (i.e., 2006- 2011); (3) Pay any tax and interest if applicable on the unfiled returns (there probably won’t be any US tax or interest); and (4) Complete and sign under penalties of perjury a 20-question questionnaire. In Part 1 of this series, we discussed how only Canadians who “reside in Canada” could take advantage of this new amnesty. In Part 2, let’s review some more of the unusual conditions of the new amnesty program.

The Taxpayer Cannot Owe More Than $1,499 in US tax in any of the tax years beginning in 2009 and ending on 2011.

We suspect this requirement generally won’t be problematic. Although the US does impose tax on income earned by its citizens and residents no matter where they earn it anywhere in the world (e.g., Canada), due to the tax credit system and the relief offered by the US-Canada Tax Treaty, as long as the taxpayer has been paying the appropriate tax in Canada he or she probably (although not certainly) won’t owe any US tax. So owing not more than $1,499 in US tax in any of the tax years beginning in 2009 and ending on 2011 is probably not a difficult hurdle to overcome.

The taxpayer has filed a US tax return for any tax year subsequent to 2008.

Sort of an unusual requirement (not having filed the taxes), but one can suppose the rationale behind it is the IRS wanting to help only those people who more or less have been unaware of their obligation to file their US taxes (not the ones who knew of their obligation but simply tried to pay less than they should have in prior years).

The taxpayer presents a “low compliance risk”

Ah, this is where it gets really interesting. I want to apply for the new amnesty so as to clear up my unfiled US back taxes, but I must be considered by the IRS as a low compliance risk. How do I know if I’m a low compliance risk?

Based on the questionnaire the taxpayer is required to complete, the IRS will determine whether the taxpayer is considered “low compliance risk”. According to the IRS, the taxpayer’s risk level may rise above “low” if he or she has any of the following:

-Any of the returns submitted through this program claim a refund;
-There is material economic activity in the US;
-The taxpayer has not declared all of his/her income in his/her country of residence;
-The taxpayer is under audit or investigation by the IRS;
-FBAR penalties have been previously assessed against the taxpayer or if the taxpayer
has previously received an FBAR warning letter;
-The taxpayer has a financial interest or authority over a financial account(s) located outside his/her country of residence;
-The taxpayer has a financial interest in an entity or entities located outside his/her country of residence;
-There is US source income; or
-There are indications of sophisticated tax planning or avoidance.

So what do we learn here? If you have US source income (like from the sale of a US house), and you did not at least file a nonresident tax return, you may not be an ideal candidate for the new amnesty program (although at least with real estate you as a Canadian should have had an excess tax amount automatically withheld at the time of sale due the FIRPTA rules). It is of course entirely possible the taxpayer has bank accounts in other countries, it’s hard to see what is so damaging about that. Based on this list, the factors which give me pause in going forward with the program are owing back US taxes (above $1,500 per year), or being at all involved in any FBAR hot water. If you have any of the remaining factors, you should at least explore the possibility to joining the new IRS amnesty program for dual citizens who haven’t filed US tax returns recently.

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What we’re talking about here are Canadians who had the legal requirement to annually file US tax returns and FBARs (reports of foreign bank accounts…ie, your bank accounts in Canada which had more than $10,000 (US) in them at any point in the year), but who haven’t filed a US tax return or a FBAR in years (if ever). Which Canadians have the obligation to complete US tax returns? Those Canadians who are also US citizens primarily, or maybe a Canadian who obtained a US green card but did not relinquish the green card upon moving back to Canada.

What Does the Amnesty Provide?
Really, it provides peace of mind. You haven’t been filing your US tax returns (or FBAR’s) for years, you know you have that obligation, and you don’t know how to “come clean”. Under the amnesty program, for those who qualify, the IRS will not impose penalties nor conduct an audit.

What Must You Do To Comply With the Amnesty?

1) File all tax returns with appropriate related information returns required for the past three years (i.,e, 2009, 2010, and 2011);

2) File Foreign Bank Account Reports (FBARs) for the past six years (i.,e, 2006- 2011);

3) Pay any tax and interest if applicable on the unfiled returns (but odds are there probably won’t be any US tax or interest, I will explain…);

4) Complete and sign under penalties of perjury a 20-question questionnaire (we will discuss some of the more interesting questions).

And that’s it. All your worries about years of unfiled tax returns can be over. Go back and forth between the US and Canada free of concern that your unfiled taxes are going to be a problem, and maybe prevent you from visiting the US for a long time.

Let’s Start Looking at Some Specifics in the Amnesty.

The taxpayer is “eligible” for the streamlined procedure if he or she meets certain factors, including the following factors:
1. The taxpayer has not resided in the US since December 31, 2008;
2. The taxpayer has not filed a US tax return since 2008;and
3. The taxpayer does not owe more than $1,499 in any of the tax years beginning in 2009 and ending on 2011.

Only Canadians Who “Reside in Canada” Can Take Advantage of this New Amnesty, What Does that Mean?

To be permitted to use the amnesty, the applicant must permanently reside in Canada, and must not have “resided” in the US prior from 2009 to present. But so many Canadian snowbirds live part-time (for several months a year) in Palm Springs, or La Quinta, or San Diego or Phoenix. So does living in the US just shy of 6 months a year qualify you to take advantage of the new amnesty? My guess is yes, that as long as you’re not a US resident, you do qualify for the new amnesty (basically, if you’re not in the US more than 6 months a year, and for the Canadian in the US between 4 to 6 months each year, that person must be careful to complete the Form 8840 (the closer connection form…closer connection to Canada) each year). So my guess is as long as you’re not a US resident, you do qualify for the new amnesty. That’s just a guess though, as there is no clear guidance on this point yet.

Note the Canadian who has been dutifully completing Canadian tax returns each year is unlikely to owe any (much less $1,500) US taxes for the past few years, due to the credit system between the two countries. We’ll pick up this concept, and look at other factors of the new amnesty program, in Part 2 of this series.

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…To evaluate this, the distinction between Rule #1 (California income taxes incurred due to residency), as opposed to Rule #2 (California income taxes incurred due to sourcing) is extremely important. Taxpayers are more or less in control of their residency; they can pull up stakes and move. However, the source of income is not as easily controlled. In many cases, the operations that bring in the income rely on California’s market, which is often the market the owner knows and understands. There is no point in moving out of state to avoid the application of Rule #1, if Rule #2 is still going to apply. The tax is the tax is the tax.

But let’s look at the nuts and bolts. It’s not unusual for a business owner to have a corporation and several related tax pass-through entities, such as limited liability companies or limited partnerships, which produce income by providing goods or services here in California. The corporation often provides the LLCs with administrative services, and charges accordingly. Generally, the owner will hold the corporate stock in a family trust. In case like this, creative relocation can have worthwhile tax benefits. Here’s how.

First, remember Rule #1. Since the point of most business enterprises is to get money into the pockets of the owner, if the owner remains a California resident, relocating the corporation won’t help a bit by itself. Assuming all the income from operations passes through the entities (including the trust) to the owner, it will be taxed by California because of Rule #1. All of a resident’s income is taxable by California. So in situations like this, if a strategic relocation is in the cards, step one is for the owner to change residency to a lower tax or non-income tax state. Obviously that’s a big step. It means major change. But if reducing state income taxes is the goal, it’s the sine qua non.

Second, remember Rule #2: moving out-of-state won’t change anything if the source of the income derives from California. The premise here is that the owner’s market is in California, so he can’t move the operations. Paying California income taxes on that is the price we pay for benefiting from the Golden State’s large market. That said, what doesn’t have to be performed here is the administrative services: the management, accounting, etc., that the corporation carries out for LLCs. The source of income from personal services is the location where the services are performed, and not where the nonresident lives, the location where the contract for services is entered into, or the place of payment. Cal. Code Reg §18662-5. Therefore, if the services aren’t performed in-state, it’s not California source.

Thus step two involves creating a new entity in a lower tax or non-tax state (or the owner can perform those services upon changing residency) to provide the administrative services. In that situation, neither Rule #1 nor Rule #2 applies to the fees charged by the corporation. The services are not rendered in California, so they are not California source. Neither the entity nor the owner are residents, so their global income isn’t subject to California taxation.

Now, there are complexities with this, as with any tax situation.

The rule about location of performance is strict. If even some of the work is performed in California (say by the owner coming to California to inspect the business), the payment, or a portion thereof, will be deemed California source under special allocations rules. Cal. Code Regs.18 18662-2. Indeed, if the entity is performing other services in-state, or otherwise doing business in California, all the income from the services may be taxable by California. In the Matter of the Appeal of William-Sonoma, Inc., and Subsidiaries (June, 26, 2012). Therefore, to avoid the application of Rule #2, it is very important to “wall-off” any nonresident entity or person from doing any business in California.

Furthermore, new (and somewhat complex) rules went into effect in 2011 regarding what constitutes “doing business in California” for entities. Partnerships and LLCs are considered doing business in this state if they have general partners or members in this state. Likewise, partners and members are considered doing business in this state if the partnership or LLC is doing business in this state. Further, if a partnership or LLC has employees working in California, it might result in the entity being deemed doing businesses in California, even if most of its operations have nothing to do with California. The point is, depending on how the owner’s entities are interrelated, one or all of them might be deemed “doing business in California” for taxation purposes. Therefore, relocators need to carefully scrutinize those relationships to insure none of them can be used to impute “doing business in California” to the nonresident entity.

It’s also noteworthy that any equity distributions from the California entities to the out-of-state entity or the owner (and presumably they will be significant) derives from operations in this state. California applies a source-based concept of taxation for full-year nonresident partners. Appeal of Lore Pick, 85-SBE-066; (June 25, 1985), Appeal of George D. Bittner, 85-SBE-111 (October 9, 1985), Appeal of Estate of Marion Markus, 86-SBE-097 (May 6, 1986); FTB Legal Ruling 2003-1. Essentially, California requires owners of pass-through entities to treat items of income, deduction and credits earned by such entities as if the items were earned by the owners at that time.

Similarly, nonresident shareholders are taxed on the portion of their distributive shares of an S corporation’s income or loss, which are derived from sources within the state. Valentino v. Franchise Tax Board (1993) 25 Cal.Rptr. 282; Rev. & Tax. Cd, §17951. This is a bright-line rule that can’t be avoided. (Dividend income from C-corps is treated differently and generally is sourced not to operations but to where the recipient resides, but that’s another story).

So, in my scenario, while you may be able to free service contracts from California taxation, the same isn’t true for the profits of the companies engaged in operations.

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Canadian visitors to Palm Springs, Rancho Mirage, Indian Wells and all of California may wish to take note of a new pilot program the US Department of Homeland Security and the Canada Border Services Agency is instituting for visitors from both countries crossing the US-Canada border. It’s a pilot program, which is not the official policy for US-Canada border crossings yet. But could easily become that (and probably will).

Which US-Canada Border Crossings is the Pilot Program Being Tested?
The following border crossings are where the program is initially being tested:

1) Pacific Highway, Blaine, Washington / Pacific Highway, British Columbia;

2) Peace Arch, Blaine, Washington / Douglas (Peace Arch), British Columbia;

3) Lewiston-Queenston Bridge, Lewiston, New York / Queenston-Lewiston Bridge,

4) Ontario; and Rainbow Bridge, Niagara Falls, New York / Niagara Falls Rainbow Bridge, Niagara Falls, Ontario.

What Information Is Being Collected at These US-Canada Border Crossing Points?

It will include collecting and exchanging biographic information of third-country nationals, permanent residents of Canada, and lawful permanent residents of the U.S. There is no indication the collected information is all that different than the information collected prior to inception of the pilot program, Note also, the Canadian government is advancing plans to use biometrics for immigration and border security that would bring them in line with the U.S. and other countries.

So What’s So Different About What’s Going on in the Pilot Program?

The big new feature of the pilot program is the enhanced sharing of information between the US and Canada. It will now be easier for authorities on both sides of the border to identify those individuals who have overstayed their visa (which may have a detrimental effect on their ability to visit the other coutnry again any time soon). They can also more easily identify those individuals who have “removal orders” against them. In the past, the coordination between the two sides was so not so great.

What Does This Mean for Canadian Part-Time Coachella Valley Residents?
It’s hard to see any direct impact. Palm Springs Airport is not one of the locations for the pilot program. I think the take-away is that a greater sharing of information between Canada and the US is going to become the norm. Monitor your days spent in the US, do not overstay the 6 month a year period (if you’re here on a standard B-2 tourist Visa allowing you 6 months in the US a year). If you overstay, it’s clearly getting easier for authorities on both sides of the border to figure it out, and for Canadians it will easily lead to a suspension of your rights to visit the US in the future. Also, for the Canadians who have some US source income (you sell or rent a house; you conduct some business in the US), make sure to do your US taxes each year by June 15 (for the prior year). Failure to properly file and pay required taxes is another reason you will be suspended from returning to the US. In this increasing era of shared information, more and more each country will know of the other’s citizens who do not follow the rules.

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It’s no secret that California has a high state income tax rate. In fact the Golden State competes with New Jersey and New York for the highest rate in the nation. Nonetheless, despite somewhat overblown media reports, most Californians aren’t in a position to tear their businesses up by the roots and transplant them to low or zero income tax havens like Nevada and Florida. Often those businesses have to operate in California, since that’s where the market for the product or service is, and typically for small businesses, the owner has to be present here in state for the enterprise to grow.

But that’s not always the case, especially when a taxpayer owns numerous entities and some of the income derives from service contracts (usually for management work) among the entities or between the entities and the owner. In that case, some strategic use of out-of-state entities can result in large tax savings that might make the major step of relocation worthwhile.

But before we can address the benefits and pitfalls of relocation, we need to first give an overview of California’s income tax system relating to residency. California taxes residents with respect to their “global” income. This means that for a California resident, income from whatever source – whether in-state or out-of-state – is subject to California taxation. There may be credits for payment to other states, and there may be other mitigations of the taxes due. But leaving that aside, California residents generally must pay significant state income taxes on all the income they make, from whatever source. Let’s call this Rule #1: taxation of all income based on the California residency of the taxpayer.

In contrast, nonresidents only have to pay California income taxes to the extent that the income is “California source.” If a nonresident has no California source income, the taxpayer isn’t liable for any California income tax. California source income means income derived from a business or real property with a situs in California, or from work performed here. That income is subject to taxation by California, even if the taxpayer is not a resident. Let’s call this Rule #2: taxation based on the source of the income being situated within California.

The rules relating to who is a resident and who isn’t get very complex and fact specific. I won’t get into them here. See Christopher Manes’ A GUIDE TO SUCCESSFUL (TAX-FREE) SNOWBIRDING and THE PART-TIME RESIDENT TAX TRAP, on the Sanger & Manes website. Suffice it to say that if a taxpayer follows the necessary steps, he can change residency to a lower tax state. The issue is, when is such a major relocation worthwhile? We’ll review question that in Part II.

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So, we get this question a lot in our Palm Springs law office. There is no one-size-fits all on this issue. Here’s an overview of many of the most popular methods for Canadians to minimize the estate tax. If you want to get into specifics, call our office at (760) 320-7421.

Non-Recourse Mortgage

What is it? A non-recourse mortgage is a mortgage secured by the house, with no personal liability for the borrower.

What does it accomplish? It provides a dollar for dollar reduction in the value of the US house/assets for US estate tax purposes (difficult to find US lenders offering non-recourse mortgages to foreign citizens and they will generally only provide them for a percentage (say 50%) of the value of the home).

Insurance Pays for the US Estate Tax

What is it? Snowbird purchases life insurance to pay for US estate tax upon death.

What does it accomplish? The cost of insurance can be considerably cheaper than the estate tax itself.

US House owned via a Foreign (not US) Corporation.

What is it? When the Snowbird dies, he does not own a US house (which is subject to the US estate tax), but owns instead shares of a foreign corporation (specifically not subject to the US estate tax).

: Shares of foreign country’s corporation is not part of a US estate, so very favorable for the US estate tax.

(i) Shareholder benefit taxation in Canada and other countries (must pay tax on rental value).
(ii) Poor for US income tax purposes. When any corporation sells the house, the corporation pays 35% tax of the appreciation (instead of 15%).

US House owned via a Partnership (either US or foreign partnership).

Again, when the Snowbird dies, he does not own a US house (which is subject to the US estate tax), but an interest in a foreign partnership (which may or may not be subject to the US estate tax).
Pros: Partners are taxed as individuals. So upon sale, they are entitled to the low 15% capital gains rate.

Cons: Uncertainty on whether US estate tax is imposed on value of partner’s interest. However, domicile of partners (presumably foreign) is a positive factor in partnership interest not being subject to the US estate tax, but where partnership is conducting business also important.

Important Final Partnership Note:
Partnerships may “check the box” and elect to be taxed as a corporation. Many practitioners believe a partnership electing to be taxed as a corporation is more clearly not subject to the US estate tax. However, the partnership checking the box is now subject to the higher 35% corporate tax when selling the house.

QDOT (Qualified Domestic Trust)

What is it? A trust which holds the Snowbird’s US property.

What does it accomplish? Upon the death of one spouse, property in the QDOT is transferred free of tax to the other spouse (not otherwise available to non-US citizens). Avoids probate upon death of first spouse.

What are QDOT requirements? At least 1 trustee must be a citizen or bank (if QDOT holds more than $2 M, then the trust must be a US Bank, or the trustee can furnish a bond).

Only legally recognized spouse for Federal US purposes qualify (i.e. no same sex spouses).

No more than 35% of the value of real property in the trust can be outside the US.

Published on:

Recall that the US imposes its estate tax on the value of property anybody (US citizen or not) owns in the US (the US “situs property”) upon their death. The following types of property constitutes US situs property for the purposes of the US estate tax:

1) All real estate located in the US;
2) Tangible personal property located in the US (these are objects which can be moved touched or felt, such as jewelry, boats and art (which the Canadian citizen might hang in their US home));
3) Shares of stock of a US corporation.

So a Canadian is absolutely subject to the US estate tax, imposed on the value of their US situs assets. Note, a Canadian is also subject in Canada to deemed disposition tax on death (where we pretend the decedent sold his or her assets right before death, and the tax is paid on the gain component). The US Canada Tax Treaty provides that the Canadian decedent does not have to pay both a US estate tax and a Canada tax on the deemed disposition, but they’ll have to pay the larger one of the two . In these times of relatively flat growth in the value of US real estate, with respect to the US assets the Canadian is probably more likely looking at the specter of paying the US estate tax (which is just based on value, not growth) , and not the Canadian tax on deemed depositions at death.

How Do We Calculate the US Estate Tax Imposed Upon Canadians in 2012?

In 2012, Americans may exempt $5,000,000 of their assets from the estate tax, and the highest rate of US estate tax is 35%. The US/Canada Tax Treaty permits Canadians to utilize a portion of the $5,000,000 exemption as determined by the following formula:

$5,000,000 x (Value of US Property/ Value of Worldwide Assets)= exemption available

Jeff the Canadian Snowbird has $10,000,000 in worldwide assets, and purchases a Palm Springs house for $1,000,000. How much US estate tax will Jeff owe if: Jeff dies in 2012?

Answer (generally…not exact):

1st Determine the exemption available:

$5,000,000 (US exemption) x ($1,000,000 (US assets)/$10,000,000(worldwide assets)=

$5,000,000 x 1/10= $500,000 exemption available
$1,000,000 (US assets) – $500,000(exemption available)= $500,000 subject to estate tax
$500,000 x 35% (highest rate of US estate tax in 2012)= $175,000 estate tax owed

What’s going to change in 2013?

The $5,000,000 exemption amount in 2012 is scheduled to revert to $1,000,000 in 2013.
The highest estate tax rate is 35% in 2012, which is scheduled to revert to 55% in 2013.

How does that impact Canadians? Let’s look at the example again for 2013:

Example for 2013:

Jeff the Canadian Snowbird has $10,000,000 in worldwide assets, and purchases a Palm Springs house for $1,000,000. How much US estate tax will Jeff owe if: Jeff dies in 2013?

1st Determine the exemption available:

$1,000,000 (US exemption) x ($1,000,000 (US assets)/$10,000,000(worldwide assets)=

$1,000,000 x 1/10= $100,000 exemption available
$1,000,000 (US assets) – $100,000(exemption available)= $900,000 subject to estate tax
$900,000 x 55% (highest rate of US estate tax in 2013)= $495,000 estate tax owed in 2013!!!

We’ll talk about popular strategies for Canadians to minimize or avoid the estate tax, in the next post.