Cross-Border Estate Planning: Freezes, Alter-Ego Trusts, and Bypass Trusts

Canadian estate planning uses structures that have no direct US equivalent. The estate freeze, alter-ego trust, joint partner trust, and Canadian testamentary trust each serve specific Canadian purposes (deferring capital gains tax on death, avoiding probate, income splitting among family members). When the estate owner, the trust settlor, or any beneficiary is a US person (citizen, green card holder, or US resident), these structures collide with the US estate tax, gift tax, generation-skipping transfer tax, and foreign trust rules.

The collision produces two categories of problems: unexpected US tax liability (estate tax on assets the Canadian structure was designed to shelter) and compliance obligations (Form 3520, Form 3520-A, FBAR, Form 706-NA) that cost thousands per year to maintain.

Estate freezes

An estate freeze is a Canadian technique where the business owner exchanges their common shares for fixed-value preferred shares, and new common shares (with all future growth) are issued to the next generation (or to a family trust holding for the next generation). The effect is to cap the freezor’s capital gains exposure at death at the current value, with all future appreciation accruing to the next generation.

Canadian treatment: the freeze is generally a tax-deferred transaction under ITA 85(1) (rollover). No immediate tax. The freezor holds preferred shares with a fixed redemption value. On death, the deemed disposition of the preferred shares triggers capital gains tax on the frozen amount.

US treatment (if the freezor is a US person):

• Gift tax: the issuance of new common shares to the next generation (or a family trust) at nominal value, while the freezor takes back preferred shares, is a transfer of value. The US treats the difference between the fair market value of the common shares (reflecting future growth potential) and their nominal subscription price as a gift. The gift may be covered by the lifetime gift tax exemption ($13.99M for 2025), but it must be reported on Form 709 (Gift Tax Return).
• IRC 2701 valuation: the IRS applies special valuation rules under IRC 2701 to transfers of interests in corporations where the transferor retains a senior equity interest (preferred shares). IRC 2701 can value the retained preferred shares at zero for gift tax purposes (unless the preferred shares carry “qualified payment rights,” such as cumulative dividends at a market rate). If the preferred shares are valued at zero, the entire fair market value of the corporation is treated as a gift. This is the opposite of the intended Canadian result (which was to freeze the value, not create a gift).
• Mitigation: structure the preferred shares with cumulative, mandatory dividends at a market rate (a “qualified payment right” under IRC 2701). This allows the preferred shares to retain their value for US gift tax purposes, reducing or eliminating the deemed gift.

US treatment (if the freezor is NOT a US person but the corporation has US-situs assets):

• The freeze itself is not a US tax event for a non-US-person freezor
• On the freezor’s death, US estate tax may apply to US-situs assets held by the corporation (look-through rules can apply to closely held corporations)

Alter-ego trusts and joint partner trusts

An alter-ego trust (for individuals 65+) or joint partner trust (for couples, one aged 65+) allows the settlor to transfer assets to a trust during their lifetime, with the trust property reverting to the settlor (or surviving spouse) during their lifetime. The primary purpose is probate avoidance: on death, the trust assets pass to the beneficiaries without going through the estate.

Canadian treatment: no tax on the transfer to the trust (ITA 73(1) spousal rollover applies). The settlor is taxed on the trust’s income during their lifetime. On the settlor’s death (or the surviving spouse’s death for a joint partner trust), a deemed disposition triggers capital gains tax.

US treatment (if the settlor is a US person):

• Grantor trust: the US treats the alter-ego trust as a grantor trust (the settlor retains beneficial enjoyment). The settlor is taxed on the trust’s income annually on their 1040. This is consistent with the Canadian treatment (where the settlor is also taxed on the income).
• Foreign trust reporting: the trust is a foreign trust (established and administered in Canada). The settlor must file Form 3520-A (Annual Information Return of Foreign Trust with a US Owner). The beneficiaries must file Form 3520.
• US estate tax: because the settlor retains beneficial enjoyment during their lifetime, the trust assets are included in the settlor’s US gross estate (IRC 2036(a)(1)). The probate avoidance benefit in Canada does not produce estate tax avoidance in the US.
• Gift on death: when the trust assets pass to the remainder beneficiaries on the settlor’s death, this is a transfer subject to US estate tax. If the beneficiaries are not US persons, the transfer may also have Canadian implications (Part XIII withholding on trust distributions to non-residents).

US treatment (if the settlor is NOT a US person but the trust holds US-situs assets):

• US estate tax applies to US-situs assets (US real estate, US securities) on the non-citizen settlor’s death. The exemption for non-resident non-citizens is only $60,000 (vs $13.99M for US citizens), though the treaty may provide an expanded credit (Article XXIX B(2)).

Bypass trusts (spousal trusts and credit shelter trusts)

A bypass trust (or credit shelter trust) is used in US estate planning to use both spouses’ estate tax exemptions. In Canada, the equivalent structure is the spousal trust (ITA 70(6)), which defers capital gains tax until the surviving spouse’s death.

The cross-border conflict:

• US goal: use the deceased spouse’s estate tax exemption by funding a bypass trust with assets up to the exemption amount ($13.99M for 2025). The surviving spouse has access to the trust income (and sometimes principal), but the trust assets are not included in the surviving spouse’s estate on their death, preserving the deceased spouse’s exemption.
• Canadian goal: defer capital gains tax by using a spousal trust (ITA 70(6)). The assets roll to the trust at the deceased’s adjusted cost base, and capital gains are deferred until the surviving spouse’s death (or the trust’s deemed disposition).

The conflict: a US bypass trust that gives the surviving spouse access to income but not outright ownership may not qualify as a Canadian spousal trust under ITA 70(6) (which requires that the surviving spouse be entitled to receive all the income of the trust during their lifetime and that no other person may receive or use the trust property during the surviving spouse’s lifetime). If the trust does not qualify under ITA 70(6), the deemed disposition on the deceased’s death triggers capital gains tax immediately, rather than being deferred.

The QDOT overlay: if the surviving spouse is not a US citizen, the unlimited marital deduction is not available, and a Qualified Domestic Trust (QDOT) is required to defer the US estate tax. The QDOT must meet specific requirements (US trustee, withholding on distributions of principal exceeding $11K). Coordinating a QDOT with a Canadian spousal trust adds another layer of complexity.

Treaty coordination: Article XXIX B

The Canada-US tax treaty, Article XXIX B, provides coordination between the Canadian deemed disposition at death and the US estate tax:

1. Non-discrimination: each country must allow its own residents the benefits it provides to its own citizens for estate/inheritance tax purposes
2. Unified credit: the treaty provides that a Canadian resident who is not a US citizen is entitled to a pro-rata share of the US estate tax unified credit, based on the ratio of US-situs assets to worldwide assets
3. FTC for Canadian tax: the US allows a credit against the US estate tax for Canadian income tax paid on the deemed disposition at death (and vice versa)

The treaty credit helps, but it does not eliminate double taxation in all cases. The Canadian capital gains tax and the US estate tax are different types of tax (income tax vs transfer tax), and the credit mechanism is imperfect. For large estates with assets in both countries, some double taxation may remain.

The 21-year rule

Canadian trusts (except certain testamentary trusts in the first 36 months) are subject to a deemed disposition of their assets every 21 years. The trust pays capital gains tax on unrealized gains as if the assets had been sold.

For US persons, the 21-year deemed disposition creates a Canadian tax event with no corresponding US event. The Canadian tax paid may not generate a usable FTC in the US (because there is no US income to offset). This tax is a pure cost with no cross-border relief.

Planning response: if a 21-year deemed disposition is approaching and the trust has US-person beneficiaries, consider distributing the appreciated assets to the beneficiaries before the deemed disposition. The beneficiaries take the assets at the trust’s cost base in Canada (ITA 107(2)), and the trust avoids the 21-year tax. The beneficiaries then hold the assets directly, simplifying the US reporting.

What should I do next?

If you have a cross-border estate (assets in both countries, family members in both countries, or dual citizenship), review your existing structures for cross-border compatibility. If you are creating new structures, engage both a Canadian and a US estate planning professional. Start with the treaty credit analysis (Article XXIX B) to understand how much of the double taxation can be eliminated.

• Do I need a QDOT for my non-citizen spouse?, the QDOT mechanics for non-citizen spouses
• Canadian trust with a US beneficiary, the accumulation distribution trap for existing trusts
• Selling my Canadian business before or after moving to the US, the LCGE planning that interacts with estate freezes

This guide is general information, not tax advice for your specific situation. Which points apply, and how, depends on your facts.