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By Elena Hanson
Special to the Financial Independence Hub
Congratulations! You are sending your son or daughter to college in the United States to further their education and help put them on the road to a great career. But have you as the parent done your due diligence to make sure this doesn’t end badly with a big chunk of money ending up in the hands of the IRS? It could happen.
The IRS has long arms and extensive resources, and once it starts examining the earnings and assets of your child who is attending a U.S. school, well, as the saying goes all is fair in love and war. What’s more, the IRS might even wind up investigating the finances and assets of the whole family!
How do you avoid a muddle with the IRS? Good, sound, cross-border tax planning. That’s how. It will protect the income and assets of your child, and of you, and ensure full compliance in Canada and the U.S.
Start with the Visa
Let’s go to the beginning. Your son or daughter has been accepted for admission to the U.S. university or college of their choice, which means they have an F-1 Student Visa or a J-1 Exchange Visitor Visa. All the necessary documentation is complete and there is nothing to worry about.
Well, not exactly. As Canadians you better be up to snuff on all the rules for your child to attend school south of the border or Uncle Sam might have the last laugh, and here’s why. The moment Bobby or Jennifer sets foot in the U.S. the IRS day-counter gets rolling. They keep tabs on the number of days your child is in the country and this is why you, the parent, must do everything to make sure your Canadian child retains their status as a non-resident alien.
Tax residency in the U.S. is based on citizenship/lawful permanent residence (i.e., Green Card) and/or the Substantial Presence test (i.e., days present in the U.S.). This means that if your son or daughter is not a U.S. citizen or a Green Card holder, they will likely meet the criteria for the Substantial Presence test, which is calculated based on the number of days spent in the country over a three-year period. So, if your child’s magic number is 183 days or more, they are considered a U.S. tax resident.
Key is avoiding U.S. residency status
Thus, avoiding U.S. residency status is key and you can do that by filling out a form: Form 8843, which is called ‘Statement for Exempt Individuals.’ It allows students to exclude the number of days they are present in the U.S. for purposes of the Substantial Presence test. But the student must avoid any activities that disqualify this exemption. That could be looking for a job or buying a home in the U.S., or marrying a U.S. person.
If the student has a home in Canada and actively maintains it, but they do not qualify for the exemption as per Form 8843, they can still avoid U.S. taxation on their worldwide income and those IRS filings because of the Canada-US Income Tax Convention (the Treaty). And even if your child is not able to maintain their non-resident status, being aware of a few important things can be a big help.
It all has to do with good tax planning. Here are some examples:
1.) If the student receives more than $100,000 directly from their parents, Canadian relatives or a Canadian estate during the year, that amount is considered a “foreign gift” and must be reported to the IRS. Failure to do so can result in a penalty equal to the greater of $10,000 or up to 25% of the value of the gift! So, instead of depositing funds for tuition and medical expenses to the student’s own bank account, parents should make their payments directly to the educational institution or medical care provider.
2.) A U.S. student who exceeds the 183-day threshold and is not exempt must report their Canadian summer vacation earnings on a U.S. tax return, and pay taxes on this income even though it was not earned in the U.S.
3.) The student should not be a shareholder of a Canadian family business. Why? This will avoid being taxed on corporate profits under one of two anti-deferral regimes, even when those profits are not currently distributed. U.S. tax compliance is complex and the tax rates, plus underpayment interest, can exceed corporate share of income.
4.) If the student is a discretionary beneficiary of a Canadian family trust, the trust should not make any distributions while the student is physically in the U.S. Otherwise, the student may be subject to an annual trust’s prorated or entire income. Also, if the trust owns a Canadian private company there will be an additional layer of anti-deferral corporate taxation.
5.) The taxation of investment products is not always the same, so care must be exercised on what is held in investment portfolio(s) that are owned or co-owned by the student.
6.) A student who is taxed as a U.S. resident is subject to reporting requirements by the IRS. This includes the Report of Foreign Bank and Financial Accounts (FBAR). It means that the student must disclose all non-U.S. (i.e., Canadian) bank accounts owned individually and jointly if the total of the accounts hold more than $10,000 USD.
Another good thing to know is that scholarships and fellowship grants may not end up being ‘free’ money. While scholarships and fellowship grants used to pay for tuition, other school fees, books, supplies, and equipment for courses are tax-free, any part of a scholarship or fellowship grant that goes to room, board, travel, optional equipment, and other auxiliary expenses are taxable.
Doing your due diligence goes a long way and so does having professional advisors who know the rules.
Elena Hanson is the founder and managing director of Hanson Crossborder Tax Inc. Together with Darren Coleman, a wealth management adviser with Raymond James, she is currently doing a podcast series called Two Way Traffic, which is about cross-border tax and financial issues. Watch for Part 2 of this series from Darren Coleman.
