Insurance and the U.S. estate tax

By Nadja Ibrahim | July 21, 2009 | Last updated on July 21, 2009
4 min read
  • If Jerome controls the company owning the insurance, the full value of the insurance proceeds will form part of his estate for U.S. estate tax purposes.
  • Even if Jerome does not control the company, the value of his shares in the company will increase as a result of the value of the insurance proceeds received. That increased value of the shares is included in Jerome’s U.S. estate tax calculation.
  • Generally speaking, for Canadian tax purposes, insurance proceeds are paid out of a corporation as a tax-free capital dividend to its shareholder(s). However, if the insurance proceeds are paid out to a U.S.-citizen shareholder or to a spousal trust and the spouse is a U.S. citizen, the proceeds may be subject to U.S. income tax. This is because the U.S. does not recognize the Canadian concept of a tax-free capital dividend account. This issue often arises with joint last-to-die policies held in a corporation when one of the insured shareholders is a U.S. citizen.

Insurance can be an effective tool for Canadian estate planning purposes because its proceeds are received tax-free. However, under many circumstances, U.S. citizens living in Canada may have to include the value of the insurance for the purposes of determining their U.S. estate tax liability. So you’ll need to work on some careful tax planning to avoid the above scenarios.

This article contains excerpts from an article that originally appeared in the spring 2009 issue of PricewaterhouseCoopers’ Wealth and Tax Matters.

Nadja Ibrahim is a partner in the high-net-worth tax services practice of PricewaterhouseCoopers LLP.

(07/21/09)

Nadja Ibrahim

Individuals in Canada often purchase insurance to help fund tax liabilities that arise on death. In addition, some insurance products are purchased as an investment vehicle to shelter income from tax.

Generally speaking, estate planning with insurance is effective in Canada because insurance proceeds are received tax-free. However, for U.S. citizens living in Canada, great care is required to prevent those proceeds from being subject to U.S. estate and income tax. As a result, proper planning is required if your client is a U.S. citizen and the potential purchaser or ultimate beneficiary of the policy.

A U.S. citizen is subject to U.S. estate tax on the fair market value of his worldwide assets. Currently, because of the prevailing estate tax credits, the first US$3.5 million is excluded from tax. To the extent the estate is valued at over US$3.5 million, it is taxed at a top rate of 45%.

Let’s assume your client, Bill, is a U.S. citizen who owns an insurance policy on his life. If he dies owning the policy, the entire amount of the proceeds received on death will need to be included in his worldwide estate for U.S. estate tax purposes. This is the case regardless of whether or not the estate is the beneficiary of the policy. So even if Bill’s other worldwide assets are less than the US$3.5 million estate tax exemption, the insurance could push the value over the limit, thus creating exposure to U.S. estate tax.

How to avoid the U.S. estate tax

If your client is a U.S. citizen and married to a non-U.S. citizen, one way to avoid the application of U.S. estate tax is to have the spouse own the policy on the U.S. citizen’s life.

For example, if Bill already owns the insurance policy, he could allow the policy to lapse and have his spouse, Sally, purchase new insurance. Bill could also transfer the insurance to Sally. However, to prevent the insurance from being included in his estate for U.S. estate tax purposes, he must survive for three years after the transfer. And you’ll need to ensure that Bill’s transfer of the policy will not be subject to U.S. gift tax.

If Sally is going to be the owner of the insurance on Bill’s life, her will must be drafted carefully so that he does not obtain ownership of the policy if Sally is the first to die.

Another option is to create a Canadian resident irrevocable life insurance trust (ILIT) to hold the insurance policy. The ILIT would hold the policy for the benefit of the beneficiaries, who are generally the same as those named in the U.S. citizen’s will. Ideally, the insurance premiums would be funded by the ILIT through contributions received from a non-U.S. citizen. However, if the U.S. citizen must fund the policy, tax advice is essential to avoid the application of U.S. gift tax.

Corporate-held insurance

In the case of a Canadian family-owned or private business, insurance is often held by the company, because it normally has more after-tax dollars for making premium payments. And, payment of insurance proceeds on the shareholder’s death to the shareholder’s estate has tax benefits. However, if your client, Jerome, is a shareholder and a U.S. citizen, this typical Canadian estate planning could result in harsh U.S. estate and income tax consequences, such as the following:

  • If Jerome controls the company owning the insurance, the full value of the insurance proceeds will form part of his estate for U.S. estate tax purposes.
  • Even if Jerome does not control the company, the value of his shares in the company will increase as a result of the value of the insurance proceeds received. That increased value of the shares is included in Jerome’s U.S. estate tax calculation.
  • Generally speaking, for Canadian tax purposes, insurance proceeds are paid out of a corporation as a tax-free capital dividend to its shareholder(s). However, if the insurance proceeds are paid out to a U.S.-citizen shareholder or to a spousal trust and the spouse is a U.S. citizen, the proceeds may be subject to U.S. income tax. This is because the U.S. does not recognize the Canadian concept of a tax-free capital dividend account. This issue often arises with joint last-to-die policies held in a corporation when one of the insured shareholders is a U.S. citizen.

Insurance can be an effective tool for Canadian estate planning purposes because its proceeds are received tax-free. However, under many circumstances, U.S. citizens living in Canada may have to include the value of the insurance for the purposes of determining their U.S. estate tax liability. So you’ll need to work on some careful tax planning to avoid the above scenarios.

This article contains excerpts from an article that originally appeared in the spring 2009 issue of PricewaterhouseCoopers’ Wealth and Tax Matters.

Nadja Ibrahim is a partner in the high-net-worth tax services practice of PricewaterhouseCoopers LLP.

(07/21/09)

Individuals in Canada often purchase insurance to help fund tax liabilities that arise on death. In addition, some insurance products are purchased as an investment vehicle to shelter income from tax.

Generally speaking, estate planning with insurance is effective in Canada because insurance proceeds are received tax-free. However, for U.S. citizens living in Canada, great care is required to prevent those proceeds from being subject to U.S. estate and income tax. As a result, proper planning is required if your client is a U.S. citizen and the potential purchaser or ultimate beneficiary of the policy.

A U.S. citizen is subject to U.S. estate tax on the fair market value of his worldwide assets. Currently, because of the prevailing estate tax credits, the first US$3.5 million is excluded from tax. To the extent the estate is valued at over US$3.5 million, it is taxed at a top rate of 45%.

Let’s assume your client, Bill, is a U.S. citizen who owns an insurance policy on his life. If he dies owning the policy, the entire amount of the proceeds received on death will need to be included in his worldwide estate for U.S. estate tax purposes. This is the case regardless of whether or not the estate is the beneficiary of the policy. So even if Bill’s other worldwide assets are less than the US$3.5 million estate tax exemption, the insurance could push the value over the limit, thus creating exposure to U.S. estate tax.

How to avoid the U.S. estate tax

If your client is a U.S. citizen and married to a non-U.S. citizen, one way to avoid the application of U.S. estate tax is to have the spouse own the policy on the U.S. citizen’s life.

For example, if Bill already owns the insurance policy, he could allow the policy to lapse and have his spouse, Sally, purchase new insurance. Bill could also transfer the insurance to Sally. However, to prevent the insurance from being included in his estate for U.S. estate tax purposes, he must survive for three years after the transfer. And you’ll need to ensure that Bill’s transfer of the policy will not be subject to U.S. gift tax.

If Sally is going to be the owner of the insurance on Bill’s life, her will must be drafted carefully so that he does not obtain ownership of the policy if Sally is the first to die.

Another option is to create a Canadian resident irrevocable life insurance trust (ILIT) to hold the insurance policy. The ILIT would hold the policy for the benefit of the beneficiaries, who are generally the same as those named in the U.S. citizen’s will. Ideally, the insurance premiums would be funded by the ILIT through contributions received from a non-U.S. citizen. However, if the U.S. citizen must fund the policy, tax advice is essential to avoid the application of U.S. gift tax.

Corporate-held insurance

In the case of a Canadian family-owned or private business, insurance is often held by the company, because it normally has more after-tax dollars for making premium payments. And, payment of insurance proceeds on the shareholder’s death to the shareholder’s estate has tax benefits. However, if your client, Jerome, is a shareholder and a U.S. citizen, this typical Canadian estate planning could result in harsh U.S. estate and income tax consequences, such as the following:

  • If Jerome controls the company owning the insurance, the full value of the insurance proceeds will form part of his estate for U.S. estate tax purposes.
  • Even if Jerome does not control the company, the value of his shares in the company will increase as a result of the value of the insurance proceeds received. That increased value of the shares is included in Jerome’s U.S. estate tax calculation.
  • Generally speaking, for Canadian tax purposes, insurance proceeds are paid out of a corporation as a tax-free capital dividend to its shareholder(s). However, if the insurance proceeds are paid out to a U.S.-citizen shareholder or to a spousal trust and the spouse is a U.S. citizen, the proceeds may be subject to U.S. income tax. This is because the U.S. does not recognize the Canadian concept of a tax-free capital dividend account. This issue often arises with joint last-to-die policies held in a corporation when one of the insured shareholders is a U.S. citizen.

Insurance can be an effective tool for Canadian estate planning purposes because its proceeds are received tax-free. However, under many circumstances, U.S. citizens living in Canada may have to include the value of the insurance for the purposes of determining their U.S. estate tax liability. So you’ll need to work on some careful tax planning to avoid the above scenarios.

This article contains excerpts from an article that originally appeared in the spring 2009 issue of PricewaterhouseCoopers’ Wealth and Tax Matters.

Nadja Ibrahim is a partner in the high-net-worth tax services practice of PricewaterhouseCoopers LLP.

(07/21/09)