United States citizens living in Canada face the same exposure to U.S. estate tax they’d face if they lived in the U.S. They can also use many of the same strategies U.S. residents use to deal with the tax liability. This includes owning life insurance in an irrevocable life insurance trust (ILIT). Although setting up and administering an ILIT for these clients can be complicated, the potential tax benefits may be well worth the effort.
In this article we’ll take a closer look at:
- The taxing reality for U.S. citizens living in Canada
- ILITs – A valuable solution
- Administrative and other details, including:
ILITs – in brief
An irrevocable life insurance trust (ILIT) can help avoid estate taxes on life insurance proceeds. Essentially, it owns a life insurance policy on your life, removing the policy and death benefit from your estate. Because it’s irrevocable, once a policy is part of that trust, there’s no taking it back to own in your own name. However, as long as you don’t receive a benefit from the trust, you can still name the trust beneficiaries, and specify terms related to their receiving trust benefits.
The taxing reality
When U.S. citizens live in Canada, they must comply with:
- U.S. income tax laws,
- Canadian income tax laws, and
- the U.S. transfer tax system (U.S. gift and estate taxes).
Under the U.S. gift and estate tax systems, gratuitous transfers that U.S. citizens make during life and at death are taxed.1 But there are ways to curtail these taxes. For example:
- the annual gift tax exclusion allows for gifts to anyone up to $14,0002 per person per year3 without having to file a gift tax return or pay gift tax.4
- the unified credit eliminates gift or estate tax on transfers up to $5.45 million5 over a lifetime6 (although the amount used to shelter gifts from gift tax while someone’s living directly reduces the amount available to shelter gifts from estate tax at death).
The gift and estate tax rates are also progressive and cumulative. Rates start at 18% for taxable gifts over $10,000 and rise to 40% when cumulative lifetime taxable gifts exceed $1 million.7 The initial taxable gifts a client makes are taxed at the lower rates and permanently occupy the lower tax brackets. This forces the taxation of later gifts into the higher tax brackets, requiring greater amounts of the unified credit to eliminate tax.
The unlimited marital gift and estate tax deduction can also come in handy. It eliminates tax for property transfers between U.S. citizen spouses.8 Although this deduction doesn’t apply to transfers made to non-U.S. citizen spouses, a U.S. citizen can still give money or property worth up to $148,0009 per year to their non-U.S. citizen spouse without having to pay gift tax.10
Finally, charitable donations11 and money paid on behalf of another person directly to a school for tuition12 or to a doctor or hospital for medical care13 aren’t subject to gift or estate tax.
All these deductions can be helpful. But for clients whose net worth exceeds $5.45 million, some wealth may still be lost to estate tax at death. Consider this simplified example: if a U.S. citizen worth $7 million didn’t have an estate plan and died in 2016, their heirs could expect to lose $620,000 to estate tax (i.e., $7 million – $5.45 million = $1.55 million, 40% of which is $620,000).
ILITs – A valuable solution
Canadians who want to address estate tax issues can buy life insurance to replace the money their estate will lose to taxes. But if a U.S. citizen owns a policy on their life, the death benefit will be added to the value of their taxable estate.14 If their net worth exceeds $5.45 million, that’s like naming the Internal Revenue Service (IRS) as a beneficiary for 40% of the insurance proceeds. And that’s where an ILIT can help.
When a client creates an ILIT to own a life insurance policy, they must appoint a trustee to administer the trust. Almost anyone can serve as the trustee, as long as it’s not the client, a trust beneficiary or the client’s spouse. U.S. citizens living in Canada may want to name a Canadian citizen and resident as trustee, for reasons outlined below.
They also name the trust beneficiaries — people they’d name as policy beneficiaries if there wasn’t an ILIT to own the policy. The ILIT is the beneficiary of the life insurance policy.
At the same time, clients need to know what they can’t do. Because they won’t have rights to any trust or policy benefits, they’re not entitled to:
- transfer policy ownership to someone else,
- designate or revoke a beneficiary to the life insurance policy,
- take policy withdrawals,
- borrow from the policy cash values, or
- pledge the policy as security for a loan.
And because the client won’t own the policy or have any rights to policy or trust benefits, the policy death benefit won’t be part of their estate. The death benefit:
- won’t attract estate tax and
- will go, tax-free, to the client’s intended recipients.
Applying for the life insurance policy
Once a client appoints their ILIT trustee, the trustee applies for and owns the policy. If the ILIT doesn’t yet exist, the best practice is for someone other than the client or their spouse to apply for the life insurance policy, to start the underwriting process. Otherwise, the IRS could claim that the client had ‘incidents of ownership’ in the trust assets because they (or their spouse) applied for the policy. Incidents of ownership are any rights that would give the client an economic benefit.15 For example, in connection with a life insurance policy, the excluded rights noted earlier (though not an exhaustive list), would be incidents of ownership.
Although U.S. courts say it doesn’t matter who applies for the policy — it’s who owns it when it’s issued that matters — having the client or their spouse apply for the policy, then step aside before it’s issued, still carries some risk. One difficulty is that the creation of a life insurance policy may take place over several different dates. For example:
- a policy’s issue date is usually the day the life insurance company approves and accepts the application.
- a policy’s effective date is the day the life insurance company’s legal obligations under the policy begin.
- a policy date is the date the insurance company puts on the policy, often the same as the issue date, but sometimes later, to allow time for policy delivery.
Adding to the potential confusion is the fact that tax authorities may use the same terminology as the industry, but may have different definitions for those terms. Having someone other than the client or their spouse apply for the policy avoids the potential difficulty and confusion.
For clients who are uninsurable or very heavily rated (making a new life insurance policy too expensive), if they already own a policy, they could transfer it to the ILIT, as long as they’re aware of the issues:
- The 3 year rule16 – Any property that a U.S. citizen transfers within 3 years of death is included in their taxable estate at death. This discourages ‘deathbed’ transfers by rendering them ineffective for estate tax planning purposes. The only way to avoid this rule is to live for another 3 years after the transfer.
- Gift tax – The transfer is treated as a taxable gift to the trust beneficiaries. Unless the trust beneficiaries have the right to take the gift, the client won’t be able to use the $14,000 per trust beneficiary annual gift tax exclusion. Even if the policy qualifies for the annual gift tax exclusion, the client will still have to file a gift tax return and use some of their unified credit to avoid gift tax if the policy cash value exceeds $14,000 per trust beneficiary.
- Deemed disposition – Under Canadian law, the transfer is treated as a disposition of the policy. The client will have to pay tax on the policy’s taxable gain: cash surrender value (CSV) minus adjusted cost basis (ACB).17
The Canada-U.S. Tax Treaty (the Treaty) offers no way to avoid the potential for double taxation resulting from Canadian tax on the taxable gain and U.S. gift tax on the policy cash value.
Given these complications, whenever possible the trustee should be the owner of a new policy from the date it’s issued.
Canadian life insurance policy tax implications
As noted earlier, an ILIT trustee should be a Canadian citizen and resident, not a U.S. citizen or resident. That’s because the policy will be a Canadian policy, issued by a Canadian life insurance company, and will conform to Canadian rules governing the income tax treatment of life insurance policies. If an American citizen or resident owned the policy, even as trustee, the policy could have to conform to U.S. tax rules. That would require an actuary to determine each year whether the policy conformed to those rules. Naming a Canadian citizen and resident as trustee avoids that issue.
Having the ILIT own a Canadian life insurance policy won’t affect the U.S. estate tax outcome. There’s no rule that ILITs may own only American life insurance policies.
Premium excise tax
Internal Revenue Code (IRC), sections 4371 – 4374 and Treasury Regulations 46.4371 and 46.4374 impose an excise tax on the premiums paid for any life insurance policy issued on the life of a U.S. person, but purchased from a foreign insurer.18 The tax is 1% of the gross premiums paid and applies to all U.S. citizens, wherever they live.
Even though a trustee will own the policy, the IRS also holds the insured person jointly liable to pay the tax (if different from the policy owner). As a result, a U.S. person living in Canada won’t be able to avoid the premium excise tax just by placing a Canadian life insurance policy in an ILIT.
Canadian tax considerations
For U.S. citizens living in Canada, ILITs also need to conform to Canadian law. One requirement is the 21-year deemed disposition rule. A life insurance policy is not an asset that must be disposed of every 21 years, however:
- the proceeds of insurance, if retained in the trust, will be deemed disposed of every 21 years, and
- half of any capital gains earned on those proceeds will be brought into trust income unless paid to the trust beneficiaries.
Even if there are minor beneficiaries, this shouldn’t pose much of a problem. In most cases, money from an ILIT is flowed out soon after death, provided the trust beneficiaries are of age and have capacity to receive the funds. If money is held for a minor beneficiary, they should reach legal age before the 21-year rule applies.
Attribution rules also warrant consideration. Generally speaking, any income resulting from money that the client transfers to a spouse or child, even in trust, is attributed to the client. An ILIT isn’t exempt from these rules. However, as long as the gifts to the trust pay only the life insurance policy premiums and the trustee’s reasonable expenses, there should be little or no trust income to attribute or tax. Since the death benefit is paid tax-free, and can be transferred to the trust beneficiaries tax-free, there should be no attribution on the death benefit. Any income earned on a death benefit held in trust for a beneficiary won’t be attributed to the client because they will have died by this point.
Creating and administering an ILIT is complicated. But the potential tax benefits can be substantial, making the effort and expense worthwhile. Encourage your clients to seek appropriate tax and legal advice when considering and creating an ILIT.
This article is based on a financial bulletin authored by Stuart L. Dollar, Director, Tax and Insurance Planning, Sun Life Financial, Using irrevocable life insurance trusts (ILITs) to plan for U.S. estate tax, May 2016.
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1 Internal Revenue Code (IRC), sections 2001 and 2501
2 All figures are in U.S. dollars unless otherwise indicated
3 2016 limit, indexed for inflation when cumulative years of inflation justify a $1,000 increase in the exclusion
4 IRC, section 2503(b)
5 2016 amount, indexed for inflation
6 IRC, section 2010(a)
7 IRC, section 2001(c)
8 IRC, section 2523(a)
9 2016 amount, indexed annually for inflation
10 IRC, section 2523(i)
11 IRC, section 2522(a)
12 IRC, section 2503(e)(2)(A)
13 IRC, section 2503(e)(2)(B)
14 IRC, section 2042
15 Treasury Regulation, section 20.2042-1(c)
16 IRC, section 2035
17 Income Tax Act, (ITA), section 148
18 Casualty and indemnity bonds, and reinsurance are also subject to the tax, but a discussion of them is beyond the scope of this article.