Shield insurance proceeds from U.S. estate tax

Life insurance can play an important role in estate planning. But complexities arise for those subject to U.S. estate tax.

While life insurance proceeds are generally not taxable in the hands of a beneficiary, U.S. law includes the value of life insurance in the gross estate of the deceased if he or she owned the policy. Factors used to determine ownership include who can cancel or make changes to the policy’s terms, who is paying the premiums, and who can leverage the policy for investment purposes.

If a client has life insurance in her taxable estate, it can mean paying U.S. estate tax when none would otherwise be due. Consider an example of an unmarried U.S. citizen with a net worth of $5 million in real estate and investments. If that person were to add a $1-million life insurance policy, its inclusion in the gross estate would push the estate’s value beyond the current exclusion amount, and result in approximately $264,000 in tax. Here’s why, and what you can do about it.

Estate tax basics

U.S. citizens are subject to estate tax on death, regardless of where they live or where their assets are located. Current rules provide for a $5.34-million exclusion; anything beyond that is taxed at 40% of the fair market value of the estate.

Even Canadian citizens and residents are subject to U.S. estate tax if they own real estate in the U.S. or stock of U.S. corporations. Unlike U.S. citizens, Canadian citizens are only taxed on the value of their U.S. assets. But life insurance can have significant tax consequences for Canadians who die owning U.S. assets. That’s because the amount of estate tax credit they may claim under the U.S.-Canada Tax Treaty depends on the value of their worldwide estate (calculated using U.S. principles). In particular, purchasing a large life insurance policy reduces available treaty credits, which means there may not be enough credits to cancel out the estate tax on U.S.-situated assets.

Fortunately, there’s an effective solution to the life insurance problem: an Irrevocable Life Insurance Trust (ILIT). An ILIT is an inter vivos trust created to hold a life insurance policy in a way that excludes it from a taxable estate.

Structuring the ILIT

Trusts are separate from the settlors, trustees and beneficiaries. Consequently, assets the trust holds are not considered any person’s property. That said, the Internal Revenue Code (IRC) contains provisions that can claw trust property back into the estate of an individual for tax purposes.

Section 2035 of the IRC requires that a decedent’s estate be increased by the amount of any gift made within three years of that person’s death. This means that if a person currently owns life insurance, and wants to transfer ownership to an ILIT’s trustee, the person must survive at least three years in order for the ILIT to shelter that policy from the decedent’s estate.

Section 2036 deals with transfers where the transferor retains an interest in the transferred property. The retained interest rule applies where the transferor has the ability to determine who may use or enjoy the property. In the context of an ILIT, this means no benefit can be realized where the policy’s owner acts as the ILIT’s trustee.

Section 2038 says any revocable transfer will not be effective in removing an asset from one’s taxable estate. For ILITs, this means the trust must be irrevocable; no substantive changes can be made after the trust is settled.

Section 2041 causes trust assets to be included in the estate of anyone holding a general power of appointment over trust property. This means the ability to distribute trust capital to oneself during one’s lifetime, to one’s estate on death, or to creditors at any time. This means the person transferring the policy into the ILIT cannot be a beneficiary.

In summary, for the ILIT to effectively shield life insurance proceeds from the taxable estate, the policy owner cannot be either a trustee or a beneficiary. Instead, she would be the settlor of the trust, a reliable third party would be the trustee, and her spouse and descendants would be beneficiaries.

How to prevent gift tax

U.S. law also imposes tax on certain gifts. Canadian citizens and residents are only taxed on gifts of tangible property situated in the U.S.

So, funding an ILIT shouldn’t give rise to U.S. gift-tax problems for Canadians. However, U.S. citizens (regardless of where they live) are taxed on any gift over the annual exemption amount, which is $14,000 per recipient per year (in 2014).

You have to determine a life insurance policy’s value when transferring it to an ILIT. If it’s a cash-value policy, there may be gift tax due on the transfer. The transferor can elect to use lifetime credits against gift tax to avoid paying immediately, but this will reduce the estate tax exclusion amount by the same amount. Term policies have no cash value, so they can be transferred to an ILIT without gift-tax issues.

Beyond the initial funding of the ILIT with the life insurance policy, arrangements must be made to allow the trustee to pay premiums each year. One option is to transfer cash or securities to the trust along with the policy; income can be used to pay the premiums. But this would likely result in additional gift tax up front (or utilization of lifetime credits); furthermore, the income generated by those productive assets would likely be attributed to the transferor under the U.S. Grantor Trust rules.

Another option for paying premiums is through annual gifts to the trust. As noted, gifts of up to $14,000 can be made to as many people as one likes without incurring gift tax. The key factor here, though, is that the gift must be of a present interest in the gifted property; future interests do not qualify for the annual exemption.

For transfers to an ILIT to qualify for the annual gift-tax exemption, beneficiaries must be able to withdraw funds immediately if they choose. This is commonly referred to as a “Crummey Power,” named after the 1968 court case that approved this scheme. Assuming Crummey Powers are properly drafted into the trust agreement, the grantor can make limited annual gifts to the trust to pay premiums on policies held within the ILIT.

Using ILITs

When properly structured, ILITs can provide tax-free cash upon death without increasing the estate tax burden on a person’s estate. But if the life insurance was purchased to provide the cash needed to pay the deceased’s estate tax or other debts, the ILIT’s objective of separating the proceeds from the estate can be problematic. This is because the trustee (rather than the executor) will receive the funds. So planning is needed to ensure the funds will be available to the executor.

The trust agreement should permit (but shouldn’t require) the ILIT’s trustee to purchase illiquid assets from the estate or make loans to the estate to provide the cash needed to properly administer and settle it.

These loans or purchases should be structured to reflect terms that an arm’s length transaction might reach through negotiation. Specifically, loans should bear an interest rate with an established repayment schedule, and any purchases should be for fair market value.

David is a Florida attorney, Canadian legal advisor and the managing partner at Altro Levy. He can be reached at 416-477-8155 or daltro@altrolevy.com.

Jonah is a partner who leads the Altro Levy Vancouver practice and specializes in cross-border tax and estate planning. He can be reached at 604-569-1445 or jspiegelman@altrolevy.com.