Paul F. Keul, CPA, CA, TEP, client service partner, S+C Partners LLP Chartered Accountants, Mississauga, Ont.
Patricia Wong, 36, was born in Claremont, California. A star student at Harvard, she went on to earn a doctorate in aeronautics from MIT. After spending a few years with an aircraft firm in Chicago, she took a lucrative position with a Montreal-based company.
Two years after settling in Canada she married Yves Moreau, a charming but less financially stable sculptor. Patricia’s now a dual U.S.-Canadian citizen and subject to tax on both sides of the border.
The couple has one child, Mireille. Since Patricia lived in the U.S. for more than five years, and lived there for more than two years after she turned 14, U.S. law says any children she has abroad are also U.S. citizens.
When Patricia was six, her parents’ Californian advisor suggested they buy basic whole life insurance for Patricia and her two siblings under the umbrella of one of their own policies. When she left for Harvard at 18, her parents transferred the policy to her name.
Parents do this to ensure children can add coverage at reasonable rates later in life.
“Many whole life policies have guaranteed insurability options, so if the insured develops a health condition that would make it difficult to get insurance, the existing policy allows her to buy another $25,000 or $50,000 of coverage at standard rates,” explains Paul F. Keul, a partner at S+C Partners LLP Chartered Accountants.
Degree of difficulty
7 out of 10. Keul says advisors must educate themselves on the cross-border tax implications on all financial instruments, including insurance. Once advisors grasp the fundamentals, they’ll know which questions to ask clients, what the planning options are and which outside experts to bring in.
Patricia’s Canadian advisor says the U.S. policy may be worth keeping, but it no longer provides enough coverage. She’s considering a $1-million universal life policy. But both policies have potential tax implications in Canada and the U.S., and Keul stresses poor planning can mean major headaches with both CRA and IRS.
In the U.S. (as in Canada), a certain amount of income generated within an insurance policy is tax exempt. Companies structure their policies to stay within these thresholds. Sometimes markets outperform and growth goes beyond the limit. This additional amount is subject to tax, so for the Canadian policy it will show up on the T5.
Problem is, “the Canadian and U.S. formulas for determining exempt status are different. Growth within a Canadian policy may not be exempt for U.S. tax purposes; similarly, a U.S. policy could be exempt in Canada. It’s case-specific,” Keul says. Patricia’s advisor has to deal with two key issues:
- Is her U.S. policy exempt in Canada? If not, what are her tax obligations and are they onerous enough to make terminating the policy a better option?
- Would her new Canadian policy be exempt in the U.S.? If not, would there be any strategies to shield growth and proceeds on death from U.S. tax?
The advisor’s first step is to contact the U.S. insurance provider to determine the policy’s tax status in Canada. But Keul says this is hit-or-miss.
“Tax experts at the insurance company know the formulas for their own jurisdictions inside out, but may not pay attention to the rules on our side of the border.”
Turns out, the U.S. provider doesn’t have the information Patricia needs, so she doesn’t know whether she has a Canadian tax liability. Terminating the policy wouldn’t solve her problem, because doing so would give her a lump sum of $15,000—which may not be exempt. Keul says she needs to hire an insurance tax consultant to determine the policy’s status, which costs about $2,000.
Proper planning for the Canadian policy is more complex and getting it wrong can mean giving the IRS too much money. The best option, Keul says, is to purchase the policy through an irrevocable life insurance trust (ILIT). This will cost about $2,500.
To do this, Patricia appoints Yves as trustee. She puts money in to cover premiums and cash value for investment growth. On her death the proceeds of the policy will be distributed to the trust, which is structured to pass the proceeds to Yves and Mireille. All of this happens tax-free. If Yves dies first, the trust will distribute the funds to Mireille.
If Patricia doesn’t use an ILIT, she’ll be faced with the U.S. estate tax of 40%. The exemption is currently $5.25 million and will rise with inflation.
Given Patricia’s age and income, it won’t be long before her exemption room gets used up because it encompasses her house, RRSPs, bank accounts and investments.
With an ILIT, the proceeds of her Canadian policy do not count towards her estate. But they would if she bought the policy in her own name. That means over $1 million of wasted exemption room—and a much higher estate tax bill.
Patricia hires an insurance tax expert to determine if her U.S. policy is exempt in Canada. Turns out it is, so she keeps it. She sets up an ILIT to hold her Canadian universal life policy, shielding the proceeds from U.S. estate tax.
Dean DiSpalatro is the senior editor of Advisor Group.