Many Canadians use life insurance policies as an estate planning tool to ensure their families are cared after and to pay tax owed by their estates on accrued capital gains on their assets. However, Canadians who own US situs assets such as US real estate or stock in US corporations and US citizens living in Canada may be subject to US estate tax on their death due to life insurance policies that they own at the time of their death. This blog elucidates this issue and presents means to limit or avoid US estate tax liability in relation to life insurance policies.
US Estate Tax
The United States levies the estate tax on the death of all US citizens, regardless of where they live, and on certain Canadians who die owning US situs assets. We will briefly distinguish between the rules as they apply to US citizens and to Canadians who own US situs assets.
At death, a US citizen is subject to tax on the fair market value of his/her worldwide assets even if he/she resided outside of the United States. However, he/she is entitled to a lifetime exemption amount that is annually adjusted for increases in the cost of living. Before the Tax Cuts and Jobs Act came into effect on January 1, 2018, the lifetime exemption was $5 million USD, plus annual adjustments for inflation. In 2017, the exemption was set at $5.49 million USD. This law doubled the lifetime exemption to $11.2 million USD. However, the increase is temporary and is due to expire on January 1, 2026 unless it is renewed by the US Congress.
If you are a US citizen and your worldwide assets have a total fair market value of less than $11.2 million USD, you will not be subject to US estate tax. However, if the fair market value of you worldwide assets exceeds $11.2 million USD, the portion of your assets that exceeds $11.2 million USD will be taxed at 40%. It is however possible to take advantage of additional credits to reduce, avoid or differ US estate tax that would ordinarily be owed.
Unlike US citizens, a Canadian who dies owning US situs assets is not subject to US estate tax on his/her worldwide assets. Instead, a two part test is applied to determine if a Canadian who owns US situs assets is subject to US estate tax. First, if he/she owns US situs assets with a cumulative fair market value at death of less than $60,000 USD, no estate tax is owed. However, if he/she owns US situs assets with a fair market value of over $60,000 USD, the second part of the test will apply. The Canadian decedent’s worldwide assets must be valued.
Like US citizens, Canadians are entitled to the lifetime exemption amount of $11.2 million USD. If a Canadian dies owning worldwide assets with a fair market value of over $11.2 million USD, he/she will be subject to US estate tax at a rate of 40% only on the value of his/her US situs assets that exceeds $60,000 USD. For example, a Canadian whose US situs assets have a fair market value of $100,000 USD at the time of death will be subject to US estate tax on an amount of $40,000 USD (100,000 – 60,000 = 40,000). However, if the Canadian’s assets have a fair market value of less than $11.2 million USD, no US estate tax will be owed.
The Inclusion of Life Insurance in a Taxable US Estate
Section 2042 of the United States Internal Revenue Code (IRC) stipulates that a life insurance policy is included in the taxable estate of a decedent if he/she owned the policy at the time of death. Ownership of a policy is assigned to the person who has the “incidents of ownership” of the policy, namely the right to name or change a beneficiary to the policy, the right to borrow against the policy, and the right to surrender or exchange the policy. If you have these rights and you are either a US citizen or a Canadian who owns US situs assets, you must include your life insurance in computing your worldwide assets.
Ownership of life insurance policies may be problematic for a US citizen or a Canadian who owns US situs assets because as they can pay out considerable sums of money, they can push a worldwide estate beyond the exemption amount and even additional available credits to offset US estate tax liability. It is crucial that you review your life insurance policy to determine if you are deemed to be the owner of the policy and therefore of the life insurance proceeds.
There are elaborate rules for determining if an individual owns a life insurance policy. For example, individual shareholders of a corporation are deemed to own the corporately owned life insurance on their lives if they own a controlling interest in the corporation. Each shareholder would therefore be required to include the life insurance proceeds in his/her worldwide assets under US estate tax rules. This rule can be avoided if the beneficiary is a third party.
One Solution: ILITs
An irrevocable life insurance trust (ILIT) is an available tool for removing a life insurance policy from a person’s worldwide estate for US estate tax purposes. Instead of applying for a life insurance policy directly, you will create an ILIT to purchase a life insurance policy on your life. Since you will not own the life insurance policy, it will not be included in your taxable estate for US estate tax purposes.
You will appoint at least one trustee to administer the ILIT and you will designate trust beneficiaries (i.e. the persons who would have been beneficiaries of the life insurance policy if it was personally owned). However, the trustee cannot be any of the following: you, your spouse or a trust beneficiary. The trustee should be a person who is only a Canadian citizen and resident in order to avoid complex tax rules relating to foreign trusts in other jurisdictions.
As grantor, you will not have any of the incidents of ownership; these will solely belong to the ILIT. Moreover, the ILIT will be irrevocable. You will not have the power to revoke, alter, amend or terminate the trust, nor can you retain the power of modify the interests of the beneficiaries. By naming a third party as trustee to administer the ILIT’s assets, you will be able to demonstrate that you do not retain any power or authority over decision making in relation to the life insurance policy.
Funding the ILIT is a key consideration. Although an existing life insurance policy may be transferred into an ILIT, we strongly discourage doing this for two reasons. First, US citizens and US tax residents such as Green Card holders who transfer a life insurance policy to an ILIT may be deemed to have made a taxable gift by the IRS and will therefore be subject to US gift tax on the transfer at a rate of 40%. Second, pursuant to section 2035 of the IRC, if you die within three (3) years of transferring the policy into an ILIT, the life insurance proceeds will be included in your taxable estate. This rule applies to both US citizens and Canadians who own US situs assets.
You may gift amounts of up to $14,000 USD to an ILIT to ensure that the ILIT pays the annual premiums. By availing yourself of the benefit of the annual US gift tax exemption of $14,000 USD per person, you can ensure that these annual gifts will not be subject to US gift tax.
In addition to removing life insurance policies from your taxable US estate, the ILIT confers another benefit. Since you can designate the beneficiaries of the ILIT, you can direct that the life insurance proceeds be distributed into tax advantageous structures for family members and friends based on factors such as whether or not they are US citizens.
The comments offered in this article are meant to be general in nature and are not intended to provide legal advice regarding any individual situation. Before taking any action involving your individual situation, you should seek legal advice to ensure it is appropriate for your circumstances.
About the author
Sergei Titorenko is an Associate at Levy Salis LLP and a member of the Quebec Bar. He devotes his practice to US and Canadian tax and estate planning, Canadians doing business in the United States, Americans living in Canada, US real estate transactions for Canadians, and cryptocurrency transactions.