Shield insurance proceeds from U.S. estate tax

Life insurance can play an important role in estate planning. But complexities arise if you’re subject to U.S. estate tax.

While life insurance proceeds paid to a beneficiary are generally not taxable, 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 you have life insurance in your 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 significant 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 give a $5.43-million exclusion; anything beyond that is taxed at 40% of the fair market value of the estate.

Canadian citizens and residents are subject to U.S. estate tax if they own real estate there, or if they own 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 a solution to the life insurance problem: an Irrevocable Life Insurance Trust (ILIT), an inter vivos trust (which means it’s created while the donor is alive) that holds a life insurance policy in a way which excludes it from a taxable estate.

Structuring the ILIT

Since trusts exist separately from their settlors, trustees and beneficiaries, the assets held in those trust s 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.

To effectively shield life insurance proceeds, the policy owner cannot be either a trustee or a beneficiary. Instead, you would be the settlor (the person who creates the trust): a reliable third party would be the trustee, and your spouse and descendants would be beneficiaries.

How to prevent gift tax

U.S. law imposes tax on certain gifts, but Canadian citizens and residents are taxed only 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. 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 2015.

You have to determine a life insurance policy’s value when transferring it to an ILIT. If it’s a cash-value policy, a gift tax may come due on the transfer. The transferor can choose to use lifetime credits against gift tax to avoid paying immediately, but this will reduce the estate tax exclusion by the same amount.

Term policies have no cash value, and can be transferred without gift-tax issues.

Beyond the initial funding issues, arrangements must be made to let a trustee to pay annual premiums. One option is to transfer cash or securities to the trust along with the policy and use those funds to pay the premiums. Unfortunately, this may result in additional gift tax up front (or utilization of lifetime credits). And, any income generated by those productive assets would likely be attributed to the transferor under the U.S. Grantor Trust rules.

Another option way to pay premiums is through annual gifts to the trust (remember, gifts of up to $14,000 can be made without incurring gift tax). The key factor is that the gift must be for a present interest in the gifted property; future interests don’t qualify for the annual exemption.

Using ILITs

A properly structured ILIT can provide tax-free cash upon death without increasing the estate tax burden. 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, since the trustee (rather than the executor) will receive the funds.

The trust agreement should permit, but not require, the ILIT’s trustee to purchase illiquid assets from the estate or lend the estate cash needed for administration and settlement. These loans should be structured as an arm’s length transaction. Specifically, loans should bear an interest rate and have an established repayment schedule.

David A. Altro is a Florida attorney, Canadian legal advisor and the managing partner at Altro Levy. He can be reached at 416-477-8150 or daltro@altrolevy.com.

Jonah Z. Spiegelman 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.