Cross-Border Life Insurance Part 3: Death Benefit Clarity through Irrevocable Life Insurance Trusts (ILITs) Planning

Written by Carson Hamill CIM®, CRPC®, Associate Portfolio Manager & Assistant Branch Manager & Dean Moro BComm, CIM®, Associate Portfolio Manager

Life insurance is a cornerstone of estate planning, a financial safety net designed to protect your loved ones after you’re gone. But when you start crossing borders—specifically between the U.S. and Canada—things get complicated fast. If you’re a U.S. citizen living in Canada, or if you have family members on both sides of the border, purchasing life insurance can feel like stepping into a legal and tax minefield. Don’t worry, though—I’m here to guide you through this intricate landscape, helping you avoid the pitfalls that could turn your well-intentioned plan into a financial quagmire.

• The Death Benefit Dilemma: Is It Tax-Free or Taxed?
• What’s in the ILIT? A Trusty Twist on Cross-Border Policies
• The 1% Excise Tax: The IRS Is Always Watching
• The Takeaway: Don’t Go It Alone

The Death Benefit Dilemma: Is It Tax-Free or Taxed?

Let’s start with the heart of the matter: the death benefit. When a U.S. person receives a death benefit from a Canadian life insurance policy, the tax implications can be murky. If the policy qualifies as “U.S. exempt,” the good news is that the proceeds are excluded from taxable income for U.S. income tax purposes. It’s like hitting the jackpot without Uncle Sam dipping into your winnings. But, if the policy doesn’t pass the “exempt test,” a portion of that death benefit could be taxable in the U.S., turning your financial windfall into a bit of a mixed blessing.

Here’s where things get even more tangled. Determining whether a Canadian policy qualifies as an insurance contract under U.S. tax law isn’t as straightforward as you might think. It’s a bit like trying to decipher a foreign language—just when you think you’ve got it, you realize there’s more nuance than you first understood. If the policy is recognized as an insurance contract by the IRS, then the death benefit is typically received tax-free. However, if the policy doesn’t meet the IRS’s definition—and it has a cash surrender value—the beneficiary could be staring down a tax bill on part of the proceeds.

This tax issue is particularly thorny if there’s a substantial cash surrender value. The IRS might consider this portion of the death benefit as taxable income to the U.S. beneficiary. To mitigate this risk, some advisors suggest making the proceeds payable to the estate rather than directly to a U.S. beneficiary. But be warned: while this might sidestep some immediate tax concerns, it could introduce new challenges in the estate planning process, potentially complicating probate and other legal matters.

What’s in the ILIT? A Trusty Twist on Cross-Border Policies

Now, let’s venture into the world of trusts—specifically, the Irrevocable Life Insurance Trust (ILIT). For the uninitiated, an ILIT is a trust designed to hold a life insurance policy, removing it from the insured’s estate for tax purposes. Sounds like a great idea, right? But throw in the cross-border element, and things get a bit trickier.

Let’s say the ILIT is structured as a Canadian resident trust because the insured is a Canadian resident. If you’re a U.S. taxpayer and the lucky beneficiary of this foreign trust, the U.S. has some rules that can rain on your parade. Specifically, the U.S. “throwback rules” apply when a U.S. person receives distributions from a foreign trust. These rules are designed to prevent U.S. taxpayers from deferring tax by accumulating income in a foreign trust. If the trust has accumulated income from prior years and then makes a distribution to you, the IRS may not only tax it at ordinary income rates but also tack on an interest component. It’s like buying something on layaway—by the time you get it, you’re paying more than the sticker price.

If the ILIT holds a life insurance policy and that policy pays out upon the insured’s death, the death benefit could be seen as investment income if it’s been accumulating within the trust. This means that, as a U.S. beneficiary, you could be taxed on that income at ordinary U.S. income tax rates, with the added “bonus” of an interest component under the throwback rules. It’s a perfect example of how a good estate planning tool in one country can morph into a tax liability when you cross the border.

The 1% Excise Tax: The IRS Is Always Watching

Just when you thought you’d navigated all the complexities, there’s one more wrinkle to consider: the IRS’s 1% excise tax on insurance premiums paid to non-U.S. companies. This tax is like the IRS’s version of a finder’s fee—they’re always keeping an eye on U.S. citizens, no matter where they live. So if you’re a U.S. citizen living in Canada and you purchase a Canadian life insurance policy, you’re not off the hook. The IRS will impose a 1% tax on your premium payments, reminding you that you can’t escape their reach.

What’s particularly interesting—or perhaps frustrating—is that this tax applies even if your Canadian policy is held in an ILIT. In this scenario, the excise tax is still your responsibility as the insured. It’s like signing up for a lifetime subscription service you can’t cancel, with the IRS automatically deducting their fee every time you pay your premiums.

The Takeaway: Don’t Go It Alone

Cross-border life insurance planning is not for the faint of heart. The combination of U.S. and Canadian tax laws, IRS regulations, and the intricacies of trusts can create a labyrinth of potential pitfalls. Whether it’s navigating the death benefit dilemma, untangling the complexities of ILITs, or dealing with the ever-watchful IRS and their 1% excise tax, the challenges are real and numerous.

Before diving into cross-border life insurance, it’s crucial to consult with a cross-border tax advisor who understands the intricacies of both U.S. and Canadian laws. They can help you craft a strategy that minimizes tax liabilities, avoids common traps, and ensures your estate planning goals are met without unwanted surprises.

In the end, cross-border life insurance might seem like a straightforward solution, but it’s anything but simple. It’s a maze that requires careful navigation and expert guidance. Therefore, before you take the plunge, arm yourself with the right advice and make sure your plans are as solid as they can be—because when it comes to cross-border financial planning, the devil is always in the details.

About Snowbirds Wealth Management

Gerry Scott is a portfolio manager and founder of Snowbirds Wealth Management, an advisory firm focussed on the cross-border market. Together with Dean Moro and Carson Hamill, associate portfolio managers with Snowbirds Wealth Management, they provide investment solutions for Americans living in Canada, and Canadians residing in the United States. Licensed in both Canada and the US, they provide tailored investment solutions to minimize the tax burden when moving assets across borders.

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