In Canada, life insurance is often used as an effective estate planning strategy to ensure family protection, estate preservation and investment solutions. Although these advantages are indisputable, many Canadians with U.S. assets and U.S. citizens living in Canada may be shocked to learn that owning life insurance may expose their estates to U.S. estate tax upon their death.


According to U.S. estate tax law, Canadians are subject to U.S. estate tax upon death on the fair market value of their U.S. situated (situs) property (such as U.S. real property or U.S. securities) when the following two conditions apply: First, that such U.S. property exceed a value of $60,000 and second, that the individual’s worldwide assets exceed a value of $5,000,000 indexed for inflation (hereinafter the “World Wide Asset Exemption”). In 2012, the U.S. estate tax rate caps at 35%.
Unlike Canadians, U.S. citizens (including those residing in Canada), face up to 35% U.S. estate tax on the fair market value on their worldwide assets at the time of death. In 2012, as a result of the current World Wide Asset Exemption, the first $5,000,000 indexed for inflation is excluded from tax. After December 31, 2012, the World Wide Asset Exemption will be reduced to $1,000,000 and the maximum tax rate of 35% increases to 55%.

When calculating the value of an individual’s worldwide assets, the value of life insurance that was owned by the individual and payable at his or her death is included. Consequently, a worldwide estate that would have otherwise been below the World Wide Asset Exemption may be pushed over such threshold with the inclusion of life insurance and cause a U.S. estate tax liability or if the estate is already taxable, it will increase the U.S. estate tax by reducing the Canada-U.S. Tax Treaty credits. As life insurance policies often pay out considerable sums of money in the hundreds of thousands of dollars, it is likely that such policies will have a significant impact on the deceased’s exposure to such tax.


To determine if life insurance proceeds are included in the value of the deceased’s worldwide assets for the purposes of calculating his or her U.S. estate tax liability, one must examine if the deceased was the owner of the life insurance policy and who are the named beneficiaries of the life insurance proceeds.

Pursuant to section 2042 the Internal Revenue Code (IRC), an individual demonstrating “incidents of ownership” to a life insurance policy shall have the proceeds of such policy included in the value of his or her total worldwide assets for the purposes of calculating U.S. estate tax. Incidents of ownership to a life insurance policy is based on an individual’s right to name or change a beneficiary to the policy, the right to borrow against the policy and the right to cancel, surrender or exchange the policy. As a general rule, individual shareholders who have a controlling interest in their corporations are deemed to have incidents of ownership over the corporately owned life insurance on their lives and will have to include the proceeds as part of his or her worldwide assets for the purposes of calculating U.S. estate tax. However, the Code of Federal Regulations (26 C.F.R. §20.2042-1(c)(6)) does not apply this general rule where the value of the insurance proceeds are payable to the corporation or to a third party for valid business purposes. Unfortunately, such individual shareholder will nevertheless will have to include this amount in his or her worldwide assets for the purposes of calculating U.S. estate tax as the value of his or her shares at death reflect the insurance proceeds received by the corporation.


Canadians and U.S. citizens with a potential U.S. estate tax liability may find an Irrevocable Life Insurance Trust (ILIT) to be a very effective tax savings solution.

An ILIT is typically a trust for the benefit of one’s spouse or children that is named beneficiary of a life insurance policy on the life of an insured individual. For U.S. estate tax purposes, the assets included in the ILIT will be removed from the estate of the insured, thereby reducing the insured’s estate tax liability.

In order to achieve the optimal tax strategy, the ILIT must be properly crafted to avoid any adverse gift, estate, generation-skipping and income tax consequences in the United States. In this context, the ILIT must be irrevocable (i.e. that the insured not retain the right to revoke, alter, amend or terminate the trust, nor that the insured retain the power to modify the interests of the beneficiaries). Additionally, the ILIT must own all of incidents of ownership in the policy and that the insured not retain any control that would demonstrate incidents of ownership that would cause the policy to be included in his or her estate. In order to demonstrate that the trust owns all incidents of ownership, a third person (other than the insured), bank or trust company should be appointed as trustee to administer its assets and have the power and authority of all decision making.

When considering how the ILIT should be funded, it is more advantageous if a new life insurance policy can be applied for and issued directly to the life insurance trust, rather than transferring an existing policy to it. The proceeds from an existing life insurance policy that are transferred to a newly formed ILIT are deemed to be included in the estate of the insured should he or she die within three years after the transfer is executed (IRC 2035). Furthermore, for U.S. citizens and U.S. residents, the transfer of an existing life insurance policy with a cash value to an ILIT may be considered by the IRS as a “taxable gift” levied against the insured or donor.

An ILIT will also provide U.S. citizens or U.S. residents with the ability to qualify for the annual gift tax exclusions should they make annual contributions into the ILIT (up to $13,000.00 per beneficiary) for the purposes of providing the trustee with funds to make the life insurance premium payments.

Also, an ILIT gives the insured tremendous amounts of control over how the insurance proceeds will be used by the beneficiaries. For example, insured Canadians with sizable insurance policies who wish to pass on the insurance proceeds to their adult children residing in the U.S., can structure the ILIT so that the insurance proceeds once funded into the ILIT can then be distributed into a Cross Border Dynasty Trust in order to shelter their U.S. resident children’s assets from U.S. estate tax across multiple generations.


For individuals exposed to U.S. estate tax or individuals likely to be exposed to U.S. estate tax in the future with the expected reduction of the World Wide Asset Exemption from $5,000,000 indexed for inflation to $1,000,000, an ILIT is an effective estate plan to reduce or even in some cases eliminate one’s U.S. estate tax liability.