Estate Planning Case Study – Insurance for Americans Living in Canada

Insurance for Americans Living in CanadaHow does insurance impact the estate planning needs for Americans living in Canada? At Cardinal Point Wealth Management, we put together the following case study on this subject to show some of the major considerations that our clients have faced.

Thomas and Joyceare a high-net-worth couple who resides in British Columbia. They are both U.S. citizens and are considered to be residents of the U.S. for gift and estate tax purposes. As such, they will face U.S. estate tax exposure when their worldwide estate exceeds $5.34 million (U.S. dollars). Let’s look at some of the key implications:

U.S. Gift Tax

U.S. citizens also face U.S. gift tax based on transfers of wealth during their lifetime. Thomas and Joyce are entitled to make tax-free gifts if such gifts are not greater than the annual exclusion of $14,000. Any gifts in the current tax year that exceed the annual exclusion amount would be considered as taxable. A U.S. gift tax return would be required to be filed to report the taxable gifts. Our case study couple is entitled to a lifetime gift tax exclusion of $5.34 million. As long as their lifetime gifts do not exceed this amount, no actual gift tax will have to be paid.

U.S. Estate Tax

Under the Canada-U.S. Tax Treaty, the decedent’s estate could use the marital credit upon the first death.This would effectively double the U.S. estate tax exemption. The maximum U.S. estate tax rate for the 2014 tax year is 40% when one’s U.S. taxable estate exceeds $1 million.

Under U.S. estate tax rules, if one is deemed to have “incidents of ownership” within a life insurance contract (either by owning the policy, paying the premiums, having the right to change beneficiaries, or utilizing or assigning the cash values of the contract), then the life insurance proceeds would form part of the U.S. gross estate for the decedent.

In Joyce’s case, she would be deemed to have “incidents of ownership” of her policy. Therefore, not only would her financial assets form part of her U.S. gross estate, but the proceeds at her death—an additional $5 million in current death benefits—would also be included within her U.S. estate tax calculation. This will cause a large part of the insurance proceeds to be exposed directly to U.S. estate tax upon her death.

In Thomas’s case, given that the policy that he owns is on the life of Joyce, only the cash value under the policy would be included in his U.S. gross estate at his death for U.S. estate tax purposes.

Canadian Estate Tax

Canada does not have an estate tax per se. It has two levels of income tax that are imposed on worldwide assets:

  1. The first is a deemed disposition tax (effectively, a capital gains tax) that is imposed on all assets exclusive of one’s principal residence and any registered assets held at death. Given that our case study couple lives in British Columbia, the net income tax imposed on any assets deemed disposed of upon death would be 22.90%.
  2. The second tax is an ordinary income tax imposed on the fair market value of the couple’s registered assets and Thomas’s IRA upon death. This amount would be 45.8% for the 2014 tax year.

Because Thomas and Joyce are married, any income tax in Canada imposed at the first death can be deferred if the decedent’s estate goes to the surviving spouse directly or in trust. Upon the death of the surviving spouse, income tax at death would then be imposed.

U.S. Estate Tax Exposure: A Hypothetical Analysis
Under the Canada-U.S. Tax Treaty (Article XXIX B), Thomas and Joyce could be eligible to apply a foreign tax credit to reduce their exposure to tax on assets in both jurisdictions.

Appendix C includes a hypothetical analysis of the couple’s potential exposure to U.S. estate tax, assuming no additional planning and assuming that Thomas became a decedent this tax year with the transfer of his estate going to Joyce. In another example, we assumeJoyce’s death this year and project that her U.S. estate tax exposure would be $4,827,040 for 2014.

Under these assumptions, the estate would be taxed at the highest U.S. estate tax rate. Therefore, it is projected that approximately 26% of their estate could be depleted due to U.S. estate taxes. This is the case even though the couple does not physically live in the U.S. and the majority of their assets are in Canada.

Let’s assumeJoyce was to predecease Thomas, with Thomasdying this tax year. tax is calculated to be $4,787,352. Estate tax depletion would also be 26%.

Structuring Insurance Proceeds

The amount of life insurance held on Joyce’s life is included in her U.S. estate and creates a large part of the exposure that would be faced upon her death. Given this, some might suggest that it would make sense to remove the life insurance from the estate. This is a popular planning strategy and can be achieved through the transfer of life insurance to a specific type of trust referred to as an Irrevocable Life Insurance Trust (ILIT). Such a trust would be considered as the owner, premium payer and beneficiary of the insurance.

If structured properly, insurance proceeds would not be included within the decedent’s estate. However, in this case study, given the amount of cash value that Joyce has within the policy, any transfer to such a trust would be subject to the U.S. gift tax over the annual $14,000 threshold. Therefore, a U.S. taxable gift of $846,630 (cash value of $860,830 less $14,000) would be created. A U.S. gift tax return would have to be filed and Joyce’s U.S. estate tax exemption would be reduced from $5.34 million less the taxable gift amount. Further, given the structure of the trust,the couple would not be able to utilize the cash values of the policy to supplement future retirement needs on a tax-favored basis. The objectives of the insurance and the trust conflict with each other.

As opposed to Joyce’s estate being exposed to $4,787,352 of tax, her estate tax exposure would be reduced to U$707,977 if the insurance was not included within her estate and additional will planning was provided.

projected US estate tax saving - ThomasIf the couple was each to incorporate the use of a Canadian Spousal Rollover Trusts for the surviving spouse—which would qualify under U.S. estate tax rules—they could save approximately $2.1million in U.S. estate taxes from the $4.8 million exposure upon the second death.

projected US estate tax saving - cathy

Given the large amount of current U.S. estate tax exposure present within Thomas and Joyce’s estates, they might want to consider utilizing a different, far more cost effective form of life insurance to cover off this exposure. Such a policy would be what is referred to as a joint last-to-die policy. It would be utilized specifically to fund the projected U.S. estate or income tax in Canada upon the death of the surviving spouse. To avoid the death benefit from being included within the surviving spouse’s gross estate, the property would need to be acquired and held within the ILIT structure previously discussed.

Other Considerations

It is likely that the U.S. estate tax exemption could increase over time due to projected and scheduled inflation adjustments. However, it is also very likely that the couple’s worldwide estate and the value of life insurance death benefits will likely increase greater than the inflation rate. Therefore, it will be important to monitor Thomas and Joyce’s exposure to U.S. estate taxes on an annual basis.

Given the size of the couple’s worldwide estate, we have also recommended that they consider making annual gifts up to the annual exclusion amount to those that they care about (family members, friends, etc.).

We’ve also taken into account specific provincial considerations. For example, British Columbia has a probate fee that is based on the value of assets that would be expected to go through probate. Probate is the legal process and certain assets within the estate will have a probate fee assessed. As part of this case study, we have included calculations of the couple’s projected probate exposure. The various probate fees that are projected to be imposed have also been included within the U.S. estate tax analysis.

Meeting Your Estate Planning Needs
In coordination with our cross-border estate planning partners, Cardinal Point Wealth Management can review your existing estate plans and further assist (if required) in the creation of a flexible cross-border estate plan that will consider your specific long-term goals. Given today’s ever-changing estate and gift tax rules,this is an extremely important piece of your overall plan wealth management plan.

Get in touch with Cardinal Point today to begin the conversation and ensure that your cross-border plan is tailored to your unique situation.

Potential costas of probate in BC

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