An irrevocable life insurance trust (ILIT) is an estate planning vehicle worth some consideration for U.S. citizens living in Canada.  Many estate advisors are unaware that U.S. citizens subscribing to life insurance on their life will have the death benefits included in the value of their taxable estate for U.S. estate tax purposes.  An ILIT may provide an opportunity to avoid such an outcome.

What is an ILIT?

An ILIT is an irrevocable trust (usually a grantor trust) that owns the life insurance policy on the life of the individual. The ILIT is usually set-up and financed by the grantor (the insured) and administered by trustees[1] in accordance with the discretionary powers detailed in the deed of trust.  The beneficiary(ies) of the ILIT would be the persons that would be the beneficiaries of the insurance had it been in the individual’s name.

The advantage of an ILIT is that the death benefits will reach the beneficiaries tax-free, while avoiding the death benefits being subject to U.S. estate tax.  This is because the insured does not own the policy nor does he or she have any rights to the policy, the death benefits (obviously) or the trust benefits.

U.S. Tax Considerations

For U.S. estate planning purposes, the ILIT provides control as to how the insurance benefits are to be used and when the beneficiary(ies) can access the insurance benefits.  Also, the ILIT can be used to fund the potential U.S. estate tax exposure thus, preserving the assets of the estate.

The trustee of the ILIT should open a separate bank account for the ILIT, for the payment of the annual contributions (to be under the annual gifts exclusion). Further, the Crummey power provision should also be included to allow beneficiaries to withdraw contributions for a limited time.

The U.S. citizen living in Canada that is considering an ILIT needs to also consider some U.S. tax compliance obligations.  Since the ILIT would likely be considered a Canadian trust, the U.S. citizen will need to file Form 3520 to report the ownership of foreign trust.

Don’t Forget About the Canadian Tax Implications

The ILIT will most likely qualify as a Canadian trust therefore, there are a few Canadian tax implications to be considered; mainly, the Canadian attribution rules and the 21-year deemed disposition rule.

The attribution rules under subsection 75(2) ought to be considered if the grantor is funding the trust.  The income would be attributed back to the grantor but more importantly, under subsection 75(2), should the beneficiary(ies) of the trust predecease the grantor, only the grantor or his or her spouse can receive the policy on a rollover basis. This would defeat the purpose of the ILIT since the funds would then form part of the taxable estate.

Also, if the ILIT is a Canadian trust, it would be subject to the 21-year rule.  Interestingly, an insurance policy would not be considered capital property of the trust therefore, the 21-year rule may have little impact on the ILIT if its sole asset is the insurance policy.  Nonetheless, an estate or tax advisor considering the benefits of the ILIT ought to consider the 21-year rule as part of the estate plan.

In the right circumstances, an ILIT may bring tax and estate planning benefits to a high-net-worth U.S. person living in Canada.  If so, it will require careful tax and legal considerations and it is also key for the trustee to administer the trust properly.

[1] The trustees cannot be a beneficiary nor a spouse of the grantor.