Beware of U.S. tax traps – especially when your clients are U.S. citizens

If you have clients planning to leave gifts or assets to heirs in the U.S., you could help prevent them and their heirs from getting snared in one or more of these 3 potential tax traps:

1. 1. State inheritance taxes
   2. Transfer for value rule
   3. A gift tax trap called the “unholy trinity”

Not all state taxes are created equally

6 states have an inheritance tax: New Jersey, Maryland, Pennsylvania, Kentucky, Iowa and Nebraska. Someone who lives in one of these states will pay tax on property they receive as an inheritance.

Fortunately, life insurance death benefit proceeds aren’t taxed in any of the 6 states. If a client has an heir living in one of these states, and wants to make sure that all their heirs benefit equally, that heir should get only life insurance proceeds, to reduce or eliminate the inheritance tax. Other beneficiaries could then receive assets of equal value, so that all heirs receive an equally tax-friendly inheritance.

This rule’s born in the U.S.A.

The transfer for value rule comes as a surprise to many Canadians, because there’s nothing like it in Canadian law:

• If a client transfers ownership of a policy, or an interest in a policy, to someone else for any valuable consideration, that’s a transfer for value.
• “Valuable consideration” is whatever you give for the policy or for the interest in the policy. It’s a very broad concept. It can be money or property, but doesn’t have to be. It could be giving up a right to do something you had every right to do in exchange for the policy or the interest in the policy. Or it could be transferring that right to the other person, also in exchange for their policy or an interest in their policy. The key point is that you’re giving up something in exchange for what you’re getting.
• For example, giving someone the right to designate a beneficiary to a policy is a transfer of an interest in a policy. If you get anything in exchange for that right, and if the person on the other end of this exchange is a U.S. citizen or resident, the transfer for value rule could apply.
• In Canada, the law would apply to a U.S. citizen who receives an interest in a life insurance policy in a transfer for value, because that person would be subject to U.S. law. It would not matter to the IRS that the person who transferred the policy was not subject to U.S. law, like a Canadian citizen or resident. Nor would it matter if the policy was issued by a Canadian insurance company.

If a client violates the transfer for value rule, the death benefit is taxed as income to the beneficiary (to the extent it exceeds the consideration paid for the policy and the premiums the new owner paid until the date of death). It’s a very severe tax consequence, and something that most Canadians probably would know nothing about.

Fortunately, there are some exceptions:

• Outright gifts – also called the “basis” exception, it usually applies to transfers between family members, like when a parent transfers a life insurance policy they own on their child’s life to that child. In Canada, this transfer would not be taxable. Under U.S. law, it could be a taxable gift, depending on the policy’s value, but it won’t be a transfer for value.
• Transfers to:
  • Insured – a business can transfer a policy it owns on a key person to that key person. The transfer itself may be treated as a taxable transaction, but the death benefit will be tax free.
  • Partner of the insured / Partnership where insured is a partner – this exception facilitates cross-purchase agreements and key person insurance in partnerships. If A and B own their own personal policies, they can transfer them to their partnership or to each other in order to support the terms of a buy-sell agreement, without triggering the transfer for value rule. It won’t matter that A and B are also shareholders of a company through which they carry on business, and that the partnership is a side business. As long as the partnership is a legitimate business, the IRS will respect the exception.
  • Corporation where insured is an officer or shareholder – a transfer of a life insurance policy to a corporation can work, when the insured is an officer or shareholder. But this exception won’t work if a client transfers a policy to a fellow shareholder or to a director of the corporation.
• Collateral assignment of life insurance policies as security for a loan – unless the assignment is absolute, it doesn’t count as a transfer, and the transfer for value rule doesn’t apply.
• Transfers between U.S. person spouses – not taxed under the Internal Revenue Code (IRC). While there may be a transfer for value, there’s no tax due. But the spouses both have to be U.S. persons (citizens, residents or green card holders).

Transfers for value can occur where you least expect them. The general approach should be to regard any transaction involving a U.S. person (owner, insured or beneficiary) as suspect, even if the transaction isn’t intended to be a transfer, and to make sure the client gets tax and legal advice. The consequences for violating this rule are too severe to take lightly.

Unholy trinity – nothing to do with religion!

The “unholy trinity” is also called the Goodman rule problem, based on a 1946 legal decision the IRS won (Goodman v. Commissioner, 156 F.2d 218, 1946). In that case, Mrs. Goodman owned a life insurance policy on the life of her husband. She designated their children as the beneficiaries of the policy, not herself. When Mr. Goodman died, the children got the death benefit, income-tax free.

You might ask, “So what’s the problem?” The problem is that Mrs. Goodman had to pay gift tax on the death benefit her children received.

Unlike Canada, the United States has a gift tax. If a U.S. citizen or resident gives anything of value to someone else, they have to pay gift tax, based on a percentage of the gift’s value. There are exemptions:

• A U.S. citizen or resident can give up to $14,000 per year to anyone without having to pay tax or even file a gift tax return (2016 amount, indexed to inflation when inflationary increases justify a $1,000 increase in the exclusion).
• U.S. spouses can also make gifts to each other in unlimited amounts.
• Gifts to charity are exempt, as are payments made directly to medical service providers (doctors and hospitals) to pay for someone else’s medical bills, and directly to educational institutions to pay for someone else’s education expenses.

After Mr. Goodman died, the IRS treated the arrangement as a completed gift, because the beneficiary designations could not be changed. Further, the insurance company was contractually bound to pay the insurance proceeds to the beneficiaries. Essentially, before death, the beneficiary designation was a trap set to spring shut at Mr. Goodman’s death. And that’s exactly what it did.

Down-to-earth solutions

One fix for the “unholy trinity” is simple. The policy owner names themselves as the beneficiary. That way, they aren’t making any gifts to anyone when the insured dies. The drawback is that, if they had wanted someone other than themselves to get the insurance money, they’ll have to figure out how to get the money to that person without triggering substantial gift taxes. Still, they’ll have time to figure it out, and there are strategies that can help reduce or eliminate gift tax.

Another fix is to transfer ownership of the policy to the intended beneficiary. The transfer may produce tax consequences, but these tax consequences may be smaller than the tax consequences that would arise from having the death benefit amount treated as a gift. And it avoids the problem of the policy owner receiving the death proceeds and then having to transfer those proceeds to the intended beneficiaries.

Yet another fix is to transfer the policy to an irrevocable life insurance trust:

• The trust is the owner and beneficiary.
• The former policy beneficiary is now the trust beneficiary.
• The trust controls the disposition of proceeds.

Again, the transfer may produce tax consequences, though these again should likely be smaller than the tax consequences that could arise from having the death benefit amount treated as a gift.

If you have clients who are U.S. citizens or Canadians with relatives living in the U.S., look into their finances to see if state inheritance taxes, the transfer for value rule, or the “unholy trinity” gift tax trap will affect the tax they or their heirs have to pay. They’ll be thankful you showed them how to shake the hand at the end of the long arm of the IRS.

Resources

• See
  http://www.mcguirewoods.com/news-resources/publications/taxation/state_death_tax_chart.pdf for a list of states that impose death taxes, and the type of death tax each state imposes.
• If you have questions or would like to learn more about tax and wealth strategies, please contact a member of the Sun Life Wealth sales team.

You might also like…

• Canadians with U.S. retirement plans: Minding that money when they come home
• What Canadian clients need to know about U.S. taxes – part 1
• Canadians with U.S. retirement plans: Things to consider before coming home

¹ Estimate from the U.S. State Department, 2013