By Elli Shochet, CFP
This two-part series explores the challenges and solutions faced by Canadian families with U.S. connections. Part One examines insurance planning strategies that can help protect assets, simplify transfers, and preserve legacies across generations. Part 2 highlights common pitfalls in cross-border wealth planning.
Insurance is meant to protect families, but for Canadians with U.S. ties, the wrong structure can turn protection into exposure. Conflicting tax codes, different definitions of “exempt” policies, and mismatched corporate rules mean that without careful planning, strategies designed to safeguard wealth may instead create new tax liabilities for spouses, children, or corporate shareholders.
Exempt rules differ in Canada and the U.S.
In Canada, life insurance is tax-exempt if it passes the CRA’s exempt test. In the U.S., the IRS applies its own rules under Internal Revenue Code Section 7702. A Canadian policy that qualifies at home may fail the U.S. test and be treated as a Modified Endowment Contract (MEC). That means loans and withdrawals could be taxable, and the cash value might be taxed on an accrual basis. Families with U.S. citizens must ensure their policies pass both exemption tests. Once a policy fails the exempt test in the U.S. it cannot be reconstituted as an exempt policy.
Estate tax can pull insurance into the U.S. net
In Canada, death benefits are paid tax-free. In the U.S., while the benefit is not taxed as income, it is included in the estate if the insured held “incidents of ownership.” If the estate value — including insurance — exceeds the U.S. exemption (USD $13.99 million per person in 2025, scheduled to change in 2026 to $15 million indexed for inflation). Tax of up to 40% may apply. Structures such as ownership by a Canadian spouse or an Irrevocable Life Insurance Trust (ILIT) can help, but must be carefully managed to avoid gift tax or access issues.
U.S. excise tax applies to premiums
Even if a policy is issued in Canada, if it insures a U.S. citizen, the IRS applies a 1% excise tax on every premium under Internal Revenue Code Section 4371. This cost applies regardless of whether the policy is owned personally, by a Canadian spouse, or through a corporation — and it often goes unnoticed until years later.
Corporate-owned insurance: CRA vs. IRS
Canadian corporate ownership offers significant advantages. When the insured dies, the policy proceeds flow into the corporation tax-free, and the death benefit (minus adjusted cost basis) is credited to the Capital Dividend Account (CDA), allowing Canadian-resident shareholders to withdraw funds tax-free.
The IRS does not recognize the CDA. For U.S. persons living in Canada, distributions that are tax-free in Canada are treated as fully taxable dividends in the U.S. In addition, non-resident shareholders face Canadian Part XIII withholding tax (25% by default, reduced under the treaty) on dividends flowing across the border. Without careful planning, the strategy designed to unlock corporate surplus can instead drain value for U.S. family members.
ULCs solve some problems but create others
There are circumstances where Canadians may incorporate ULC (Unlimited Liability Companies) in British Columbia, Alberta and New Brunswick. This can align Canadian and U.S. tax by allowing the CDA to be paid out under Canadian rules and treated as a tax-free payment under U.S. rules. A ULC is treated as a flow-through entity for U.S. purposes, reducing PFIC and dividend mismatches. However, ULCs eliminate shareholder limited liability and, if used to hold U.S. securities, may expose estates to U.S.-situs tax as though the assets were held directly. Treat ULCs as a potential tool, not a universal solution.
Case in Point
Recently, Al G. Brown & Associates reviewed a long-standing family insurance plan. The Canadian husband owned a $20 million corporate policy. His wife, a dual U.S.-Canadian citizen, was the intended beneficiary. From a Canadian perspective, the plan was sound: the corporation would receive the death benefit tax-free, and she would access it through the CDA without further tax. From a U.S. perspective, however, her share of the distribution would be taxed as a dividend, creating a liability of approximately $5 million.
If she were to predecease him, the next generation would face an equally complex situation. The couple’s four children are shareholders — two reside in Canada, two in the U.S. While the Canadian-resident children would be taxed on those dividends by the IRS even though they are tax-free in Canada. The U.S.-resident children would first face a 25% Canadian withholding tax on their shares as well as dividend tax by the IRS. Partial relief through the treaty would still leave an effective tax rate of about 15%. What appeared to be a $20 million inheritance would shrink materially through cross-border leakage.
Ultimately, restructuring the corporate ownership, incorporating U.S. tax-exempt testing, and coordinating advice across both jurisdictions allowed the family to safeguard the life insurance policy’s intent. Had this been done at inception, the plan would have avoided decades of exposure — underscoring the importance of building cross-border considerations into insurance planning from the start.
Families with U.S. connections cannot assume Canadian planning alone will protect wealth. With the proper structure, insurance can preserve value, create liquidity, and protect family harmony. Without it, the same policy can drain millions through taxation on both sides of the border.
Al G. Brown & Associates coordinates with cross-border tax and legal experts to minimize double taxation and mitigate tax risk. Contact Elli Schochet CFP, at info@algbrown.com.
This article is provided for general information purposes only and does not constitute legal, accounting, or tax advice. Cross-border tax rules are complex and subject to change. Readers should not act on the basis of this material without obtaining advice from qualified tax and legal professionals with expertise in Canada–U.S. cross-border planning, tailored to their specific circumstances.
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Q1: Why is cross-border insurance planning so complex for Canadian families with U.S. ties?
Canada and the U.S. apply different tax and policy definitions. A life insurance policy that qualifies as tax-exempt in Canada may fail the U.S. “exempt” test under Section 7702 and be treated as a Modified Endowment Contract (MEC). That means policy loans, withdrawals, and even annual growth could be taxed by the IRS. Once a policy fails, it can’t be reclassified as exempt. Families with U.S. citizens or residents must ensure policies meet exemption tests of both countries from the start.
Q2: How can life insurance create unexpected U.S. estate tax exposure?
In the U.S., death benefits are not taxed as income but are included in the taxable estate if the insured retained “incidents of ownership.” If the estate, including the policy, exceeds the U.S. exemption, estate tax of up to 40% can apply. Ownership by a Canadian spouse or through an Irrevocable Life Insurance Trust (ILIT) can help, but both require careful management to avoid gift tax or loss of access.
Q3: What are the tax risks of corporate-owned insurance for families with U.S. members?
In Canada, corporate-owned policies can distribute tax-free proceeds to shareholders via a Capital Dividend Account (CDA). The IRS does not recognize CDAs. For U.S. citizens, these payments are treated as fully taxable dividends. In families with both Canadian and U.S. shareholders, this can trigger double taxation—Canadian withholding on one side and U.S. income tax on the other. Coordinated cross-border structuring, including potential use of a ULC, can reduce – but not eliminate- this risk.
