F. Income Tax Rules Applicable to U.S. Taxpayers who Own Annuities
1. Tax During Accumulation Period
If the annuity contract holder is a natural person, income on the annuity contract will generally not be taxable during the accumulation period of a deferred annuity. If, however, the annuity holder opts to take a non-annuity distribution ("NAD") (which may take the form of a withdrawal, loan, assignment, or pledge), then the distribution will typically be subject to tax as ordinary income to the extent of the income on the contract.69 The distribution may also be subject to a 10% withdrawal penalty.70 If a non-annuity distribution exceeds the income on the contract, the excess distributed will not be subject to tax, but the distribution will reduce the owner's investment in the contract. If the holder takes a loan against the annuity contract, or assigns or pledges the contract, then the investment in the contract will be increased by the amount included in the holder's gross income as a result of that loan, assignment, or pledge.71
If a non-natural person is proposed as the annuity contract holder, additional care must be taken to ensure that the contract will still qualify as an annuity. Otherwise, income on the contract will be taxable to the holder as ordinary income during both the accumulation and annuitization periods. A non-natural person will not be taxed on the contract income if the non-natural person merely holds the annuity as an agent for a natural person. Section 72(u)(3) sets forth additional exceptions to the non-natural person rule, including exemptions for annuity contracts that are acquired by a decedent's estate, annuity contracts held under a § 401(a) or § 403(a) plan, an IRA, or a § 403(b) program, and immediate annuities.72
2. Tax During Annuitization Period
During the annuitization period, each payment under an annuity has two components: (i) income on the annuitant's investment in the contract and (ii) principal.73 Generally, a part of each annuity payment constitutes a return of the cost of the annuity and is excluded from income. The remainder of the payment is income to the annuitant. For U.S. citizens and residents, the return on the annuity is taxed at ordinary income rates. Nonresident aliens are subject to a 30% tax and withholding under §§ 871 and 1441.
The taxable and nontaxable portions of the annuity are calculated using the "exclusion ratio." Application of the exclusion ratio limits gross income to "that part of any amount received as an annuity bearing the same ratio to such amount as the investment in the contract (as of the annuity starting date) bears to the expected return under the contract (as of such date)."74 The exclusion is, however, limited to the holder's unrecovered investment in the contract.75
Non-annuity distributions paid during the annuitization period are generally included in gross income and taxed as ordinary income to the recipient.76
3. Tax Following Annuitant's Death
Section 72(s)(1) requires that, in order for a contract to be treated as an annuity contract for U.S. income tax purposes, the contract must provide that:
"(A) if any holder of such contract dies on or after the annuity starting date and before the entire interest in such contract has been distributed, the remaining portion of such interest will be distributed at least as rapidly as under the method of distributions being used as of the date of his death, and
(B) if any holder of such contract dies before the annuity starting date, the entire interest in such contract will be distributed within 5 years after the death of such holder."
In addition, § 72(s)(2) provides that, to the extent that the remaining portion referred to in § 72(s)(1)(A) is paid out to a designated beneficiary over the beneficiary's lifetime and the distributions begin within one year of the holder's death, then the remaining portion shall be treated as distributed in a lump sum on the date that the distributions begin.
While those provisions, which are subject to various exceptions for surviving spouses and for retirement-related annuities, direct the timing of the distributions and maximum duration of any deferral, it is § 691 that confirms the tax character of the distributions and provides the distinguishing disadvantage of annuities versus life insurance. Whereas life insurance proceeds are excludable from the beneficiary's gross income, § 691 identifies such distributions as income in respect of a decedent having the same character in the hands of the beneficiary as it did in the hands of the decedent. The result is that any deferred gains not taxed prior to the holder's death will ultimately be taxed as ordinary income upon the beneficiary's receipt or deemed receipt, as the case may be. Moreover, since the annuity was likely included in the holder's gross estate for U.S. estate tax purposes, those deferred gains can potentially be subject to successive taxes.77 This taxation of the annuity assets following the annuitant's death is the primary reason why life insurance is generally superior to annuities as a tax planning tool.
G. Income Tax Rules Applicable to Non-U.S. Taxpayers who Own Annuities
1. Generally Similar to Rules for U.S. Taxpayers
As with life insurance, an NRA will be subject to tax on amounts received under an annuity contract only to the extent that such amounts would be included in the gross income of a U.S. citizen or resident. Thus, the rules governing the taxation of annuities discussed above generally apply equally to an NRA as to a U.S. citizen or resident.
2. Withholding
The primary difference between the taxation of NRAs and U.S. citizens and residents is the difference in tax rates applied to each. Amounts received by an NRA under an annuity contract will generally be subject to the 30% tax under § 871 and withholding under § 1441, rather than the ordinary income tax rates under § 1.
3. Original Issue Discount ("OID") Problem Applying to Non-U.S. Issued Private Placement Variable Annuity Contracts
There is an important exception that applies to annuities issued by certain foreign insurers. In 2002, the IRS issued final regulations under § 1275 clarifying that annuities issued by a foreign insurer that is not, or does not elect to be, subject to tax under subchapter L of the Code on income earned on the annuity contract will not be taxed as annuities under § 72.
Instead, they will be treated as "debt instruments" subject to current taxation under the "original issue discount" provisions of the Code.78
A "debt instrument" is broadly defined to mean a bond, debenture, note or certificate or other evidence of indebtedness.79 While the very nature of a variable annuity seems to preclude treatment of the insurer's obligations as some form of indebtedness, a fixed annuity contract does constitute evidence of an indebtedness owed by the insurance carrier to the annuitant. As such, any accreted value of a fixed (whether immediate or deferred) annuity issued by a foreign insurer not subject to tax under subchapter L of the Code on income earned on the annuity contract will be currently taxable to the annuity's owner for U.S. tax purposes.80
H. Transfer Tax Rules Applicable to U.S. Taxpayers who Own Annuities
Under § 2039, with respect to U.S. citizens and residents, it is clear that the value of an annuity or other payment made under an annuity contract (the "annuity payment") is included in a decedent's gross estate if (i) the annuity payment is receivable by the beneficiary because the beneficiary survived the decedent and (ii) the annuity payment was payable to the decedent, or the decedent possessed the right to receive the annuity payment (alone or in conjunction with others), for life, for a period not ascertainable without reference to his or her death, or for a period which did not in fact end before his or her death.81 The amount includible in the gross estate is limited to a part of the annuity payment proportionate to the amount of the purchase price contributed by the decedent.82
I. Transfer Tax Rules Applicable to Non-U.S. Taxpayers who Own Annuities
In contrast with life insurance, rights under an annuity contract issued by a U.S. domestic insurance company are generally considered U.S.-situated property includable in the gross estate of an NRNC.83 Because no specific exclusion for annuity contracts exists like the exclusion for life insurance policies, most commentators believe that the rules applicable to U.S. citizens and residents under § 2039 also apply to determine whether an annuity payment made pursuant to a U.S.-situated annuity contract is subject to tax in the NRNC's estate. Some commentators, however, argue that because § 2105(a) does not specifically use the term "life insurance contract," but instead refers to "the amount receivable as insurance on the life of a non-resident not a citizen of the United States," an annuity contract could satisfy § 2105(a) and not be deemed property within the U.S. The key to this argument would be to show that the annuity contract involved an actual insurance risk at the time the transaction was executed.84
A private letter ruling issued in October 2008 not only highlights a very limited exception to this rule for NRNC clients, but it also serves to demonstrate one of the many convoluted ways in which these rules sometimes apply. In this private letter ruling, annuity proceeds held by three life insurance carriers on behalf of an NRNC were not property situated within the U.S. under § 2105(b)(1) and were, therefore, excluded from the NRNC's gross estate under § 2103.85 The decedent, an NRNC, was the beneficiary under an annuity owned by her brother, a U.S. citizen and resident of "State." Following her brother's death, the decedent failed to submit a claim prior to her own death to the insurance companies who issued the annuity contracts. Therefore, the proceeds of the annuities were still being held by the insurers. Relying on § 871(i), the IRS held that, under these facts, the annuities were equivalent to deposits being held by the insurers and were excluded from the decedent's gross estate for estate tax purposes under § 2103.
IV. PLANNING STRATEGIES
A. Domestic vs. Offshore PPLI
1. In General
PPLI or PPVA issued by an offshore carrier has enhanced tax advantages because state premium taxes should not be payable when the client completes all aspects of the transaction offshore. This results in a savings of approximately 2-3% of the premium in most states. Additional savings are also available through the acquisition of the variable contract offshore, regardless of whether the contract is purchased from a foreign company that has elected, under § 953(d), to be taxed as a domestic corporation (a "953(d) company") or a foreign company that has not made this election. Where the foreign company has not made the § 953(d) election, the effect of federal deferred acquisition cost ("DAC") tax that otherwise might be assessed on the premium (which is usually about 1-1.5% of premiums paid) can be avoided but a 1% U.S. federal excise tax on premium payments is payable for policies issued by a foreign insurer on the life of a U.S. resident.86 On the other hand, in the case of offshore carriers that have made a 953(d) election and are therefore subject to the DAC regime, a reduced DAC of less than 1% of premium is the norm. Consequently, the absence of the state premium tax and reduced or no federal DAC tax offshore, along with no or low premium sales loads, contributes to the substantially improved yields compared to taxable investments.
2. Statutory Asset Protection
High net worth clients in the U.S. often desire to globalize their holdings in a manner that protects them from future creditor risk as well as local political and economic turmoil. By virtue of its preferred status under certain state exemption statutes, life insurance represents an excellent asset-protective vehicle for the high net worth client, especially when coupled with sophisticated offshore planning. As a consequence of the separate account protection that typically exists in the jurisdictions where carriers reside, the insurance company must segregate the assets inside a private placement policy from its general account, which then protects the policy assets from the claims of the creditors of the life insurance company. In addition, some U.S. states exempt not only the debtor's interest in a life insurance policy's cash surrender value, but also the death proceeds themselves from the claims of creditors.87 However, the exemption statutes vary from state to state, and in some cases, the domestic exemption statute is inadequate or restrictive as to the allowable exemption amount or the class of persons entitled to benefit from the exemption.88
Many offshore jurisdictions offer legislation related to life insurance contracts that is comparable to, or better than, similar legislation under U.S. state law. Such offshore legislation may include specific exemption language and a pro-debtor protection regime. In addition, the laws of an offshore jurisdiction might allow the inclusion of spendthrift provisions in the policy itself, which limit the policy owner's rights in the policy, thereby affording another level of asset protection to the policy. If invested with an offshore manager, the assets inside the separate account of the policy will not only receive protection from creditors by virtue of the exemption statute, but it will also be harder for a U.S. creditor to reach the policy's assets because they are located offshore. The client will also enjoy investor confidentiality and financial privacy under the laws of many offshore jurisdictions, to which similar laws in the U.S. generally do not compare.
B. Planning for the U.S. Taxpayer
1. Domestic Gifting Trust Ownership of Policy
In addition to the considerable income tax benefits of PPLI, holistic planning considerations may dictate the need for a flexible framework for transferring wealth to children or further generations in a transfer tax efficient manner. A previously-funded domestic trust— particularly a generation-skipping transfer ("GST") tax-exempt trust—thus becomes a natural PPLI purchaser.89 The domestic trust's investment in PPLI allows that portion of the trust assets to grow income-tax deferred during the insured's lifetime; then, upon the insured's death, the trust receives the death benefit proceeds income tax-free. This works well for both grantor and non-grantor trusts. For grantor trusts—for example, a grantor trust that has received the remainder interest of a successful GRAT, the assets can grow at an efficient, substantial rate without adding to the grantor's income tax base. In that case, the grantor or the grantor's spouse would be the likely insured. For non-grantor trusts where the current generation does not require distributions, the trustee can grow all or a substantial portion of the trust's assets without the impact of the compressed marginal income tax rates and without having to force out distributions of DNI (to avoid paying income tax at the trust level). The current generation of beneficiaries could serve as insureds (perhaps the already-well-heeled children of the trust's settlor). Note that, under either scenario, to the extent that the trustee needs to make distributions prior to an insured's death, the trustee can make a tax-free withdrawal or loan against the policy, if the policy is structured as a non-MEC.
2. Irrevocable Life Insurance Trusts (on a Grand Scale)
Given the size of the premiums required to purchase a PPLI policy (generally in excess of $2,000,000), traditional ILIT planning which relies on annual exclusion gifts to fund policy premiums, does not work well with PPLI. Thus, clients must either be willing to utilize their gift tax lifetime exclusions or engage in an alternative funding mechanism (such as a private split-dollar life arrangement structured as an intra-family loan).90 By implementing either of these tools, the senior generation can pass assets in a leveraged manner to future generations at a significantly reduced transfer tax cost.
Regardless of the funding mechanism, it is important for the settlor's gift(s) to the ILIT to be completed gift(s) for gift tax purposes. For that reason, the settlor should not retain a testamentary power of appointment.91 In addition, the settlor should retain no other power under the trust agreement that would cause the trust assets to be includible in the settlor's estate for estate tax purposes.92 Moreover, the allocation of GST exemption (if available) to the initial funding (and any additional assets contributed to the trust) permits the policy proceeds to be received and passed free of GST tax as well.93 This planning effectively removes the death benefit proceeds of the PPLI policy from the estate of the settlor/insured, while the assets in the trust will also avoid the GST tax.
a. Lifetime Exclusion Gifting
For policies with total premiums in the range of the client's remaining gift tax lifetime exclusion of $1,000,000 (or, effectively, $2,000,000 for spouses), the funding of the ILIT is relatively straightforward. For policies with larger premiums, clients will have to attempt to employ some technique for transferring assets on a discounted basis (for so long as such opportunities exist under the U.S. transfer tax system) or will have to elect to pay gift tax, where the transfer tax environment makes such an approach sensible.
b. Private Split-Dollar Funding
For the largest policies or for clients who have already used their gift tax lifetime exclusions, a private split-dollar life insurance arrangement presents an attractive funding alternative. Such arrangements have traditionally been one of the most popular and widely-used methods available for funding life insurance premiums in an intra-family gifting context.94
In a typical private split-dollar arrangement, the settlor of an ILIT that is a grantor trust for U.S. income tax purposes will loan the premium amounts to the trustee of the ILIT in exchange for the trustee's promise to repay the loans with interest.95 The trustee's obligation is limited to repayment of the premiums plus accrued interest, meaning that, upon the insured's death, the trustee receives income and transfer tax-free the amount by which the death benefit proceeds exceed the accrued loan obligation. Moreover, under certain circumstances, the trustee's obligation can be non-recourse96 and the repayment obligation can be deferred until the settlor-insured's death.97 Upon the insured's death, the trustee receives the death benefit proceeds and satisfies the repayment obligation to the settlor's estate, thereby allowing the executor to use those loan repayment funds in satisfaction the estate tax liability attributable to the accrued loan obligations (which was a note receivable includible in the settlor's gross estate). Although that receivable was subject to estate tax, the excess death benefit proceeds should not be, as long as the ILIT and the split-dollar arrangement were properly structured to avoid the purview of § 2042.
Furthermore, because the growth of the PPLI policy's cash value and death benefit should far exceed the growth of the accruing repayment obligation, the trustee has effectively arbitraged the borrowed premium dollars. This is greatly facilitated by the fact that interest on a split-dollar loan obligation accrues at the applicable federal rate ("AFR") applicable to the month of the premium payment98.
One important caveat to the preceding discussion is that U.S. securities laws seem to preclude split-dollar financing of domestic (U.S.-issued) PPLI policies, due to their status as securities under U.S. securities laws99. Offshore PPLI policies are not considered "securities" for such purposes and are, therefore, not subject to that financing limitation. As a result, clients
interested in employing split-dollar arrangements to fund PPLI policies should strongly consider acquiring their policies offshore.
c. The Impact of Section 684 on Offshore ILITs
Most offshore carriers require that the policy owner have an offshore situs (due to state regulatory concerns). Thus, if an ILIT invests in an offshore PPLI policy, it must either set up a foreign company for purposes of owning the policy or the ILIT must itself have a foreign situs. If the ILIT is settled as a foreign trust for legal purposes, the settlor's counsel should also ensure that it is classified as a domestic trust for U.S. tax purposes, in order to avoid the potential, negative application of § 684.
Specifically, § 684 treats a transfer of property by a U.S. person to a foreign trust as a sale or exchange for an amount equal to the fair market value of the property transferred. Thus, the transferor is required to recognize gain on the difference between the fair market value of the transferred property and its basis. The rules set forth in § 684 do not apply to the extent that the transferor or any other person is treated as the owner of the trust under § 671, which will typically be the case with a foreign trust with U.S. beneficiaries.100 However, upon the death of a U.S. person who was treated as the owner of a foreign trust during that person's lifetime, gain will be recognized under § 684 if such foreign grantor trust's assets do not receive a step-up in basis under § 1014(a). This will be the case in a traditionally-structured ILIT to which completed gifts have been made.101 In order to avoid the application of § 684, Settlor's counsel can structure the ILIT to be classified as domestic for U.S. tax purposes by satisfying the definitional requirements set forth in § 7701.102
In the event this "hybrid" trust structure is undesirable, however, the other option is to establish a domestic ILIT that then forms an offshore company as an asset of the trust to be the policy-owning vehicle. A simple "check the box" election under Treasury Regulations §§ 301.7701-1, 301.7701-2, and 301.7701-3 ensures disregarded entity treatment.
C. Planning for Foreign Non-Grantor Trusts with U.S. Beneficiaries
PPLI is also beneficial for other types of clients, such as foreign trusts with U.S. beneficiaries. This market is typically served by offshore carriers, including offshore subsidiaries of large U.S. carriers.
1. What is a Foreign Non-Grantor Trust ("FNGT")?
In the simplest terms and as its name implies, a FNGT is a foreign trust that is not a grantor trust. Under § 7701(a)(31)(B), a foreign trust is any trust that is not a U.S. person. A trust is a U.S. person if it satisfies two requirements:
- a court within the United States is able to exercise primary supervision over the administration of the trust, and
- one or more United States persons have the authority to control all substantial decisions of the trust.103
A "grantor trust" is a trust that is treated, for U.S. federal income tax purposes, as having an owner—typically the trust's grantor (the person who transferred assets to the trust)—under the principles set forth in §§ 671-679.
Trusts with foreign owners offer unique tax benefits because they can avoid U.S. income taxes in many situations. With a foreign owner, the foreign grantor trust is treated for U.S. income tax purposes as an NRNC, and the foreign grantor is taxed only on the trust's U.S.- source income. For this reason, foreign grantor trusts are not favored under U.S. tax policy, and Congress has taken steps to significantly restrict the opportunities for foreign persons to use these types of trusts.104 Thus, unlike U.S. domestic trusts, which are not difficult to qualify as a grantor trust (assuming proper structuring), a foreign trust will only be a grantor trust in very limited circumstances. Specifically, a foreign trust qualifies as a grantor trust if:
- the trust is revocable;
- distributions from the trust may be made only to the trust's grantor or the grantor's spouse; or
- the trust is a compensatory trust.105
Instead, most foreign trusts are FNGTs with respect to which the foreign person who created the trust is not considered the owner of the trust's assets for U.S. tax purposes. These FNGTs are subject to draconian tax rules intended to eliminate the ability to defer the payment of income tax by U.S. beneficiaries of the trust. If a FNGT has one or more U.S. beneficiaries, all of the worldwide distributable net income ("DNI") in the trust should be distributed to the beneficiary or beneficiaries each year. If all of the trust's DNI is not distributed, it is carried forward as UNI in the trust. UNI, when distributed, is subject to additional interest charges– which have been compounded over the length of time the UNI exists in the trust, on top of the regular tax owed by the trust's beneficiaries, as well as potential penalties.
2. Background: Pre-1996 Tax Framework
The Small Business Job Protection Act was signed by President Clinton on August 20, 1996. The 1996 Act changed income tax law and reporting related to foreign trusts in two significant areas: (i) for U.S. beneficiaries who receive distributions from trusts created by foreign persons, and (ii) for U.S. persons who create foreign trusts.106 Prior to the enactment of the Small Business Job Protection Act in 1996 (the "1996 Act"), a foreign person could establish a foreign grantor trust with one or more U.S. beneficiaries. As with all grantor trusts, the foreign grantor was essentially treated as the owner of the trust for U.S. federal income tax purposes.107 If a trust is classified as a grantor trust, the trust is essentially viewed as a pass-through entity, because the grantor is deemed to be the owner of part or all of the trust for U.S. federal income tax purposes. This was advantageous for several reasons. As long as the trust's assets were invested in property producing income from foreign sources or capital gain income from domestic or foreign sources, the income derived by the trust generally would, for U.S. income tax purposes, be treated as that of the foreign person who was the grantor and would not, therefore, be subject to U.S. federal income tax. Secondly, distributions from the trust to U.S. beneficiaries were classified as distributions from a grantor trust, so U.S. beneficiaries who received distributions from the trust were not subject to U.S. federal income taxation on such distributions.108 Lastly, under the terms of the trust, there was usually no requirement for trust income to be distributed each year, so monies could accumulate in foreign grantor trusts as long as desired and be distributed to the beneficiaries income tax-free at some later time.
3. Post-1996 Tax Framework
The 1996 Act effectively eliminated the grantor trust status of these foreign trusts by treating a person as the owner of a trust's assets only if that person is a U.S. citizen, U.S. resident, or domestic U.S. corporation.109 As a result, a foreign person who creates a trust is no longer considered the owner of the trust's assets, and the trust is classified as a non-grantor trust.110 When a trust has been classified as a foreign non-grantor trust, it may still be possible for the trust to defer U.S. federal income taxation because, with certain exceptions,111 the earnings of such a trust would not ordinarily be taxed directly by the U.S. government. However, when the trust distributes its income to a U.S. beneficiary, the distribution is then taxable to the U.S. beneficiary.
4. Tax Consequences of Foreign Non-Grantor Trust
a. Distributable Net Income ("DNI")
Generally, when distributions of distributable net income ("DNI") are made from a FNGT, the beneficiaries of the trust are taxed on their share of the distributions, and the trust receives a deduction from its taxable income to the extent of those distributions.112 A U.S. beneficiary is taxable on any amounts of income currently distributed from the trust's worldwide DNI.113 The character of the income on trust assets when distributed to the U.S. beneficiary is determined at the trust level, even though the trust itself may not pay U.S. income tax on such income or gain.114
b. Undistributed Net Income ("UNI")
To the extent that DNI is not distributed in a taxable year to the trust beneficiaries, it is accumulated in the trust and becomes UNI, carried forward to the next tax year and beyond until it is finally distributed to the trust beneficiaries.
When a distribution is made from a FNGT, the distribution is first considered a distribution of the trust's DNI. If the distribution exceeds DNI, the excess is deemed to carry out any UNI that has accumulated in the trust. If the trust has no UNI, or if the distribution exceeds both the trust's DNI and UNI, then the excess is considered a distribution of trust principal. These principal distributions are not taxable income to the beneficiary.
c. Accumulation Distributions
Distributions from FNGTs of UNI are classified as accumulation distributions and taxed according to the "throwback" rules.115 In general, the throwback rules tax accumulation distributions to a U.S. beneficiary at the tax rate that would have been paid if the income had been distributed in the year that the trust originally earned such income.116 The net result is that, at the time of distribution, a U.S. beneficiary would be subject to tax first on the trust's current year DNI and, if current year distributions exceed DNI, then on the trust's UNI.117 Additionally, when a distribution is made that is classified as UNI, an interest penalty is assessed and applied to the tax on the accumulation distribution.118 This interest charge is compounded over the period during which the trust has UNI. The effect of the interest charge can cause an effective tax rate of 100% to apply after several years of accumulation. Furthermore, to the extent that capital gains are accumulated and distributed as UNI, they are stripped of their favorable tax character.119 Thus, the longer UNI remains in the trust, the bigger the problem. And, to the extent that the trust is continuing to earn income, the problem will grow even larger each year that distributions are not sufficient to carry out the entirety of the trust's DNI.
5. PPLI as a Solution to the Accumulation Distribution Problem
a. In General
Despite the effective elimination of foreign grantor trusts (created by foreign persons) and all of the attendant benefits, all hope concerning favorable tax treatment is not lost. When planning on behalf of a trust to which these rules apply, the goal is to reclassify trust income as something that is exempt from income tax in order to mirror the structure of the old foreign grantor trusts. PPLI achieves this goal because income earned inside the policy is not taxed currently to the owner of the policy. Moreover, income distributed from the policy during the life of the insured is generally non-taxable under current law, if the distributions are properly structured.120 Finally, all amounts paid out of the policy as a death benefit to the policy beneficiary are not subject to U.S. income tax at all.
For existing FNGTs with UNI (and previously foreign grantor trusts with income accumulated after the 1996 Act), PPLI can be an effective tool to stem the ever-increasing accumulation of income inside these trusts. In a typical situation, trust assets are used to pay life insurance premiums. As trust assets are gradually depleted by annual premium payments, the accumulation of income ceases. The trust still contains previously undistributed net income that is taxable to the U.S. beneficiary and subject to the interest penalty when the trustee makes a distribution in excess of DNI. However, in the case of trusts with large amounts of UNI, it may be advisable for the trustee to use trust assets to purchase at least one PPLI policy that is a MEC because a withdrawal from a MEC generates DNI that is taxed as such if distributed to the beneficiary in the same year as the withdrawal. This strategy allows distributions of trust assets in excess of current year non-insurance income to be taxed as DNI and avoid the throwback tax and penalty associated with a distribution of UNI. Finally, when the trust no longer has UNI, discretionary distributions can be made from the non-MEC life insurance policy via policy withdrawals or loans and, because these amounts are received by the trustee income tax-free, they are generally non-taxable when distributed to the U.S. beneficiary.
b. Modified Endowment Contract ("MEC")
Investment in a MEC policy can be a useful tool for a planner working with a FNGT that has a UNI problem. Purchasing a life insurance policy that is structured as a MEC can provide a mechanism for facilitating distributions from the FNGT without subjecting the beneficiaries of the FNGT to the throwback tax. Withdrawals from the MEC policy will be considered ordinary income (i.e., DNI) in the year of withdrawal (up to the amount of the difference between the cash value of the policy over the premiums paid into the policy).121 Because distributions of DNI from a FNGT are not subject to the throwback tax, the trustee of the FNGT may distribute a sum equal to the amount of the withdrawal to the trust beneficiaries without the distribution being considered an "accumulation distribution." Despite the fact that the distributions from the MEC constitute ordinary income to the recipients, and a tax penalty of 10% may be incurred with respect to distributions made prior to age 59 ½, the cost associated with these penalties may still be less than the throwback tax that would otherwise be incurred under the UNI rules.
D. Planning for Foreign Persons Residing Temporarily in the U.S.
Investment in a variable annuity can be a highly successful planning technique for clients contemplating a temporary move to the U.S., but not planning to permanently relocate. Not only can the client defer U.S. federal income tax on inside build-up in the annuity during his or her stay in the U.S., the client can also avoid both federal income tax and federal estate tax if the annuity purchase and surrender are properly planned and implemented.
Prior to relocating, the client should acquire an annuity contract from a foreign insurer.122 By funneling his or her non-U.S. assets into the annuity for the term of the client's U.S. residency, the client can avoid the tax on these worldwide assets that would otherwise be incurred as a result of the loss of NRA status. Then, when the client leaves the U.S. and resumes NRA status, the client can cash out of the annuity and resume the pre-residency status quo.
Purchase from a non-U.S. carrier is key to this temporary resident strategy. If the annuity contract is purchased from a U.S. insurer, or a foreign subsidiary of a U.S. insurer, then the contract will be a U.S.-situated asset subject to both federal income tax and federal estate tax (if the client were to die while resident in the U.S.).123 If the contract is U.S.-situated, then when the client cashes out of the annuity upon returning to his or her home country, the client will receive U.S.-source income subject to the 30% federal income tax imposed on income earned by NRAs.124 Further, a U.S.-situated contract will also subject the client to mortality risk because the annuity contract will be included in the client's estate should the client pass away while residing in the United States.125
Also critical to the strategy is ensuring that the client does not surrender the annuity while still considered a U.S. resident. Otherwise, the client will lose the benefit of acquiring the contract from a foreign insurer as the client will be subject to all of the income from the surrender as part of the tax on the client's worldwide assets.
While a similar strategy could be implemented using life insurance, most clients will most likely want to pursue the strategy using an annuity, as the annuity purchase will generally be less expensive. If the client desires to receive a death benefit component, however, a life insurance purchase should be considered.
As with any planning involving foreign clients, the practitioner should assess the tax impact to the client in the client's home jurisdiction prior to implementing this strategy. Specifically, the practitioner should consider whether surrendering the annuity following a return to the client's home jurisdiction will result in negative tax consequences that would outweigh the benefit to the client of pursuing the strategy under U.S. tax law.126
V. INVESTMENT CONSIDERATIONS AS TAX RATES INCREASE
While PPLI has multiple advantages as discussed throughout this article, one of PPLI's primary attractions is the tax advantages afforded life insurance under the Code. PPLI premiums accrete free of federal income tax during the life of the insured, and the death benefit passes to the beneficiary free of any federal income tax. A very favorable investment structure develops when coupled with underlying investments that are actively managed and which would typically generate investment income subject to ordinary income taxation (e.g., hedge funds, commodity funds, and high-yield taxable bonds).
The tax regime in the U.S. is changing pursuant to the passage of Health Care and Education Reconciliation Act of 2010 which, beginning in 2013, imposes a 3.8% surcharge on net investment income.127 Further, it is widely anticipated that the current administration will let the majority of, if not all of, the Bush tax cuts expire at the end of 2010 resulting in capital gains tax rates increasing to 20% from 15% and top ordinary income tax rates increasing to 39.6% from 35%. In summary, these tax rates changes will cause ordinary income to be taxed at a top rate of 43.4%, capital gains at 23.8% and tax on qualified dividends will increase to 43.4% from a low of 15% today. Further still, state income tax rates will increase in many jurisdictions.
The impact of these future tax changes is best exemplified by illustrative analysis. Table 1 presents a hypothetical comparison of a series of investments applying the current tax environment to private placement life insurance. Table 2 presents a hypothetical comparison of a series of investments applying the higher future tax rates as compared to private placement life insurance.
Under either scenario, PPLI generates the higher net investment return over any reasonable investment horizon. Assuming four annual investment deposits of $2.5 million under current tax assumptions [Table 1], after 20 years, a taxable investment portfolio will have a value of $24.5 million versus a value of $36.0 million within the PPLI policy. As a result of the power of compounding, after 40 years a taxable investment portfolio will have a value of $64.6 million versus a value of $157.5 million within the PPLI policy.
Under the future tax environment [Table 2], after 20 years, a taxable investment portfolio will have a value of $21.8 million versus a value of $36.0 million within the PPLI policy. Again, as a result of the power of compounding, after 40 years a taxable investment portfolio will have a value of only $50.4 million versus a value of $157.5 million within the PPLI policy. After 40 years, under the future tax environment scenario [Table 2] almost 213% more value emerges creating a compelling argument for PPLI on the tax advantages alone, notwithstanding the other benefits of PPLI discussed throughout this article.
VI. FOREIGN BANK ACCOUNT REPORT (FBAR) REGULATIONS
Another important planning issue that should not be overlooked by advisors is the U.S. reporting obligations that may arise with respect to certain PPLI policies and PPVA contracts. U.S. persons with foreign bank and financial accounts have long been required to annually disclose information to the U.S. Treasury Department. This information is reported on Treasury Form 90-22.1, Report of Foreign Bank and Financial Accounts, commonly referred to as "FBAR." The FBAR is required to be filed not only for outright ownership of an account, but also for accounts owned by entities in which the U.S. person owns a more than 50% interest and for various trust accounts. Penalties for failure to report the required information can be severe, ranging from $10,000 to the greater of $100,000 or 50% of the balance of the account. Criminal penalties may also apply.
The FBAR and accompanying instructions were revised in the fall of 2008 to require more detail regarding reportable foreign accounts and expand the definition of United States persons required to file the FBAR. This revision sparked much attention in the professional and business press late in the spring of 2009, just before the June 30 filing deadline. In response to public comments on the revision, the IRS suspended the filing requirements for certain persons and certain types of accounts until June 30, 2010, pending the issuance of new regulations.
Proposed regulations were issued February 26, 2010. The new regulations provide some clarity, but questions remain. Because these regulations were issued in proposed form, they are subject to revision before being finalized. Guidance from the IRS was issued simultaneously with the proposed regulations, postponing the filing of 2009 FBARs for some U.S. persons until June 30, 2011.
The general FBAR reporting requirement remained the same in the wake of the proposed regulations and IRS guidance: a United States person having a financial interest in, or signature authority over, a bank, securities, or other financial account in a foreign country is required to file the FBAR.
Instructions for the 2008 FBAR expanded the definition of a United States person to include persons in and doing business in the U.S. Under the proposed regulations, however, the definition of a U.S. person is narrowed to mean a U.S. citizen, a U.S. resident, an entity formed in the U.S., or a trust or estate formed under the laws of the U.S.128 Pending finalization of the regulations, the requirement to file an FBAR due June 30, 2010 is suspended for persons who do not meet the definition in the proposed regulations.
Reportable accounts include the obvious, such as bank and brokerage accounts. The regulations make it clear that FBAR reporting is also required for other types of financial accounts, including insurance policies (with cash value) and annuity contracts where such policies or contracts were purchased outside the U.S. from a non-U.S. issuer. Thus, offshore PPLI and PPVA contracts should be reported on the FBAR of a person with a beneficial or legal interest in such contracts.
Footnotes (Cont'd. from Part 1)
69. See § 72(e)(2)(B), (4). With respect to the tax rate applied to NADs, U.S. citizens and resident aliens are subject to the standard rate structure for gross income. See §§ 1, 72. NRAs, on the other hand, are generally subject to a flat 30% tax and withholding on the income derived from the NAD. See §§ 871(a), 1441.
70. § 72(q).
71. See § 72(e)(4).
72. § 72(u)(3).
73. Regs. § 1.72-1(c)(1).
74. § 72(b)(1). The investment in the contract is defined as the aggregate amount of premiums or other consideration paid for the contract, minus the aggregate amount received under the contract before such date, to the extent that such amount was excludable from gross income under the Code. § 72(c)(1). If the annuity is for life, the expected return is determinable based on the life expectancy of the annuitant, in accordance with tables prescribed by the Treasury Secretary. § 72(c)(3)(A). If the annuity is for a term certain, the expected return is the aggregate of the amounts receivable under the contract as an annuity.
75. § 72(b)(2).
76. See § 72(e)(2)(A); Regs. § 1.72-1(d). Under § 72(c)(2), special rules apply to contracts including a refund feature. Additional rules also apply to the taxation of distributions following the death of the annuitant. These rules are beyond the scope of this article. Persons dealing with such distributions should refer to § 72 and contact an experienced tax professional for additional information.
77. Although § 691(c) allows the beneficiary to deduct a proportionate share of the U.S. estate taxes attributable to the annuity's includible value, in most cases that deduction does not entirely eliminate double taxation of the deferred gains.
78. See §§ 163(e), 1275(a)(1)(B); Regs. § 1.1275-(1)(k).
79. § 1275(a)(1)(A).
80. While this rule typically applies only to fixed annuities and not to variable annuities, caution should be exercised with all foreign annuities, as it may be possible that different types of annuitization provisions in variable annuity contracts could trigger the application of § 1275.
81. § 2039(a); Kathryn Henkel, Estate Planning and Wealth Preservation: Strategies and Solutions ¶ 13.04[1] (1998).
82. § 2039(b).
83. See Regs. §§ 20.2104-1(a)(4), 20.2105-1(e); Spielman, U.S. International Estate Planning ¶ 10.03[14][a][iv] (1998); see also Guaranty Trust Co. of N.Y. v. Comr., 16 B.T.A. 314 (1929) (distinguishing between insurance contracts and annuity contracts). Pursuant to the Treasury Regulations related to §§ 2104 and 2105, annuities "issued by or enforceable against a resident of the United States or a domestic corporation" are considered to be situated in the U.S. Regs. §§ 20.2104-1(a)(4), 20.2105-1(e). Under this rule, annuities issued by offshore insurance companies that have made a 953(d) election to be treated as a domestic corporation ("953(d) carriers") should be considered situated in the U.S. and includable in the NRNC's gross estate for U.S. tax purposes. See Regs. §§ 20.2104-1(a)(4), 20.2105-1(e); § 953(d). Annuities issued by offshore insurance companies that have not made a 953(d) election ("non-953(d) carriers") will not be considered situated in the United States and are not includable in the NRNC's gross estate. Therefore, NRNCs who are not engaged in pre-immigration planning and do not intend temporary U.S. residence should carefully consider whether investment in a policy issued by a U.S. domestic carrier or 953(d) carrier is appropriate, given the particular circumstances at hand. While investment in a policy issued by a domestic carrier or a 953(d) carrier may be appropriate, it may also be the case that the costs of such investment outweigh the benefits to the potential policy owner.
84. See generally Helvering v. Le Gierse, 312 U.S. 531, 539-40 (1941) (highlighting risk-shifting and risk-distributing as essential elements of a life insurance contract).
85. PLR 200842013.
86. See § 4371.
87. Premiums paid with express or implied intent to defraud creditors, however, generally are not protected. Such premiums, plus interest, are usually recoverable by a defrauded creditor out of insurance proceeds.
88. For a complete state-by-state treatment of the exemption statues relating to life insurance and annuities, see DUNCAN E. OSBORNE AND ELIZABETH M. SCHURIG, ASSET PROTECTION: DOMESTIC AND INTERNATIONAL LAW AND TACTICS, ch. 8 (1995).
89. The GST tax is a transfer tax (in addition to the estate tax) that is imposed on transfers that skip a generation and at a rate equal to the highest marginal estate tax rate. The purpose of this tax is to prevent the avoidance of estate tax at the skipped generation. That is, in the absence of the GST tax, clients could, for example, leave property directly to their grandchildren, without subjecting that property to a transfer tax at their children's generation.
90. See infra Section IV.B.2.b.
91. See Regs. § 25.2511-2(b).
92. See §§ 2036 to 2041.
93. See § 2642.
94. A comprehensive treatment of split-dollar planning and its history is beyond the scope of this article.
95. Treasury Regulations issued in 2003 pursuant to §§ 61 and 7872 provide for two basic approaches to split-dollar arrangements: the economic benefit regime and the loan regime. In this intra-family context, the loan regime is the most straightforward and likely the most effective. See Zaritsky ¶ 6.05 for further discussion of the two regimes and the circumstances in which one is favored over the other.
96. See Regs. § 1.7872-15(d).
97. See Regs. § 1.7872-15(e)(5)(ii). Note that the IRS takes the position that interest accrued under a split-dollar loan arrangement is personal, non-deductible interest to the ILIT and interest income to the grantor. Regs. § 1.7872-15c. However, to the extent that the arrangement is entered into between a grantor trust and its grantor, Rev. Rul. 85-13 suggests that there is no loan for federal income tax purposes, and thus none of the interest accrued during the grantor's lifetime is considered taxable interest income. Nevertheless, if repayment does not occur until the grantor has died, the IRS has an argument that the entirety of the accrued interest—and not just the interest accrued after the grantor's death—is taxable interest to the grantor's estate (and is simultaneously nondeductible to the trust).
98. See Regs. § 1.7872-15(e)(4).
99. See C.F.R §§ 221.1-221.7 (Regulation U).
100. See § 679.
101. See Regs. § 1.684-3(c).
102. Under the regulations to § 7701(a)(31), a trust is a foreign trust unless both of the following conditions are satisfied: (a) a court or courts within the U.S. must be able to exercise primary supervision of the administration of the trust; and (b) one or more U.S. persons have authority to control all substantial decisions of the trust. Regs. § 301.7701-7(a).
103. § 7701(a)(30)(E).
104. The Small Business Job Protection Act of 1996 (P.L. 104-188) significantly restricted the tax advantages available to foreign individuals seeking to establish trusts with U.S. beneficiaries.
105. § 672(f). In some circumstances, a U.S. beneficiary of a trust could be considered the owner of the trust that is otherwise owned by a foreign person if that U.S. beneficiary transfers assets to the foreign person for less than full and adequate consideration. Id. Also, any foreign grantor trust that was in existence prior to September 20, 1995, is "grandfathered" and will continue to be a grantor trust as to any property transferred to it prior to such date provided that the trust continues to be a grantor trust under the normal grantor trust rules. Regs. § 1.672(f)-3(a)(3). Separate accounting is required for amounts transferred to the trust after September 19, 1995, together with all income and gains thereof.
106. See Harrison, Kirschner, & McCaffrey, "U.S. Taxation of Foreign Trusts, Trusts with Non-U.S. Grantors and Their U.S. Beneficiaries," International Trust and Estate Planning 1-2 (July 2008) (hereinafter referred to as "Harrison").
107. See generally §§ 671-679.
108. Rev. Rul. 69-70, 1969-1 C.B. 182.
109. Any foreign grantor trust that was in existence prior to September 20, 1995, is "grandfathered" and will continue to be a grantor trust as to any property transferred to it prior to such date provided that the trust continues to be a grantor trust under the normal grantor trust rules. Regs. § 1.672(f)-3(a)(3). Separate accounting is required for amounts transferred to the trust after September 19, 1995, together with all income and gains thereof.
110. There are exceptions to this rule that are beyond the scope of this article. See Regs. § 1.672(f)-3. See also Harrison 2-7.
111. Exceptions include certain income, dividends, rents, royalties, salaries, wages, premiums, annuities, compensations, remunerations, and endowments or other "fixed or determinable annual or periodic gains, profits, and income" ("FDAP" income) derived from the U.S. and income that is effectively connected with the conduct of a U.S. trade or business. See Giordani, Ripp & Jetel, "United States: Private Placement Life Insurance Planning," Mondaq Business Briefing, (11/24/09).
112. For more information on FNGTs, see supra Section IV.C.1.
113. This situation applies to discretionary distributions from foreign complex trusts; the situation would be somewhat different for U.S. beneficiaries of foreign simple trusts or foreign complex trusts with mandatory distribution provisions. See Harrison 23.
114. Capital gain income is included in determining DNI, and retains its character in the hands of the U.S. beneficiary if distributed in the year that it was earned by the trust.
115. See §§ 665-668. The throwback rules were imposed by U.S. lawmakers as a defense against the tax-deferral opportunities associated with the use of FNGT.
116. §§ 666(b), (c); § 667(a).
117. Id.
118. See § 668.
119. For additional information regarding the throwback rules and the method of calculating the throwback tax, see Amy P. Jetel, "When Foreign Trusts Are Non-Grantor," 147 Trusts & Estates (April 2008).
120. In general, this means making withdrawals from a non-modified endowment life insurance policy up to the policy basis, then switching to policy loans.
121. § 72(e)(10); (2)(B).
122. By purchasing the annuity contract prior to moving to the U.S., the client can avoid a 1% excise tax on the purchase. NRNCs are exempt from this excise tax.
123. Rev. Rul. 2004-75, 2004-2 C.B. 109; §§ 72, 2039.
124. § 871(a).
125. § 2039
126. As noted, the practitioner and the client should always carefully consider the tax impact to the client in the client's home jurisdiction prior to implementing any U.S. planning strategy. The client's failure, while residing in the U.S., to comply with the tax, regulatory, and legal requirements imposed by the client's home jurisdiction could subject the client to civil and even criminal penalties under U.S. law. See generally Pasquantino v. U.S., 544 U.S. 349 (2005) (upholding wire fraud convictions of defendants in connection with scheme to evade Canadian liquor importation taxes).
127. See Health Care Legislation Tax Provisions, AALU Washington Report, Apr. 12, 2010, AALU Bulletin No: 10-40.
128. It should be noted that the proposed regulations make clear that an entity must file regardless of whether it has made a disregarded entity election. Additionally, the deemed owner of a trust under the grantor trust rules must also file.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.