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| Offshore
Life Insurance in Wealth Preservation Strategies |
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| A certain
cachet exists regarding offshore investing and planning that seems to imply
that it is only the purview of the super-wealthy, cloaked in practiced
secrecy, hushed whispers and knowing winks. For estate planning purposes,
suitability is determined more on citizenship and residency status of the
donor/grantor and heir/beneficiary than the size of the hypothetical offshore
bank account. This article will address options for the U.S. domestic
and non-U.S. donor/insured to preserve wealth for the U.S. domestic and/or
non-U.S. heir/beneficiary. |
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| General
Concepts |
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| Jurisdictions.
When we speak of offshore jurisdictions, typically we are referring to
such locales as the Bahamas, Bermuda, the Cayman Islands, Guernsey, Turks
and Caicos, etc. A case can be made that the United States is likewise
an offshore “haven” in a particular circumstance. |
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| Income,
gift and estate tax issues. With any strategy, there are income,
gift and estate tax implications. The usual concern for the offshore
investor is the income tax and associated reporting obligations.
For U.S. residents, transfers of appreciated assets to an offshore trust,
pass-through entity or corporation triggers a gains/excise tax. Depending
on domestic ownership percentages of these entities, there is a variety
of ways the U.S. Treasury imposes tax, in some cases even a penalty.
For example, a passive foreign investment company (“PFIC”) has its capital
gains recharacterized as ordinary income. |
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| Estate
planning. Techniques that minimize or eliminate the income tax
drag while falling within gift and estate tax exemptions are valuable to
those seeking to preserve inter-generational wealth. For truly long-term
accumulation, access and management, transfers in trust of liquid assets
subsequently moved into the tax protection of a life insurance policy represent
a superior alternative. |
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| Products.
Investment companies (mutual funds), investment partnerships and foreign
corporations, to the extent that U.S. residents are shareholders, generate
taxable income at the shareholder level. Cash value life insurance
products, both domestic and offshore, are treated uniquely by the IRS Tax
Code (the “Code”). Only life insurance can claim four specific tax
characteristics as its own. These characteristics are: |
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1. tax-free
build-up of cash values, including dividends, interest, realized capital
gains and unrealized appreciation;
2. first-in,
first-out (“FIFO”) accounting treatment of premium contributions and withdrawals;
3. the
ability to borrow against cash value at low interest rates; and
4. income
tax-free death benefits combined with a tax-free step-up in basis to the
beneficiary(ies). |
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| The above
characteristics combined in one product and used to the investor’s best
advantage can have very powerful and compelling financial results.
Essentially, we are trading off paying income taxes on portfolio income
and transactions (depending on portfolio turnover, anywhere from 20% to
50% of the annual pre-tax returns) for the cost of the insurance wrapper,
which averages approximately 2% per year over the life of the policy.
Although this unique treatment applies to all life insurance policies,
we will be dealing with private placement variable universal life insurance
(“PPVUL”). |
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| Product
focus: offshore v. onshore |
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| The variable
universal life chassis. The most exciting opportunity in this
product chassis is the “PP” part - private placement. This product
allows for equity management on a private placement basis, i.e., hedge
funds. It also removes the long-standing objection to any insurance
product that incorporates money management, “My personal investment manager
can beat the insurance company hands down.” In this case, the private
client’s money manager and the insurance company’s money manager is the
same person. |
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| Variable,
the “V” in PPVUL, means that the underlying investments representing the
cash value are not part of the carrier’s general account (a defined term
meaning an invested asset on the books of the life insurance company).
Rather, the assets are placed in “separate accounts” that are legally segregated
from the books and claims of the insurance carrier’s creditors. |
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| These accounts
have two advantages: it is possible to invest in equities rather than ultra-conservative
bonds, and there is no risk of compromising the assets in the event of
a carrier bankruptcy or reorganization. |
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| There are
two types of insurance policy “chassis,” if you will, that allow for cash
value. They are the whole life and universal life (“UL”) policy types
(term insurance does not have cash value). Whole life is an older
design, and while it has more guarantees associated with it, it does not
have the flexibility of the UL product. The UL contract is a “buy
term and invest the difference” type policy, with the investment internal
to the contract. |
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| Premium
taxes. State premium & DAC taxes. For U.S. domestic
products, there is a deferred acquisition cost (“DAC”) tax of 1% on the
premium dollars as they are contributed. Similarly, there is a state
premium tax, which varies from state to state and averages approximately
2%. |
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| Excise
tax. For transfers of assets (cash) by a U.S. resident to an
offshore insurance contract, the state premium and DAC taxes do not apply.
Rather, there is a 1% Federal excise tax levied on these premium contributions.
There are two fortunate advantages to the offshore policy: reporting requirements
are less stringent (an insurance contract is not an offshore corporation,
partnership, bank account or annuity) and the excise tax is significantly
less than the capital gains/excise tax mentioned previously. |
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| Earnings
and investment opportunities. An attraction of the PPVUL policy,
whether a U.S. domestic or offshore product, is the opportunity to have
the funds managed by noted money managers. Some of these managers
are closed to new investors, yet they maintain a separate account for life
insurance products that can accept deposits. Additionally, the offshore
product allows access to managers that otherwise would not be available
to U.S. domestic investors under a conventional investment program. |
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| Charges
and costs. In general, initial setup charges are higher for domestic
products, but the ongoing charges tend to be lower than in the offshore
products. All other things being equal, a domestic “chassis” will
outperform the offshore product over time due to these lower ongoing charges. |
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| One-time
charges. Along with the taxes mentioned above, there are charges
based on the premium contributions as monies are placed inside the insurance
contract. Typically, these are set-up fees and sales loads of the
magnitude found in the mutual fund industry, 1% to 5%. All fees of
this type are listed and fully disclosed in the offering memorandum for
each contract |
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| Ongoing
charges. There are also charges taken on an annual basis.
These include the investment managers’ fees (which would be paid anyway),
insurance company administration and overhead charges and the actual cost
of the insurance itself. The cost of insurance (“COI”) of the policy
is based on the net amount at risk - the difference between the value of
the invested assets and the death benefit at the time. |
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| What’s
the downside? Investor control. In order to qualify as
life insurance, the owner of the policy cannot exercise control over the
investment decisions made at the specific investment level. The owner
can choose among managers but cannot direct a manager into a particular
investment or strategy. |
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| MEC/Non-MEC
status. To preserve tax characteristics 2 and 3 above, for a
given amount of premiums going in, there must be a minimum level of insurance,
otherwise the IRS views the contract as an investment and taxes any withdrawal
or borrowing as ordinary income. A contract that violates these restrictions
is called a modified endowment contract (“MEC”). Maintaining the
non-MEC status of a policy is critical if tax-free withdrawals are ever
contemplated. |
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| Liquidity
issues. An issue familiar to investors experienced in hedge fund
investing is liquidity. In this case, PPVUL, as its investments are
hedge funds, must operate under the same limitations regarding access to
cash. Generally, access is available on a monthly basis, although
those managers following less liquid investment objectives (commercial
real estate bridge financing, for example) may have only semi-annual access. |
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| Guarantees
(or lack thereof). With any VUL chassis, there are limited or
no guarantees on the performance of the invested assets, as the insurance
company has little or nothing to do with managing the funds. As such,
all the risk is borne by the owner of the policy that the investments will
perform as initially projected. |
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| There is some
conventional wisdom in the marketplace that offshore products are less
expensive to maintain than domestic products, and therefore provide a higher
level of financial performance. While it is true that the domestic
products do have higher one-time charges (at least a 2% difference just
in taxes alone), overall the ongoing charges are comparable. Some
argue that the higher level of domestic regulation creates a higher cost
structure. This may be true in the absolute, but as a practical matter,
the charge that has the most dramatic effect on performance is the COI.
Domestically, these rates are competitively set at the outset and are typically
difficult to increase due to the regulatory environment. Offshore
jurisdictions may be somewhat more lax in insurance company oversight,
resulting in potentially much higher COI and administrative charges down
the road. |
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| Specific
examples |
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| Most concerns
about domestic/offshore planning center on the income tax issues.
By contributing cash to a PPVUL contract and keeping within the guidelines
to preserve the non-MEC status of the policy, there will never be any income
taxation on the underlying investments during the life of the insured.
Funds are accessible during life on a tax-free basis as withdrawals (up
to the tax basis in the policy = sum of premiums paid) and via policy loans
thereafter. At death, there is no income taxation on the proceeds
of the insurance. If structured appropriately, there may be no estate
tax on the proceeds for one, two or more generations. |
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| U.S. domestic
donor/insured, U.S. domestic beneficiary. This situation is straightforward.
Assume a trust, domestic or foreign based, is set up to hold a life insurance
policy. For income tax purposes, as long as there is a U.S. beneficiary,
the trust is treated as a grantor trust. For estate tax purposes,
this trust could be set up to be outside the estate of the grantor, but
premium contributions would be treated as gifts. If a married couple
were to allocate their entire $2 million generation skipping transfer tax
(“GSTT”) exemptions to periodic gifts to the trust that also qualify for
their unified credit exemptions (currently $1.3 million, increasing to
$2 million over time), there could be no estate tax levied for the duration
of the trust. Generally, this is about 100 years, but opportunities
exist in certain states that could extend that period. |
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| U.S. domestic
donor/insured, non-U.S. beneficiary. If a trust were set up by
a non-U.S. person in an offshore jurisdiction for his or her benefit, it
could be treated as a non-grantor trust. A U.S. donor could enter
into a private split-dollar agreement with the trustee. “Split dollar”
is a premium-funding program where the premium obligation is split, typically
between an employer and an employee. The employer’s contribution
is treated as an interest-free loan, and is eventually repaid from policy
cash values or the death benefit if the insured dies while the loan is
outstanding. Recent rulings have blessed this treatment among family
members, bypassing the need for an employer-employee relationship.
There is no transfer of assets, as the loan is due and payable back to
the U.S. benefactor. There is no income tax issue, as during the
life of the insured, there is no tax on the cash value increases, and as
such no taxable income at the trust level. If the trust has separate
assets to pay its (small) share of the premium, there is no gift tax due.
The amount of the loan remains in the estate of the U.S. benefactor, but
the death benefit in excess of that (or the entire death benefit if the
loan has been repaid) passes into the offshore trust estate tax free. |
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| Non-U.S.
donor/insured, U.S. domestic beneficiary. An offshore trust set
up by a foreign grantor for a U.S. beneficiary (an “inbound trust” in the
IRS’s parlance) faces perhaps the most onerous exercise for interpreting
the tax treatment of transactions on an ongoing basis. In certain
circumstances, proposed regulations even allow the IRS to recharacterize
any trust distribution as the agency sees fit - taxable income rather than
corpus, for example. It is preferable to have an offshore trust if
there is a bona fide non-U.S. donor. A foreigner is not subject to
U.S. gift and estate tax rules except regarding U.S. situs property.
Any insurance policy would of course provide the tax protections enumerated
above |
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| Non-U.S.
donor/insured, non-U.S. beneficiary. There is an interesting
development that may seem counterintuitive at first - the United States
as an offshore domicile. For the non-U.S. resident with a non-U.S.
beneficiary, a potentially very attractive situation exists. The
United States does have a comparatively stable currency, legal and political
system. Depending on the treatment of distributions, etc. in the home country,
there may be no tax worldwide. With the changes in state statutes
eliminating the rule of perpetuities, it is possible to set up a trust
with an insurance contract that could potentially be entirely free from
any U.S. taxation. Maintaining the trust structure in the U.S. under those
circumstances could preserve wealth for multiple generations in a very
safe environment. |
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| Conclusion |
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| Income tax
rules regarding offshore transactions play havoc with wealth accumulation
and preservation objectives. Private placement variable life insurance
eliminates current taxation on investment returns and enhances asset accumulation.
Proper use of proven insurance techniques maximizes the opportunities available
for both U.S. domestic and non-U.S. clients to build, transfer and preserve
wealth for generations. |
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