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Life insurance is a product acquired when there is a perceived liquidity need.  Sometimes a salesperson has to work hard to convince his or her clients of this need.  Ignored or not, the need exists.  Insurance provides an assured source of cash even for people who have a large net worth.  Just because someone is wealthy, they do not necessarily have the funds readily available to meet their estate costs, tax, property conservation and family or business survival needs.

In terms of personal estate planning, insurance can provide the immediate cash to solve the income replacement needs of family members who are surviving the decedent.  For many families, even wealthy ones, when the income earner dies, the ready and available cash, which in the past might have been paid on a monthly basis, disappears.  Many times, a substantial amount of cash is needed to pay accumulated debts and expenses or to pay off mortgages or other debts which have been personally guaranteed by the decedent.

Life insurance is a complex financial product.  Evaluating different insurance policies is difficult to do, even for the experts.  A plethora of variables make comparison shopping difficult.  The acquisition of insurance should be done in consultation with an experienced professional advisor. 

Understanding variable insurance policies

Variable insurance products were developed by insurance companies primarily to meet competition from mutual fund type investments.  If nothing else, the insurance industry is very creative and extraordinarily competitive.  Essentially, variable life insurance is a whole life insurance policy which allows the policy owner to direct the investment of the cash values within a selection of pre-set investment vehicles.  These are usually mutual funds operated by the insurance company.

Variable insurance is valuable to people who want to maintain control over their cash values and who feel that because they have an ability to make solid investment decisions, are willing to take an investment risk.  Variable life insurance does not have a fixed return and the policy owner bears the risk of the investments which support the policy values.  If the policy owner makes astute choices among the available investments, the policy will become quite valuable.  Of course, the reverse is also true. 
 

There is a risk that the market value of the underlying assets will drop causing the policy value to decline.  Risk and reward are part of an investor’s everyday life.

Most variable life policies allow policy owners to switch their investments in the underlying funds several times a year.  Generally, there is no charge for the transfer of funds between the underlying investments, and the transfers are tax-free.  The income earned by these investments underlying the policies' cash values may be accumulated tax-free or on a tax-deferred basis.  The tax treatment depends on whether or not the gains are distributed during the policy owner's life or are funded at death.

Many professional planners and business advisors recognize that variable life insurance and, in particular, variable universal life insurance are important in solving business problems.  The attractive features of these policies include their flexibility, their growth of cash values and the resulting death benefits.  When used as a non-qualified deferred compensation plan, for example, a variable policy can potentially provide higher tax deferred cash value accumulations than a traditional whole life policy or even a universal life policy. 

When a variable product is used to fund a buy/sell agreement, it is likely to keep pace with the increase in the value of a closely-held or family-held business.  Variable life policies are predominant in funding key-man insurance and other business plans. 

Variable life insurance is not a perfect insurance plan for all purposes.  The main drawback is that the policy owner bears all the risk of the investments.  Unlike traditional whole life policies, there is no minimum schedule of cash values.  Nor is there a fixed return.  The policy cash value is equal to the market value of the underlying assets, which are generally held in separate accounts.  If the market is down when the insurer dies, the death benefit may be significantly less than would otherwise be payable under the guaranteed minimum benefit of a whole life policy. 

When a variable universal life policy provides flexibility with regard to changes in premiums and death benefits, there is the possibility that the policy could become a modified endowment contract (MEC).  Such a characterization is not good for tax purposes.  If a policy is classified as an MEC, the distributions under the contract are taxed under the interest-first rule rather than the cost recovery rule.  Of major importance is that these distributions will further be subject to a 10% penalty if they are made before the policy owner turns 59½-years-old, dies or becomes disabled.

The cost-recovery rule essentially treats the amounts received as the return of the policy owners investment in the contract.  Under this rule the policy owner is entitled to recover the full amount of the investment and any funds distributed in excess of that investment  are then treated as taxable interest or gain in the policy. These additional amounts generally include policy dividends, lump sum cash settlements of cash surrender value, cash withdrawals and amounts received on the partial surrender of the policy.

Variable policies also have variable tax consequences.  With a variable insurance product, capital appreciation loses its character as capital gain.  Where there are distributions because of a withdrawal or a surrender of the policy, the amount received becomes taxable as ordinary income.  While the maximum or marginal tax rate is 39.6%, it is well known that the effective rate can be much higher due to certain computational complexities within the operations of the Internal Revenue Code.  However, if the policy is not drawn down, the increase in value will clearly increase the available death benefit which can be structured to be received by the beneficiaries free of any income or estate tax.

Advantages of an offshore variable policy

There are certain significant tax and planning advantages in having an offshore insurance policy.  For tax purposes, an offshore policy and a domestic policy must meet the same rules.  That is, there is nothing available offshore that cannot be available onshore in terms of insurance product design. However, offshore insurance companies do have policies available which meet the US rules, but are not offered by US companies.  Such policies allow the policy owner to utilize the services of one or more independent investment advisors. 

The tax code specifically provides that the use of an independent investment advisor shall not be prohibited.  This flexibility allows the independent advisor to have investments in both public-type investments as well as private-type investments.  In other words, the investments are not required to be restricted to mutual funds offered by an insurance company. 

Additionally, offshore insurance policies offer a level of security not available domestically.  In the Cayman Islands, for example, the underlying insurance law provides that assets held in the segregated asset accounts of an insurance company will not be subject to the claims of the insurance company's creditors.  Assets held in these segregated asset accounts can only be paid to the policy owner in the event of the liquidation of the insurance company. 

In the case of a domestic policy, the policy owner is an unsecured creditor of the insurance company and must therefore rely on the financial solvency of the insurance company in order to be assured of the policy benefit being paid off at death.  This risk, which is significant, is avoidable in an insurance policy which has been issued offshore under the right insurance law.

Finally, as a practical matter, an offshore policy gives a high level of asset protection for the assets held under the policy.  Most states provide for some amount of protection for life insurance proceeds, but not fully.  Some states, such as Florida, have laws which may expose insurance policies to a lawsuit making them available to creditors.  For example, while Florida exempts life insurance proceeds and cash surrender value, there have been cases where the acquisition of insurance was held to be a fraudulent conveyance even though the proceeds are exempt.  By acquiring an offshore policy, it is possible to gain a much higher level of real wealth protection.  In a world with plenty of uncertainty, there is no sense taking avoidable risks.

Creative insurance holding vehicles

While trusts have been the predominant legal arrangement for owning insurance, a trust is by no means the only vehicle.  A partnership or a limited liability company may be even better as an ownership vehicle.  One of the significant disadvantages of the insurance trust is that the insured may not for tax reasons be the trustee of the trust which owns the insurance policy on his or her life.

For tax purposes, where a partnership owns an insurance policy on a partner's life and receives the insurance proceeds upon that partner's death, it is not likely that the proceeds will be received as income to the partnership or any of the remaining partners.  However, the basis of each partner's interest in the partnership will be increased as a result of that partnership's receipt of the insurance proceeds covering the deceased partner's life.  These are extremely interesting tax attributes, particularly for obtaining flexibility in planning.

Recent developments in US tax law also allow limited liability companies to be easily treated as partnerships under the check-the-box rules.  With some offshore jurisdictions providing special or heightened creditor protection for limited liability companies, the use of an LLC--which for US tax purposes is treated as a partnership--becomes an outstanding insurance planning platform. 

While the life insurance trust has significant restraints and limitations, such as irrevocability, a limited liability company structure is a flexible arrangement and allows changes to be made in the future that were not contemplated when the policy of insurance was first acquired.

As a further refinement, an insurance limited partnership or LLC can be utilized as part of a plan to be funded by monies set aside in an IRA.  In this way, insurance may be acquired using pre-tax dollars. 

The important point to note is that insurance is not only a valuable financial product, but there are a number of legal entities that can be used offshore to serve as insurance policy-holding structures. 

Conclusion

Modern estate planning is designed both to meet present known concerns and to provide the flexibility to adapt to future contingencies.  Regardless of the point in time, there will be needs for cash to meet financial requirements - taxes, debts, income replacement to name but a few. 

Insurance as a financial product is in a unique position to meet these real life financial needs.  When using offshore insurance in offshore holding vehicles, this important financial product becomes an even more powerful planning tool.
 

Denis Kleinfeld, C.P.A., J.D., is a principal of the Miami, Florida-based Kleinfeld Law Firm.  Mr. Kleinfeld's primary practice focus is on sophisticated national and international income, estate and wealth protection planning for private clients, privately-held companies and directors of public companies.  He is the author of numerous articles and a well-known speaker at national and international conferences.  Mr. Kleinfeld graduated from the University of Illinois (B.S. in Accountancy) and received his J.D. from Loyola University of Chicago, School of Law in 1970.  Prior to entering private practice in 1975, he served as an attorney for the Internal Revenue Service in the Estate and Gift Tax Division. [Copyright 1999 O.F.C. Publications Inc. This article was published in the November/December 1999 issue of Offshore Finance U.S.A. magazine]