< Magazine Index > < Index For This Edition > < Subscribe >

General Concepts

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.

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.

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.

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:

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).

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”).

Product focus: offshore v. onshore

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.

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.  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.

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.

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%.

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.

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.

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.

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.

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.

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.

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.

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.

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.

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.

Specific examples

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.

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.

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.

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.

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.

Conclusion

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.
 

William D. Kornreich is President and Robert M. Burkarth III is Senior Vice-President of Wealth Preservation Associates Ltd. based in New York City.  They assist U.S. domestic and multi-national clients with strategies for the creation, transfer and preservation of wealth.  The authors would like to acknowledge the help of G. Warren Whitaker, an international tax and trust attorney with the firm of Hughes and Whitaker, who assisted with the examples used in this article. [Copyright 1999 O.F.C. Publications Inc.  This article was published in the May/June 1999 issue of Offshore Finance U.S.A. magazine]