Private Placement Insurance

PRE-IMMIGRATION PLANNING – A DEFENSE AGAINST U.S. INCOME TAX

2008-04-19T06:32:37-04:00

Persons immigrating to the U.S. for a period that is temporary, but sufficiently long as to become a U.S. taxpayer, will be taxed on all of their income world-wide. They may be able to avoid all or part of the tax that would otherwise be imposed on their securities portfolio by investing in a U.S tax compliant private placement annuity. This should be done prior to immigrating to the United States.

If the annuity is purchased prior to arrival in the U.S., the conveyance of currently held securities to an insurance company in return for the annuity is not a U.S. taxable event.

The assets inside the annuity can be managed by an investment advisor/ custodian of choice.

During the period of U.S. residency, income from interest, dividends and capital gains is tax deferred. The ownership of the annuity is also legally not reportable on the U.S. 1040.

After the annuity holder is no longer subject to U.S. income tax, the annuity can be liquidated, and no U.S. income tax will be imposed.

The result – all of the securities portfolio income that would otherwise be taxable while in the U.S. may be shielded from the imposition of U.S. income tax.

PRIVATE PLACEMENT ANNUITIES – FREQUENTLY ASKED QUESTIONS

2008-04-19T06:23:30-04:00

G. Kristin Delano, Esq.

The following are some questions that I frequently am asked. The answers assume that the annuity is going to be owned by a person who, regardless of nationality or domicile,. is a U.S. taxpayer during the period of annuity ownership. Questions from readers are welcome.

Q: How would my money be invested?

A: One of the attractive features of private placement annuities is the ability of the insurance/annuity company to choose any legitimate financial institution to make the investment decisions and act as custodian of the funds.

Q: You mean the insurance/annuity company doesn’t do the investing?

A: The companies with which I am familiar don’t want to make the investment decisions. If the investment manager doesn’t do well, then the investment manager can be replaced instead of the annuity company.

Q: Can I transfer my existing portfolio of securities into an annuity?

A: Yes. In fact, the insurance/annuity company can establish an account with your current investment manager after which the annuity can be funded with a simple in-house transfer of the securities from your account to the new account.

Q: What kinds of investments can be put into an annuity?

A: The investments can be in stocks, notes, mortgages and non-U.S. real estate.

Q: Are there any investments I can not put into an annuity?

A: The investments should not include U.S. real property interests or anything that will receive a K-1 (from entities that aren’t taxable but instead pass through the items of income, gain, loss, deduction and credit through to the owners). A discussion of U.S. real property interests is beyond the scope of this site/blog.

Annuities should also not own any property that is controlled by the annuity owner.

Q: Must the assets of the annuity be invested in securities that are actively traded?

A: No. The annuity contract can be written to permit the assets to be distributed to the annuity owner in kind. As the insurance/annuity company is then not required to make payments in cash, it need not be concerned with illiquidity.

Q: What about diversification?

A: The annuity must hold at least 5 separate investments. Not more than:

55% of the assets can be in a single investment;

70% of the assets can be in any two investments;

80% of the assets can be in any three investments; and

90% of the assets can be in any four investments

Q: Is there any requirement that the investment manager/custodian be domiciled in any particular jurisdiction?

A: As long as the investment manager/custodian is legitimate, it can be located in any country. It need not be in the country where the insurance/annuity company is domiciled. However, the insurance companies are regulated companies, and their assets are required to be audited. They must have access to necessary management and financial information.

Q: Is there any guarantee as to a minimum amount to be distributed from the annuity.

A: The kinds of annuities contemplated on this site are 100% variable and have no guaranteed payout. These annuities have no insurance or mortality element. Instead, they are analogous to a corporate charter.

When a corporate charter is obtained from the issuing government authority and assets are put into it, the shareholders ultimately can receive the value of what was put into the corporation plus or minus items of income and expense.

When cash or securities are delivered to a private placement annuity company as premium in return for a 100% variable annuity, the annuity holder ultimately receives the value of the premium plus or minus the profits and losses from investments less all administrative expenses. There is no guaranteed return.

Q: What are the administrative expenses?

A: The annuities with which I am familiar charge a 1% set up fee and a 1% administrative fee each year. So in the first year the annuity company’s fee will typically be 2% and 1% every year thereafter. The annuity company will also pass through all charges from brokerage, custodial and investment advisor fees.

Q: What about the U.S. federal excise tax.

A: If the annuity is sold by a company other than a U.S. insurance/annuity company, any premium that is paid after the annuity owner is a U.S. taxpayer, will be subject to a 1% excise tax. Premium paid prior to the time that the annuity owner becomes a U.S. taxpayer is not subject to that tax.

Q: What about surrender charges?

A: The companies with which I am familiar do not impose a surrender charge.

Q: Why haven’t I heard of these annuities before?

A: Usually annuity and life insurance products are marketed via a sale force. The annuities that people generally hear about have up front charges that cover substantial commissions. The kinds of companies that sell those annuities also have significant advertising and marketing budgets. They usually impose surrender charges to recover this expenses in the event of an early liquidation.

Q: I am planning to be in the U.S. only for a period of years after which I intend to return to my home country. I am considering purchasing an annuity to shield the income on my securities portfolio during the period within which I will be a U.S. taxpayer. What happens if I decide to remain in the U.S.?

A: In the first place, if you funded the annuity with appreciated securities, your basis in the annuity will be marked to the fair market value of the securities at the time they are paid as premium in return for the annuity. Distributions from the annuity will only be taxed to the extent of the appreciation occurring subsequent to the purchase. If the securities were owned directly by the person moving to the U.S., upon sale that person would be taxed on the entire difference between the net sales proceeds and their original purchase price. The securities would not be marked to market at the time of entry into the U.S.

Secondly, the insurance/annuity company may be more suitable for holding the annuity assets during the deferral period. When the owner wishes to annuitize and receive payments over a period of years or for the rest of that person’s life, it is recommended that the original private placement annuity be exchanged for an annuity issued by a U.S. domestic carrier. This can be a tax free exchange under §1035 of the U.S. Internal Revenue Code.

PRIVATE PLACEMENT ANNUITIES - AN OVERVIEW

2008-04-12T11:08:07-04:00

G. Kristin Delano, Esq.

U.S. tax compliant deferred annuities sold by international life insurance companies are a simple and cost effective way to:

Enjoy the wealth accumulation benefits of income tax deferral;

Enjoy the flexibility of investment choices that are available in an international environment; and

Protect wealthy individuals’ assets from the claims of creditors in those states such as Florida where annuities are exempt from creditors’ claims.

The purpose of the following is to explain:

The nature of international deferred annuities;

The advantages of annuity ownership;

The U.S. income tax consequences of annuities;

The U.S. income tax requirements that must be satisfied in order for an insurance policy to be respected as an annuity for U.S. income tax purposes;

The benefits of an international annuity vs. a U.S. domestic annuity;

The relative security of an investment in an international insurance company; and

The unique ways annuities may be put to work to solve the problems of particular U.S. tax payers.

What are Annuities

An annuity is a contract between an insurance company and an individual that becomes a legal envelope into which the annuity owner will deposit cash or investment assets. It may be helpful to think of it as being analogous to a corporate charter – another type of legal envelop people use to hold their assets. Just as different legal and tax consequences result from putting assets into a corporation, so also there are different legal and tax consequences which result from contributing assets to an annuity.

The insurance company will have legal title to the assets held for the account of the annuity, but frequently those assets are held in the U.S. Only title to those assets needs to be removed to an international financial center. Deferred annuities accumulate the income and reinvest it during the deferral period.

Advantages of Annuity Ownership

Two principal advantages to the ownership of annuities, whether intentional or domestic, is a deferral of income earned on the principal within the annuity contract, and, in some states, asset protection. In those states, assuming the transaction in which the annuity is purchased is not entered into for the purpose of defrauding creditors, the assets of the annuity are put beyond the reach of the creditors of the individual that owns the annuity.

U.S. Income Tax Consequences of Annuities

So long as the annuity satisfies the requirements of the U.S. tax code, the owner will not be taxed on the investment income inside the annuity during the deferral period. After the deferral period, annuity payments will be treated as having an income increment and an increment that represents the return of capital. The income increment will be determined at the time of the commencement of regular annuity payments and will be based upon the expected return of the contract over the life of the annuitant (or the life of the contract) and is determined from actuarially based tables published from time to time by the IRS.

Annuity payments are those regular and periodic payments that are calculated to systematically liquidate the principal and the income earned on that principal over a designated period of time that is either longer than one year or over the life of an individual. All other payments (non-annuity payments) are not treated as annuity payments and are subject to the “income first” rule”. Non-annuity payments are treated as consisting entirely of income up to the entire amount of income that has been earned inside the annuity between the initial issue date and the date of a given distribution. Once all of the income has been taxed, the remainder will be treated as a tax free return of invested capital. Loans are taxed as non-annuity payments. The entire amount of any non-annuity payments made prior to age 59½, including policy loans, will also be subject to a penalty of 10% of the amount distributed.

With few exceptions, international deferred annuities are taxed identically to U.S. domestic annuities. One difference is the imposition by the United States of a one time 1% U.S. federal excise tax on the amount of premium paid.

The second difference is that certain investments inside the annuity will be subject to tax. A 30% withholding tax will be imposed on dividends paid with respect to stocks held for the benefit of the annuity. Secondly, capital gains from the sale of U.S. real property interests (as defined by Internal Revenue Code §897) will be subject to tax as if the foreign insurance company were an ordinary domestic corporation against which 10% of the proceeds of sale will be withheld. For this reason, U.S. real property interests should never be part of the investment portfolio of an international annuity.

It is also worth pointing out that ownership of an international insurance policy does not give rise to an IRS reporting requirement. There is no box to be checked on the 1040 asking about ownership of such a policy.

Funding An Annuity - Tax Consequences

The purchaser of an annuity will realize gain on the transaction if appreciated property is used to pay the premium. For example, a person considering purchasing an annuity might have an account with a stockbroker. He may want the securities within the account to become securities within an annuity. He would do this by establishing an annuity with an insurance company. The insurance company would establish an account with the stock broker, and the assets of the individual’s account would be transferred to the insurance company’s account. This will constitute the sale or exchange of all of the securities in the individual account in return for the annuity, and is a taxable event. The purchaser of the annuity will recognize the gains and losses in his account at the time of the conversion. Therefore, the purchaser may want to plan the timing of taking gains and losses and roll into the annuity gradually over time rather than simply converting the portfolio in a single transaction.

U.S. Tax Requirements For Annuity Treatment

To be respected as an annuity for U.S. income tax purposes and have the benefit of the deferral of tax on the income inside the policy, the insurance contract must satisfy certain requirements:

First, it must meet the definition of an annuity. While the Internal Revenue Code doesn’t provide a specific definition, there is judicial authority that would require an annuity to be the sort of policy customarily regarded as an annuity in accordance with the trade practices of life insurance companies. With respect to a deferred annuity, after the period of deferral, the policy should provide for a series of payments over a period either longer than one year or for the life of one or more named individuals that will systematically liquidate the principal and earned income of the policy.

The investments made for the benefit of the annuity must satisfy the diversification requirements established by Treasury Regulations § 1.817-5. That is, as of the end of any calendar quarter, the assets of the annuity must be invested in at least five investments, and not more than 55% of the value of the assets within the annuity can be in one investment. Not more than 70% can be in two investments, not more than 80% can be in three investments, and not more than 90% can be in four investments. The portfolio will be considered adequately diversified if it is diversified as of the last day of the calendar quarter (or 30 days thereafter). According to IRS regulations, market fluctuations will not result in a violation of diversification requirements unless there has been an acquisition that is either wholly or partially responsible for the violation.

The annuity contract must have certain provisions for distribution on the occasion of the death of the annuitant. Specifically, if regular annuity payments were being made prior to the death of the annuitant, the post death payment must liquidate the remainder of the principal and income at least as rapidly as was the case with the payments prior to death. If the annuitant dies prior to the first annuity payment, then the policy must distribute the entire remainder of the principal and interest within five years of death.

The annuity must be owned by one or more individuals and not by a corporation or other entity. Ownership can be in a trust as long as the trust is holding title for the benefit of individuals.

International Annuities Vs. Domestic Annuities – Flexible and Cost Effective

With two important exceptions noted above, international annuities are taxed the same as domestic annuities. The reason to select an international annuity over a domestic policy is flexibility and price.

These contracts enjoy significant flexibility, because State insurance regulators do not regulate them.

Flexibility As To The Form Of Annuity Contract. The form is a matter of contract to be agreed upon between the insurance company and the purchaser of the annuity;

Flexibility As To The Kinds Of Assets That Can Be Held For The Benefit Of The Annuity. As assets can be distributed in kind (they need not be converted to cash prior to distribution) it is possible to invest is illiquid assets such as a minority interest in a closely held corporation; and

Flexibility As To The Investment Manager Hired To Direct The Investment Of The Capital Held For The Benefit Of The Annuity. While the owner of the annuity cannot direct the investment and reinvestment of the assets of the annuity, generally an international insurance company will appoint a money manager or stock broker acceptable to the purchaser to have discretion with respect to investments. Further, as the owner of the annuity is free to do an IRC §1035 tax free exchange of a given annuity for an annuity issued by another company, foreign or domestic, the issuing insurance company is likely to be cooperative in replacing fund managers from time to time as requested by the policy owner.

Cost Effective. International annuities generally are no load investment vehicles. They don’t have a sales commission built in, and there is usually no penalty (other than an income tax penalty) for an early withdrawal or a 1035 exchange for another annuity. That is they are generally much more cost effective than their U.S. counterparts.

International Insurance Products – The Security of the Investment

Investors can take comfort in the security of the assets in their annuity for a number of reasons. First, Cayman Islands law provides, “No one other than the policyholder can make a claim against the segregated account cash value of the life insurance policy or annuity.” That is, if the insurance company were to become financially troubled, the other creditors of the insurance company, including the other policyholders, can not make a claim against the assets of a given annuity. Other foreign jurisdictions have similar provisions.

The investor may also take comfort in the fact that the assets are usually held in the U.S. by an investment advisor chosen by the owner of the annuity. They are not usually held by the management of the international insurance company.

Putting Annuities to Work

A variety of structures can be put together to take advantage of the characteristics of U.S. tax compliant deferred international annuities – a deferral on the imposition of U.S. income tax, asset protection and flexibility of investment.

Asset Rich Persons with High Liability Exposure. Certain people who have not only significant assets but significant exposure to liability from creditors claims – such as doctors, attorneys, contractors, nursing home and other elder care facility operators may wish to avail themselves of the asset protection qualities of annuity policies if they live in states where annuities are asset protected.

Temporary U.S. Residents. Persons who are not U.S. citizens but who are planning to live in the United States for a long enough period of time as to make them U.S. tax payers, can put their investment portfolio inside an annuity prior to entering the United States. While in the United States they are under no obligation to report the existence of the annuity, and their investment income is sheltered from current taxation. If, after they leave the United States and are no longer subject to the imposition of U.S. income tax, they can cash in their annuity. The result is the income earned inside the annuity during the period they were a U.S. resident will never be subject to U.S. tax.

PRIVATE PLACEMENT VARIABLE LIFE INSURANCE

2008-04-12T11:02:51-04:00

G. Kristin Delano, Esq.

U.S. tax compliant variable universal life insurance policies (“VUL’s”) sold by international life insurance companies are a cost effective way to:

Enjoy the wealth accumulation benefits of income tax deferral;

Enjoy the ability to borrow against the cash value of the policy without an income tax impact if the policy is not a modified endowment contract;

Distribute the policy benefits to the beneficiaries free from U.S. income tax;

Enjoy the flexibility of investment choices that are available in an international environment;

Shield the appreciation of the cash value in the policy from estate tax depending upon the estate planning needs of the principals, through the use of a life insurance trust; and

Protect wealthy individuals’ assets from the claims of creditors in those states where VUL’s are exempt from creditors’ claims.

The purpose of this writing is to explain:

The taxation of VUL’s - investment income and distributions;

The U.S. income tax requirements that must be satisfied in order for an insurance policy to receive the tax benefits of a life insurance policy;

The benefits of an international VUL vs. a U.S. domestic policy;

The relative security of an investment in an international insurance company; and

The unique ways life insurance policies may be put to work to solve the problems of particular U.S. tax payers.

How Is VUL Investment Income Taxed

So long as the VUL satisfies the requirements of the U.S. tax code, the owner will not be taxed on the investment income inside the policy. Unless the policy is a modified endowment policy (discussed below) amounts borrowed against the cash value of the policy will not be subject to income tax, and distributions of the death benefit, including distributions of the income earned on the cash value, will not be taxed to the beneficiaries.

With few exceptions, international VUL’s are taxed identically to U.S. domestic policies. One difference is the imposition by the United States of a one time 1% excise tax on the amount of premium paid.

The second difference is that certain investments inside the VUL will be subject to tax. A 30% withholding tax will be imposed on dividends paid with respect to stocks held for the benefit of the policy. Also, capital gains from the sale of U.S. real property interests (as defined by Internal Revenue Code §897) will be subject to tax as if the foreign insurance company were an ordinary domestic corporation against which 10% of the proceeds of sale will be withheld. For this reason, U.S. real property interests should never be part of the investment portfolio of an international VUL.

It is also worth pointing out that ownership of an international VUL does not give rise to an IRS reporting requirement. There is no box to be check on the 1040 asking about ownership of such a policy.

Funding A VUL - Tax Consequences

The purchaser of a VUL will realize gain on the transaction if appreciated property is used to pay the premium. For example, a person considering purchasing a VUL might have an account with a stockbroker. He may want the securities within the account to become securities within the VUL. He would do this by establishing a VUL with an insurance company. The insurance company would establish an account with the stock broker, and the assets of the individual’s account would be transferred to the insurance company’s account. This will constitute the sale or exchange of all of the securities in the individual account in return for the VUL policy, and is a taxable event. The purchaser will recognize the gains and losses in his account at the time of the conversion. Therefore, the purchaser may want to plan the timing of taking gains and losses and roll into the VUL gradually over time rather than simply converting the portfolio in a single transaction.

U.S. Tax Requirements For Life Insurance Policies

To be respected as a life insurance policy for U.S. income tax purposes and have the associated tax benefits, the policy must satisfy certain requirements under the U.S. internal revenue code, most of which are set forth in §7702 of the Code (“IRC” or “Code”) and the associated regulations.

The VUL contract must be considered a life insurance policy under the laws of the jurisdiction of the issuing life insurance company. With most international jurisdictions, this shouldn’t present a problem.

There must be real insurance. That is there must be a shifting of the mortality risk from the policy purchaser to the life insurance company. The death benefit can not be funded with capital otherwise supplied to the life insurance company through another means, such as the simultaneous purchase of an annuity that expires at death.

The investments made for the benefit of the policy must satisfy the diversification requirements of Treasury Regulations §1.817-5. That is, as of the end of any calendar quarter, the policy assets must be invested in at least five investments, and not more than 55% of the value of the assets within the policy can be in one investment. Not more than 70% can be in two investments, not more than 80% can be in three investments, and not more than 90% can be in four investments. The portfolio will be considered adequately diversified if it is diversified as of the last day of the calendar quarter (or 30 days thereafter). According to IRS regulations, market fluctuations will not result in a violation of diversification requirements unless there has been an acquisition that is either wholly or partially responsible for the violation.

The policy must satisfy some tests that are intended to make sure the policy provides a meaningful death benefit in excess of the cash value accumulation within the policy. The policy must either satisfy the cash value accumulation test, or it must satisfy both the guideline premium limitation and the cash value corridor test. The cash value accumulation test is generally applicable to whole life policies rather than VUL’s. It requires that the cash value of the policy not be more than is required to fully fund the policy benefits.

The tests more applicable to a VUL is the combination of the guideline premium limitation and the cash value corridor test. The guideline premium limitation requires the premium paid for the policy, either in a lump sum or in level payments, not to exceed the greater of the guideline single premium limitation or the guideline level premium limitation. The guideline single premium limitation is the single premium required to fully fund the policy benefits assuming a maturity no sooner than age 95 and not later than age 100. The guideline level premium limitation is the series of level premiums required to fully fund the benefits under the policy, again assuming a maturity no sooner than age 95 and no later than age 100. The guideline premium limitation is generally applied at the time of the payment of the premium.

The cash value corridor test is applied to determine whether the cash value is excessive in relation to the death benefit of the policy. The amount of the cash value corridor that is permitted depends upon the age of the insured life. The older the insured life, the greater the cash value is permitted to be in relation to the death benefit.

Modified Endowment Contracts

If a policy qualifies as a life insurance policy under the requirements of IRS §7702, the accumulation of income inside the policy will tax deferred, and the death benefit will be distributed free of income tax. However, if the duly qualified life insurance policy is a modified endowment contract, any sums borrowed against the policy will be taxed up to the lesser of i) the amount of the loan or ii) the amount of income previously earned but untaxed inside the policy, and loans made prior to age 59½ will be subject to the 10% penalty on top of the tax otherwise assessed.

A policy is a modified endowment policy unless it satisfies the seven pay test established by IRC §7702A. The seven pay test requires that the aggregate of all premiums paid as of any given time during the first seven years of the policy be less than or equal to the aggregate of the payments that would have been made as of the same point in time if the policy provided for fully paid benefits after seven equal annual payments.

International VUL’s Vs. Domestic VUL’s – Flexible and Cost Effective

With two important exceptions noted above, international VUL’s are taxed the same as domestic VUL’s. The reason to select an international VUL over a domestic policy is flexibility and price.

Flexibility is achieved because state insurance regulators do not regulate these contracts.

Flexibility As To The Form Of Life Insurance Policy. The form is a matter of contract to be agreed upon between the insurance company and the policy purchaser;

Flexibility As To The Kinds Of Assets That Can Be Held For The Benefit Of The VUL. As assets can be distributed in kind (they do not need to be converted to cash prior to distribution) it is possible to invest in illiquid assets such as a minority interest in a closely held corporation; and

Flexibility As To The Investment Manager Hired To Direct The Investment Of The Capital Held For The Benefit Of The VUL. While the owner of the VUL cannot direct the investment and reinvestment of the assets of the VUL, generally an international insurance company will appoint a money manager or stock broker acceptable to the purchaser to have discretion with respect to investments. Further, as the owner of the VUL is free to do an IRC §1035 tax free exchange of a given VUL for a VUL issued by another company, foreign or domestic, the issuing insurance company is likely to be cooperative in replacing fund managers from time to time as requested by the policy owner.

Price. Mortality expense is generally more favorable because it is not loaded for commission. Further, there is usually no penalty (other than an income tax penalty) for an early withdrawal or a 1035 exchange for another life policy.

International Insurance Products – The Security of the Investment

Investors can take comfort in the security of the assets in their life insurance policy for a number of reasons. First, Cayman Islands law provides, “No one other than the policyholder can make a claim against the segregated account cash value of the life insurance policy or annuity.” That is, if the insurance company were to become financially troubled, the other creditors of the insurance company, including the other policyholders, can not make a claim against the assets of a given policy. Other foreign jurisdictions have similar provisions.

The investor may also take comfort in the fact that the assets are usually held in the U.S. by an investment advisor chosen by the policy holder. They are not usually held by the management of the international life insurance company.

Another important factor is the right of the policyholder to exchange a policy issued by the international insurance company for another VUL issued by either another international insurance company or a U.S. domestic company. This is tax free under the provisions of IRC §1035.