International Planning - Questions and Answers Income Tax Planning with International Life Insurance

Question 1: What is a Variable Universal Life Insurance Contract?

Answer: A Variable Life Insurance Contract is a contract (1) that provides for the allocation of all or part of the amounts received under the contract to an account which, according to applicable law or regulation, is segregated from the general asset accounts of the company and (2) the amount of the death benefit (or the period of coverage) is adjusted on the basis of the investment return and the market value of the segregated asset account. IRC 817(d).

Question 2: How does a VUL combined with a FAPT help me reduce income taxes?

Answer: Items of income, dividends, interest, rents, royalties and capital gains are not subject to income tax inside an insurance contract.

Answer: Cash values are not constructively received where they are not available without surrendering the policy. The necessity of surrendering the policy is a substantial "limitation or restriction" on their receipt. Cohen v. Commissioner, 39 TC 1055 (1963). The cash surrender values of paid-up additions are not constructively received by the policyholder. Nesbitt v. Commissioner, 43 TC 629 (1965). The same rule applies whether the policy is a single premium policy or a periodic premium policy.

Question 4: If the value of property held in my insurance policy increases in value or is sold for a profit, will I have to pay income tax?

Answer: If the contract is a life insurance contract, as defined by law, the tax on the increase in value is deferred. IRC Sec. 7702(g).

Question 5: How is “life insurance contract” defined?

Answer: The term “life insurance contract” means any contract which is a life insurance contract under the applicable law, but only if such contract (1) meets the cash value accumulation test of IRC 7702(b) or (2) meets the guideline premium requirements of IRC 7702 (c) and falls within the cash value corridor of IRC 7702 (d).

Question 6: In your answer to Question 4 you write that “the tax on the increase in value is deferred. Does this mean that I will have to pay income tax at some time in the future?

Answer: Not necessarily. Withdrawals and distributions from the cash value of the life insurance contract may be (1) return of premiums that are not taxed as income; (2) policy loans that are not taxed as income; (3) death benefits that are not taxed as income and (4) distributions upon surrender that are taxed to the extent the value of the distribution exceeds the value of premiums paid. If you have loans outstanding at the time of your death, the death benefit is reduced accordingly.

Question 7: Can I get the same income tax benefits by purchasing a VUL from a United States insurance company?

Answer: Yes. The international structure is developed and administered so that it complies with all tax laws of the United States. The structure uses the tax code in the same manner that a United States insurance company would. You, as a United States person, receive no tax benefit beyond the benefits you would be entitled to if you bought an insurance policy from a United States insurance company.

Question 8: Does an international insurance structure offer any asset protection beyond the protection that United States law offers the cash values and death proceeds of my life insurance policy?

Answer: Yes. First, there is no United States law that protects life insurance from creditors. Each state has its own law covering insurance cash values and death proceeds. Many states offer significant protection, but holding the policy inside your FAPT adds another layer of protection.

Question 9: What kind of property may I invest in my insurance policy?

Answer: Your segregated account may own almost any kind of property as long as the investments in the account are “adequately diversified.” Generally, the IRS considers the account “adequately diversified” if no more than 55 percent of the value of the total assets of the account is represented by any one investment, no more than 70 percent by any two investments, no more than 80 percent by any three investments, and no more than 90 per cent by any four investments. If the investments in your segregated account are not adequately diversified, the income on the account will be taxed. IRC 817(h); Reg. 1.817-5(b)(1); Rev. Rul. 91-17.

Question 10: May I invest my primary residence or vacation home in my segregated account?

Answer: No. If you retain control over the assets you transferred to your segregated account, the IRS will disregard the transfer and hold you responsible for paying tax on the income. The mere fact that you have transferred legal title, and not beneficial ownership, to a tax-exempt or tax-deferred entity does not alone absolve you of your responsibility to pay tax on the income earned by the transferred property. Your control over the assets in the segregated account is restricted significantly.

To avoid running afoul of the control issues and to preserve the income-tax benefits of the VUL, you may not invest personal-use property in your segregated account.

A long standing doctrine of taxation provides that “taxation is not so much concerned with the refinements of title as it is with actual command over the property taxed—the actual benefit for which the tax is paid.” Corliss v. Bowers, 281 U.S. 376 (1930). The incidence of taxation attributable to ownership of property is not shifted if the transferor continues to retain significant control over the property transferred, Frank Lyon Company v. United States , 435 U.S. 561 (1978); Commissioner v. Sunnen , 333 U.S. 591 (1948); Helvering v. Clifford, 309 U.S. 331 (1940), without regard to whether such control is exercised through specific retention of legal title, the creation of a new equitable but controlled interest, or the maintenance of effective benefit through the interposition of a subservient agency. Christoffersen v. U.S., 749 F.2d 513 (8 Cir.), rev'g 578 F. Supp. 398 (N.D. Iowa 1984). As a resident of the United States, you are taxed on all income from whatever source derived, including capital gains, interest and dividends (I.R.C. 61(a)).

Question 11: What kind of real property may I invest in my VUL segregated account?

Answer: The best kind is real property held and used solely for income and investment. To avoid taxation due to your control over the property, you should retain an independent company to manage, maintain and collect rents from the property. You may not use the property.

Question 12: How about other investments? How much control may I have?

Answer: You may not retain the right to direct the custodian of the segregated account to sell, purchase, and exchange securities or other assets held in the account. You may not exercise an owner’s right to vote account securities either through the custodian or individually. If you can select and control the investment assets in the segregated account, then the IRS treats you as the owner of those assets for federal income tax purposes. Thus, any interest, dividends, or other income derived from the investment assets is included in the purchaser's gross income. Rev. Rul. 77-85.

You may not select and control the certificates of deposit in the segregated account. Rev. Rul. 80-274.

If your segregated account invests in mutual fund shares or partnership interests that are available for purchase by the general public, the IRS will consider you the owner. However, if the mutual fund shares are available only through the purchase of an insurance contract, then the sole function of the fund is to provide an investment vehicle that allows the issuing insurance company to meet its obligations under its contracts and the mutual fund shares are considered to be owned by the insurance company and not you. Rev. Rul. 2003-92 (partnership interests); Rev. Rul. 81-225 (mutual fund shares) .

You may choose among general investment strategies (for example, among stocks, bonds and money market instruments) at the time of the initial purchase or later. Rev. Rul. 82-54. 

There must be no arrangement, plan, contract, or agreement between you and the issuing insurance company or between you and the independent investment advisor regarding the availability of a particular sub-account, the investment strategy of any sub- account, or the assets to be held by a particular sub-account. You may have the right to allocate premiums and transfer funds among the available sub-accounts, but all investment decisions concerning the sub-accounts are made by the issuing insurance company or the independent investment advisor in their sole and absolute discretion. You may have no legal, equitable, direct, or indirect interest in any of the assets held by a sub-account; you may have only a contractual claim against the issuing insurance company to collect cash in the form of death benefits or cash surrender values under the contract. Rev. Rul. 2003-91; PLR 200601006; PLR 200420017

Question 13: How does a non-U.S. insurance carrier comply with U.S. law for tax-free characterization?

An insurance company, for federal income tax purposes, is a company whose “primary and predominant business activity during the taxable year is the issuing of insurance or annuity contracts or the reinsuring of risks underwritten by insurance companies.” The mere existence of the words “insurance company” in the taxpayer's name, and the fact that state or foreign laws grant the corporation powers and regulate the corporation as an insurance company, will not determine the income tax treatment of that company.

A company is an “insurance company” only if it uses “its capital and efforts primarily in earning income from the issuance of contracts of insurance.”The IRS will determine whether an offshore corporation is an insurance company by looking at all of the relevant facts, including the size and activities of its staff, whether it engages in other trades or businesses, and its sources of income.

Question 14: If I invest in a segregated account that underlies my life insurance benefit, am I not just insuring myself? Where is the risk shifting and distribution?

Answer: On your death, the non-U.S. insurance company must pay to your named beneficiary a death benefit. The value of the death benefit equals the value of the segregated account plus a term insurance benefit. The non-U.S. carrier is contractually responsible for paying the full death benefit. The carrier enters into a reinsurance contract. The re-insurer reimburses the non-U.S. company for term insurance benefit. The IRS has noted that:

[r]isk shifting occurs if a person facing the possibility of an economic loss resulting from the occurrence of an insurance risk transfers some or all of the financial consequences of the potential loss to the insurer. The effect of such a transfer is that a loss by the insured will not affect the insured because the loss is offset by the insurance payment. Risk distribution incorporates the “law of large numbers” to allow the insurer to reduce the possibility that a single costly claim will exceed the amount available to the insurer for the payment of such a claim. Risk distribution necessarily entails a pooling of premiums, so that a potential insured is not in significant part paying for its own risks. IRS Notice 2003-34.

Question 15: May I purchase the VUL directly from a non-U.S. insurance company?

Answer: No. A non-U.S. insurance company is not authorized to solicit in the United States, and it may not sell insurance products to U.S. persons. The non-U.S. company may sell to non-U.S. entities only, therefore your FAPT or other foreign entity must own the VUL.

Question 16: Must I pay any tax when my FAPT transfers assets to the segregated account?

Answer: Yes. Although the transfer from you to the FAPT is not a taxable event, the subsequent transfer from the FAPT to the segregated account is a “deemed sale” under general tax principles, i.e. you are receiving something for value in return for your appreciated property. You will be responsible for paying tax on the difference between your cost basis and the fair market value of the asset as of the date of transfer. IRC 367, 704, 721.

Question 17: So, the segregated account may own investment real property located anywhere in the world. My use and management of it is strictly limited. All rental income goes into the segregated account and is not taxable. When the segregated account sells the real property, there is no taxable gain. How do I access the funds without paying income tax?

Answer: You may take a loan against the cash value. A loan taken from a life insurance policy that is not includable in income because it is not treated as a distribution. IRC Sec. 72(e)(5). If you surrender the policy or allow it to lapse before repaying the loan, the value of the outstanding loan is taxable to the extent the cash value exceeds the premiums paid. See Atwood v. Commissioner, TC Memo 1999-61. If you do not repay the loan before your death, the payment to your named beneficiary is reduced by the amount of the outstanding loan.

Circular 230 disclaimer: To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. federal tax information contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein.

The information contained in this communication is not legal advice and shall not be considered as such. It is for information purposes only. The use of foreign insurance contracts is case specific. Whether or not this technique is appropriate for any individual depends on a complete analysis of the individual’s assets and liabilities and personal circumstances. Consult knowledgeable professionals before employing this technique.

35 Court Street
Freehold, New Jersey 07728

michael@njapts.net                                     
© 2007 Michael B. Mangini – All Rights Reserved

This article reproduced and published on this website with

Permission from the author Michael B Mangini, J.D.

© 2007 Michael B. Mangini – All Rights Reserved