Every life insurance professional knows that life insurance can be used to reduce, defer or eliminate taxes when used inside of a trust. The same is true for the client planning to immigrate to the United States and seeking tax and structuring advice.
Meet the Chiews
Mr. & Mrs. Ben & Lia Chiew, both 45, are residents of Shanghai and planning to move to the United States within the next two years. The couple has a clothing line and will move their company’s headquarters to the Boston area while continuing to manufacture in the Pearl River region. They have USD 50m in non-company related investments at a private bank in Hong Kong and three teenage children.
Mr. & Mrs. Chiew have sought advice from an international tax expert at a major law firm who has a mix of good news and some bad news for his clients.
“Read My Lips: No New Taxes” – George H.W. Bush
The bad news is that once the Chiews move to the U.S. and become U.S. taxpayers, they will be taxed on their worldwide income. It would be wise, advises their attorney, to move their non-U.S.-domiciled investments into a trust and, technically, outside of their control, before they trigger U.S. taxpayer status.
The good news is the United States permits nearly unlimited transfers of gifts from a non-U.S. taxpayer to a U.S. taxpayer without a tax consequence. As gift tax is assessed on the maker of a gift and a non-U.S. taxpayer is not subject to U.S. taxation, no gift tax is due. While this sounds extremely generous of the Treasury Department, the thought is that the IRS will eventually get its bite of the apple after the gift ends up with a U.S. taxpayer.
While the ability of the trust to remove the transferred investments from the future estate of the Chiews is good news, the attorney points out some negatives. This type of trust is known as a ‘drop-off’ trust and if the Chiews become U.S. taxpayers within five years of forming the trust and there are U.S. beneficiaries of the trust, the income from the non-U.S. domiciled assets in the trust will be taxed by the U.S. Treasury.
In this instance, the Chiew children will be the beneficiaries of the trust and the Chiews cannot wait for five years to move to the United States.
One More Problem
Their attorney points out that if the USD 50m in investments they hope to transfer to the trust make up most of the Chiews assets, the IRS could treat the transaction as an avoidance tactic and not a planning strategy. If it looks as if the Chiews might need to tap the trust for funds to live on, this will be a red flag for the IRS.
Fortunately, the value of the clothing line and the factory in China exceeds the value of the investments to be transferred so this alleviates part of the problem. Also, the Chiews will earn robust salaries from their company while in the U.S., so it is unlikely they will need distributions from the trust.
The Chiews are happy that their securities and money in their private bank account can escape being a part of a future U.S. estate but are still concerned about the trust being taxed on the income from those assets. They press their attorney on what can be done.
Meet My Friend, The Life Insurance Professional
Many years ago, the attorney became a referral source to a life insurance professional who likewise sent clients his way but who also kept the lawyer informed about current trends in utilizing life insurance for planning for foreign nationals with a nexus to the United States. Their lawyer has a last bit of good news for the Chiews—depending on their goals, the couple can reduce, defer, or eliminate taxation in the trust using life insurance.
While it is common knowledge that money inside of a life insurance policy grows tax-deferred, can be accessed in the form of tax-free loans during life and can be received tax-free as death proceeds, it takes a life insurance professional to help select and structure the appropriate life insurance solution.
The life insurance professional advises the attorney that funds in the trust can be used to purchase one of three types of tax-compliant policies:
1) A non-MEC (“Modified Endowment Contract”) where as little as three annual life insurance premiums are paid into a contract and where the cash value of the policy can be accessed via tax-free loans. The trust will also receive the death benefit tax-free. However, given the young age of the Chiews, it is doubtful they can fund the policy with all the available funds in the trust. They will quickly buy the amount of life insurance allowed (capacity) by reinsurers with just a fraction of the funds available. Also, income from any funds in the trust waiting to be future premiums is taxable.
2) A MEC where a single premium payment is paid into a contract, creating a policy with a tax-free death benefit. However, if the trust needs to access the cash value of the policy, the proceeds will be taxable. This contract will permit more of the funds of the trust into a policy with lower insurance costs than a non-MEC contract but, again, the young ages of the Chiews means they will use up their life insurance capacity long before the funds in the trust are exhausted.
3) A Frozen Cash Value Contract where, under IRC § 7702(g), a life insurance policy with as little as a 5% corridor between the account value of the policy and the amount of the death benefit is permitted to allow the trust to receive the death benefit tax-free. This will permit the trust to invest all, or as little, of the trust funds as desired. However, the cash value of the policy remains frozen at the amount of premiums paid with all investment growth of the premiums being added to the value of the death benefit. The trust may still access the basis in the policy for tax-free withdrawals. (Super cool planning tip: Use Frozen Cash Value’s basis to annually fund a second non-MEC or MEC policy so that as much of the trust’s liquidity is held in a policy from the beginning and taxable income is greatly limited.)
The Math Has to Work
The goal of the use of life insurance is that the tax savings the trust realizes are greater than the insurance costs incurred. A life insurance professional will be able to calculate a cross-over point in time—perhaps around year ten—when the tax savings exceed the insurance costs. The life insurance professional will also show that at the likely age of mortality (perhaps in 45 years), how much in taxes the Chiews saved over their lifetimes by leveraging life insurance. (Hint: In this case, at conservative insurance cash value growth, the savings will be over USD 10m.)
There are other life insurance planning considerations such as how many policies should be sought and whether single life policies or joint-life policies should be purchased or whether the policies should be fixed, variable or private placements. Fortunately, the Chiews not only have a good lawyer, but, through their attorney, Mr. & Mrs. Chiew have an experienced life insurance professional whose solutions have made a sustainable impact on their family.
Since its inception, Life Insurance Strategies Group has solely focused on the individual high net worth life insurance market. We do not sell products. This allows us to offer unbiased, pragmatic advice. Visit us at www.lifeinsurancestrategiesgroup.com.