Life insurance can be a critical component of a U.S., ‘in-bound’ financial plan. The same tax benefits that U.S. tax residents enjoy from life insurance – the tax-free inside build-up, the income tax-free death benefit and the ability to take tax-free or tax-advantaged distributions – are often useful when non-U.S. individuals plan to move either themselves, their family or their assets to the U.S.
The U.S. Tax Component
If someone is planning to become a U.S. tax resident, it is prudent to keep as much of their net worth as possible from being subject to their future estate. By transferring assets to an irrevocable trust ahead of becoming a U.S. taxpayer, those assets will not become a part of the person’s estate. Unlike a U.S. taxpayer who is limited in how much can be transferred out of their estate by their lifetime estate and gift tax exemption and a small annual gift tax exemption, a person who isn’t subject to the U.S. tax regime can freely transfer as much as they like. However, when that person does become a U.S. taxpayer, the law requires that a person must have preserved some of their wealth to support themselves and not have transferred it all away.
Once in an irrevocable trust, there are often tax implications – either current or future – that need to be addressed. The U.S. income taxation of a foreign trust depends on whether the trust is a grantor or nongrantor trust. Income from a foreign grantor trust is generally taxed to the trust’s grantor, rather than to the trust itself or to the trust’s beneficiaries. In contrast, income from a foreign nongrantor trust is generally taxed when distributed to US beneficiaries, except to the extent U.S. source or effectively connected income is earned and retained by the trust, in which case the nongrantor trust would pay US income tax for the year such income is earned.
When the grantor is a U.S. tax resident, during his or her lifetime, the U.S. grantor must report all items of trust income and gain on his or her Form 1040, US Individual Income Tax Return, for the year earned. The trust itself will not be subject to U.S. income tax. A trust is considered a grantor trust when the grantor retains a certain degree of dominion and control over the assets of the trust and is thus treated as the owner of the trust for U.S. federal income tax purposes.
A foreign trust is also considered a grantor trust for U.S. income tax purposes when a U.S. grantor makes a gratuitous transfer to a foreign trust which has one or more US beneficiaries or potential U.S. beneficiaries of any portion of the trust. Most foreign trusts created by U.S. grantors have at least one current or future U.S. beneficiary. It is important to note that in most cases when a foreign trust is funded by a U.S. person, the trust will be treated as a grantor trust.
A foreign nongrantor trust with U.S. beneficiaries also faces taxation on any undistributed net income. Trust income must be distributed to the U.S. beneficiaries or face harsh taxation at trust rates.
Life Insurance to the Rescue
Life insurance is often utilized to reduce or eliminate all trust-related taxation in the scenarios described. For affluent clients, it may make sense to use private placement life insurance (PPLI) to keep trust funds invested but free of taxation since the investments are held inside of the policy. One version of PPLI that maintains a U.S. tax compliant income tax-free death benefit and can permit over a billion dollars of investment in a single policy is called ‘Frozen Cash Value’. Frozen Cash Value PPLI policies convert all investment growth under the policy to death benefit. By ‘freezing’ the cash value at the premiums paid, the policy does not have to have the high level of death benefit (and expense) found in traditional PPLI and retail life insurance products. In effect, taxation can be eliminated and wealth transfer super-charged.
While one of many versions of PPLI may be a fit for someone planning to move to the U.S. or a non-U.S. individual with U.S. beneficiaries, there are situations where a non-U.S. individual only wants to invest into the U.S. This can be problematic since combined tax rates related to the Foreign Investment in Real Property Tax Act (FIRPTA) and Effectively Connected Income (ECI) can approach 50%. By making highly tax-inefficient investments which trigger FIRPTA and ECI through a private placement variable annuity (PPVA), a non-U.S. individual can block these taxes. Instead of paying nearly 50% in taxes on profits, these investors will only need to pay the small annual charge for the PPVA.
These are only a couple of examples of how life insurance can provide solutions for those planning a nexus to the U.S. By seeking the advice of a U.S. international tax attorney and working with the inbound planning team at Life Insurance Strategies Group, a suitable strategy can be implemented to create tax-efficiency. At Life Insurance Strategies Group, we help our affluent individual and institutional clients navigate complex life insurance transactions. We do not sell products.
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.