Life insurance and Annuity Planning for Non-Resident Aliens from a U.S. Tax Perspective

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Overview

Many non resident  aliens (NRAs) own U.S. life insurance, i.e. life insurance issued by a life insurer domiciled in the United States. Why is this case?

A range of planning reasons explains how this came to be.

If you believe the clichés dealing with the life insurance industry that life insurance is “sold” and not bought, it will help put the marketing and sales aspects into perspective. I lived in Miami for a decade and am personally aware of the large amounts of life insurance being sold to NRAs by U.S.-based agents. In many cases, the U.S. life insurance agents are from the same country and social circles as the NRA. Many former private bankers with key client relationships became very successful life insurance agents in Miami.

The purchase of U.S.  life insurance by NRAs is rooted in sound financial planning contrary to the notion that life insurance is “sold” instead of “bought”.

  1. Privacy and Confidentiality

In many cases, the NRA is unwilling to disclose his personal income and financial statement with a local life insurance agent and life insurance company as part of the financial underwriting.

These disclosures could create serious security risks to the NRA and his family. The NRA and his family could become a target for kidnapping. In many cases (particularly in Latin America) the professional service providers with intimate knowledge of the client’s situation reside outside of the home country.

  1. Legal

Many civil law countries have forced heirship rules.  Life insurance is an excellent = planning tool for legally creating an estate distribution scheme that is more flexible than the dealing with the heirship rules in a civil law jurisdiction.

  1. Economic

The U.S. in spite of its current economic crisis is still seen as the political and economic safe haven for most of the World. Many high net worth individuals around the world have a residence in the U.S. in the event that the political and economic environment in their own home country becomes untenable.  The U.S. dollar still remains  the international currency for most of the World.

  1. Financial

Many countries lack a developed retirement system beyond the social security system of the home country. In many cases, contributions and benefits in the local social security system are limited and denominated in the local currency. A permanent life insurance contract issued by a U.S. life insurer can serve as the functional equivalent of a qualified retirement plan denominated in a more stable currency- the U.S. dollar.

Frequently, NRAs have little confidence in the local life insurance industry even if the company is a subsidiary of a much larger global life insurer. On another level, the pricing and product competitiveness of permanent life insurance in the U.S. exceeds the rest of the world. Pricing assumptions from mortality assumptions to product features favor the U.S. life insurance industry.

This article will also focus on how the tax assumptions may also favor the NRA in the purchase of life insurance issued by a U.S. life insurer.

Tax Overview

An NRA is subject to U.S. estate taxes on his U.S. situs property. The current exemption equivalent for NRAs is $60,000. Life insurance is considered intangible personal property that is considered non-U.S. situs property for federal estate tax purposes. The proceeds of life insurance on the life of the NRA decedent are not subject to federal estate taxes. However, if the NRA dies owning life insurance on the life of another person, the cash value of the policy at death is included in the NRA’s estate.

From a U.S. income tax perspective, the policy enjoys the tax advantages of any other permanent life insurance policy – (1) Tax-free buildup of cash value (2) Income tax-free death benefit (3) The ability to access the cash value during lifetime through the partial surrender of the cash value and tax-free policy loans.

The rules dealing with annuities are far less generous from an estate tax perspective. Unlike life insurance issued by a U.S. carrier, an annuity issued by a U.S. life insurer is considered U.S. situs property for federal estate tax perspectives.

The income tax treatment of annuity payments for a NRA provides for a 30 percent withholding tax under IRC Sec 871(a) unless a tax treaty provides for more favorable tax treatment. Fortunately, the majority of tax treaties with the U.S. provide that annuities are not subject to U.S. income and withholding taxes. Nevertheless, the federal estate tax remains a problem.

It is likely that many NRAs own fixed or variable annuities issued by a U.S. life insurer. Since the estate tax threshold is so low for the NRA ($60,000), the NRA should consider a tax-free exchange under IRC Sec to an annuity issued by an offshore life insurer to eliminate the estate tax exposure. Several offshore life insurers issue annuities that are U.S. tax compliant if that is the choice of the policyholder.

Planning Considerations

One of important underwriting considerations for a U.S. life insurer underwriting a policy on a NRA is the NRA’s connection to the U.S. From an underwriting standpoint, the life insurer will often require the proposed insured (the NRA) to have a substantial connect to the U.S. such as a home or a business. The life insurer will also require that premium payments be made from a U.S. bank.

Another important consideration is that some foreign jurisdictions have laws prohibiting the NRA from purchasing foreign life insurance. Generally, these rules for the NRA are not applicable if all of the elements of the insurance transaction are completed outside of the home country – (1) Medical underwriting (2) Application process (3) Premium payment (4) Policy delivery.

While many states exempt life insurance from the claims of the policyholder’s creditors, this rule is not universal. As a result, trust planning is advisable.  The NRA may establish a domestic irrevocable life insurance trust (ILIT) or alternatively, an offshore ILIT may be used. The NRA may need to purchase the policy and transfer it to the offshore ILIT. The transfer is not subject to gift taxation or the three year rule under IRC Sec 2035(d) which would provide for estate tax inclusion if the insured died within three years of the transfer.

In the case of an annuity, the NRA should do a 1035 exchange to an offshore annuity to avoid estate tax inclusion.

Summary

I am certain that large amounts of life insurance issued by U.S. carriers has been sold to NRAs. I am less certain but not optimistic about the amount of U.S.-issued annuities sold to NRAs. Not much has been written regarding life insurance planning for NRAs with respect to life insurance and annuity planning.

Published In: Finance & Banking Updates, Insurance Updates, International Trade Updates, Tax Updates

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

© Gerald Nowotny, Osborne & Osborne, PA | Attorney Advertising

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