Part I of this series on investment tax planning for non-resident aliens (NRAs) focused on the potential tax benefits of private placement variable annuities (PPVA). Part II focused on the use of PPVA contracts by NRAs to invest in U.S. real estate as well as other investments that are taxed as effectively connected income (ECI) to a U.S. trade or business. The latest installment, Part III, will focus on the use of private placement life insurance (PPLI) as part of the pre-immigration planning for NRAs.
The current state of the world has many high net worth individuals considering permanent residence or temporary residence in the United States due to political and economic instability in their home countries. The threat of kidnap and general physical insecurity for the family and children usually results in the children being educated in the U.S. and remaining there. It is fair to say that for many NRAs who are the proverbial “kings of the hill” in their home countries, it is much easier to be another face in the crowd in Miami or New York.
Aside from all of the other considerations involved in such a decision, the issue of taxation jumps to the forefront because permanent U.S. resident s are taxed in a manner similar to U.S. citizens – worldwide taxation of income and assets for estate tax purposes.
The popularity of immigration programs such as the EB5 visa programs also have encouraged and facilitated the movement of NRAs to the U.S. The EB5 visa program grants permanent resident status to a NRA who invests at least $1 million into a new business that helps to create at least ten new jobs. A lesser investment amount, $500,000, is available for investments in new businesses in high risk areas or rural areas.
The tests for U.S. residency for income tax and estate tax purposes differ from each other. For income tax purposes, the Green Card test is satisfied if the NRA secures permanent resident status during the tax year. A second test is the Substantial Presence test which is met is the NRA spends 183 days or more in the U.S. A weighted formula outlined in IRC Sec 7701(b)(1) measures the 183 standard over a several year time period. An NRA that is a U.S. resident is subject to taxation on worldwide income.
The test for the federal estate and gift tax is based on a combination of domicile and intent. Domicile is defined as where one intends to remain indefinitely. U.S. domiciliaries are taxed on worldwide. The NRA is subject to the federal gift on transfers once he becomes a permanent resident for estate tax purposes. Additionally, as a permanent resident, the NRA’s surviving spouse does not have the benefit of the marital deduction under IRC 2056A.
Without permanent residence status, 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.
Tax Treatment of Life Insurance
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 value of the policy at death is included in the NRA’s estate.
As a permanent resident, the proceeds of life insurance issued by either a domestic or foreign life insurer would be included in the taxpayer’s estate if the taxpayer retained any incidents of ownership over the policy at the time of death.
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.
Private Placement Life Insurance (PPLI)
PPLI is an institutionally priced variable universal life insurance policy intended for accredited investors and qualified purchasers as defined under federal securities law. The policy provides the ability to customize the policy’s investment options with a range of asset classes from hedge funds to private equity and real estate. The taxpayer’s investment advisor may become an advisor for investment management within the policy subject to a due diligence review by the life insurer and completion of an investment management agreement with the life insurer.
The NRA can purchase the policy with an offshore life insurer. The carrier should be a carrier that has made an election under IRC Sec 953(d) to be treated as a U.S. taxpayer for corporate tax purposes. The significance of this election deals with the U.S. tax treatment of the offshore life insurer’s separate account investments.
Without the election, the offshore life insurer would be treated as a foreign investor subject to all of the investment withholding requirements under IRC Sec 871(a) – a 30 percent withholding tax. The election puts the offshore on the same footing as a domestic life insurer that is not subject to any withholding taxes.
Frozen Cash Value (FCV) life insurance is a specialty version of PPLI issued by offshore life insurers. The product is intentionally designed to fail the U.S. tax law definition of life insurance. FCV is primarily designed for large transactions where the amount of mortality risk required within a traditional U.S. tax compliant policy exceeds the amount of available reinsurance in the marketplace.
FCV contracts resemble annuities except that the death benefit exceeds the initial premium by a fixed amount or percentage (102.5-110 percent). The policy cash value is “frozen” at an amount equal to policy premiums. The investment growth on the premium is part of a mortality reserve that is paid as part of the death benefit income tax-free. Policy withdrawals receive tax-free treatment.
The planning concept is straight-forward. The NRA sets up an offshore irrevocable trust prior to becoming a permanent resident. The trustee is the applicant, owner, and beneficiary of the offshore PPLI contract by a life insurer that has made an IRC Sec 953(d) election. The trustee has discretionary powers to distribute income and principal to the settlor, settlor’s spouse and children.
The transfer to the trust in order to fund the PPLI contract is not subject to the U.S. gift tax. The premium may be a cash premium or an in kind (non-cash) premium. The policy is fully compliant with the U.S. tax law definition of life insurance. The investment income within the policy is not subject to U.S. or foreign taxation.
The trustee may take policy loans or a partial surrender of the cash value to distribute to the trust’s beneficiaries. These distributions receive income tax-free treatment. The death benefit is income and estate tax-free. In the event, the taxpayer relinquishes his permanent resident status, the PPLI contract can be unwound without any U.S. tax consequences.
Juan Valdez, age 65, lives in Mexico City. He is a wealthy industrialist. Juan and his family have been the target of multiple kidnapping attempts and threats. His children and grandchildren have been educated in the U.S. and have continued to live in the U.S. They rarely come back to Mexico. Juan has been pursuing an EB 5 visa so that he can live in the U.S. and live close to his children and grandchildren. The future in Mexico is uncertain. He will continue to operate his businesses in Mexico and visit on an “as needed” basis. Juan would like to pursue tax planning as part of his pre-immigration in bound planning.
Juan’s brother Julio, forms a Cayman-based irrevocable trust and transfers $50 million to the trust for Juan’s benefit. The gift is not subject to U.S. gift taxes as Juan’s EB5 application has yet to be approved. The trustee, Palm Tree Trust Company, is the applicant, owner, and beneficiary of a Frozen Cash Value policy contract insuring Juan’s life. Juan and his children and grandchildren are all beneficiaries of the trust. The trust is a non-grantor trust for U.S. tax purposes.
The trustee transfers $50 million of cash and marketable securities as a single premium into an FCV contract. The policy features an insurance dedicated fund (IDF) managed by Southern Bank Investment Advisors.
Juan receives notification of his approval of his EB5 application and receives a green card. The trustee regularly makes tax-free withdrawals from the policy to distribute to Juan and his children and grandchildren. The investment income within the policy is income tax-free. The trustee will receive the death benefit income and estate-tax free treatment.
Following the death of Juan and Mrs. Valdez, the trust income will be available to the Valdez children and grandchildren without future taxation. Additionally, additional PPLI contracts insuring the lives of children might be considered.
In Life, physical safety and security for a one’s family pre-empts favorable tax planning when making the decision to move the family the United States either permanently or temporarily. Nevertheless, very effective pre-immigration tax planning using private placement life insurance and offshore trusts can position the NRA to legally avoid U.S. income and estate taxes legally. These strategies are under-utilized by NRAs and their planners.