My hedge fund investment returns are great, but the taxes are very high. Is there any way I can defer the taxes and get the benefit of compounding on the deferral?
Although there are some complicated (and expensive) derivative transactions that a few investors have tried, by far the easiest, least expensive method is to invest in the hedge find (or finds) through a privately placed variable annuity issued by an offshore insurance company. Tiffs provides complete tax deferral until funds are actually withdrawn from the annuity. Investments can even be moved from one manager to another with no tax consequences.
What Is A Variable Annuity?
A variable annuity is nothing more than a tax-deferred savings and investment vehicle. An investor acquires a variable annuity contract for a specified stun and that sum is invested by the insurance company in one or more investment structures approved by the investor. The annuity contract provides that the insurance company will pay to the investor the value, from time to time, of the investments underlying the annuity. Until money is withdrawn from the annuity by the investor, it accumulates on a tax-deferred basis. This tax-deferred accumulation can go on until the maturity date of the contract, which generally is when the investor is 85 years of age, or in some cases even older.
At maturity, the annuity must be surrendered or converted to a life annuity that pays out a specified sum at least annually for the life of the investor or certain other optional periods of time. Because most investors acquire variable annuities for their tax-deferred savings features, and withdraw funds whenever they need them, it is rare that a variable annuity is actually converted to a life annuity.
How Are Withdrawals From A Variable Annuity Taxed?
To the extent that funds withdrawn from a variable annuity represent deferred income, they are taxable at the Federal level at ordinary income rates. This means that in general, it is probably not appropriate to use a variable annuity to invest with a manager whose investment returns are taxable at total Federal and State rates of less than 30%, because the additional taxes at withdrawal can significantly offset the value of the compounding on the tax deferral.
Do I Have To Be Insurable?
No. A variable annuity is not life insurance.
Is It Necessary To Use A Variable Annuity Issued By A Foreign Insurance Company In Order To Tax-Defer Hedge Fund Investments?
As a practical matter, yes. A foreign insurance company is not subject to the burdens imposed by State insurance regulators who generally frown on hedge fired investments and impose restrictions on investor flexibility that make hedge fund investing through a domestic insurance company a practical impossibility. There are no exemptions provided for privately negotiated annuity contracts between a sophisticated investor and a domestic insurance company. All transactions must be approved by the appropriate state insurance regulator.
In 1996, Merrill Lynch and one of the leading hedge fund managers in the U.S., canceled a proposed variable annuity that was to be offered privately through Merrill's domestic insurance affiliate. According to Private Asset Management the head of Merrill's Private Advisory Services stated that the mason for the cancellation of the proposed offering was "complications in meeting state-by-state insurance rules".
A foreign insurance company, on the other hand, can allow sophisticated investors to make their own decisions as to the structure of the variable annuity and the managers they wish to use, without having to obtain an insurance regulator's approval, in the same way that such investors can make direct investments in hedge funds of their choice without obtaining a securities regulator's approval. The presumption in both cases is that sophisticated investors can take care of themselves.
If I Deal With An Offshore Insurance Company, Do I Have To Leave The Country To Sign The Papers?
Yes, either you or a representative with a power of attorney to act for you, must execute the appropriate applications and documentation outside the United States in order to ensure that no U.S. insurance regulator imposes restrictions on the contract.
Is My Money Safe With A Foreign Insurance Company?
As with all financial matters, foreign or domestic, you should do your own due diligence to determine the financial strength and integrity of the company you intend to deal with and its principals. An insurance company located in a jurisdiction that has, as a part of its general insurance law, a "separate account" statute can provide as much, if not more, legal protection for your investments as any domestic insurance company. A separate account statute provides that when a variable annuity is issued, the investment assets are maintained in a separate segregated account on the books of the insurance company and those assets can only be used to satisfy the variable annuity obligation. They cannot be used to satisfy any other obligations of the insurance company, even in the event of the company's bankruptcy.
Although separate account laws are common in the U.S., not all offshore jurisdictions have these laws. The Cayman Islands do, Bermuda does not. It pays to do your homework to ensure the safety of your investment assets.
Are The Tax Rules The Same For An Offshore Variable Annuity?
Section 72 of the U.S. Internal Revenue Code, which governs annuities, draws no distinction between a variable annuity issued by a domestic company, versus one issued by a foreign company. There are certain relatively simple rules that must be followed by any issuer, and if these are followed, then the accumulations should be tax-deferred.
Any investor considering an offshore variable annuity should review a copy of the legal opinions that the offshore insurance company has obtained regarding the U.S. tax treatment of annuities issued by the company. In addition, as with all matters involving U.S. taxation, investors should consult with and rely upon their own tax advisors as to the specific tax issues that could be involved in using any variable annuity to provide tax deferral for hedge fund investments.
What Kind Of Costs Are Involved In An Offshore Variable Annuity?
Costs vary by company, but because the companies are not subject to U.S. insurance regulation, they can be flexible in negotiating fees. Depending upon the company, fees can range from 0.65% to 1.25% per annum of the net assets in the annuity account. For very large accounts, fees of less than 65 basis points can generally be negotiated. There is also a one-time Federal excise tax on all life insurance and annuity contracts issued to or with respect to a U.S. person by a foreign insurance company. This tax is equal to 1% of the amount paid for the annuity contract.
Will An Offshore Variable Annuity Work With A Managed Account Rather Than A Hedge Fund?
Yes. There is no difference in the tax treatment.
Is There Any Advantage To Using Single Premium Life Insurance Rather Than A Variable Annuity?
If your primary goal is tax deferral, the answer is no. The internal revenue code was amended in 1988 to prevent the use of single premium life insurance as a tax deferred investment device.
While it is still technically possible to wrap a hedge fund in a life insurance contract, the costs are quite high and the real benefit, which is tax avoidance on the cash value buildup, is only available if the insured dies, which is a tough way to get a tax benefit.
Life insurance also requires that the investor be insurable, because the tax rules require that the face amount of the life insurance contract be maintained at a substantial multiple of the cash value that is invested in the hedge fund. This can also lead to real problems if the cash value (the value of the hedge fund investment) fluctuates substantially, either up or down.
Because of the high costs, the cash value build up in a life insurance contract can be substantially less that the build up in a low cost variable annuity. Over time, this difference can offset the additional tax benefits of a life insurance contract (which again can only be realized if the investor dies).
In short, an investor should only consider using life insurance to wrap a hedge fund investment, if the investor has determined that life insurance is otherwise useful in establishing an overall estate plan under which substantially all of the value will pass to the investor's heirs. Even then, the investor should consider combining a low cost variable annuity with a separate, low cost, term life insurance contract, which very likely can accomplish all of the important goals on a more cost effective basis.
What If I Die Owning A Variable Annuity?
If the investor dies, the annuity pays all of its cash value to a named beneficiary. The deferred income in the annuity is deemed to all be realized at death, and the estate of the deceased investor is liable for income taxes on the deferral. These can generally be spread over a five year period. If an investor dies owning an annuity contract, the value of the contract, after income taxes, is included in the investor's estate for estate tax purposes. While it is not widely understood, the value of a life insurance contract is also included in the owner's estate for estate tax purposes. With both annuities and life insurance, however, it is possible to exclude the values from the owner's estate through the use of a trust.
Are There Estate Planning Opportunities With A Variable Annuity?
Yes. One of the easiest methods is to name a charitable remainder unitrust trust as the beneficiary of the annuity. This avoids taxation on the built up gains in the annuity at the death of the annuity owner and also provides an estate tax deduction for a portion of the value of the annuity. The trust continues to invest on a tax free basis .and makes taxable annual annuity payments to its life beneficiaries (generally the children of the investor) based on a specified percentage of the value of the assets of the trust. At the end of the day something must be left over for a charity, which can be a family foundation. Since the annual payments to the life beneficiaries are based on a percentage of total asset value of the trust, the beneficiaries get the benefit of the tax free growth of the trust assets.
Another device involves the use of a "defective" grantor trust that allows the annuity to be treated as an immediate gift to the beneficiaries, which eliminates the value of the annuity from the investor's estate. The built up gains are treated for income tax purposes as being taxable to the investor at death, even though the annuity is owned by a trust for the benefit of others who will get its full value. This payment of income taxes by the estate of the deceased investor should not itself constitute a gift or bequest to the trust beneficiaries and therefore will escape estate taxation. Truly long term benefits may also be possible by utilizing the $1 million generation skipping tax exemption when the trust is set up, which can provide a substantial asset base from which the benefits pass from generation to generation without being burdened by estate taxes.
Investors who are interested in estate planning with a variable annuity should consult a qualified estate planning professional.
Can I Borrow Against A Variable Annuity?
The Internal Revenue Code provides that a loan against a variable annuity by the issuing insurance company to the annuity owner, or a loan by a third party that is secured by a pledge of the annuity, is treated as a taxable distribution from the annuity.
There are leveraging opportunities available, however. Depending on the lender, it may be possible for the annuity owner, particularly if it is a trust or other entity that is qualified to own an annuity, to borrow on an unsecured basis under a loan agreement containing negative pledges and other financial covenants that provide the lender with sufficient comfort that the annuity contract will be there, if needed, to satisfy the liability to the lender.
Also, there is no problem with borrowing against an annuity at the time it is acquired, since there is no deferred income in the annuity contract at that time. This means that an investor can, for example (again depending on the lender), acquire an annuity contract for $2 million, borrow up to $1 million of the purchase price and pledge the annuity contract to secure the $1 million loan with no adverse tax consequences.
Can I Exchange A Variable Annuity Issued By A Domestic Insurance Company For One Issued By An Offshore Insurance Company?
Yes. Under Section 1035 of the Internal Revenue Code, an annuity contract issued by a domestic insurance company can be exchanged on a tax free basis for one issued by an offshore insurance company. This applias even though the domestic variable annuity is invested in mutual funds and the offshore variable annuity is invested in hedge funds or with private managers.
Can I Contribute Appreciated Securities Into A Variable Annuity On A Tax Free Basis?
Sorry, but that is a taxable sale of the appreciated securities under U.S. tax law.
Who Is Scottish Annuity Company?
The Scottish Annuity Company (Cayman) Ltd. is the largest offshore provider of tax deferred variable annuities for investors in hedge funds and with private money managers. The Company has well over $100 million of variable annuities outstanding, that are invested with a variety of hedge funds and other money managers.
Variable annuities issued by the Company are intended only for the high net worth investor. The minimum contract is $1 million and the average contract issued by the Company is in the range of $2 million to $5 million.
The Company does not require investors to select from a limited pool of managers, and does not charge extra fees for selection of managers. Investors may suggest a particular manager or managers for their annuity investment accounts, but final approval and selection of all managers is at the discretion of the Company. Investors are required to conduct their own due diligence with respect to any managers used by them and the Company assumes no responsibility for the actions of such managers, whether or not they have been suggested by the investor or the Company.
The Company is not authorized to conduct business in the United States, and these materials do not constitute an offer to sell, or a solicitation of an offer to buy, any annuity contract or other product. Offers with respect to, and purchases of, annuity contracts issued by the Company may only be made and consummated at the offices of the Company in George Town, Grand Cayman, British West Indies, or such other locations outside the United States as the Company may designate.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.