United States: Private Placement Life Insurance and Annuities: Applications for U.S. and Non-U.S. Taxpayers - Part 1

Prepared in connection with a presentation by Leslie C. Giordani titled "Offshore Private Placement Life Insurance and Annuity Applications for U.S. and Non-U.S. Taxpayers" held at the 13th Annual ALI-ABA Course of Study for International Trust and Estate Planning
Chicago, Illinois
August 19-20, 2010

Copyright 2010 the American Law Institute. Reproduced with the permission of American Law Institute-American Bar Association Continuing Professional Education."

I. INTRODUCTION TO PRIVATE PLACEMENT LIFE INSURANCE AND ANNUITIES

A. A Tax, Estate, and Investment Planning Tool with Multiple Applications

Successful advisors of high net worth individuals employ a holistic approach to their clients' planning, one that addresses all of the clients' goals simultaneously, rather than focusing on component goals in isolation. It requires the advisor to construct a plan that encompasses multiple areas of concern in a simple and understandable manner, that meets clients' needs, and that recognizes the interrelationship of those areas. Essentially, it means that advisors must consider investments, income taxation, transfer taxation, asset security, and philanthropy in unison to achieve optimal results.

This article examines private placement life insurance ("PPLI", also known as private placement variable life insurance) and private placement variable annuities ("PPVA"), two core planning strategies that allow holistic advisors to address a wide variety of client needs. As an investment tool, both PPLI and PPVA enable access to sophisticated investment strategies used regularly by high net worth investors. As an income tax planning tool, PPLI reduces income tax liability because it permits such investments to grow income tax-free.¹ As an estate planning tool, PPLI has multiple applications that mitigate estate tax liability and facilitate the orderly disposition of assets at death.² In contrast, PPVA is designed to supplement the client's estate during life. As an asset security vehicle, PPLI and PPVA offer both financial privacy and, in some cases, significant protection from future creditors. And, finally, PPLI and, particularly, PPVA represent powerful tools for augmenting philanthropic goals.

High net worth advisors appreciate that what a client "keeps" is more important than what a client "earns." Thus, successful advisors must understand and be able to implement tax-advantaged and asset-protected structures for their clients' passive investments. Because their underlying vehicle is a life insurance policy or commercial annuity, PPLI and PPVA present established and conservative opportunities for tax-efficient investing in a protected environment. Life insurance and annuities as financial products have had a long history in the United States as tax-advantaged investment products that have little associated legislative risk. Recognizing this benefit, certain carriers with well-established operations both inside and outside of the U.S. have decided to offer variable polices and annuities as "private placements" in the high net worth marketplace. Such policies are fully compliant with U.S. tax rules and are, therefore, fully entitled to the preferential tax treatment that life insurance and annuities enjoy under the U.S. tax system. They are also much less expensive compared to their traditional retail equivalents, and they provide access to sophisticated investment funds. Finally, PPLI and PPVA acquired offshore offer additional asset protection benefits and cost savings as compared with equivalent products acquired in the U.S.

In addition to the income tax benefit U.S. clients seek primarily when purchasing PPLI or PPVA, there are ancillary attributes of these products that clients often view as "icing on the cake." For example, with PPLI, many clients view the death benefit payable in addition to the cash value as simply an expense associated with the policy; however, the death benefit element has many potentially useful estate planning applications. In addition, both PPLI and PPVA provide financial privacy and asset protection benefits that are of significant importance to the high net worth client. Finally, the simplification of the client's yearly tax compliance is frequently underappreciated in the planning stages, but clients tout it as a very important benefit once the policy has been in place for a few years.

B. Private Placement Variable Universal Life Insurance ("PPLI")

PPLI policies are generally structured as variable universal life contracts offered as "private placements" in the high net worth marketplace. A variable universal life policy allows not only flexibility with respect to the timing and amount of premium payments, death benefit options and levels, and withdrawals from the policy, but also allows the policy owner to allocate cash value amounts across a wide-range of investment options. PPLI policies are generally much less expensive than their retail equivalents (thus allowing for better investment accretion of premium contributions) and provide access to alternative investment classes such as hedge funds, hedge funds of funds, commodities, real estate, and options. PPLI is much less expensive than its retail equivalents for several reasons, the primary reason being agent compensation. Agent compensation for retail policies can be as high as 120% of the first year premium. Agent compensation for PPLI policies tends to be expressed as a percentage of cash value typically ranging from 0.20% to 0.50% with minimum front-end premium-based compensation.

To qualify as a PPLI purchaser, prospective policy owners who are U.S. persons must meet the criteria for "accredited investors" ("AIs") and "qualified purchasers" ("QPs") under Securities and Exchange Commission ("SEC") rules.³ Non-U.S. persons, while not required to satisfy the accredited investor and qualified purchaser rules for U.S. securities law purposes, are also required by most insurance carriers to qualify as AIs and QPs. The primary purpose for this requirement is ease of administration for the carriers and funds, who do not want to distinguish between fund investors but rather want to ensure AI and QP status for all investors in the fund.

C. Private Placement Deferred Variable Annuities ("PPVA")

PPVAs are generally structured as deferred variable annuities. With a deferred variable annuity, the annuity owner pays periodic payments to the insurance company over a stated period of time. The contract assets (i.e., cumulative payments and accreted investment return) grow on a tax-deferred basis until the contract is annuitized and payments to the annuitant commence. The annuity funds are invested through a separate account in various investment options, which the annuity owner chooses, and the annuitant accepts the investment risk and benefits of the investment performance of the account assets. Due to the variable nature of the annuities, the distributions fluctuate with the underlying investment return. PPVAs vary from traditional deferred variable annuities because: (i) there are typically no surrender charges; (ii)

the costs are typically less (not unlike PPLI without the application of the cost of insurance); and (iii) PPVAs allow for greater flexibility with investment options to include alternative asset classes such as hedge funds and funds of funds.

With all annuities, the pay-out period is determined once the annuitization occurs (i.e., pay-out commences). Typically, the pay-out option is either life certain, where the payments are guaranteed for as long as the annuitant is living, or period certain, where the pay-out is guaranteed for a certain period of time (e.g., 10 years, 20 years, etc.), provided the annuitant is living. With a period certain annuity, it is possible that the annuitant could die during the payout period. Some annuities provide that under such a scenario, the undistributed accumulated amount reverts to the insurance company, instead of being paid to a designated beneficiary.

II. ENSURING COMPLIANCE AS A U.S. QUALIFYING PRODUCT

A. U.S. Tax Treatment of Life Insurance

To qualify as life insurance for U.S. tax purposes and enjoy the tax benefits associated with life insurance, all life insurance policies must satisfy the requirements of § 7702 of the Internal Revenue Code of 1986, as amended ("Code").⁴ Furthermore, to ensure that policy cash values accrue tax-free, all variable contracts, whether life insurance or annuities, must comply with the diversification requirements of § 817(h) and with the investor control doctrine.⁵

1. Qualifying as a Life Insurance Contract

To qualify for the advantages afforded life insurance under the U.S. Tax Code, a policy must satisfy the definition of life insurance under § 7702. Under this section, a "life insurance contract" must (a) be treated as a life insurance contract under applicable state or foreign law and (b) meet one of two alternative tests, (i) the cash value accumulation test ("CVAT") or (ii) a twopart test consisting of the guideline premium test ("GPT") and the cash value corridor test ("CVCT").⁶ The purpose of these tests is to ensure that the goal of acquiring the contract is to secure life insurance by disqualifying policies created for their investment component without regard to the actual relationship between the cash value and the contractual death benefit.

a. Cash Value Accumulation Test ("CVAT")

Section 7702(b) establishes the cash value accumulation test. A contract satisfies this test if, by the contract's terms, "the cash surrender value of the contract may not at any time exceed the net single premium that a policyholder would have to pay at such time to fund future benefits under the contract" (effectively a certain relationship must exist between the cash value and the death benefit at any point in time).⁷ The CVAT assumes a maturity no earlier than the insured's age 95 and no later than the insured's age 100, and is generally applied to test whole life contracts.⁸

b. Guideline Premium Test ("GPT") and Cash Value Corridor Test ("CVCT")

Sections 7702(c) and (d) set forth the guideline premium requirements and the cash value corridor test, respectively. A policy satisfies the GPT if the sum of the premiums paid under the contract does not at any time exceed the "guideline premium limitation" at that time.⁹ The CVCT is satisfied if the death benefit under the contract at any time is not less than the applicable percentage of the cash surrender value.¹⁰ At age 40, the applicable percentage is 250%, decreasing in increments to 100% at age 95.¹¹

2. Section 7702A: Non-MEC vs. MEC

a. 7-pay Test

A policy will be considered a modified endowment contract ("MEC") under § 7702A if it was entered into after June 21, 1988 and it fails to meet the 7-pay test under § 7702A(b).¹² A contract fails to meet the 7-pay test if the accumulated amount the policy owner pays under the contract at any time during the first seven contract years exceeds the sum of the net level premiums that the policy owner would have paid on or before such time if the contract provided for paid-up future benefits after the payment of seven level annual premiums.¹³ Generally speaking, non-MECs are characterized by a premium paid over several years (typically four to seven), or even for the duration of the policy, and MECs are characterized by a one-time, initial premium payment.

b. Treatment of Material Changes

When a withdrawal is taken from any life insurance contract (whether individual or survivorship) it is typical that the death benefit will be lowered by the same amount of the withdrawal. This is to keep the net amount at risk (the difference between the cash value and death benefit) the same as it was immediately prior to the withdrawal. An insurance company will typically require new medical evidence to keep the death benefit at pre-withdrawal levels. This may or may not be something the insured is willing to undertake as there may have been a deterioration of the insured's health.

Where insurance companies elect not to employ this decrease in the death benefit, arguably they could be adversely selected against. That is, an insured, knowing that his health has deteriorated, would be wise to withdraw all the basis in a policy and the insurance company would be left with a greater risk for which it is not appropriately compensated.

If the death benefit on a policy insuring a single life is decreased within the first seven policy years, the 7-pay test described above is applied as if the policy had originally been issued at the reduced benefit level and this could cause the policy to become classified as a MEC.¹⁴

With respect to policies insuring more than one life (commonly referred to as survivorship or second-to-die policies) the rules regarding material changes are slightly different. For purposes of determining the MEC status of a second-to-die contract, § 7702A(c)(6) effectively states that any death benefit reduction below the lowest death benefit level during the first seven policy years will be treated as though the policy was originally issued at the reduced death benefit.¹⁵ Unlike the normal rule for single life contracts, which applies only for the first seven years from the date of issue, the rule for survivorship policies is perpetual and is a permanent extension of the look-back rule for MEC testing. This Code section applies for any survivorship contract entered into or materially changed on or after September 14, 1989.

Simply stated, if a withdrawal is taken from a fully funded second-to-die life contract and the death benefit is lowered, the policy will become a MEC under § 7702A(c)(6), which is likely not a desirable result.

This is particularly important for policies in which the maximum amount of premium was paid into a contract with the lowest death benefit possible, as is the case with a PPLI policy. In addition, such a policy structure has been, and continues to be a popular retirement planning technique. Many of these retirement planning scenarios are presented to clients where there are planned withdrawals to basis and then policy loans (to fund a retirement, college education, etc.). The client and advisors should perform a careful analysis with respect to the future use of the policy values during the lifetime of the insured when utilizing a fully funded (i.e., maximum 7-pay premium) design PPLI survivorship policy.

3. Section 817: Special Rules for Variable Contracts

If the client desires to invest in a variable contract (whether a life insurance variable contract such as PPLI or a variable annuity such as PPVA), then additional requirements must be satisfied under § 817 to ensure that the cash value grows tax-free. Under this section, the investments made by a segregated asset account on which a variable contract is based must be "adequately diversified."¹⁶ Further, the policy owner cannot engage in conduct deemed to be "investor control." If the account is not adequately diversified or if the contract owner violates the investor control doctrine, the contract owner will be deemed to directly own all of the policy's assets, thereby causing the separate account's income to be taxable to him or her.¹⁷

a. Diversification

b. Investor Control

B. U.S. Tax Treatment of Annuities

1. Qualifying as an Annuity

As with life insurance, annuities are tax-favored investments under the Code. Unlike life insurance, however, the primary income tax benefit of an annuity is derived from (1) the ability to defer the payment of income tax on the annuity payments and (2) the compounding effect of the tax deferral, rather than the avoidance of income tax, as with investment in a life insurance policy. Generally, under § 72(a), gross income includes any amount received as an annuity under an annuity, endowment, or life insurance contract. The income tax effect of an annuity depends, however, on numerous factors, such as whether the tax is being applied to a distribution during the annuity's accumulation period or annuitization period and whether the distribution occurs after the death of the holder of the annuity contract or after the death of the annuitant (assuming that the holder and the annuitant are different persons).

2. Section 72: Annuity Contract Defined

To qualify as an annuity, the annuity contract must satisfy the requirements of § 72. An annuity is a contract, generally issued by an insurance company, providing for regular payments to an annuitant and, potentially, to a beneficiary following the annuitant's death. The Treasury Regulations state that to be considered "amounts received as an annuity," such amounts should be:

• received on or after the annuity starting date;
• payable at regular intervals; and
• payable over a period of at least one year from the annuity starting date.³⁸

Further, the total of the amounts payable must be determinable as of the annuity starting date.³⁹

Payments may also be considered amounts received as an annuity if they are paid under a variable annuity contract, despite the fact that the total of the amounts payable under the variable contract may not be determinable as of the annuity starting date, if the amounts are to be paid for a definite or determinable time.⁴⁰ If, because of positive investment experience in the variable annuity contract or other factors, the payment with respect to the annuity exceeds the investment in the contract (adjusted for any refund feature) divided by the number of anticipated periodic payments, then only part of the payment will be considered an amount received as an annuity.⁴¹ The excess is an "amount not received as an annuity."

C. U.S. Securities Treatment of PPLI and PPVA

1. Qualification as an Accredited Investor and Qualified Purchaser

When considering whether their clients qualify as PPLI or PPVA purchasers, advisors initially must ensure that their U.S. clients meet the criteria for accredited investors and qualified purchasers under SEC rules.⁴² Private placement products offered by U.S. carriers to U.S. persons are subject to SEC regulations. Each purchaser generally must be a qualified purchaser under § 2(a)(51) of the Investment Company Act of 1940 and an accredited investor under § 501(a) of Regulation D of the 1933 Act.⁴³

2. Special Considerations for Offshore Policies

Offering memoranda for PPLI policies and PPVA offered contracts by non-U.S. carriers typically reference qualified purchaser or accredited investor standards, as used in U.S. securities law, to describe suitable investors. In the offshore context, this should be considered merely a guideline and not a strict requirement because offshore policies are not actually subject to SEC regulations. However, if the premiums of an offshore PPLI policy or PPVA contract are to be invested in funds that do require investors to be "qualified purchasers" and "accredited investors," then it can be argued that the policy owner must be a "qualified purchaser" and an "accredited investor" for that purpose.

III. TAX TREATMENT OF LIFE INSURANCE AND ANNUITIES

A. Introduction to Federal Income Tax Treatment of U.S. Citizens and Residents As Compared with NRAs

As a predicate for a discussion of the U.S. federal income tax treatment of life insurance and annuities and the planning that can be accomplished therewith, it is important to briefly address the general taxing framework applicable to NRAs, as compared with the tax rules applicable to U.S. citizens and residents. U.S. citizens and U.S. residents are taxed on their worldwide income, regardless of the source of that income and whether it is "connected" to any U.S. business.⁴⁴ This worldwide income is subject to the regular tax rates set forth under § 1.

NRAs, on the other hand, are taxed only on income from U.S. sources.⁴⁵ This includes gross income "effectively connected" with the conduct of a U.S. trade or business and gross income not connected with a U.S. trade or business but from other U.S. sources.⁴⁶ The NRA's effectively connected income is taxed at the regular tax rates applicable to U.S. citizens and residents.⁴⁷ Income from other U.S. sources is taxed at a rate of 30%, or a lower rate set by a tax treaty or tax convention.⁴⁸ This tax is applied, however, only on amounts that otherwise constitute gross income under the Code.⁴⁹ Therefore, when planning for NRAs, the practitioner must first determine whether the income would be includable in gross income under general tax principals. Then, the practitioner should consider the source of the income, including only income from U.S. sources in the total taxable income.

As with any planning involving the laws and rules of other jurisdictions, it is important to consider the potential impact of any income tax treaty between the U.S. and another country. The U.S. is party to more than 50 bilateral income tax treaties.

B. Income Tax Rules Applicable to U.S. Taxpayers Who Own Life Insurance Policies

1. Non-Taxation of Internal Build-Up

If a life insurance contract qualifies as life insurance under § 7702, the accreted value on the investment in the contract, or basis, of that policy (i.e., inside build-up) is not taxed to the contract owner during the policy's term.⁵⁰ This provides a particular benefit to investors seeking to invest tax-efficiently. Through the acquisition of a PPLI policy, such investors can invest in assets that generate taxable returns and avoid the income tax ordinarily associated with such returns.

2. Distributions During Policy Term

a. Non-Modified Endowment Contract Distributions

If withdrawals are allowed under a policy contract, the policyholder taking a withdrawal will receive cash from the insurer in exchange for a partial surrender of the policyholder's rights under the policy.⁵¹ If the policy is not a MEC under § 7702A (a "non-MEC"), then the withdrawal can be effectuated tax-free up to the premium previously paid with respect to the policy, subject to certain limitations (the "premium first" rule).⁵² To the extent that the withdrawal exceeds the policyholder's basis in the contract, the withdrawal will be fully taxable to the extent of the accumulated income in the cash surrender value.⁵³ The investment in the contract as of any date is the "aggregate amount of premiums or other consideration paid for the contract before such date, minus the aggregate amount received under the contract before such date, to the extent that such amount was excludable from gross income" at the time such amount was received.⁵⁴

Often it is beneficial to avoid policy distributions for at least the first seven to ten (and even fifteen) policy years for several reasons. First, this provides opportunity for the values to enjoy the power of compounding and accrete in a tax-free environment beyond the basis of the contract. Second, due to the application of the Guideline Premium Test and 7-Pay Test under § 7702, an early policy distribution may trigger a recalculation of the Guideline Premium Test and 7-Pay test potentially causing the policy to become a MEC.

When a policy distribution is desired, it is typically better to withdrawal an amount up to or equal to the basis in the contract as there are no current tax implications to doing so provided the policy remains in force. Once distributions equal basis (typically referred to as "withdrawals"), further distributions should then be taken as policy loans. Policy loans operate in a similar fashion to a loan from a § 401(k) plan. The policy owner is effectively borrowing its own accreted value with a promise to pay the sum back, with interest, at some future period of time. The net loan interest costs are typically between zero and 0.50%.

Policy loans and pledges or assignments of the policy, however, are generally not treated as distributions and do not reduce the death benefit under the policy.⁵⁵ To the extent that a policy loan is not repaid prior to the death of the insured, the amount of such loan (and any accrued but unpaid interest associated therewith) will be deducted from the death benefit proceeds prior to payment to the beneficiaries.

b. Modified Endowment Contract Distributions

The tax impact of the life insurance contract is different, however, if the policy is a MEC under § 7702A. The key planning consideration in deciding whether to structure a policy as a MEC or a non-MEC is whether (a) the policy owner expects to require access to policy funds during the policy term, or (b) the purpose of the policy is to pass wealth from one generation to the next without requiring access to policy cash values. If the policy owner does not plan or desire to withdraw money from the policy, then a MEC policy may be preferable due to the superior tax-free compounding effect achieved by a one-time, up-front premium payment and a smaller necessary relationship between the cash and death benefit, thus effectively reducing the insurance cost.

If the policy is structured as a MEC, an "income-first" rule will apply, and any withdrawals from the policy (whether classified as a "withdrawal" or "policy loan") will be fully taxable up to the amount of any gain in the policy assets prior to the withdrawal.⁵⁶ Furthermore, these withdrawals will be taxed at ordinary income tax rates. Also, the withdrawal will be subject to a ten percent penalty if the insured is under 59 ½ years of age. To the extent that the withdrawal amount exceeds the policy's accumulated income, the remainder of the withdrawal will be tax-free as a withdrawal of the investment in the contract.⁵⁷ For purposes of determining the amount includable in gross income, all MECs issued by the same company to the same policy owner within any calendar year shall be treated as one MEC.

3. Surrender or Maturity of Policy

When a life insurance policy is fully surrendered, or if a policy matures because the insured reaches the age to which that individual was insured,⁵⁸ the policyholder will have ordinary income to the extent that the amount received by the policyholder exceeds the policyholder's investment in the contract.⁵⁹ Extended maturity riders are required to avoid this result when insureds live to advanced ages.

4. Policy Proceeds

Under § 101(a)(1), life insurance proceeds are not included in the gross income of the insurance policy's beneficiary, absent the application of the "transfer for value" rules of § 101(a)(2) or certain other exceptions noted in § 101.

5. Transfer for Value Rule

If the interest in the policy is transferred for valuable consideration, the proceeds distributed are included in gross income under § 101(a)(2). This is known as the transfer for value rule. Under this exception, the death benefit proceeds will be includable in gross income and subject to income tax to the extent the death benefit proceeds exceed the consideration paid, plus any additional premium paid after the transfer (i.e., the basis in the contract).

It is important to note that valuable consideration must be present and it is possible that consideration can occur even in the absence of cash. Transfers can occur and not trigger the provisions of § 101(a)(2) through a § 1035 exchange as more fully described below. Further, transfers from one entity to another may occur without triggering the implications of § 101(a)(2) if the taxpayer of each entity is the same (i.e., moving a policy from one grantor trust to another).

6. Section 4371: Excise Tax on Life Insurance Premiums Paid to Foreign Insurers

If a policy is issued to a U.S. taxpayer by a foreign insurance company that has not elected to be taxed as a U.S. company under § 953(d), a tax equal to one percent of the value of each premium paid will be assessed. The taxpayer must file Form 720 to pay the tax at the time of the premium payment.

7. Section 1035: Tax-Free Exchange

Section 1035 allows for the tax-free exchange of a life insurance policy to another life insurance policy or annuity and an annuity to another annuity while maintaining the basis (i.e., cumulative life insurance premiums or annuity deposits) of the old contract. There are several important nuances to be aware of to perfect a tax-free exchange under § 1035.

These rules do not apply to any exchange having the effect of transferring property to any person other than a U.S. taxpayer. Furthermore, these rules do not apply to an annuity contract exchanged for a life insurance contact.

With respect to annuity exchanges, the contracts must be payable to the same person or persons. It is possible, however, to exchange one annuity for two or more annuities, or two life insurance policies for a single annuity contract. Within the limits above, it is also permissible to exchange a contract by a domestic insurer for one issued by a foreign insurer (and presumably vice versa) provided, however, that the annuity qualifies under § 72 and the life insurance policy qualifies under §§ 7702 or 7702A.

Mechanically, more often than not, the policy owner assigns all ownership rights to the original insurer and the original insurer then transfers the value of the life insurance or annuity to the new insurer at which time the new insurer issues an annuity contract or life insurance policy to the policy owner. Extreme care should be exercised to ensure the new annuity contract or life insurance policy continues to qualify, respectively, under §§ 72 and 7702 (or § 7702A in the case of a MEC contract). A MEC cannot be exchanged for a non-MEC.

C. Income Tax Rules Applicable to Non-U.S. Taxpayers who Own Life Insurance Policies

1. Generally Similar to Rules for U.S. Taxpayers

A non-resident alien ("NRA") will be subject to tax on amounts received under a life insurance contract only to the extent that such amounts would be included in the gross income of a U.S. citizen or resident. Thus, the rules governing the taxation of life insurance discussed above generally apply equally to an NRA as to a U.S. citizen or resident.

2. Taxable Amounts Subject to Withholding

The primary difference between the taxation of NRAs and U.S. citizens and residents is the difference in tax rates applied to each. To the extent that amounts received by an NRA under a life insurance contract are taxable, they will generally be subject to the thirty percent tax under § 871 and withholding under § 1441, rather than the ordinary income tax rates under § 1.

D. Transfer Tax Rules Applicable to U.S. Taxpayers Who Own Life Insurance Policies

While a detailed review of the transfer tax rules affecting a U.S. taxpayer who transfers a life insurance policy or its proceeds is beyond the scope of this article,⁶⁰ a high-level outline of those rules is helpful to understanding some of the planning concepts addressed herein.

1. U.S. Estate Tax Rules

For U.S. estate tax purposes, § 2042 provides that the gross estate of a U.S. citizen or resident includes the proceeds of insurance on the decedent's life, if those proceeds are (i) receivable by the executor of the decedent's estate or (ii) receivable by any other beneficiary if the decedent possessed certain "incidents of ownership, exercisable either alone or in conjunction with any other person." The term "incidents of ownership" refers to the decedent's rights to the economic benefits of the policy and includes the powers to:

1. change the beneficiary;
2. surrender or cancel the policy;
3. assign the policy;
4. revoke an assignment of the policy;
5. pledge the policy for a loan; and
6. obtain a loan against the policy's surrender value.⁶¹

The proceeds of a policy on the decedent's life will also be includible in the decedent's gross estate to the extent that the decedent possessed incidents of ownership in the policy and transferred or released those incidents or powers within three years of the decedent's death.⁶² One way to avoid that look-back is to transfer the policy via sale for full and adequate consideration, which also has the effect of avoiding any U.S. gift tax on that transfer. In order to avoid the implications of the transfer for value rule under § 101(a)(2), the client will typically transfer the policy to an ILIT or other trust that is treated as a "grantor trust" as to the client under the rules of §§ 671-678.

2. U.S. Gift Tax Rules

In the scope of domestic life insurance planning, U.S. taxpayers typically encounter the U.S. gift tax in one of two contexts: financing policy premiums through gifts; or valuing a policy that is being gifted (or transferred in a sale intended to avoid a gift).

Because the financing of premiums through gifts generally involves transfers of cash from the insured donor to the donee (which is often an irrevocable life insurance trust ("ILIT") established by the donor), the gift tax implications are relatively straightforward, invoking either the donor's annual exclusion amount under § 2503(b) or lifetime exclusion amount under § 2505(a). The most significant hurdles to be dealt with in that planning are ensuring that annual exclusion gifts actually qualify for exclusion under § 2503(b) and structuring the ILIT to avoid inclusion in the insured donor's estate under § 2042 or § 2035. One particular strategy for financing policy premiums at minimal transfer tax cost is a split-dollar life insurance arrangement, which is addressed below in Section IV.B.2.b.

The gift tax value of a life insurance policy is determined under the principles set forth in Regs. § 25.2512-6(a), which provides that the value is (i) the cost of a single premium policy of the same specified amount issued on a person the same age as the insured or (ii) the policy's interpolated terminal reserve, provided that such reserve approximates a value reasonably close to the policy's full value. Due in part to a PPLI policy's status as a variable contract, its gift tax value generally equals its cash surrender value as of the valuation date.

E. Transfer Tax Rules Applicable to Non-U.S. Taxpayers who Own Life Insurance Policies

1. Taxation of Transfers of U.S.-Situated Assets

For estate tax purposes, like under the income tax rules, U.S. citizens and residents are taxed on their worldwide assets.⁶³ In contrast, non-resident, non-citizens ("NRNCs") are generally taxed only on transfers of U.S.-situated assets.⁶⁴

As noted with respect to income tax planning, it is also important to consider the potential impact of any estate tax treaty between the U.S. and another country. The U.S. is, however, party to only 15 estate and/or gift tax treaties.⁶⁵ Therefore, the circumstances in which an estate and/or gift tax treaty will be applicable are much more limited than the application of the income tax treaties.

2. Section 2105

The Code provides for significantly different treatment of death benefits payable at the death of a U.S. citizen or U.S. resident compared with death benefits payable at the death of an NRNC.

Section 2105 specifically provides that "the amount receivable as insurance on the life of a non-resident not a citizen of the United States shall not be deemed property within the United States."⁶⁶ Therefore, the death benefits payable with respect to the life of an NRNC decedent are not subject to U.S. estate tax, regardless of whether (a) the decedent held incidents of ownership over the insurance policy, (b) the death benefits are payable to the NRNC's estate, or (c) the beneficiary is located inside or outside of the U.S.

This rule is specific to insurance on the life of the NRNC, however. If the NRNC decedent owned insurance that is situated in the U.S. on the life of another individual, then the value of that policy will be includable in the NRNC's gross estate for U.S. estate tax purposes.⁶⁷ Insurance on the life of someone other than the decedent is situated in the U.S. if the insurer issuing the policy is a domestic (rather than a foreign) insurer.⁶⁸

Footnotes

1. PPVA defers the payment of income tax liability, but, unlike PPLI, it does not allow the investments to grow completely income tax-free.

2. This article assumes the continued application of the estate tax system in effect on December 31, 2009.

3. Private placement products offered by U.S. carriers to U.S. persons are subjected to SEC regulations. See infra Section II.C.

4. § 7702(a). All "section" and "§" references are to the Internal Revenue Code of 1986, as amended, and the regulations promulgated thereunder, unless otherwise stated.

5. Significant portions of this paper have been derived from Giordani, Ripp, and Reed, "Using Life Insurance and Annuities in the U.S. Tax Planning for Foreign Clients," 39 Tax Management International Journal (Mar. 2010).

6. § 7702(a).

7. See §7702(b)(1).

8. See §7702(b).

9. § 7702(c)(1).

10. § 7702(d)(1).

11. See § 7702(d)(2).

12. See § 7702A(a).

13. § 7702A(b).

14. § 7702A(c)(2)(A).

15. § 7702A(c)(6)(A) and (B).

16. § 817(h)(3).

17. See Rev. Rul. 2007-7 IRB 469; Rev. Rul. 2003-92, 2003-2 C.B. 350; Rev. Rul. 2003-91, 2003-2 C.B. 347; Rev. Rul. 82-54, 1982-1 C.B. 11; Rev. Rul. 81-225, 1981-2 C.B. 12; PLR 200601007; PLR 200601006; PLR 200244001.

18. See § 817(h).

19. Regs. § 1.817-5(b)(1)(i).

20. Regs. § 1.817-5(b)(1)(ii).

21. Regs. § 1.817-5(c)(1).

22. Regs. § 1.817-5(c)(2)(i), (ii).

23. Regs. § 1.817-5(a)(2).

24. Regs. § 1.817-5(d).

25. Regs. § 1.817-5(f)(2)(i). Funds satisfying these two requirements are generally referred to as "insurance-dedicated funds" ("IDFs"). Notwithstanding the general rule that only insurance company segregated asset accounts may hold interests in the investment company, partnership or trust, there are some exceptions that allow other investors to hold such interests. See Regs. § 1.817-5(f)(3); see also Rev. Rul. 2007-7 I.R.B. 469 (addressing the exception of investors described in Regs. § 1.817-5(f)(3) from inclusion as members of the "general public").

26. Regs. § 1.817-5(f)(1).

27. See Rev. Rul. 2003-91, 2003-2 C.B. 347; PLR 200601006.

28. Rev. Rul. 2003-91, 2003-2 C.B. 347; PLR 200601006; PLR 200420017.

29. Rev. Rul. 2003-91, 2003-2 C.B. 347. Cf CCA 200840043 (Oct. 3, 2008). In CCA 200840043, which resulted from a withdrawn PLR, the Service opined that direct investment by the segregated asset account in assets that are available to the general public will result in a violation of the investor control doctrine; but most commentators have stated that the Service's position was unsupported by existing law and represented a material departure from the Service's previous statements on this doctrine.

30. For a more thorough examination of the investor control doctrine and its history, see Leslie C. Giordani & Amy P. Jetel, "Investing in Hedge Funds Through Private Placement Life Insurance," 6 The Journal of Investment Consulting 2, 79-82 (Winter 2003/2004).

31. 2003-2 C.B. 347.

32. Rev. Proc. 99-44, 1999-48 I.R.B. 598 ("[s]atisfying the diversification requirements does not prevent a contract holder's control of the investments of a segregated account from causing the contract holder, rather that the insurance company, to be treated as the owner of the assets in the account").

33. See, e.g., Rev. Rul. 2003-92, 2003-2 C.B. 350; Rev. Rul. 2003-91, 2003-2 C.B. 347; PLR 200244001; PLR 9752061.

34. Rev. Rul. 2003-91, 2003-2 C.B. 347; I.R.B. 2003-33.

35. PLR. 9752061.

36. See Rev. Rul. 2003-92, 2003-2 C.B. 350; Rev. Rul. 2003-91, 2003-2 C.B. 347; Rev. Rul. 81-225, 1981-2 C.B. 12; Rev. Rul. 82-54, 1982-1 C.B. 11.

37. Rev. Rul. 2003-91, 2003-2 C.B. 347.

38. Regs. § 1.72-2(b)(2).

39. Id.

40. See Regs. § 1.72-2(b)(3).

41. Id.

42. See generally, 15 USC § 80a-2(a)(51) (Section 2(a)(51) of the Investment Company Act of 1940, defining "qualified purchaser"); 17 CFR § 230.501(a) (Section 501(a) of Regulation D of the 1933 Act, defining "accredited investor").

43. See id.

44. See generally, § 1; see also Regs. § 1.1-1(b).

45. See §§ 2(d), 871.

46. See § 871. Income from other U.S. sources generally includes the amount received from sources within the U.S. as interest, dividends, annuities, and other fixed or determinable annual or periodical ("FDAP") gains, profits, and income. See § 871(a). Importantly, U.S.-source income also includes income from annuities and life insurance contracts issued by U.S. life insurance companies as well as foreign branches of U.S. life insurance companies. See Rev. Rul. 2004-75, 2004-2 C.B. 109.

47. § 871(b).

48. § 871(a); see also Regs. § 1.871-12. This tax is generally imposed through withholding at the source. § 1441.

49. Regs. § 1.871-7(a)(2). The Regulations refer to the taxation of annuities as an example, stating the amount of an annuity which is subject to tax under § 871 is determined in accordance with § 72. Id.

50. § 7702(g). If the contract fails to qualify as life insurance under the provisions of § 7702, then the income on the contract will be taxed to the contract owner annually. Id.

51. See Zaritsky & Leimberg, Tax Planning with Life Insurance: Analysis with Forms ¶ 2.05[2] (2nd ed. 2004) (hereinafter referred to as "Zaritsky").

52. § 72(e)(5). Withdrawals made within the first 15 years of the policy's life may be subject to so-called "recapture" tax. § 7702(f)(7).

53. § 72(e)(5)(A).

54. § 72(e)(6).

55. § 7702(f)(7); Zaritsky ¶ 2.05[2][b].

56. § 72(e)(10)(A).

57. § 72(e)(10)(A).

58. Most carriers offer, either as part of the policy itself or an endorsement to the policy, a maturity extension benefit allowing the policy to mature at the later of the stated maturity or the death of the insured thus avoiding any adverse tax consequences of living past the stated maturity of the policy.

59. §§ 72(e)(5)(A), 72(e)(5)(E).

60. For a more thorough treatment of these rules, see Zaritsky ¶ 3.03; Budin, 826-2nd T.M., Life Insurance, I.C, I,G.

61. Regs. § 20.2042-1(c).

62. § 2035(a).

63. See §§ 2001, 2031.

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.

64. See §§ 2101, 2103.

65. The United States has estate and/or gift tax treaties with Australia, Austria, Denmark, Finland, France, Germany, Greece, Ireland, Italy, Japan, the Netherlands, Norway, South Africa, Switzerland, and the United Kingdom. See also U.S. – Canada Income Tax Treaty, Arts. II 2(b)(iv), XXXVI3(g), XXIX B.

66. § 2105(a).

67. See § 2033; see also Zeydel & Chung "Estate Planning for Noncitizens and Nonresident Aliens: What Were Those Rules Again?" 106 J. of Taxation 20 (Jan. 2007).

68. Regs. §§ 20.2104-1(a)(4), 20.2105-1(e); Spielman, U.S. International Estate Planning ¶ 10.03[14][a][iii] (2008). Offshore insurance companies that have filed an election under § 953(d) to be treated as a domestic corporation should be considered "domestic insurers" for this purpose. See Regs. §§ 20.2104-1(a)(4), 20.2105-1(e); § 953(d). Therefore, such insurance is situated in the United States and includable in the NRNC's gross estate for U.S. estate tax purposes.

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.