How to: Minimize U.S. Tax Reporting Requirements (Legally!)
If you are an American living overseas, the walls are closing in on you quickly. If your foreign bank hasn’t already closed your account, don’t hold your breath because it is probably coming quickly. A large number of excellent articles have covered the implementation of FATCA and reporting obligations of FBAR and Form 8938.
FATCA basically requires foreign financial institutions to report their American citizen account holders to the Feds beginning in 2014 or face the consequences of a 30 percent withholding tax on the financial institution’s U.S.-sourced income. FBAR and Form 8938 (Statement of Specified Foreign Financial Assets) non-compliance carries penalties that will not only keep you up for more than a few nights but erase years of savings and investment. Lie about the existence of a foreign account on Schedule B of your Form 1040 and you may have committed tax fraud.
This article identifies a simple strategy to achieve tax-advantaged wealth accumulation while legally eliminating the U.S. reporting obligations outlined in the prior paragraph. One thing that this article is not telling you do is to commit tax fraud. If you owe back taxes pay them. The short-term pain is better than the long-term agony of regret sitting at the playground at the Big House.
Private Placement Insurance Products
Private placement insurance contracts are institutionally priced, customized variable universal life insurance and private placement variable deferred annuity contracts. At least one private placement life insurer has a private placement variable immediate annuity contract. The products are limited to accredited investors or qualified purchasers as defined under federal securities law. Basically, these are no load or very low load insurance contracts with super-charged investment flexibility.
These policies offer customized investment options for policyholders. The policies must be compliant under U.S. tax law for American citizens and resident aliens.
Tax Requirements for U.S. Insurance Contracts
Variable annuity contracts have a specific definition within the Internal Revenue Code, IRC Sec 72. Additionally, variable annuities also must also comply with the rules for variable insurance products found in IRC Sec 817(h) and Treasury Regulation 1.817-5.
Variable universal life insurance contracts must comply with the tax law definition of life insurance found in IRC Sec 7702 as well as the diversification requirements in IRC Sec 817(h) and Treasury Regulation 1.817-5.
As previously discussed both products are tax-advantaged. Variable annuities provide for tax-deferral on investment income. Depending upon whether the account value is annuitized, i.e. converted to a monthly payment for a term of years of lifetime income, a portion of each payment (exclusion ratio) is tax-free. Income that is not annuitized is normally fully taxable when distributed.
Life insurance receives very favorable tax-treatment. The offshore investment income within the policy is not subject to current taxation. The policy is able to access the investment gains within the policy on a tax-free basis through partial surrenders of the cash value and very low cost policy loans. Ultimately, the death benefit will be income tax-free and possibly estate tax-free.
For the American taxpayer overseas, the majority of U.S. tax treaties have annuity provisions provide for no tax on annuity income in the Host Country and only in the Home Country when a distribution is taken.
One subtle difference between domestic and offshore policies is the ability to make premium payments in kind or non-cash. The assignment or transfer of an appreciated investment portfolio is treated as a sale or exchange for tax purposes and triggers a taxable gain (or loss).
FBAR, Form 8938 and Offshore Life insurance
The regulations for FBAR and Form 8938 treat an offshore life insurance policy as a foreign account for reporting purposes. Therefore, a transfer to an offshore life insurer in Bermuda or Cayman Islands does not fix the taxpayer’s reporting obligation, i.e. TDF 90-22.1 and Form 8938. These rules apply to American policyholders regardless of whether or not the offshore life insurer makes an election under IRC Sec 953(d) to be treated as a U.S. taxpayer.
The regulations are very clear that accounts in certain U.S. commonwealths such as Puerto Rico, Guam, American Samoa, U.S. Virgin Islands and the North Marianna Islands are not subject to these reporting requirements.
By Gerry Nowotny, a tax and estate planning attorney with a JD and LL.M in estate planning from the University of Miami School of Law.