I.      General Points

§6:01         International Asset Protection Techniques

§6:02         Social Acceptability of Insurance and Annuities

§6:03         Overview of Private Placement Life Insurance (PPLI)

§6:04         The Private Placement Market

II.    Non-Resident Alien Tax Benefits

A.     Comparison of U.S. Citizen and Non-Resident Alien

§6:10         Hypothetical Facts

§6:11         Analysis of the Value of the Investments

§6:12         Taxes

B.     Solution for the U.S. Citizen

§6:20         The PPLI Structure

§6:21         An IBC Can Be an NRA

§6:22         Estate Tax Protection

§6:23         Taxation of U.S. Insurance Beneficiaries

III.   International Variable Universal Life (IVUL) Insurance

A.     IVUL Structure

§6:30         Establish a Domestic Irrevocable Life Insurance Trust

§6:31         Purchase an IVUL Policy

§6:32         Characteristics of the IVUL

B.     Security

§6:40         General Points

§6:41         Reinsurance

§6:42         Safe Custody Agreements

§6:43         Segregated Account

C.     Evaluating an International Policy for U.S. Tax Compliance

1.      Statutory Definition of Life Insurance

§6:50         Basic Requirements

§6:51         The Guideline Premium Limitation

§6:52         Cash Value Corridor

§6:53         Computing the Tests

§6:54         The Test Date

2.      Other Criteria

§6:60         The Contract Must Be Subject to Insurance Risk

§6:61         Diversification and Segregated Accounts

§6:62         Diversification and Look-Through Rules

§6:63         Control

§6:64         Insurable Interest

§6:65         Policy Is a Modified Endowment Contract

§6:66         U.S. Reporting Requirements

§6:67         Pre-Immigration Drop-Off Policy

D.     The Installment Sale Transaction

§6:70         General Points

§6:71         IVUL Sub-Account Can Consist of 100% of the Stock of an IBC

§6:72         The IBC Can Acquire the Insured’s Assets

§6:73         The IBC Can Pay With an Installment Note

§6:74         Thinly Capitalized IBC

§6:75         Acquisition of Assets for a Promissory Note

PREFACE

Client’s often ask me: “what is the strongest asset protection available”? Before I answer, I try to get an idea of the client’s net worth and how much he will benefit from the strategy we set up for him. Clients can be like customers in a car showroom. They want the best car but have only $15,000 to spend. I would not discuss a Mercedes with them.

For the wealthy client is an offshore trust sufficient?  Does it provide total asset protection? No! Not quite Mission Accomplished! Assets are not even 50% protected. A $100 gain is still taxed: Perhaps 20% (federal and state) for capital gains and 50% (federal + state) for ordinary income. That leaves you at most $80 to spend and after 55% estate tax, leaves your family at most $36 to spend. Guaranteed! Taxation takes at least 64%. If you invest in assets subject to ordinary income tax you and your family are left with even less. You earn $100 and a creditor will absolutely take a minimum of 64%. The wealthy want their “Investments” to grow totally asset and tax protected. Only two things matter for total asset protection

Shift your planning from equitable trusts to contractual insurance. Offshore trusts are regarded as suspect. Tell a friend you have an offshore trust, watch his reaction. Insurance is seen as socially desirable. Tell a friend you have purchased insurance and watch his reaction. You have protected your family. Exchange the (undesirable) trust equitable platform for the (desirable) insurance contractual platform. Offshore private placement life insurance (OPPLI) and Offshore deferred variable annuities (ODVA) (together referred to as “Contracts”) must be compliant with U.S. tax rules to enjoy the preferential tax treatment insurance enjoys. By virtue of lobbying, insurance has a long history as a tax-advantaged investment vehicle with minimal legislative risk. Insurance is:

Your spouse need not understand anything about your insurance structure as it concludes when you die. Your wife does need to understand how to manage an offshore trust.

Let Me Introduce OPPLI:

all within the IRS approved guidelines

Offshore PPLI - Benefits

Example: OPPLI Investment Benefits

Client has a $3m stock and bond portfolio growing 10%/year. Client wants to be totally asset protected. Federal, State and City income taxes are, 50%,   Capital Gains Tax is 20%  and  Estate Tax: 55%.

a.       $3m x 10% - 20% C/G Tax x 20 years = $17.3m to Client (lower if investments are taxed as ordinary income).

b.       Additional 55% estate tax = $7.8m to Family.

a.       $3m x 10% - 0% Tax – 1% total policy load (negotiable) = $21m to Client And $21m to Family (no estate tax).

b.       Complete Asset Protection:

Investment Benefits. Due to reduced regulation, OPPLI permits a broad universe of Investment Managers. If your Investment Advisor is registered, if you request that he manage your cash value account, the insurance company most likely will hire him. Hedge funds are frequently purchased because they and are usually tax-inefficient due to the investment strategies they employ, therefore, they can take full advantage of operating in a tax-free environment..

Section 1035: Tax-Free Exchange. You can exchange a domestic policy for an offshore policy on a tax-free basis. §1035 allows for the tax-free exchange of a life policy to another life policy or annuity and an annuity to another annuity. 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. It is also permissible to exchange a contract by a domestic insurer for one issued by a foreign insurer.

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. See §6:65 Modified Endowment Contract.

Summary

PPLI is an Investment Strategy

PPLI is a Financial and Estate Planning Strategy

I.       General Points

§6:01         International Asset Protection Techniques

International asset protection provides greater security than that available domestically. Some of the basic techniques include:

•        Offshore asset protection trusts. [See Chapter 5.]

•        Offshore limited liability companies. [See Chapter 10.]

•        International business corporations (IBCs).

More advanced techniques include:

•        Offshore Private Placement Life Insurance (OPPLI).

•        Offshore Deferred Variable Annuities (ODVAs).

§6:02         Social Acceptability of Insurance and Annuities

Offshore trusts are regarded by the U.S. government and the average American as suspect. Both courts and the media have cast a negative shadow over the propriety of debtors protecting their assets by placing them beyond their own control in offshore asset protection trusts. [See, e.g., Federal Trade Commission v. Affordable Media, 179 F.3d 1228 (9th Cir. 1999).]

On the other hand, insurance is seen as socially desirable. In light of this, the desirable asset protective and tax-advantageous insurance planning environment may be used as an alternative to the undesirable asset protective and tax-neutral trust planning environment:

•        Purchase DVAs to protect assets and allow them to grow in a tax-free insurance environment and be available at retirement.

•        Purchase OPPLIs to protect assets and allow them to grow in a tax-free environment available to the policy holder via tax-free policy loans. Insurance can go to your heirs without income or estate tax.

Asset protection plans can be reversed if the transfers are made solely to hinder or delay creditors’ collection efforts (i.e., so-called fraudulent transfers). To avoid fraudulent transfer attacks, it is better if transfers are supported by the acquisition of an asset of equivalent value (e.g. insurance). You are not depleting your estate to evade creditors, you are paying for an asset of equivalent value, and you are purchasing an asset that asset has socially desirable factors of supporting your retirement and your family, rather than the sole motivation of removing assets from your potential creditors’ reach. Insurance has a purpose other than solely asset protection. The sole purpose of many offshore trusts is asset protection.

§6:03         Overview of Private Placement Life Insurance (PPLI)

Private placement life insurance (PPLI) and deferred variable annuities (DVAs) (together sometimes referred to as “contracts”) hold within their cash value, investments that are not tax-efficient (such as hedge funds) and grow them tax-free. Investments within a PPLI are also free of income and estate tax (if the policy is held by an insurance trust) when received.

These tax advantages are the same for domestic and offshore PPLI. Both domestic and offshore PPLI are subject to Internal Revenue Code compliance. However, OPPLI is not subject to other domestic regulations (e.g. U.S. Securities and Exchange Commission, state Blue Sky laws and state Insurance Commissioners). OPPLI can be purchased with a smaller premium commitment than domestic PPLI because domestic insurers must follow an expensive regulatory route with continuing supervision, and must pay a deferred acquisition cost tax of 1% and federal and state income taxes and state premium taxes of up to 3%. These costs lower the policies investment returns.

OPPLI and offshore Deferred Variable Annuities (ODVA) also provide investment opportunities in foreign currencies and foreign currency denominated stock. When you purchase OPPLI with a face value denominated in another currency, you are in effect purchasing a leveraged currency future.

A purchaser of traditional life insurance seeks a large death benefit for the minimum amount of premium. A purchaser of PPLI wants the opposite. A purchaser of PPLI wants to pay the maximum amount of premium and receive the least amount of insurance, A PPLI is purchased for tax planning purposes with the objective of depositing cash (to invest) into the policy while maintaining the minimum death benefit required to be treated as life insurance. This funding method enhances the performance of the policy’s investment account since the cost of insurance charges are assessed only against the net amount at risk, which we structure to be as small as permitted by the Code.

Example: A $100 policy with $50 in cash value requires $50 of insurance cost. A $100 policy with $75 in cash value requires only $25 in insurance cost.

From an analytical point of view, OPPLI is of value if, after its costs are calculated, the investment return is greater than it would have been had the investor not used OPPLI. Add to this analysis the value of the income and estate tax-free death benefit that goes to the OPPLI investor’s family.

The tax benefits afforded to insurance is the result of a social policy designed to encourage each of us to provide for our retirement and for our family’s sustenance without the need for government assistance. The Tax Code protects the cash value growth in a life insurance policy from income tax, and provided the policy is purchased via an insurance trust, the death benefit from estate tax. The most common PPLI structure uses Variable Universal Life Insurance (VUL). Throughout this Chapter when you see “PPLI” it means “Private Placement Variable Universal Life Insurance” [See §§6:30 et seq.]

§6:04         The Private Placement Market

PPLI and DVAs enhance the performance and rate of return on investments that are not income tax-efficient. OPPLI and ODVAs offer the tax advantages and protection of insurance plus the advantage of the policy holder having a limited right to suggest to the insurance company the investment advisor who will manage his policy’s investment account.

The client is not buying traditional life insurance. The client is buying tax and asset protection advantages arising from the structuring of their business and investment assets within the tax-free advantages of insurance. ODVA and OPPLI customers are wealthy taxpayers who have money they want to place into tax-deferred and tax-free vehicles. They want to keep assets in jurisdictions that are not creditor friendly. Many do not want to hold dollar denominated investments; they want more secure currencies or, in many cases, they simply want currency diversification. PPLI and DVA contracts are available domestically for larger clients ($20 million plus investment accounts) and internationally for smaller-clients ($1 million plus investment accounts).

Purchasers of ODVA and OPPLI can take advantage of unique investment opportunities. International insurers are free of U.S. regulation and therefore are able to produce creative products with creditor protection.

*        In Kind Premium: The ability to pay premiums with assets other than cash is possible internationally and that avoids the need to liquidate assets. Such assets contributed in-kind as policy premium is then part of the cash value of the policy with less IRS investor control issues (see §6:63 Control). PPLI purchasers want investment options; they want the ability to recommend to the insurance company their own investment managers and they want products customized to their need.

High net worth clients prefer OPPLI over domestic PPLIs because:

•        Investment Advisors. They have existing investment advisors. International insurers allow investors to suggest the use of their advisors with as little as $1 million under management rather than the much larger amounts required with domestic insurers.

•        Non-U.S. Registered Securities. International insurers offer a platform for investing in international securities that are not available to investors onshore.

•        Lower Costs. International insurers’ reduced cost of doing business can be passed along to policy owners as lower policy loads and charges compared to those associated with domestic PPLI.

•        IRS Tax Compliant. Offshore policies are IRS tax compliant and receives the same protection as domestic policies with respect to legislative attacks on their tax-favored status.

[§§6:05-6:09 Reserved]

II.      Non-Resident Alien Tax Benefits

Many of my wealthier clients discuss expatriation to protect their wealth from what they perceive as an overreaching tax system. They point to the fact that they are currently working 50 hours per week and 50 weeks per year. They are spending 2,500 hours of their life time working every year. They enjoy their work. What they do not enjoy is that between federal and state taxes of over 50% (when President Obama taxes come in. in 2011) the government is taking 1,250 of their life every year. They then go on to mention property tax, sales tax, inventory tax and a host of other extractions which when added to the income tax leave them with even less than of their life time hours for themselves. And then they mention the estate tax, the tax which more than any other really infuriates them. From the less than 1,250 of their yearly life hours left them after taxation, they must give the government another 55% (or 687.5 of their life hours), before their children receive the 562.5 hours of the 2,500 hours they worked. Their children get 23%, the government 67%.

To these clients their only answer is expatriation. To these clients I explain it is not their person which needs expatriation it is their wealth. I then explain to them what; below I will explain to you. And what I will explain to you, is unbelievable, but true, the U.S. is a tax haven for the rest of the world, but not for its own citizens. Our government from a taxation point of view treats foreigners who invest in our country better than Americans who invest in our country. And then I explain to them if they want to be taxed or rather not taxed, they can expatriate their assets. By expatriating their assets their assets can be taxed the same as a foreigner’s assets.

A.      Comparison of U.S. Citizen and Non-Resident Alien Tax Benefits

§6:10         Hypothetical Facts

To understand the tax difference in investing as a non-resident alien (NRA) via an OPPLI and investing directly as an American we will compare the hypothetical tax experience of Lois Los Angeles, an American, and George Berlin, a German not living in the U.S. (a NRA). Both Lois and George want to invest well and retire in 35 years. They both invested $200,000 in the U.S. stock market. Both believe they can grow their money at 10% per year.

§6:11         Analysis of the Value of the Investments

Lois and George have each visited their accountants to see what their retirement would look like financially. To keep this calculation easier to understand, I have not calculated the effect of their present $200,000 tax basis. The results are as follows:

Lois Los Angeles

10% investment yield - 20% (federal and state capital gains tax) = 8% after tax yield.

$200,000 x 8% (compounded monthly) x 35 years = $3,259,000.

George Berlin

10% investment yield - 0% tax = 10.0% after tax yield

$200,000 x 10% x 35 Years = $6,528,000

Lois was startled that she would only have $3.2m and George would have $6.5m. She then visited George’s accountant and received even worse tidings.

Estate Tax

George’s $6.5m would go to his children estate tax-free (there is no estate tax where George lives).

Lois’ $3.3m will be subject to estate tax (55%). Her children would only get $1.5m.

Capital Gains

An NRA is not taxable on U.S. Capital Gain if he satisfies both of the following:

•        He is not physically present in the U.S. for more than 183 days during the year.

•        He is not engaged in a U.S. trade or business.

Therefore, George is not taxed by the U.S. [IRC §871(a)(2).]

As an American, Lois is subject to U.S. tax capital gains tax.

Portfolio Interest

Under certain conditions (“portfolio interest”), an NRA is not subject to the 30% withholding tax that applies to other U.S. source interest income received by NRAs. [IRC §871(h).] However, if the income is effectively connected with a U.S. trade or business, it remains subject to U.S. tax. Portfolio interest includes interest on unregistered (bearer) obligations that meet all of the following requirements. [IRC §871(h)(2)(A)(i)]:

•        It is sold under procedures reasonably designed to prevent sale or resale to U.S. persons. [IRC §163(f)(2)(B)(i).]

•        Interest on the obligation is payable only outside the United States or its possessions. [IRC §163(f)(2)(B)(ii)(I).]

•        The obligation states on its face that any U.S. person who holds it will be subject to limitations under U.S. tax laws. [IRC §163(f)(2)(B)(ii)(II).]

Example. Father is a Taiwan citizen. Son emigrated to the U.S. and became a citizen. Father gave son a $1m Portfolio Interest 8% loan that son used to buy a home. Son is in the 50% tax bracket (2011 federal and state). Son deducts his $100,000 interest payment and saves $50,000 in tax. As the loan is a portfolio interest loan, father receives the full $100,000 payment without any U.S. withholding tax. The family is ahead $50,000.

[§§6:13-6:19 Reserved]

B.      Solution for the U.S. Citizen

          Now Lois understands. Non resident aliens are preferred by the Tax Code over American citizens. How can an American be taxed like an NRA without expatriating?

§6:20         The PPLI Structure

If Lois did not want to pay $5 million in extra income and estate tax, she should have “expatriated” her stock when it was worth $200,000. She could have accomplished this through a Variable Universal Life privately placed life insurance structure (PPLI or PPLI Structure).

The PPLI would own the stock, and be taxed on its sale the same as NRA. NRAs do not pay capital gains tax. If the PPLI was held in an insurance trust, there would be no estate tax. The same tax efficiencies are available to both U.S. and foreign based PPLI structures. Both foreign and domestic policies that want to receive the U.S. tax benefits of insurance must be U.S. tax compliant. They both must follow the same U.S. tax rules.

The present transfer of the $200,000 stock to the PPLI could be by sale or gift, or by contributing it to the OPPLI  policy as an “in kind” premium payment. The later sale of the stock by a PPLI would be tax-free. The PPLI, as all NRAs, does not pay U.S. tax on U.S. portfolio income and U.S. capital gains.

§6:21         An IBC Can Be an NRA

An International Business Corporation (IBC) held as an investment of the PPLI is not subject to tax on income from foreign sources not effectively connected with a U.S. business.

However, an IBC is taxed on income that is either:

•        From U.S. sources.

•        Effectively connected with a U.S. trade or business.

[IRC §871(a)(1).]

From U.S. Sources

The IBC will be taxed on its U.S. source income, which includes income from all sources worldwide which is effectively connected with the conduct of a U.S. trade or business. [IRC §872(b)] This is particularly the case if the IBC has an office or other fixed place of business in the U.S. during the tax year. [IRC §864(c)(4)(B).]

NOT Effectively-Connected With a “Trade or Business in the U.S”

If the IBC trades in stocks and securities for its own account through a U.S. resident broker, or other independent agent, the IBC is not considered as engaging in or conducting a “trade or business within the U.S.” [See Higgins v. Commissioner, 312 U.S. 212 (1941) (holding stocks and securities for investment does not constitute engaging in a U.S. trade or business); see also IRC §864(b)(2)(A) (specifying the types of trading and investment activities in stocks and securities that will not cause a foreign taxpayer to be considered engaged in U.S. trade or business).]

This rule does not apply if at any time during the year the IBC has an office or other fixed place of business in the U.S. through which, or by the direction of which, the stocks and shares transaction are effected. The volume of the transaction during the tax year is not taken into account in determining whether the IBC is engaged in a trade or business within the United States. [Treas. Reg. 1.864-2(c)(1).]

§6:22         Estate Tax Protection – The Irrevocable Life Insurance Trust (ILIT) 

Lois can form an irrevocable, discretionary, dynastic trust perhaps with a protector (an advanced ILIT). The purpose of this trust is to hold the policy and receive the insurance proceeds on the insured’s death and thereby protect those proceeds against creditors or lawsuits and avoid the imposition of a projected 55% estate tax in 2011. To the extent the insurance proceeds are more than enough to provide for her (Lois’) family, the balance will go to her grandchildren, again without tax, if she utilizes the generation skipping transfer tax (GSTT) exemption. See §6:30, Establish a Domestic Irrevocable Life Insurance Trust, below.

6:23           Taxation of U.S. Insurance Beneficiaries

There is no income tax on the receipt of insurance proceeds. Gains made after the receiving trust received the insurance proceeds are taxed.

Lois can be taxed exactly as George. She must purchase an OPPLI and must either sell her stock for cash, or an installment note, or a self cancelling installment note (SCIN), to the policy or contribute it as an in kind premium payment. The OPPLI can later sell the stock tax-free. The OPPLI assets (like George’s) will grow tax-free and be received into an asset-protected insurance trust free of estate and income tax and if the insurance trust is so structured, GSTT exempt.

[§§6:24-6:29 Reserved]

III.    Offshore Private Placement Life Insurance (“OPPLI”)

A.      The Structure

§6:30         Establish an Irrevocable Life Insurance Trust (ILIT)

ILITs are a commonly used estate and tax planning tools to hold life insurance. ILITs provide U.S. estate tax savings and probate avoidance. From an asset protection standpoint, so long as the trust settlor gives up dominion and control over the ILIT and retains no benefits (unless set up in a domestic asset protection state such as Delaware or an offshore jurisdiction which protects self-settled trusts), an  ILIT shelters the cash surrender value of the policy during the settlor’s lifetime. Upon his death, provided the ILIT is discretionary (See Chapter 4) the policy proceeds continue to be protected from the settlor’s and beneficiaries creditors.

Procedure.The client sets up and funds an ILIT. This may be done with advanced features such as discretionary provisions, letters of wishes, and protectors (discussed below and see Chapter 4 and 5). The ILIT’s beneficiaries are normally the client’s heirs. The ILIT’s purpose is to keep the insurance proceeds out of the client’s estate.

An ILIT may be established as either a domestic or foreign trust for U.S. tax purposes. A foreign trust for U.S. tax purposes is one that does not have both (a) a U.S. court that is able to exercise primary supervision over its administration (the court test) and (b) one or more U.S. persons with the authority to control all substantial decisions of the trust (the control test). See Chapter 5, Low Profiler. If a foreign ILIT is drafted and maintained as a domestic trust for U.S. tax purposes, the burdensome foreign trust compliance requirements are avoided

What Are The Benefits Of Using An Offshore ILIT (or a Low Profiler see Chapter 5) To Hold Your OPPLI?

Potential Tax Trap Effects of §684

Code §684(c) provides that a domestic trust that becomes a foreign trust is treated as having transferred all of its assets to a foreign trust immediately before the change and gain must be recognized in the amount of the excess of the fair market value of the transferred property over its adjusted basis. In the foreign ILIT context, transfers to the trust by the settlor should not trigger §684, until the death of the settlor when the grantor ILIT becomes a non-grantor ILIT. See §684(b)

Compliance Considerations

The application of the IRS reporting rules depends upon whether the ILIT is a domestic or foreign trust for U.S. tax purposes. If it has foreign status, the settlor, the U.S. beneficiaries, and the trustee all have their own potential reporting obligations. Failure to meet these requirements is subject to large penalties. In general, IRS Forms 3520 and 3520-A are due annually from a U.S. settlor and the trustee, respectively, for an ILIT treated as a foreign trust for U.S. tax purposes. In addition Treasury Form 90-22.1must be filed. If the “foreign” trust complies with the Court and Control test (See Chapter 5), the filing requirements are avoided.

Continued Existence Of The Trust After Death Of Insured

If, following the receipt of the policy proceeds, the foreign ILIT is not wound up, the tax consequences become complex. If income thereafter, is accumulated rather than paid annually, the ILIT will eventually be subject to the throwback rules of  §§665(a) and (c) (concerning Distributable Net Income [DNI] and Undistributed Net Income [UNI])and the Code §668 interest charge. This situation may be avoided by the annual distributions of the entire amount of the trust’s income. To simplify the tax and reporting issues while still offering asset protection for the beneficiaries, the trust could either feed (be distributed into) a domestic trust or it could be redomiciled into the United States.

Domestic Asset Protected ILIT

The client could, if the situation warrants, establish the trust under the laws of a domestic asset protection state (DAPT). The law in DAPT states provides that a person may create a discretionary trust for his own benefit free from the claims of his future creditors even though the trust is a self-settled trust.

A transfer to a DAPT, wherein the client retains no rights and is only a discretionary beneficiary is a completed gift for U.S. gift-tax purposes because of the interplay between the Tax Code and the law governing creditors’ rights. A DAPT should cause the death proceeds to be excluded from the client’s estate for transfer-tax purposes, irrespective of the fact that he may benefit from the cash value of the policy (albeit at the trustee’s discretion) during his lifetime.

§6:31.5      Gifting and Split Dollar Agreements

Transfers to an ILIT in excess of the unified credit exemption amount ($1 million in 2011) will incur U.S. gift tax. Contributions to the ILIT that will be used to purchase life insurance can be structured as a split dollar arrangement in which you advance funds to the ILIT to finance the purchase of the life insurance policy in exchange for the obligation of the trust to repay that amount to you in the future. For example, you could settle the ILIT with $100,000 gift, and the ILIT could thereafter enter into a split dollar contract pursuant to which you advance the ILIT the balance necessary to pay the premiums each year on the life policy. If the funds needed by the ILIT exceed your unified credit then a split dollar arrangement would allow additional transfers without incurring gift tax since the ILIT has the obligation to repay the advance.  The split dollar contract can be structured in a number of ways, but generally requires the borrower (here, the ILIT) to repay the advance out of the death benefit proceeds of the policy at the time of the insured's death or out of the cash surrender value of the policy at some earlier time during the insured's lifetime.

§6:31         Purchase an OPPLI Policy

The ILIT (or the IAPT or DAPT) purchases and owns the U.S. tax compliant OPPLI on the client’s (or other’s) life. Insurers issuing international policies are usually not approved for policy sale or solicitation within the U.S. The individual states regulate the conduct of the sale of life insurance. Penalties and taxes attach on the sale of unauthorized life insurance within that state. Therefore, all aspects of the sale, solicitation, and negotiation for the policy may need to occur outside the United States. The following issues are involved in the purchase of the IVUL:

•        Will the IRS consider the international insurer to be “doing business” in the United States?

•        Is the purchase subject to a particular state’s premium tax?

•        Does the international insurer fall afoul of a particular state’s insurance regulatory environment?

•        Does the insurer run afoul of the Securities and Exchange Commission’s or a particular state’s Blue Sky Laws?]

§6:32         Characteristics of the OPPLI and/or ODVA Contract

Segregated Account

To be U.S. tax compliant the law under which the insurance company is licensed needs to provide that each policy’s assets must be walled off into a segregated account, so that creditors (or bankruptcy) of the insurance company and creditors of other policies are precluded from attaching the assets of the client’s policy.

The Contracts assets must be held by the insurance company in a “segregated account.” [IRC §817(d) (stating that the term “variable contract” means a contract that provides for the allocation of all or a part of the amounts received under the contract to an account that is segregated from the general asset accounts of the company). See also Notice 89-96, Sec II.D, 1989-2 CB 417, “A International life insurance company must separately compute its . . . income with regard to segregated asset accounts under section 817 or comparable provisions under International law.”

The diagram of this structure is as follows:

For this diagram, see “Figure 6-43 Segregated Account.pdf” in the “Diagrams” folder on your CD.

Diversification

The Contracts assets are “diversified” into a minimum of five sub-accounts. (Sometimes the sub-account is referred to as an “investment account.”)

International Business Corporation (IBC)

A sub-accounts could consist of 100% of the stock of an IBC.

[§§6:33-6:39 Reserved]

B.      Security

§6:40         General Points

The non-U.S. regulated insurance company usually has two commitments to its insured:

•        To pay the beneficiary the face value of the policy.

•        To pay the beneficiary the assets in the sub-accounts.

In some cases to reduce the cost of the insurance component, OPPLI is written so that the payout is the greater of the cash value (the sub-accounts) or the policy face value).  There are several ways by which the client can be assured that the company will honor these commitments:

•        Reinsurance.

•        Safe Custody Agreements.

•        A Segregated Account.

§6:41         Reinsurance

The insurance company should reinsure its policies with a major reinsurer. Therefore the net worth of the reinsurer, not the insurer, is of primary importance. International insurers generally reinsure almost all of the risk. An international carrier’s liability for a policy it issues is generally a very small fraction of the face amount.

§6:42         Safe Custody Agreements

A bank or brokerage firm may hold the assets of the policy, the five diversified sub-accounts of the segregated account (see §§6:43 and 6:61). Therefore the net worth of the major bank or brokerage house, not the insurer, is of primary importance. If the client needs more security, a safe custodial account can be used. The insurance company is paid its fees from the custodial account and the bank or brokerage house safeguards the remainder of the assets.

[§§6:44-6:49 Reserved]

C.      Evaluating an OPPLI for U.S. Tax Compliance

1.       Statutory Definition of Life Insurance

§6:50         Basic Requirements

An OPPLI (or a domestic policy) will be treated as life insurance for U.S. tax purposes if it meets the Code definitions of life insurance. If the policy fails at any time to meet the definition of a life insurance contract, then the income on the contract for any taxable year of the policy holder shall be treated as ordinary income by the policy holder during that year. [IRC §7702(g)(1)(A).] Furthermore, the income on the contract for all prior taxable years shall be treated as received or accrued during the taxable year in which the contract ceases to meet the definition of life insurance. [IRC §7702(g)(1)(C); Rev. Rul. 91-17 1991-1 CB 190).]

There are two basic parts of the Code definitions.

First, the policy must be a life insurance contract under the “Applicable Law.” [IRC §7702(a). See also Wickum, Wesley C. and Rhonda A. v. Commissioner, TC Memo 1998-270.] This is met if an insurance company in good standing in the jurisdiction in which it is authorized to do business issues the policy and the policy is considered a life insurance contract in that jurisdiction.

Second, the contract must meet one of the two following tests:

•       The Cash Value Accumulation Test. [IRC §7702(a)(1).] (We do not use this part of the test in constructing OPPLIs, so it will not be analyzed.)

•       The Guideline Premium Requirement and the Cash Value Corridor. [IRC §7702(a)(2)(A) & (B).]

§6:51         The Guideline Premium Limitation

A PPLI meets the Guideline Premium Limitation if the sum of the premiums paid under the policy does not at any time exceed either of the following:

•       The guideline single premium. This is the premium required to fund future benefits under the contract. [IRC §7702(c)(3).]

•       The sum of the guideline level premiums to such date. [IRC §7702(c)(2)(B).] The guideline level premium is the level annual amount, payable over a period that does not end before the insured attains age 95, which is necessary to fund future benefits under the contract. [IRC §7702(c)(4).] This limitation distinguishes between PPLI contracts under which the policy holder makes traditional levels of investment through premiums (i.e., insurance is of prime importance) and those contracts that are purchased to place investment accounts within the tax-free wrapper of the insurance policy’s inside buildup (i.e., where insurance is incidental).

§6:52         Cash Value Corridor

The cash value corridor disqualifies contracts that allow excessive amounts of cash value to build up relative to the life insurance risk.

A PPLI contract meets the “cash value corridor test” if the death benefit under the contract at any time is not less than the “applicable percentage” of the contract’s cash surrender value. [IRC §7702(d)(1).] The “applicable percentages” are set forth in a statutory table. [IRC §7702(d)(2).]

Example: Under the table, an insured person, who is 60 years of age and has a life insurance contract with $100,000 in cash surrender value, must have a death benefit at that time of at least $130,000 (130 percent of $100,000). [IRC §7702(d)(2).]

§6:53         Computing the Tests

The IRC provides general rules for computing the limitations in the guideline premium/cash value corridor tests. [IRC §7702(e)(1).] These rules restrict the actual provisions and benefits that can be offered in a life insurance contract to the extent that they restrict the allowable cash surrender value or the allowable funding pattern. Nevertheless, in certain cases (e.g. the cash value grows to fast), to avoid disqualification, the death benefit may be increased. [IRC §7702(e)(2).]

§6:54         The Test Date

Changes in the future benefits of the policy will occur when the policy is variable. [IRC §817(d)(3).] In a variable policy, the determination of whether the contract meets the tests need be made only when the death benefit under the contract changes, but in any case no less frequent than once a year. [See IRC §7702(f)(9).]

     §6:55       Creative Structuring: Alternative Cash Value Policy Structures

The cash surrender value of a policy is essentially the amount the policy owner will receive upon an early termination of the policy and represents the maximum amount that can be borrowed from the policy. "Cash surrender value" can be limited by underwriting restrictions based on the "net amount at risk" (NAR), the carrier is willing to take.

Example: A policy has a death benefit of $3 million. The total value of the segregated account is $1 million. If the insured dies the insurance company pays $3 million (provided the policy was written so the payout was the greater of Face or Cash Value) consisting of $1 million in the segregated account plus $2 million of the company's own cash (or from its reinsurer), which would constitute a $2 million "net amount at risk."

                 Had the policy been written so the payout was the Face plus Cash Value, the insurer would have needed $3 million, not $2 million of reinsurance so the policy would have cost more.

When a policy is issued, the insurance company evaluates its potential exposure as measured by the NAR. If some event causes this economic exposure to increase way beyond the original NAR, the insurance company will either increase the death benefit or force a partial termination of the policy to bring the NAR within its acceptable parameters. A forced partial termination would be a taxable event to the policy holder and, therefore, should be avoided if possible.

In parallel to the NAR concerns, the "cash corridor" test, discussed above, requires the death benefit to be a certain multiple of the cash surrender value of the policy. The cash corridor test percentage decreases as the insured ages. If the value of the segregated account gradually increases, the gradually increasing cash value is not likely to cause the NAR to exceed (after application of the cash corridor test) the insurance carrier’s capacity. However, where there is "exploding" policy values, that, when combined with the cash corridor test limitations, the carrier to retain the tax-qualified status of the policy, may force partial (taxable) terminations of the policy or risk running afoul of  §7702. It is preferred to have a mechanism in place to automatically adjust the cash surrender value of the policy to remain within acceptable risk parameters. The creative policy structures discussed below address this "exploding" policy value issue by balancing the ability to access funds within the policy during the insured's lifetime, and the expected growth rate of the policy segregated account.

“Frozen Cash Value" Policy Structure.

We can "freeze" the cash value of the policy by defining it to be the lesser of

a)     the sum of the premiums paid, or

b)     the actual value of the policy segregated account (i.e., cash value is frozen to never exceed actual premiums paid).

Therefore, if the policy terminates prior to the insured's death, the policy holder will receive at most the premiums paid and will not receive any of the earnings within the segregated account. For this reason, this structure is appropriate only if you intend to keep the policy in effect for the remainder of the insured's life. It is more advantageous to borrow tax-free against the policy (if available) rather than to terminate the policy if lifetime access to such funds is desired.

The U.S. tax consequences of an insurance contract are measured by the increase in the cash value of the policy over the amount of aggregate premiums paid into the policy. IRC §7702(g) provides that if a contract is a "life insurance contract" under the laws of the country where the policy is issued but does not meet the IRC §7702(a) requirements for a tax-free "life insurance contract", then the policy owner is taxable each year on the "income on the contract," which is defined in this context to include the sum of: (i) the increase of the net surrender value of the contract during the taxable year, and (ii) the cost of life insurance protection provided under the contract during the taxable year, over the premiums paid during the contract year. The effect of these provisions is the U.S. tax exposure to this type of structure should be limited to the mortality charge in the contract because there is no increase in the net surrender value under the "frozen cash value" structure. This policy structure can be particularly attractive if the policy is to be funded with very large premiums.

A "frozen cash value" policy can be funded in full immediately because the MEC rules, tax loans against the policy, only to the extent the cash surrender value exceeds the premiums paid into the policy. Since the cash surrender value will never exceed the premiums paid into a "frozen cash value" policy, the policy owner could be permitted to borrow the entire cash surrender value which should, generally be equal to the aggregate premiums without triggering any U.S. tax.

The "frozen cash value" policy structure permits the mortality charge within the policy to typically decrease over time and eventually be eliminated, depending upon the investment returns and growth within the policy segregated account. This occurs because there is no increase in the cash surrender value that would require a corresponding increase in the death benefit under the cash corridor test. Therefore, the "net amount at risk" to the insurance company should decrease over the life of the policy as the value of the segregated account increases.

Example:     A carrier's retention and reinsurance capacity is equivalent to $100X. This amount is more than sufficient to deal with the cash value at the time the policy is issued. However, significant growth in the underlying assets will consume the carrier’s available capacity in a few years. Since the policy holder wants to have access to the cash value during his lifetime but feels that the amount procured by the initial premium is all that is needed, he negotiates with the carrier to estab­lish that the initial amount of the cash value is to remain “fixed” throughout the term of the policy.  Under those circumstances, it would be unnecessary to ever raise the ceiling of the carrier's capacity because the policy's cash value never increases. Perhaps as important, the policy­holder's basis in the contract will always equal or exceed the cash value which leads to the income tax result that the policyholder never need be concerned about being taxed with respect to any loans or partial withdrawals, or even whether the policy is classified as a modified endowment contract under §7702A

"Limited Cash Value" Policy Structure.

It is preferable to structure premium payments under a "limited cash value" policy as a five year pay-in to avoid MEC status because the cash surrender value is expected to increase over the total premiums paid into the policy. Under this structure, the cash surrender value is permitted to gradually increase over the life of the policy based on (1) the growth of the value of the segregated account, and (2) the increasing age of the insured. The cash surrender value under this structure is more specifically defined as the greater of the following two amounts:

The cash surrender value under this structure at any particular time will be the greater of the cumulative paid-in premiums and a certain percentage of the value of the segregated account. The exact percentage of the segregated account will vary based on the age of the insured and will increase over the term of the policy as the insured ages.

Example: The trust invests $1 million into the policy as premiums. Assume the insured is 50 years old and will be 60 when the value of the segregated account has increased to $10 million The cash surrender value under the limited cash value" structure at that time will be the greater of:

When the insured reaches age 75 and the segregated account value is $10 million, then the cash surrender value under this policy structure will be $9,523,810 (i.e., $10 million ÷ 105%).

The amount payable to the policy owner upon cancellation of the policy prior to the insured's death will be the cash surrender value of the policy on that date, which for a "limited cash value" policy will always be defined as less than the accumulated value of the underlying segregated account (although the available percentage increases over time as the insured ages). It is better to access earnings within the policy during the insured's lifetime by borrowing against the policy as tax-free loans rather than terminating the policy (which would be a taxable transaction).

Assuming a reasonable investment return within the segregated account, the result should be a decreasing annual mortality charge that will be eliminated when, and if, the value of the segregated account equals or exceeds the initial stated death benefit of the policy.

As stated above, these policy structures each offer the advantage of eliminating the reinsurance expense after the policy segregated account grows in excess of the Initial Specified Amount determined under the guideline premium test (i.e. the initial stated death benefit of the policy) because there will no longer be any "net amount at risk" to the insurance company (i.e., the death benefit becomes equal to the value of the segregated account). In practical terms this means that once the value of the assets within the segregated account have grown to equal or exceed the value of the initial stated death benefit of the policy (i.e., the Initial Specified Amount), then the annual costs of maintaining the policy in force are significantly reduced because there will be no further "mortality" charge on the policy.

 [§§6:56-6:59 Reserved]

2.       Other Criteria

§6:60         The Contract Must Be Subject to Insurance Risk

To be insurance, there must be a sharing of risk. [Helvering v. Le Gierse, 312 U.S. 531 (1941).]

Risk shifting occurs when a person facing the possibility of economic loss transfers some or all of the financial consequences of the loss to the insurer. [Rev. Rul. 89-61, 1989-1 CB 75.] If the insurer guarantees a minimum death benefit, risk shifting has occurred because the guaranteed amount must be paid regardless of the amount in the segregated account.

§6:61         Diversification and Control

There are two relevant items under §817, diversification and control.

    §6:61.1    Diversification

Section 817(h), containing the variable contract “investment diversification” rules, was enacted by Section 211(a) of the Deficit Reduction Act of 1984 (Pub. L. 98-369) “in order to discourage the use of tax-beneficial variable annuities and variable life insurance primarily as investment vehicles.” The investor control doctrine was not specifically addressed in the final regulations under §817(h), although some have viewed the doctrine as being preempted by §817(h) and the regulations thereunder. The diversification rules determine whether a contract is life insurance for federal income tax purposes. They apply to life insurance and annuity contracts that are variable. They apply equally offshore and onshore.

A “variable contract” means a contract that, among other things, provides for the allocation of all or a part of the amounts received under the contract to an account which is segregated from the general asset accounts of the company. [IRC §817(d)(1); Treas. Reg. §1.817-5(b).] The diversification rules are applied to sub-accounts of the segregated account. The diversification rules require no fewer than five different sub-account investments.

Any sub-accounts will be deemed to be adequately diversified if they meet the diversification requirements of §851(b)(4). No more than:

Diversification is tested on the last day of the calendar quarter (i.e., March 31, June 30, September 30, December 31) and must meet the test then or within 30 days.

§6:62         Diversification and Look-Through Rules

The sub-accounts may be invested in shares of one fund. If that fund was treated as a separate investment for purposes of IRC §817, the sub-accounts would not meet the diversification requirements. However, a fund can be managed so that it qualifies for certain “look-through” rules. Look-through treatment applies if an investment is offered through a partnership that is not registered under a federal or state law regulating the offering or sale of securities. Hedge funds are virtually always organized as unregistered partnerships eligible for look-through treatment. [Treas. Reg. §1.817-5(f)(2)(A).]

§6:63         Control

The second significant issue under §817 involves investor control. In order for income generated by PPLI and DVA assets to qualify for tax deferral, those assets must be treated as owned by the insurer rather than by the policyowner. The IRS takes the position that, for variable contracts, if the insured as policyowner retains certain incidents of ownership, this may cause him to be treated as directly owning the underlying segregated account assets for U.S. tax purposes. The insurance company must control the management of the policy’s assets. Control issues go back to rulings on wraparound annuities in the late ’70s and early ’80s. In Rev. Rul. 77-85, 1977-1 C.B. 12, the Service held that the bundle of rights given the policyholder in an “investment annuity” amounted to a direct investment in the underlying account assets. Therefore, the policyholder would be treated as the owner of the assets and taxed on their earnings. The “bundle of rights” included substantial control over the selection of the assets and the possession of voting rights with respect to them.

 Rev. Rul. 81-225 (1981-CB 12) discusses an annuitant purchasing an annuity from an insurance company. The results should be similar for a policyowner purchasing a PPLI from an insurance company. Herein the insurance company purchased and sold shares of mutual funds which were also offered for sale to the public. The ruling held that the policyholders of those variable annuity contracts which invested in publicly available mutual funds would be treated as the owners of the mutual shares.

Where the insurance company controls the investments in mutual fund shares and the shares are only available through the purchase of an annuity or a life policy, the insurance company is considered the owner of the mutual fund shares. If the funds are available to the general public, the annuitant or policy owner will be considered the owner and will be taxed currently on the income. Therefore the fund should be unique to the insurance company and available only through the purchase of an insurance product. [Rev. Rul.81-225, 1981-2 C.B. 12.]

If the arrangement between the insurer and the insured is similar to the arrangement between a traditional brokerage firm and its investors, the insured will be held to be the beneficial owner. Christoffersen v. U.S., 749 F.2d 513 (8th Cir. 1984).

In July 2003, the IRS released two revenue rulings addressing investor control. These were the first guidance on investor control since 1982.

Revenue Ruling 2003-91, 2003-2 C.B. 347 describes two situations involving the purchase of a variable contract within the meaning of §817(d) from a life insurance company (InsCo).

Assets supporting the Contracts were maintained by InsCo in a separate account divided into sub-accounts (“Sub-Accounts”) available solely through the purchase of a Contract. They were not otherwise available for sale to the public. InsCo engaged an independent investment advisor (“Advisor”) to manage the investments of each Sub-Account which at all times met the diversification requirements of §817(h). Twelve Sub-Accounts were available under the Contracts, and InsCo could increase or decrease this number at any time, although there would never be more than 20 Sub-Accounts.

Holder specified the allocation of premiums paid among the Sub-Accounts at issuance and thereafter could transfer amounts among the Sub-Accounts at the rate of no more than one transfer per 30 days. There was no prearrangement or agreement between Holder and InsCo or between Holder and Advisor

regarding the availability of a particular Sub-Account, the investment strategy of any Sub-Account, or the assets to be held by a particular Sub-Account. All investment decisions were made by InsCo or Advisor in their sole and absolute discretion. Holder could not select or recommend particular investments or investment strategies, and could not communicate directly or indirectly with any investment officer of InsCo or its affiliates or with the Advisor regarding the selection of any specific investment or group of investments held in a Sub- Account. Holder had no legal, equitable, direct, or indirect interest in any of the assets held by a Sub-Account. All decisions regarding the choice of Advisor or the choice of any of InsCo’s investment officers that were involved in the investment activities of the Separate Account or any Sub-Account were made by InsCo in its sole and absolute discretion. Holder could not communicate directly or indirectly with InsCo regarding these matters.

The IRS concluded in both situations that the Holder would not be considered the owner for tax purposes, of the assets because he could not select or direct particular investments, could not sell, purchase, or exchange assets in the Sub-Accounts, and investment in the Sub-Accounts were available solely through the purchase of a Contract. The IRS noted that Holder’s ability to transfer Contract values among Sub-Accounts did not; in itself indicate that he had control over those assets for tax purposes. In so stating, however, the IRS observed that the investment strategies of the Sub-Accounts were “sufficiently broad” to prevent Holder from making particular investment decisions through investment in a Sub-Account. The IRS concluded a variable contract owner’s “ability to choose among broad, general investment strategies such as stocks, bonds or money market instruments” did not cause an investor control problem and that the 13 strategies listed in the ruling can be viewed as “broad, general investment strategies” for purposes of the investor control doctrine.

Revenue Ruling 2003-92, 2003-2 C.B. 350 describes three situations involving the purchase of a variable annuity contract and/or variable life insurance contract from a life insurance company (“InsCo”). In each situation, the variable contract was not registered under federal securities laws, and was sold through “private placement” offerings).

In the first situation, Holder purchased an annuity. The assets supporting the annuity were held in a segregated asset account that was divided into 10 subaccounts which met the asset diversification requirements of §817(h). Holder specified how premiums were to be allocated among the Sub-Accounts at issuance of the annuity, and could change the allocation at any time. In the first situation, each Sub-Account invested in a publicly traded partnership available to investors without purchasing an annuity. Each partnership had an investment manager that selected the partnership’s investments. The second situation described in the ruling is identical to the first, except that Holder purchased a life insurance contract. In the third situation, Holder purchased both an annuity and a life insurance contract, but interests in the partnerships were available for purchase only through the purchase of a variable contract.

The IRS concluded that “the holder of a variable annuity or life insurance contract will be considered to be the owner, if interests in the partnerships are available for purchase by the general public.” However, in the third situation the partnership interests were available for purchase only by a purchaser of a variable contract, InsCo is the owner for tax purposes. This Ruling is the first time that the IRS has published guidance on investor control issues in the context of a private placement life insurance or annuity contract.

PLR 9433030 gives the following guidance to avoid the policy holder being deemed the owner:

•       The funds in the segregated account should be invested at the direction of the insurance company.

•       Other than a policy owner’s right to allocate premiums and contract value among a family of funds, the policy holder cannot select or control the investments.

•       None of the investments purchased directly by the segregated account should be available to the general public.

•       The insurance company should be able to represent that “the Policy Owner, including any officer, director, employee, or agent thereof, will not communicate directly or indirectly with any ‘investment officer’ of the Insurer of its affiliates. ... ‘investment officer’ refers to anyone whose responsibilities include giving investment advice to or making investment decisions.”

•       There should not be a prearrangement, plan, or agreement between Policy Owner and Insurer regarding investment in any particular investment item or items.

•       The policy holder cannot select or identify particular investments to be made by the separate accounts.

•       The policy owner has no legal, equitable, direct or indirect interest in any of the assets. The policy owner should have only a contractual claim against Insurer to collect proceeds in the form of death benefits or surrender values under the policies.

•       The policy holder should not be able to achieve the same investment position or result by means of any product other than the insurance policy.

Private Letter Ruling 9433030 further stated: We cannot too often reiterate that “taxation is not so much concerned with the refinements of title as it is with actual command over the property taxed…” It makes no difference that such ‘command’ may be exercised through specific retention of legal title or the creation of a new equitable but controlled interest, or the maintenance of effective benefit through the interposition of a subservient agency.

At what point does the insurer’s willingness to work with the policy holder create an investor control situation? Some retail insurance products have a separate account offering 50 investment options to choose among. Is that an investor control issue when you can choose among 50 different investment options? Is there a limit? Rev. Rul. 2003-91, supra, states that the contract will provide up to 20 investment options, but the IRS’ analysis makes no reference to that figure as a limitation on the permissible number of investment options. Instead, the IRS concludes that the investment strategies identified in the facts are “sufficiently broad” to avoid an investor control problem.

Are there any limits to the permissible number of transfer/exchanges among funding options? Rev. Rul. 2003-91, supra, states that the contract allows unlimited transfers among investment options, subject to fees for more than one transfer per 30 days.

The policy owner cannot dictate to the fund manager what specific assets should be owned by the policy. But the policy owner can request a particular fund manager based upon his asset allocation model and investment philosophy See §6.68, below.

In order to help the IRS enforce the investor control doctrine, the Obama Administration’s Fiscal Year 2010 Revenue Proposals contains a measure that would impose on life insurance companies certain informational reporting requirements regarding each life insurance and annuity contract that is partially or completely invested in a “private separate account” (defined as a separate account in which a group of related persons owns a 10% interest).

§6:63.5 In-Kind Premium Payment and Freezing

Clients can make in-kind premium payments of property other than cash when a client prefers to invest non-cash assets. For instance the client may wish to pay the premium with pre-IPO stock. He contributes it at its appraised value, assume $100,000. When it appreciates to $1 million, the PPLI can sell it without paying tax.

You can freeze the value of rapidly appreciating assets and stock by placing them into an OPPLI. You make an in-kind premium  payment of your stock for your OPPLI. It becomes part of the diversified portfolio of your OPPLI and is managed by the policies independent investment manager. The stock then obtains the benefits of income free growth within the policy.

     §6:64  Insurable Interest

The concept of “insurable interest” underlies whether the contract will qualify as life insurance for tax purposes. If a person buys a policy in which there is not an insurable interest (e.g., a family relationship or some kind of economic relationship), then the contract may not be life insurance for federal income tax purposes, in which case, the policy loses all tax benefits. However, insurable interest issues in the international market are a bit more forgiving than they are in the onshore market.

§6:65         Policy Is a Modified Endowment Contract

Modified Endowment Contract (MEC) rules were enacted to reduce the incentive of investors who purchased short-term investments through life insurance contracts to defer tax on the underlying investments, while others who purchased directly were taxed. Frequently, the design of life insurance planning is to maximize the growth of policy cash values without jeopardizing the policy owner's ability to have tax-free access to those values during the insured's lifetime. If the policy owner funds the policy too quickly, thereby causing it to be classified as a MEC, he will pay tax on policy values that he accesses during his lifetime at ordinary income rates to the extent of any gain in the policy assets before the loan or withdrawal.

A contract is a MEC if it fails to meet the 7-pay test under IRC §7702A(b). A contract fails to meet the 7-pay test if the accumulated amount the policy owner pays under the contract 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.

Generally speaking, non-MECs are characterized by a premium paid over four or five years and MECs are characterized by a one-time premium payment. If the purpose of the policy is to pass wealth from one generation to the next without requiring access to cash values, a MEC structure is preferable due to the superior tax-free compounding effect achieved by a one-time, up-front premium payment. Because of unfavorable tax treatment of loans from MECs, MECs should not be used if policy loans are important. [IRC §72(e)(2) & (10).]

§6:66         U.S. Reporting Requirements

Forms 3520 and 3520-A

Whoever settles an offshore ILIT to purchase the PPLI must report settling the offshore ILIT on Form 3520, Annual Return to Report Transactions With International Trusts and Receipt of Certain International Gifts, and Form 3520-A, Annual Information Return of International Trust With a U.S. Owner. However, if the Low Profiler [see Chapter 5, International Asset Protection Trusts] is used, these forms need not be filed.

Excise Tax

The U.S. imposes an excise tax of one percent (1%) on each dollar of premium paid to an international life insurance company [I.R.C. §4371(2).] on an OPPLI or ODVA issued with respect to a citizen or resident of the U.S. [IRC §4372.] Pay the excise tax in a timely manner, and file IRS Form 720 (Quarterly Federal Excise Tax Return) reporting such payment.

Gift Tax Return

Upon transferring cash to an ILIT in order to acquire a PPLI or to pay premiums, a gift tax re­turn is filed. The applicable yearly exemption amount against any taxable gift and the election to apply the exclusion against the gift and the generation-skipping transfer tax are re­ported on the gift tax return

At Death — Form 712

When the policy pays out proceeds as a death benefit, the executor of the estate will file Form 712, Life Insurance Statement.

TDF 90-22.1

Under the Bank Secrecy Act, U.S. citizens need to report their interest in foreign trusts, foreign bank accounts, and foreign financial accounts. Although is has been questionable whether the TDF needs to be filed in the case of an OPPL or ODVA, the IRS has concluded the TDF must be filed.

Recently (February 23, 2010), see Department Of The Treasury, 31 CFR Part 103 RIN 1506–AB08 Financial Crimes Enforcement Network; Proposed Amendment to the Bank Secrecy Act Regulations—Reports of Foreign Financial Accounts, Treasury stated: “The definition of other financial account also includes an account that is an insurance policy with a cash value or an annuity policy. Life insurance policies that have a cash surrender value are potential money laundering vehicles because cash value can be redeemed by a money launderer. Similarly, annuity contracts pose a money laundering risk because they allow a money launderer to exchange illicit funds for an immediate or deferred income stream or to purchase a deferred annuity and obtain clean funds upon redemption”.

§6:67         Pre-Immigration Drop-Off Policy

A wealthy family coming to the United States for a determinable number of years, can buy a U.S.-qualifying product from an international company before they arrive in the U.S. and get the benefits of tax deferral. When they return home and are no longer U.S. taxpayers, they can cash the policy in.

§6:68         Investment Advisor

An insurance company may use an independent investment advisor to manage the assets underlying its PPLIs and DVAs. See §817(h)(5). The insured can suggest to the insurance company that they appoint a particular manager, but cannot appoint or control the manager. IRC §817(h)(5) states that “[n]othing in this subsection shall be construed as prohibiting the use of independent investment advisors”).

[§6:69 Reserved]

D.      The Installment Sale Transaction

§6:70         General Points

An International Business Corporation (IBC) owned by a PPLI can purchase assets from an entity or individual. The terms of the payment may include an installment note or a self canceling installment note (SCIN).

§6:71         Sub-Accounts Can Consist of 100% of the Stock of an IBC

A variable contract must meet either the safe harbor rules of the Code or the diversification requirements of the Regulations. [Treas. Reg. §1.817-5(b)(1).] The diversification rules do not restrict the percentage of any one investment the segregated asset account holds; they only restrict the percentage of segregated account assets that can be invested into a single investment. An account should be acceptable as long as 100% ownership of an IBC does not comprise more than 55% of the value of the total assets of the account.

The Regulations allude to the possibility of 100% ownership by describing a situation where “[all] of the beneficial interests in P [a partnership] are held by one or more segregated assets accounts of one or more insurance companies.” [See Treas. Reg. §1.817-5(e) and Example 1 in Treas. Reg. §1.817-5(g).]

§6:72         The IBC Can Acquire the Insured’s Assets

The segregated asset requirements of the Regulations for IRC §817 provide no restrictions or guidelines on the source of assets acquired.

However, a review of case law provides some guidance. [See Christoffersen v. U.S., 749 F.2d 513 (8th Cir. 1984).] In Christofferson, the IRS claimed that the Christoffersons maintained sufficient control over the investment assets so that income on the assets was taxed to them rather than the insurance company. A policy holder cannot select or identify particular investments to be made by the separate accounts. With an IBC, a board of directors, independent of the insurance company to avoid the issue of a subservient agency, could evaluate and ratify a purchase from a policy holder.

§6:73         The IBC Can Pay With an Installment Note

An installment sale is a sale of property at a gain where at least one payment is to be received after the tax year in which the sale occurs. The installment method cannot be used to report gain from the sale of inventory or stocks and securities traded on an established securities market. Under the installment method, income is included in each year part of the gain is received.

§6:74         Thinly Capitalized IBC

If the IBC is thinly capitalized, will the assets transferred to the IBC for an installment note be included in the insured’s estate? The primary issue with this question is whether the note holder has any retention of income, possession, or enjoyment of the property sold.

A thinly capitalized corporation can enter into an installment sale with a taxpayer under the following circumstances:

•       The corporation receives the assets in return for its installment note.

•       The corporation has a board that is not related to or subservient to the seller.

•       The board approves the acquisition, and the parties enter into a written contract.

•       The note should be based on the fair market value of the assets.

•       The seller should not have shadow control over the corporation.

§6:75         Acquisition of Assets for a Promissory Note

Will the acquisition of the insured’s assets for a promissory note result in failure of the “Cash Corridor Test”?

No. The cash corridor test will fail if the equity in the IBC grows to the point where it, along with the equity in the other four diversified sub-accounts, exceeds the prescribed death benefit ratio. Initially the installment note obligation (less the initial down payment) offsets the value of the assets sold for the note.

           §6:76      Issues of Concern and Creative Structuring

The IRS is not pleased with a technique which:

A major tenet of "investor control" (See §6:63 Control, above) deals with the degree a policyholder can direct or influence the selection of the assets held as part of a policy's separate account. If a policyholder engages in a transaction (the installment sale) in which previously-owned assets immediately after such transaction constitute the values under a contract established by the policyholder, the Service could argue that the in­vestor control doctrine has been violated.

What is less clear is what the outcome will be when there is a less obvious connection between the actions by the policyholder and the assets which constitute the policy val­ues at the insured's death. What if the obligor under the installment sale (the IBC) is not owned by the policy's separate account at the time of the installment sale transaction? What difference, if any, does it make as to exactly how and when the obligor entity (or its assets gets connected to the life insurance policy?

The more the insured can distance himself sub­stantively and time wise from the policy and the policy from the obligor entity, the less likely that the IRS will be able to argue that the insured controlled the assets comprising the separate account. For this reason, try to utilize obligor entities that were neither formed under nor owned by the policy prior to or at the time of the installment sale transaction. Perhaps, the only connection should be an option by the separate ac­count over the IBC (or its assets) perhaps only exercisable at a designated time such as the death of the insured.

International Life Insurance

For Tax Advantaged Offshore Investing