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US Taxation of Foreign Life Insurance Annuity

The purchase of life insurance has long been touted as a vehicle for financial protection. For years, insurance salesmen have pointed out to prospective purchasers three fundamental benefits: 1) death, 2) disability, 3) income. The death benefit means that the face value of the policy is paid to a designated beneficiary in the event of the death of the inured. The disability benefit states that the policy premiums will be paid should the insured become disabled. And the income benefit occurs if the insured decides to take out cash values from the policy or convert these to an annuity. Regardless of who benefits from the policy, there are no income tax consequences.

In today's sophisticated markets, some financial advisors are promoting the insurance annuity as a foreign investment vehicle for avoiding U.S. taxation. Appreciated property can be transferred to an offshore insurer tax free. One way this works is that a foreign insurance company arranges to invest part of the insurance policy proceeds into a foreign investment corporation that will then purchase appreciated assets from the policy holder in exchange for a private annuity. Once the assets are transferred, the annuitant can invest the property proceeds in an assortment of investment funds held by the insurer without tax consequences on any resulting income. So all that apparently remains is to understand how an annuity works.

An annuity is a series of payments under a contract. Fixed period annuities pay a definite amount regularly for some period of time. Annuities for a single life are like fixed period annuities except that the payments extend for the life of the annuitant. Joint and survivor annuities pay the annuitant until death and then continue paying his or her designated survivor (usually spouse). Variable annuities pay an irregular income stream depending on the success of underlying investments. Annuities are funded by property and/or cash.

There are, however, several disadvantages to an annuity. Upon your death (or death of survivor), the insurer keeps the property you transferred when you funded the annuity. This means that you cannot pass the property on to your heirs. Secondly whether you die sooner or later, the insurer has no further obligations to make annuity payments. This is like setting up a certificate of deposit with a financial institution that agrees to pay you interest and then upon your death retains both the property and the interest. Thirdly the annuity is not adjusted for inflation, and so its value diminishes over time.

But are there really no tax consequences? Any U.S. person transferring assets to a foreign trust is still subject to taxation according to grantor trust rules. IRS takes the position that a foreign trust funded by or for a U.S. taxpayer, no matter how structured, is still a grantor trust. Therefore the income is taxable. In order to have the tax benefits of a non-grantor trust, there can be no beneficiaries during the lifetime of the annuitant. A private annuity that cannot make distributions to anyone until after the death of the annuitant is not an annuity.

If a foreign corporation is the annuity payer and the annuitants are the owners of the corporation, they will be subject to reporting investment income on their personal tax returns according to Subpart F rules of a foreign controlled corporation. In the event that the foreign corporation is not owned by the annuitants, then upon their deaths the advisor or firm that set up the annuity in the first place could end up keeping the property.

There is also some risk in that the payer might not make the annuity payments through the lifetime of the annuitant. Because, in order to both avoid paying capital gains taxes on appreciated property at the time of transfer and regular taxes on future income, the annuity must be private. Private annuities are by law unsecured.

When asked about the tax treatment of insurance annuities, IRS agent Rick Smith of the Paris office commented: 'The person is buying an annuity contract and the insurance company is investing the money of the purchaser in stocks, etc. The insurance company is the owner of the investments. In this situation, the value of the stocks and the sale of the stocks do not affect the income of the individual. The individual has (taxable) income when he receives distributions on the annuity contract. His basis is his cost of purchasing the contract. . . . If the account is more like an investment account where the individual is the true beneficial owner, the (tax) treatment would be different. . . . The appreciation of the value of the investment is not normally taxable income to the individual. It's only taxable when the investments are disposed of.'  So the private annuity is a means by which transferred property can increase in value without tax consequences to the investor. Otherwise when he or she receives distributions of income on the annuity will there be U.S. tax reporting requirements.

From 2002 IRS is challenging private annuity transactions involving foreign entities created by non-grantor foreign trusts that are funded by the taxpayer. Not surprisingly, foreign companies marketing U.S. tax compliant investment products are keen to avoid problems with the Securities and Exchange Commission. Otherwise they prefer that underwriting and applications for their products occur confidentially offshore. Therefore any one considering a private annuity transaction should carefully consider the risks and consults a disinterested tax advisor before taking the plunge. - Sources: www.irs.gov and U.S. Tax Guide of Offshore Life Insurance