Life insurance to the rescue?
Recent changes in the foreign tax provisions of the U.S. Tax Code provide a new opportunity to revisit the possible incorporation of traditional life insurance or foreign private placement life insurance issued by either a foreign carrier or U.S. carrier. In the past, U.S. practitioners relied heavily on entity structure to achieve a desired result. Given some degree of uncertainty with a new, far more complicated proposed structure, we believe practitioners will want to consider integrating other strategies including, perhaps, life insurance.
Past Practice
Prior to a change in the Tax Cuts and Jobs Act (the 2017 Tax Act), practitioners generally relied on a single foreign blocker corporation (FC) to hold U.S. non-real property assets. Any passive foreign income company (PFIC) assets would be held by a foreign grantor trust (FGT) or through another foreign company that elected to be treated as a disregarded entity for U.S. tax purposes. After the non-citizen, non-resident (NCNR) of the United States died, the trustee of the FGT or executor of the estate would file a check-the-box election effective at least two days and no more than 29 days after the date of death. Lacking a U.S. shareholder for 30 days, the FC didn’t become a controlled foreign corporation (CFC), and therefore, Subpart F income inclusion for U.S. beneficiaries (heirs of the NCNR who were U.S. persons) didn’t occur (this process was known as the “30-day rule”). The FC also blocked imposition of U.S. estate tax on the U.S. portfolio assets owned by the FC. Moreover, the basis in the underlying portfolio assets would be stepped up to their fair market value (FMV) on the date of the check-the-box election (a deemed liquidation of the FC).
Traditionally, U.S. advisors counseled multi-jurisdictional NCNR families with next generation heirs as U.S. citizens or long-term residents (U.S. persons) to organize an FGT. Typically, the NCNR parent would establish a revocable trust (that would be an FGT for U.S. income tax purposes) in a common law country with low and sometimes no taxes, located outside the NCNR’s country of domicile and residence. The primary asset of the FGT would be a non-U.S. corporation, an FC, that’s an eligible entity for U.S. tax purposes. (An eligible entity is a business entity that isn’t classified as a corporation and is eligible to elect its U.S. tax classification on Form 8832.) The FC would hold title to the U.S. portfolio investments.
Under prior law, this arrangement maintained certain U.S. income tax benefits during the NCNR’s lifetime and avoided U.S. estate tax on the NCNR’s portfolio investments at the death of the NCNR. Following the death of the NCNR, the FC would make a check-the-box election to be treated as a disregarded entity separate from its owner (that is, the FGT prior to the death of the NCNR). An FC making a check-the-box election is deemed to liquidate for U.S. tax purposes at the end of the day immediately before the effective date selected on Form 8832. Most U.S. advisors would cause the deemed liquidation of the FC to occur less than 29 days after the death of the NCNR. This prevented the punitive U.S. CFC anti-deferral income tax rules (that is, Subpart F income) from applying to U.S. persons inheriting portfolio investments directly or indirectly through a former FGT that becomes a foreign non-grantor trust (FNGT) after the death of the NCNR.
In sum, there was no Subpart F income inclusion for U.S. shareholders if an FC wasn’t a CFC for an uninterrupted period of at least 30 days during its tax year. But, this changed with the 2017 Tax Act. For tax years of foreign corporations beginning after Dec. 31, 2017, the 2017 Tax Act eliminated the 30-day threshold. As one commentator has succinctly noted:
Prior to the [2017 Tax Act], upon the death of the grantor in [this] scenario, there would have been a tax-free adjustment not only in the shares of the FC, but also in the underlying investment portfolio held in the name of the FC upon the deemed liquidation, and, as a result, little or no income or gain would be generated, and the [foreign, now non-grantor] trust structure would have a new basis in all of its investment portfolio assets. See IRC Section 1014 and 1012(a).1
Multi-Tiered Structure
Practitioners have recently begun debating how best to deal with the 2017 Tax Act’s elimination of this somewhat obscure 30-day rule that provided post-mortem relief to the estates of NCNRs with family members who are U.S. persons.
At the recent Society of Trust and Estates Practitioners/New York State Bar Association International Estate Planning Conference, leading practitioners recommended using a two-tiered holding company structure involving at least three FCs to address the change in the CFC rules. The elimination of the 30-day rule means that it’s no longer possible to make a check-the-box election on a single FC owning appreciated non-U.S. real estate assets, without generating Subpart F income (assuming sufficient ownership by U.S. persons after the death of the NCNR). If a check-the-box election is made prior to the NCNR’s death, the NCNR will die holding U.S. situs assets through a disregarded foreign entity, risking U.S. estate tax inclusion of U.S. situs assets (such as U.S. securities).
This entity planning needs to be implemented prior to the NCNR’s death and employs a multi-tier FC structure. First, the NCNR or more probably the NCNR’s FGT (for example, established in the Cayman Islands) sets up two FCs. Second, these two FCs, in turn, together own the stock of a third lower tier FC. To avoid the non-recognition tax treatment under Internal Revenue Code Sections 332 and 337, each of the upper tier FCs would own less than
80 percent of the stock of the lower tier FC. The lower and upper tier companies would be liquidated following the NCNR’s death in a carefully scripted sequence.
First, the two upper tier FC holding companies would check the box on the lower tier FC effective one day prior to the death of the NCNR. By creating a deemed taxable liquidation of the lower tier FC with the filing of the check-the-box election to be treated as a disregarded entity, the upper tier FC’s basis in the underlying assets (that is, U.S. securities) of the former lower tier FC will equal the FMV on the date of the deemed taxable liquidation of the lower tier FC. The two upper tier FCs would continue in corporate form beyond the NCNR’s date of death. This prevents inclusion of the underlying assets in the NCNR’s U.S. gross estate.
Second, two days after the NCNR’s death, both upper tier holding company FCs will make simultaneous check-the-box elections. The inside basis of the underlying assets (that is, U.S. securities) previously held by the lower tier FC prior to its deemed taxable liquidation would be stepped up or down to the FMV of such assets on the day after the death of the NCNR, which will be the date immediately before the deemed liquidations of the two upper tier FCs under check-the-box elections.
Consequences for Beneficiaries
After the death of the NCNR, U.S. heirs will continue to be potentially adversely impacted by the U.S. foreign anti-deferral rules that impose harsh adverse tax consequences on direct and indirect U.S. shareholders of FCs that shelter passive investment income offshore. An FC that prevents U.S. estate tax for NCNRs on their U.S. securities can become problematic to U.S. heirs.
Going forward, if the FC is a CFC for even one day during the tax year, there could potentially be phantom income inclusion for the U.S. beneficiaries. Moreover, the 2017 Tax Act greatly expanded the type of phantom income that could flow up to U.S. shareholders of a CFC. In addition to the passive investment income inclusion under Subpart F, with the adoption of IRC Section 951A and the global intangible low taxed income (GILTI) regime, certain active trade or business phantom income could now be generated by the FC.
U.S. persons (citizens or residents) who inherit the foreign trust/FC structure can become owners of a CFC for U.S. income tax purposes. If, in aggregate, they exceed 50 percent ownership, 10 percent or more U.S. shareholders of the FC will be subject to tax on the investment income of the FC, including capital gains that will be taxed at ordinary income rates, in the year such income or gain is earned by the FC, regardless of when it’s distributed to shareholders. The U.S. shareholders may incur some degree of double taxation because there will be withholding taxes imposed on the FCs for U.S. source income and dividends, as well as taxation in any other country. Outside normative U.S. income taxation, Subpart F inclusion and U.S. tax on phantom income in the year earned by the FC may not generate offsetting foreign income taxation in the same year (as most foreign countries don’t have an identical CFC tax system), limiting potential foreign tax credits that would arise in a later year.
The FC may also be a PFIC as to any U.S. person who’s a beneficiary of the foreign trust. PFIC classification is based on the nature of the investments held in the FC. An FC is a PFIC if 75 percent or more of its gross income for the tax year is passive income or the average percentage of assets held by the FC that produces passive income is at least 50 percent.2 Unlike the CFC rules, PFICs don’t have minimum percentage U.S. shareholder requirements.
Key Considerations Going Forward
Leading commentators Dina Kapur Sanna and Carl Merino of Day Pitney LLP advise that, provided the NCNR doesn’t own U.S. real property interests or interests in partnerships engaged in a U.S. trade or business, the key considerations going forward are whether the trust will invest in U.S. situs assets and foreign investment funds that are likely to be treated as PFICs.3 They and other leading legal commentators now recommend that NCNRs implement the previously described, multi-tier holding company structure involving at least three FCs to achieve basis step-up without the drag of potential Subpart F and GILTI phantom income.
If the NCNR owns U.S. real property, generally a separate elaborate property by property structure is advised. As U.S. real property is a U.S. situs asset for which there’s generally no income or estate tax relief under a tax treaty, NCNR investors often will hold U.S. real property through an FC or an FNGT which, in turn, owns each U.S. property in a separate U.S. corporation or single member U.S. limited liability company (LLC). Under the 2017 Tax Act, gains on disposition of U.S. real property would be subject to U.S. corporate income tax of 21 percent for federal income tax purposes (down from 34 percent) plus state income tax. While U.S. corporate ownership might be desirable after the 2017 Tax Act, there could also be a second level branch profits tax of 30 percent on earnings that are deemed to have been repatriated by the U.S. corporation up to the FC. During the life of the NCNR, for each separate property, the FC might own a separate U.S. corporation or single member Delaware LLC (for which a check-the-box election has been made to treat such LLC as a U.S. corporation for income tax purposes). On the death of the NCNR, if the FC will become a CFC, the trustees of the FNGT might consider domesticating the FC so that the U.S. beneficiaries avoid the branch profit tax. If all the owners of the FC are U.S. persons after the death of the NCNR, it might be possible to domesticate the FC (that’s converted to a U.S. corporation for tax purposes) and then elect S corporation treatment to prevent a second level of tax on a future sale of the U.S. real property.
In a blog posted immediately after the elimination of the 30-day rule, another leading legal expert, Charles “Chuck” Rubin offered up some potential strategies for 2018 and thereafter to deal with this change in the tax law.4 In this blog, after pointing out that under the 2017 Tax Act, the repeal of the 30-day window can result in immediate CFC status as of the death of the NCNR whose stock in the FC is inherited by heirs who are U.S. persons, Rubin surmises that there may be investment- oriented mitigation strategies.
Rubin suggests active churning of the underlying stock portfolio during the life of the NRA matriarch. The broker on the account would have to be given clear instructions during the lifetime of the NCNR to periodically sell and repurchase the appreciated portfolio securities (not subject to the U.S. tax rules on wash sales) inside the FC without being subject to U.S. income tax. Such sales and repurchases will increase the income tax basis of the securities on a regular basis. He identifies certain potential problems with this strategy, including the difficulty of churning a non-traded U.S. security (privately owned company or investment) and possible step transaction issues. The broker will be earning added commissions that we believe would have to be disclosed and consented to by all the heirs of the NCNR.
Alternatively, Rubin suggests domesticating the FC after the death of the NCNR and then making a Subchapter S election to avoid double tax on appreciation. While potentially effective, we find most clients today don’t want to be told that they must hold all securities owned by a U.S. tax entity for five years before they can sell any one security. Market volatility suggests most investors would hesitate to organize a tax strategy that limits trading in their publicly traded U.S. portfolio for 60 months.
U.S. Tax-Compliant Insurance Policy
If an NCNR is insurable and wishes to minimize U.S. tax complications and U.S. tax reporting for heirs who are U.S. persons, advisors should consider use of some type of U.S. tax-compliant life insurance product. Generally, a policy requirement will be to satisfy one of the two actuarial tests described in IRC Section 7702(a). If a policy fails both actuarial tests, in most cases, it won’t be a life insurance policy for U.S. income tax purposes, causing two adverse U.S. income tax consequences. First, the policy owner must recognize annually the growth in the cash value as ordinary income. Second, the death benefit won’t be excluded from gross income under IRC Section 101.
By purchasing a U.S. tax-compliant life insurance policy, the NCNR will defer and possibly eliminate tax recognition of annual accretion in the cash value growth in the policy. If the policy isn’t surrendered during life, at death the cash value account effectively disappears by converting into a death benefit. Mechanically, this obviates income taxation on the growth of the cash surrender value during the insured NCNR’s lifetime.
Holding the policy until death is equivalent to receiving a U.S. basis step-up at death (basis in policy during life is generally the premiums paid, but leveraged cash death benefit is generally payable following the death of the NCNR). Even if the policy isn’t included in the gross estate of the NCNR and provided the U.S. transfer-for-value rules are observed, if the policy is owned by an FGT that becomes an FNGT after the death of the NCNR, there’s effectively basis step-up in the policy at the death of the NCNR.
When the NCNR knows that he’ll be survived by heirs who are U.S. persons, the FGT that’s fully revocable during the NCNR’s life might be structured so that benefits for such U.S. heirs will pour over at the death of the NCNR to a U.S. dynasty trust organized in a low tax jurisdiction with favorable state trust laws (including repeal of the rule against perpetuities). This will eliminate the possibility that the portion of the death benefit poured over to benefit U.S. heirs and invested through a U.S. domestic entity (trust) will become subject to the onerous U.S. tax rules otherwise applicable to FNGTs after the death of the NCNR (that is, pour over to a U.S. trust will avoid the accumulation throwback rules, deferred interest charge and conversion of capital gains to ordinary income rules, all of which are applicable to an FNGT that accumulates income for distribution in a year later than the year earned). Such punitive tax rules don’t apply to a U.S. trust. Still, domestic trust investments need to be handled in a tax-efficient manner.
A U.S. tax-compliant life insurance policy can obviate punitive CFC and PFIC rules. Due to investor control rules that must be adhered to for U.S. tax-compliant life insurance, it’s more likely that PFIC status can be avoided.
The non-U.S. admitted foreign carrier can obviate CFC status altogether for the policy and the policy owner, either an FGT or FC, by making an IRC Section 953(d) election to be treated as a U.S. domestic insurance company for U.S. tax purposes. Non-U.S. admitted carriers that make a Section 953(d) election will pay a U.S. premium tax like a U.S. admitted domestic carrier.
Aside from avoiding CFC status for the policy and its owner by making the Section 953(d) election, other U.S. tax implications of such election affect non-U.S. admitted foreign carriers. The U.S. admitted foreign carrier will generally absorb the income tax and administrative costs to comply with U.S. informational tax reporting requirements, with the result that a Section 953(d) compliant policy generally has higher premiums than a comparable non-Section 953(d) policy. The subtlety of a Section 953(d) electing non-U.S. admitted carrier voluntarily paying U.S. income tax on its investment and premium income, however, is that the U.S. Tax Code provides a special deduction for insurance companies allowing them to deduct reasonable reserves required to be held to satisfy future death benefit claims. As a practical matter, non-U.S. admitted carriers electing Section 953(d) treatment simply absorb (primarily through premiums) the cost of income tax compliance in the United States, including CFC and PFIC tax reporting required of the carrier.
Turning to a PFIC, often high-net-worth individuals’ investments fail the previously mentioned income or asset tests. Further, the rule is that “once a PFIC, always a PFIC,” so a U.S. person heir can inherit attribution of PFIC status.
The U.S. Tax Code specifies when PFIC ownership can be attributed to a U.S. person, even though the U.S. person doesn’t own the PFIC directly. There’s no rule for attributing PFICs through an insurance policy.5 IRC Section 1298(a) doesn’t import other typical tax attribution rules, such as the related party rules in IRC Section 267 or the constructive ownership rules in IRC Section 318, to the PFIC rules. There’s no look-through of an insurance policy that causes a PFIC to be attributed from an insurance policy through to the policy owner.
For a variety of reasons explored in greater detail in the second part of this article, the NCNR with heirs who are U.S. persons might consider investing in a private placement variable life insurance policy issued by a non-U.S. admitted carrier located outside the United States. This is particularly appealing for global NCNR investors who are attracted to hedge funds, private equity, commercial real estate or any other asset that can be properly valued but is potentially tax inefficient.
We remain concerned that the Internal Revenue Service hasn’t approved the use of the complex multi-tier FC holding company entity structure approach. It’s uncertain whether the IRS might apply a substance-over-form approach or the step transaction doctrine to disregard one or more of the three FCs on the ground that it has no non-tax business purpose. We believe that the current U.S. Tax Code provides clear support for the proposition that the PFIC and CFC rules shouldn’t apply to a U.S. tax-compliant policy issued by a foreign carrier making a Section 953(d) election, which will allow for the inside build-up in a policy held until death and then the death benefit itself to escape U.S. income tax.
In Part II of this article, we’ll explore the details concerning different types of policies available to NCNRs.
Endnotes
1. Todd Rosenberg and Scott Snyder, “Post-Morten Considerations with Foreign Grantor Trusts After H.R. 1, Tax Cuts and Jobs Act,” The Florida Bar Journal (March 2018).
2. Internal Revenue Code Section 1297(b)(1).
3. Dina Kapur Sanna and Carl Merino, “Tax Planning for U.S. Beneficiaries Using Foreign Trusts and Foreign Entities,” 14th Annual STEP/NYSBA International Estate Planning Conference (March 22-23, 2018), at p. 78.
4. Charles Rubin, “Obscure Provision of New Tax Act Complicates Tax Planning for Nonresidents with U.S. Beneficiaries,” Rubin on Tax (Jan. 15, 2018), http://rubinontax.floridatax.com/2018/01/obscure-provision-of-new-tax-act.html.
5. For an excellent concise analysis of this highly technical issue, see the blog post of Haoshen Zhong, “PFIC Wrapper Miniseries #2: Participating Life Insurance,” at Hodgenlaw PC (Dec. 1, 2016), https://hodgen.com/pfic-
wrapper-miniseries-2-participating-life-insurance/.