Only minimal protection exists under federal bankruptcy laws for life insurance and annuity contracts, but laws in some states exempt certain annuities and life insurance policies from creditor claims. It’s also difficult for a creditor to sustain a fraudulent conveyance argument if you purchase a life insurance contract or (especially) an annuity. This is because you take back value (the promise of future payments) in exchange for your investment.
An annuity is a contract where an insurance company or other guarantor agrees to make a series of payments to someone for the rest of their life, their joint lives (e.g., husband and wife) or for a fixed number of years in exchange for a single premium. The contract may also provide for a guarantee of enough payments to be at least equal to the amount paid for the contract.
Annuities can be immediate, in which case you receive payments immediately after paying a premium, or deferred, in which case payments are postponed for a specified number of years. In a “fixed annuity,” payments are guaranteed to be of a certain size for the duration of the contract. In a “variable annuity,” some or all of the funds are invested in securities. The value of the annuity and thus the size of the payments vary depending on the performance of the underlying investments.
Income earned within an annuity is tax deferred until you cash in the contract or receive payments from it. The income component of the payments is subject to ordinary income tax: your marginal federal income tax rate (maximum 35% in 2012) plus applicable state income tax. This is in contrast to the top federal rate of 15% on long-term capital gains. Consequently, an annuity is most beneficial for the portion of your portfolio that generates ordinary income rather than long-term gains. A 10% federal penalty tax applies to most withdrawals from an annuity before you reach age 59-1/2.
Annuities are usually purchased for income during life, rather than to pass assets to heirs. To the extent that an annuity policy guarantees a minimum payment in the event of your death, that payment will be an asset of your estate. For this reason, an annuity isn’t a tax-efficient way to pass assets on to your heirs.
In contrast, life insurance provides a guaranteed death benefit to your loved ones or a named charity. In addition to its asset protection advantages in some states, life insurance enjoys uniquely preferential treatment under the Internal Revenue Code:
* All earnings accumulate free of taxes until withdrawal. There’s no tax on the appreciation in value or accumulation of income of the investment account maintained within a life insurance policy.
* The death benefit can pass to beneficiaries tax-free. In addition, with proper structuring, the investment component of the policy (if any) can flow to beneficiaries free of both estate and generation-skipping taxes. As discussed earlier in this chapter, this is possible using a life insurance policy in conjunction with a life insurance trust.
* Tax-free loans are possible. The proceeds of any loans, plus interest, need not be repaid and are deducted from the proceeds at death. However, if the policy loan is still outstanding when you surrender your policy or it lapses, the amount of the loan (including any interest due) is taxable to the extent there is gain in the policy.
* Tax-free exchanges are possible. Among other planning possibilities, the Internal Revenue Code permits the tax-free exchange of a life insurance policy for an annuity contract. It’s possible to purchase a life insurance contract to protect your loved ones against financial problems if you die prematurely, and later, convert it into an annuity to provide a lifetime income stream.
Almost every state protects the death benefit of an insurance policy from creditors where a spouse or child is the beneficiary. However, the policy’s cash value may not be exempt. Similarly, stocks or other investments purchased through life insurance and annuity policies may not be protected from creditors. Life insurance under a group policy may enjoy greater protection than a policy you own.
In most states, for an annuity to be protected, it must be payable to someone other than the contract owner. And even if a creditor can’t get at the assets in an annuity during the deferral period, it may be able to attach the payments, once they begin. Whatever protection exists may also not extend to alimony or child support, criminal fines, punitive damages, or federal tax claims, among other possible exemptions.
A variable annuity contract you purchase in the United States is generally protected from the claims of the issuer’s creditors. However, the same protection isn’t always present with respect to your own creditors. In many U.S. states, a policy owner can be required by court order to liquidate the annuity policy and secure any cash value for the benefit of judgment creditors.
Most states restrict creditors from seizing annuity contracts. But a determined creditor can simply wait until the policy matures and then attach your annuity payments. What’s more, if you relocate from a state with excellent protection for annuities to one with less stringent provisions, you may lose the legal protection that previously applied.
The Many Advantages of Offshore Variable Annuities
In contrast, if you purchase an offshore variable annuity contract, foreign law will govern the contract. By selecting the appropriate jurisdiction, you can achieve significantly greater asset protection than in any U.S. state. However, you may also need to travel to a foreign country to purchase the annuity contract. Many foreign insurance companies require the insured to sign the documents and to make the premium payments outside the United States to avoid claims of U.S. jurisdiction by the SEC or individual states.
Offshore variable annuity policies may also include provisions similar to those in a spendthrift trust. For instance, the annuity contract may prohibit the beneficiary from assigning a future benefit to a creditor or making an assignment in exchange for some immediate benefit. As in the United States, the strongest protection generally exists if you name a beneficiary or beneficiaries other than yourself.
Offshore variable annuities provide numerous other advantages:
* Tax-deferred access to offshore securities markets. An offshore variable annuity is one of the few ways that U.S. investors can participate in foreign securities markets without suffering adverse tax consequences. This is particularly true with respect to offshore mutual funds. NOTE: Unlike domestic fixed annuities, income compounding in offshore fixed annuities isn’t tax-deferred. Offshore variable annuities are frequently used as an investment vehicle for an offshore asset protection trust (OAPT). An OAPT doesn’t generally offer tax deferral for a U.S. investor, but it can if OAPT assets are invested in an offshore annuity that meets the IRS requirements for a tax-deferred annuity.
* Asset protection for a lower initial cost than offshore trusts. Offshore variable annuities offer affordable asset protection. Especially for annuities not held within some type of offshore structure, there are generally no fees associated with their purchase, and investment minimums are as low as $50,000. In contrast, the cost of creating an OAPT can exceed $15,000, plus several thousand dollars in annual maintenance and compliance fees. However, commissions and ongoing costs are often higher than offshore trusts. There may be a front-end load as high as 6%. This load, if imposed, is generally payable over an extended period (typically, five years, or 1.2% per year). Depending on the size of the annuity contract, and how its assets are managed, ongoing expenses can range up to 3% annually.
* Less controversial than other forms of offshore asset protection. Annuity contracts are less controversial than other offshore asset protection measures, especially offshore trusts. Judges skeptical of offshore asset protection arrangements may view an offshore variable annuity more favorably than an offshore trust
* Significantly increased privacy in comparison to domestic annuities. U.S. annuity contracts aren’t recorded or registered in any government database. However, policyholder and beneficiary information is included in the database of the insurance company. If a judge compels you to disclose the existence of a domestic annuity, a creditor can secure complete details about the policy from the issuing company. Few restrictions exist on how domestic insurance companies use the information in their databases. In contrast, many offshore insurance companies won’t disclose any details about your annuity policy to any U.S. creditor, even in response to a U.S. court order. This is true even if you disclose the existence of an annuity in a deposition or under court order. An exception may apply if the annuity is issued under the laws of a country with a treaty with the United States to permit information exchange in tax or criminal investigations. This exception won’t apply with respect to civil litigation or non-government creditors.
* Avoidance of possible foreign exchange controls. Virtually every U.S. annuity policy is denominated in U.S. dollars. In contrast, foreign insurance companies permit premium payments, withdrawals, borrowings, and payment of death benefits in different currencies. In some contracts, you can switch the policy’s underlying currency. This is easiest and most practical with a portfolio of bonds.
* Protection from U.S. dollar depreciation. The ability to select the underlying currency of an offshore annuity is valuable protection against the sinking U.S. dollar. And it can help protect you against foreign exchange controls. Historically, most countries have exempted annuities from foreign exchange controls, regardless of the currency in which they are denominated, because they are classified as retirement or pension accounts, rather than investments.
* Lower taxes and commissions. Most U.S. states impose a tax on the gross premiums received by insurance companies for policies sold in that state. Typically, this tax amounts to 2% or more of your gross premium. The Internal Revenue Code also forbids insurance companies from deducting actual expenses incurred in writing new contracts. Instead, the insurer must write these costs off over a period of years. These taxes put U.S. insurance companies at a significant disadvantage compared to companies located in countries that don’t impose a corporate income tax, such as the Isle of Man or the Bahamas, or a low corporate income tax, such as Switzerland. Finally, most U.S. insurance companies have a multilevel commission system that awards as much as 15% of your policy premium to agents, supervisors, and agency managers. While commissions exist offshore, they are generally lower and paid only at one level.
* Lower regulatory costs. Variable annuities issued by U.S. insurers are among the most highly regulated financial instruments. They’re overseen not only by the insurance commissioners and securities departments of all 50 states but also by the SEC. All these agencies require extensive disclosure of information about the product and the company. The rules and regulations are different in each state and sometimes conflict with each other. In contrast, most offshore jurisdictions have streamlined regulation, with only one agency responsible for overseeing insurance companies. For this reason, the administrative cost of policies issued in foreign jurisdictions is generally lower than those issued in the United States.
You can exchange an existing domestic annuity to an offshore insurance company via a “1035 exchange,” as I described in Chapter 4. The mechanism of the exchange is relatively simple. All you generally need to do is to provide the offshore insurer with an absolute assignment of ownership together with an official request to your current insurer requesting the surrender of your annuity policy. Your U.S. insurer should subsequently transfer the funds offshore and the offshore insurer will issue a new annuity policy. If the exchange is done properly, tax deferral continues with the new policy.
The Amazing Private Annuity
Until 2006, it was possible to transfer highly appreciated assets to a “private annuity” (also called a “contract annuity”) and legally defer tax on the gains. This is no longer possible. However, private annuities still provide a flexible solution for many types of offshore planning, although they’re typically financed with after-tax funds.
A private annuity is an arrangement in which you (the “annuitant”) transfer property to another person or company (the “obligor”) in exchange for the obligor’s unsecured promise to make periodic payments to you for the remainder of your life. When you die, the annuity payments stop. But the obligor receives the remaining property, free of estate tax.
In a typical private annuity arrangement, the obligors may be your adult children. If your children don’t have sufficient independent income to make these payments, they can sell or borrow against the property you convey to them to generate cash to make the payments. It’s also possible to have the obligor be an offshore company set up for the sole purpose of issuing a private annuity contract. The obligor can’t be in the business of selling annuities, so it can’t be an insurance company. To ensure that your intended beneficiaries receive the equivalent value of the remaining property, the arrangement can include a life insurance component that pays a tax-free death benefit to designated heirs.
More sophisticated private annuity arrangements can serve as a fiscal “kernel” to set up additional entities and possibly purchase assets to be transferred into the structure. Such arrangements exist only for your benefit, or the benefit of anyone else you choose—your spouse, children, etc.
It may be possible for the annuity company to place a portion of the underlying account values in a foreign corporation or other entity that operates an ongoing international business, with all profits tax-deferred. Many other types of investments are possible, including private hedge funds, pre-IPO investments, real estate lending, venture capital, or acquisition of operational businesses. At your death, the assets held within the structure can pass free of both income and estate taxes to your heirs, provided the structure includes a life insurance component.
The annuity company can also capitalize an “intellectual property and critical information” (IPCI) company, where intellectual property rights can be purchased, brought into the company, and licensed back out. International licenses for copyrights, trademarks, patents, public appearances, etc., can all be handled by this structure. This can be a particularly effective structure for a U.S. person who wishes to license intellectual property abroad and legally defer tax on the income it generates until payments from the private annuity begin.
The Unique Benefits of Offshore Private Placement Life Insurance
Life insurance purchased outside the USA enjoys the same preferential treatment as domestic life insurance. While it is generally not possible for a U.S. resident to purchase ordinary life insurance outside the USA, specially configured offshore life insurance policies are available. These policies offer the same competitive advantages in comparison with U.S. policies as offshore variable annuities.
The most innovative offshore insurance products are “private placement variable universal life” (PPVUL) policies. As with private annuity arrangements, it may be possible for the investment manager of the PPVUL policy to place a portion of the underlying account values in a foreign corporation or other entity that operates an ongoing international business, with all profits accumulating free of tax. If you require income during life, the policy can acquire a company that creates an annuity to make regular payments to you, your spouse and children, etc. Like all annuity payments, the income portion of the payment is taxable.
It’s possible to customize a PPVUL policy to provide for enhanced protection against judgments or exchange controls. For instance, the PPVUL policy can be configured to allow premium payments “in kind” (e.g., in the form of securities pledged to the policy)—rather than in payments transferred from a financial institution. It may also be permitted to pay for goods or services purchased by an insured person in the form of policy loans. All these strategies augment asset protection and may effectively circumvent exchange controls, although there is no assurance they would remain legal in a financial crisis. In addition, invoking these strategies may trigger adverse tax consequences.
The individual to be insured in an offshore VUL policy must be in good enough health to qualify for life insurance. In virtually all cases, a medical exam is necessary. However, if you’re in poor health, and are therefore a poor actuarial risk for life insurance purposes, it may be possible to make the insured person or persons your spouse, your children, grandchildren, etc.
Like an ordinary life insurance policy, at the death of the last insured person on the policy, the beneficiaries receive the death benefit and the cash value of the policy (premiums paid, plus growth, less account charges). The policy may also be (and typically is) configured so that these payments pass to an irrevocable life insurance trust, free of income and estate taxes. It’s possible to avoid generation-skipping taxes as well if you allocate your generation-skipping transfer tax exemption to the initial funding of the ILIT.
Initial fees for such a structure are typically 1%-2% of premium dollars contributed. Insurance-related costs (mortality, expense, and cost of insurance charges) should average, over the life of the contract, less than 1% annually. Asset management fees are typically 0.5%-2% depending on the asset manager(s) selected.
A PPVUL policy is worth considering if you’re seeking a flexible, tax-advantaged, and comprehensive estate plan providing tax efficiency and access to a wide selection of international asset management options.
To be cost-effective in both the acquisition of an insurance contract and to reduce ongoing fees, the minimum practical premium for a PPVUL policy is around $5 million. However, smaller policies are available, albeit with higher set-up fees relative to your investment.
Whatever the premium payment you decide upon, you need not invest this sum all at once. Indeed, if you want to withdraw or borrow invested funds on a tax-advantaged basis, you should pay the premiums in equal installments, typically in annual payments over four to seven years.
Typically, the owner of your PPVUL policy will be an offshore trust set up as an irrevocable life insurance trust (ILIT). While there are many possible variations, a simple PPVUL structure involves a married couple setting up an offshore ILIT for the benefit of their children. A gift tax return is usually required.
After the ILIT is funded, the trustee purchases a PPVUL policy from an offshore insurance company. A small portion of this contribution is used to fund the cost of insurance, with the balance placed in a segregated investment account. That account is then invested into sub-accounts with investment managers recommended by the policyholder, but ultimately approved by the insurance company. Each sub-account must comply with IRS asset diversification tests.
Offshore variable annuity, offshore private annuity, and PPVUL arrangements must in all cases be custom-tailored. The Nestmann Group, Ltd. has considerable experience in this area. Please contact us for more information.
Copyright (c) 2011 by Mark Nestmann
