Published by: Private Wealth Advisor; Campden Publishing / Campden Media
Author: Patricia Donlevy-Rosen, Esq.
Date of Publication: April, 2000
Financially savvy US clients with sizeable portfolios look to shield their investments from unexpected market fluctuations by portfolio diversification, and from creditor attacks by using asset protection plans that include offshore trusts. They may also seek to minimise the tax impact of their investments through the use of annuity products. Having a client’s offshore trusts purchase appropriate offshore deferred variable annuities can achieve the desired diversification and performance, while minimizing the current tax burden and diminishing threat of future litigation.
Annuities are contracts where one party agrees to make a payment or a series of payments at an agreed time to another party. Contracts qualifying for US income tax purposes as annuities will provide a tax-deferred (not tax-free) structure where investments may grow. ‘Tax-deferred’ means US income taxes will not be imposed on earnings and gains generated within the annuity contract for a given period, provided specific statutory and regulatory requirements are satisfied.
The parties involved are the issuer, the owner, the annuitant and the beneficiary. The issuer undertakes making payments and, under some contracts, invests the premiums and credits the earnings. The owner, usually an individual, is the one who pays the contract premium, chooses the annuitant (who may be himself, and is entitled to surrender the contract at any time, in whole or in part, for the contract’s cash value and receive payments while the annuitant is alive.
Generally, the owner is also the relevant taxpayer even if some portion of the annuity payment is assigned to someone else. If, however, a deferred annuity is annuitised and its payments are to be made other than to the officially named owner, that other person may be considered the de facto owner of the contract once annuitisation occurs. If so, they may be the taxpayer with respect to the payments.
The annuitant is the individual whose life measures the contract’s payment period. The beneficiary is the party entitled to receive payments due under the contract, if any, following the death of the annuitant or owner. Annuities are classified by:
- the method of payment (lump sum or periodic);
- the time the annuity payment begins (immediate or deferred);
- the unit measure by which amounts are accumulated or payments made (fixed or variable);
- the period over which payments will be made;
- the number of lives over which payments will be made.
Deferred annuities are popular because they permit the value of the contract to increase tax-free during the time before payments begin. At any time, but preferably after the expiration of penalties for premature surrender, both under the contract and the Internal Revenue Code (IRC) the owner may elect to:
- surrender the contract for a lump sum;
- take staged withdrawals;
- elect a one-life or two-life annuity either with or without a guaranteed minimum;
- leave amounts on deposit with the issuer to pay interest.
Staged withdrawal is usually chosen. It avoids immediate tax on a lump sum distribution, and the mortality risk and lack of flexibility associated with annuitisation. Penalties apply for premature withdrawals, and the death of the owner triggers a distribution. An election for annuitisation should be made within 60 days of the contract date providing for a lump sum distribution to avoid the constructive receipt of income.
A variable annuity provides a choice of investment alternatives. It is defined by IRC Section 817(g) as a contract that yields the payment of a variable annuity computed on the basis of recognised mortality tables and by either:
- the investment experience of a segregated asset account;
- or the company-wide investment experience of a company that issues only variable annuity contracts.
The contract will not qualify unless the diversification requirements of IRC Section 817(h) are met in the segregated asset account.
The deferred variable contracts considered here are non-qualified annuities for US Federal tax purposes. A non-qualified annuity is one issued apart from a tax-qualified pension, profit sharing, or retirement plan or arrangement. Premiums are paid in after-tax dollars; they are neither excludable nor deductible from gross income for federal tax purposes, and are not subject to limits (of premiums paid) under federal tax law. The IRC, the income tax, and estate and gift tax regulations that explain the IRC’s rules, judicial decisions, and Internal Revenue Service (IRS) rulings (public and private) prescribe their federal tax treatment. While no income taxes are due on the annuity as it has earnings, income taxes will be due once it is distributed.
Under the IRC Section 72, a part of each annuity distribution will be a return of the monies paid for the contract. This ‘investment in the contract’ is the aggregate amount of premium or premiums paid not deductible for income tax purposes by the taxpayer upon purchasing the non-qualified annuity. Therefore, this return will be received tax-free. The other part of each payment will be deemed the previously tax-deferred earnings on the contract and subject to current taxation as ordinary income. The IRC provides an ‘exclusion ratio’ to ascertain these taxable and non-taxable parts.
With respect to fixed annuities, the investment in the contract is certain at the annuity starting date, so the exclusion ratio is a fraction, the numerator is the investment, and the denominator is the expected return. For purposes of computing the exclusion ratio, it is fixed and determined at the annuity starting date.
The investment consists of the aggregate amount of premiums minus the aggregate amount received under the contract before the annuity starting date, to the extent that such amount was excludable from gross income under IRC Section 72(c)(1).
The expected return rate used in computing the exclusion ratio depends on the type of annuity contract involved. Where the life expectancy of one or more individuals will be used to determine the expected return, IRS actuarial tables determine the return.
In other fixed annuity contracts, such as a 20-year term, they are the total amounts receivable under the contract as an annuity. The resulting fraction is then used to determine the part of each distribution that is an ‘amount received as an annuity’, and thus not subject to US income tax.
Once the investment in the contract has been distributed, any further payments will be fully taxable if the starting date of the annuity was after 31 December 1986. If the starting date was before 1 January 1987, the exclusion ratio is applied perpetually to distributions.
With variable annuities where payment amounts are expected to fluctuate, the expected return rate cannot be determined at the starting date. The excludable portion of each periodic payment must be determined using a special rule under Regs. 1.72-2(b)(3) and 1.72-4(d)(3), which provides that:
- the expected return equals the investment in the contract, such that the exclusion ratio is 100%;
- the amount received as an annuity with respect to each payment;
- the balance of the payment is the amount not received as annuity after the starting date and it is fully included in gross income.
If, however, the amount received in a year is less than the investment in the contract allocable to that year, the taxpayer may elect to re-determine the amount received as an annuity as prescribed in the regulations. For example, ‘A’ buys a variable annuity for a US$50,000 premium, choosing a variable payment option with annual annuity payments for life. On the annuity starting date, ‘A’ has a 25-year life expectancy. The excludable amount of each payment would be calculated by dividing the investment in the contract by the annuitant’s life expectancy (US$50,000/25=US$2,000). The non-annuity portion (taxable) would be the total payment (which would vary depending on investment performance) minus US$2,000.
An owner/investor should be aware of the consequences of using annuities to avoid unanticipated tax liabilities. The income tax treatment of non-annuity distributions depends on whether they are received before or after the annuity starting date. When non-annuity distributions (eg, lump sum withdrawals) are made before, they are usually treated as first, consisting of previously deferred income on the contract taxable as ordinary income, and second, as a nontaxable return of the investment in the contract. (For purposes of IRC Section 72(e), the term ‘investment in the contract’ has a slightly different definition than it has for purposes of determining the exclusion ratio. It is defined as the aggregate amount of premiums or other consideration paid for the contract before the specified date, minus the aggregate amount received under the contract before such date, to the extent that such amount was excludable from gross income under IRC.)
Whenever annuity distributions are received after the starting date, the amounts are fully included in gross income to the extent of the contract deferred income unless the distribution is for a full refund, redemption, surrender or maturity. Owner/investors must be alert to the consequences of taking a loan using an annuity contract – the amount received is an ‘amount not received as an annuity’ and is included in the owner’s gross income. This is the situation whether the loan is received directly from the insurer or indirectly from a third party. Any part of the contract pledged, or subject to an agreement to be pledged, is treated as “an amount not received as an annuity”.
Also, if an owner transfers an annuity contract as a gift, at the time of transfer he is deemed to have received an amount equal to the deferred income on the contract as a non-annuity distribution. The inclusion in gross income will increase the investment in the contract.
Another trap for the owner who might wish to make a full surrender, a partial withdrawal, receive a loan, pledge or give the annuity as a gift – in some way make an early withdrawal – is the penalty tax. Before either purchasing an annuity or taking a distribution, the owner must remember that, subject to certain exceptions, a 10% penalty tax is imposed on the taxable portion of distributions received from an annuity contract (eg, before the recipient is aged 59.5). The 1998 adoption by the IRS of final regulations classifying certain ones as debt instruments, subject to the original issue discount (OID) rules, created another problem for annuities as potential investment vehicles. If an annuity contract is treated as a debt instrument, the owner will be required to annually include in gross income the computed OID amounts for the applicable period.
Annuity contracts will, however, be excepted from treatment as debt instruments if IRC Section 72 applies to the contract and periodic payments under the contract are life contingent. Although one might assume this Section would also apply to such a contract, the issue is not discussed in the regulations. To avoid a future problem, before buying an annuity one should secure a written opinion from a qualified US tax attorney that the offshore annuity will be treated as an annuity for US income tax purposes.
OTHER INCOME TAX ISSUES
The tax-deferred benefits of an annuity are only available where, subject to certain exceptions under IRC Section 72(u)(1), the annuity contract is held by a natural person. The pertinent exception is the ‘trust/agent’. From legislative history and private letter rulings this appears to apply in the case of a natural person who is treated as the trust owner under the grantor trust rules.
Letter rulings 9810015, 9639057, 9322011, and 9316018 said that grantor trusts held contracts as agents for the grantors (who were natural persons). In the first two of these rulings, the IRS applied principles under the Second Restatement of the Law of Agency to find that a trust subject to control of the grantor(s) was the grantor’s agent. Even without this degree of control, under Rev. Rul. 83-13, the grantor should be treated as the tax owner of the annuity held in his grantor trust.
Therefore, the exception will be available to a foreign trust created by a US person with US beneficiaries. Such a trust is a grantor trust under IRC Section 679 (other grantor trust rules under IRC Sections 671 to 677 may also be applicable). The exception will probably not be available when a corporation creates a trust to acquire an annuity contract.
ESTATE AND GIFT TAXATION
The transfer without consideration of a deferred annuity by an individual owner is subject to federal gift tax where the gift is complete. A gift is complete if the donor relinquishes all rights in the contract; it may be limited to an annuity payment or payments.
The gift tax may be applied when a donor gives a donee the entire contract, a series of payments, or a single payment. If the gift is complete and the rules do apply, a taxpayer/donor may give up to $10,000 as gifts (indexed for inflation after 1998) in a calendar year to each of an unlimited number of donees without incurring a gift tax for the donor or income tax for the donee, just as with other types of property.
On any amount in excess of the $10,000 (or applicable amount in years after 1998), the donor must either pay gift tax or decrease the available unified credit under the estate tax. This would apply to a transfer to an irrevocable trust where the gift is complete.
The grantor trust itself could use its own funds to purchase an annuity contract without any special estate or gift tax consequences, as long as the arrangement qualifies for the trust/agent exception for income tax purposes.
Whether the annuity is held by an individual or by the donor’s grantor trust, the present value of the annuity at the grantor/owner/donor date of death will be included in his estate. This rule applies to the part of the payment to go to any beneficiary by surviving the decedent proportionate to the purchase part contributed by him. So, if the decedent made no contribution to the annuity contract premiums, nothing will be included in his estate. Likewise, if annuity payments stop at the owner’s death, nothing is included in the gross estate.
OFFSHORE ANNUITY ADVANTAGES
Offshore annuities provide a wider variety of investment options. In general, US variable annuity contracts limit the investment of the monies to mutual funds, often limited to those offered by the insurance company that issued the contract. These investment choices may include general equity funds, balanced funds, bond funds and specialty funds, such as international funds.
Their portfolios may have many different managers, either affiliates of the life insurance company or independent investment advisers. US Federal tax law imposes strict limitations on the investments and the ability of the contract owner to select them. The investments must be adequately diversified and the owner may not possess investor control.
A carefully selected offshore annuity provides more investment options. Instead of limiting the investments to the issuer’s mutual funds, the client’s chosen investment advisor (but not the client) can direct the annuity investments in any type of security (subject to reasonable diversification requirements). The investment advisor can he the client’s US investment advisor or any other unrelated person. The investment must be diversified and held in a segregated account. If not, the owner will lose the tax deferral altogether and be taxed currently on all income earned under the contract.
With offshore annuities, the internal investment is not derived from a menu supplied by the issuer, the estimated investment returns are not quoted – they are variable. The variable return will be determined solely by the performance of the investments in the owner’s underlying segregated account. Such a segregated account has the added benefit of not including the client’s assets in the balance sheet assets of the issuer and, thus, not subjecting the client’s assets to the debts of the offshore issuer.
An offshore issuer with no US agents, subsidiaries, affiliates, or other US-based connections will not be subject to the jurisdiction of a US Court. This is a valuable wealth preservation tool, because a garnishment or attachment order issued by a court in the US will be meaningless to the offshore annuity issuer.
A US claimant (against the owner of the annuity) would have to seek an order from an appropriate court in the country where the issuing entity is resident to effect a garnishment (if such a remedy is even available in that jurisdiction). This benefit would not be available if the owner is subject to the jurisdiction of the US court. In that case, the owner could be ordered to exercise his rights under the contract for the benefit of the owner’s claimants, including surrendering the contract and paying over the proceeds to them. Thus, greater protection can be obtained by having the annuity contract owned by an offshore trust not subject to the jurisdiction of any US court.
Some US states, as well as some foreign jurisdictions, have adopted specific legislation providing protection for annuity contracts from creditors of the owner and the beneficiaries.
In Switzerland creditors are precluded from reaching assets in an annuity, but the contract must be irrevocable and may only have one or more individuals (but no entities) as beneficiaries. Although the creditor protection offered is virtually absolute (even though owned by a US person), the required beneficiary designations make it difficult to integrate this type of annuity in a US individual owner’s estate plan. If an offshore trust is the beneficiary, there is substantial flexibility.
The offshore annuity is a wealth preservation tool because its existence is not as apparent as most other investments. Foreign financial and bank accounts must be reported by US citizens and residents (and their trusts). Annuity contracts, however, do not fall within this classification so they are not subject to the foreign account reporting requirements and are less easily discovered. They will not appear on the owner’s income tax return.
By having an offshore trust own the offshore annuity contract, the client secures the utmost protection and flexibility. As detailed before, if a US person directly owns an offshore annuity, it may not be protected from his creditors unless the laws of his state of residence specifically exempt them – as does Florida. Even in states with specific exemptions there will be no protection where it is found the acquisition was done with the intent to hinder, delay or defeat the claim of a creditor, under applicable fraudulent transfer laws.
Protection is weak, since a US court having jurisdiction over the US owner could order him to surrender the contract and repatriate the funds. If, however, a properly structured offshore trust owned the offshore annuity, no US court would have jurisdiction over either the owner (offshore trust) or over the offshore issuer. Protection is strong, if not absolute.
Protection is subject, of course, to the fraudulent transfer rules of the trust’s situs jurisdiction. If the proper jurisdiction has been chosen the rules should be much more pro-debtor/investor/grantor than the those of any US state.
Besides providing more investment options and substantially stronger protection, greater flexibility for distribution of the proceeds can be obtained by holding an annuity in an offshore trust through dispositive provisions. For example, the trust can authorise the trustee to withhold direct distributions to a substance-addicted or otherwise impaired beneficiary.
The trust can also set the way the trustee may use trust assets or income without making a direct distribution. An annuity contract provides only for direct payments. Under a properly drafted trust, a trustee can be authorised to withhold a direct distribution to a beneficiary involved in litigation. A trustee may be authorised to employ trust assets and pay income indirectly; an annuity contract alone cannot be this flexible.
INCOME TAX ADVANTAGE
Ownership of the offshore annuity by an offshore trust provides another income tax advantage to surviving beneficiaries. During the life of the US grantor/donor, all annuity payments received by the offshore trust will be taxable on the US income tax return of the grantor/donor as if received directly. After their death, however, payments from an offshore annuity made to a foreign trust will only be taxable as ordinary income when actually distributed to the beneficiaries.
A SMALL TAX COST
A ‘one-time’ 1% excise tax is imposed by IRC Section 4371 on the premium paid for an annuity contract purchased by a US person issued by a foreign issuer on the life of a US citizen or resident. This tax is imposed on the US person making the annuity premium.
Therefore, the tax would be due even if it were acquired by the US person’s offshore trust. Some states impose an excise tax on annuities sold by US issuers. Nevertheless, this cost, and the acceptance fee charged by reputable issuers, is competitive with the initial load charges of US issuers.
PURCHASING THE ANNUITY
If a US individual buys an offshore annuity directly, he completes the application, submits it to the issuer, and upon its acceptance, wires funds representing the premium to the account designated by the issuer. If the more protective and flexible route is taken, the offshore annuity will not be held directly by the individual, but in an offshore trust. To accomplish this, the offshore trustee, not the individual, will complete and submit the annuity contract application to the issuer. When the issuer approves the application, the individual will wire funds for the premium to a bank account of his offshore trust. The offshore trustee then transfers the premium amount to the account of the issuer, and the annuity will have been implemented.
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