Private placement life insurance provides the ability for both a foreign grantor trust and a foreign non-grantor trust to make investments into assets deemed to generate U.S. source income and to avoid U.S. taxation to the grantor or the non-grantor trust, respectively.
First, it helps to know what a foreign trust is and that starts by defining what a foreign trust is not—and that is a U.S. trust. A U.S. trust is a trust which meets two requirements:
A U.S. court can exercise primary supervision over trust administration (“Court Test”); and,
One or more U.S. persons can control all substantial trust decisions (“Control Test”).
All other trusts are considered by the Internal Revenue Service to be foreign trusts. This means, contrary to popular thought, that the residency of the trust creator, the residency of the beneficiaries and the location of the property in the trust are irrelevant to the classification of the trust.
Foreign Grantor Trust
Any grantor trust is a pass-through entity where the trust’s creator (“grantor”) is responsible for reporting the trust’s income and paying any applicable taxes thereon. A U.S. grantor would therefore pay U.S. income tax on the trust’s worldwide income.
In the case of a foreign grantor trust, the foreign grantor must only pay U.S. income tax on the trust’s U.S.-source income. Distributions from the foreign grantor trust to U.S. beneficiaries are not taxable.
Foreign Non-Grantor Trust
It follows that a foreign non-grantor trust would have similar characteristics to a U.S. non-grantor trust in that both are considered separate taxpayers. A foreign non-grantor trust, though, must only pay taxes in the United States on its undistributed U.S.-source income.
Unlike with a foreign grantor trust where distributions to U.S. beneficiaries are not taxable, distributions to U.S. beneficiaries from a foreign non-grantor trust are taxable up to the amount of the trust’s distributable net income. That distributable net income is generally considered to be the trust’s taxable income from both U.S. and non-U.S. sources. A foreign non-grantor trust is able to deduct these distributions taxable to U.S. beneficiaries.
U.S. Source Income and Life Insurance
Common U.S. sources of income for foreign grantor and non-grantor trusts include Effectively Connected Income (“ECI”) and Fixed, Determinable, Annual and Periodical (“FDAP”) designations. ECI is income that is connected to a person or entity that is engaged in business or a trade within the United States. FDAP generally includes items generating passive income such as rents, royalties, dividends, annuities and interest for U.S. based assets.
An increasingly utilized technique to reduce or eliminate U.S. income taxation on U.S. source income-generating assets to either the grantor of a foreign grantor trust or to the foreign non-grantor trust is for the trust to make those investments inside of a U.S. tax-compliant private placement life insurance (“PPLI”) contract.
In a PPLI transaction, the insurance company becomes the underlying beneficial owner of the assets in-exchange for a policy whose value is tied to the value of the asset held by the insurance company. Therefore, the trust would own a U.S. tax-compliant life insurance policy where there is tax deferral on the inside build-up of cash value and not the income tax-generating U.S.-source income assets as those assets would be deemed to be owned by the insurance company.
If the U.S. source income-generating assets are held until the death of the insured within a PPLI policy, the death benefit is received U.S. income tax-free by the trust. In effect, having the U.S. source income-generating assets held with the policy permits all the growth in the assets to escape U.S. income taxation while held and when sold at the death of the insured since they are converted into a death benefit.
Why wouldn’t a foreign non-grantor trust which is not subject to tax on accumulated non-U.S. source income continuously defer taxation by never paying out taxable distributions to U.S. beneficiaries? Beware the Throwback Rule!
Once the current year’s distribution exceeds the trust’s distributable net income, it is treated as being paid from prior years’ undistributed income (“accumulation distribution”). This “throwback” to an accumulated distribution is taxed at the highest income tax rate that would have been applied if the income had been distributed to the beneficiary in the year it was received. Worse yet, any accumulated long-term capital gain loses its favorable character and is taxed at the higher ordinary income tax rate and the beneficiary is also subject to a non-deductible interest charge on the accumulation distribution based on how long it was retained by the trust.
U.S. beneficiaries are required to report distributions received from a foreign trust on Form 3520.
U.S. grantors of foreign trusts are required to annually file Forms 3520 and 3520-A.
U.S. grantors of both foreign grantor and foreign non-grantor trusts are required to file Form 3520 to report the creation and transfer to the trusts.
As with any complex planning strategy, a client should seek the advice of an international tax attorney or accountant when considering trust applications. Additionally, private placement life insurance is a highly specialized area of the life insurance industry and care should be taken to properly vet a life insurance professional for expertise in this field.
Jay C. Judas, JD M.Sc. is the CEO of Life Insurance Strategies Group, an independent and experienced life insurance advisory firm. He is also a part of our world class team.
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