A tax shelter is most often just a complicated way to spend money and get in trouble. They range from:
- the low-thought do-it-yourself variety (throw some assets into an unreported offshore structure and hope for the best) to
- the extremely sophisticated variety (complicated transactions using exotic financial finaglings designed by highly compensated lawyers and accountants).
In either case, the taxpayer is simply playing the audit lottery—they’re hoping to not get noticed by the IRS or to create a sufficient smokescreen if they do get noticed.
Contrary to the above structures, offshore life insurance is actually an IRS-sanctioned tax shelter that delivers real results and can stand up to IRS scrutiny (if structured correctly). Like all good things, there’s a catch—the structure has several rigid requirements and tax complications a-plenty. Do not even consider pursuing this structure without an experienced tax attorney by your side.
Offshore Life Insurance Basics
The broad outlines of the structure are as follows:
- First, you contribute cash and/or assets to an offshore trust, which can be set up in various ways depending on your estate planning and other long-term goals.
- Next, the trust you formed purchases a “variable universal life insurance policy” (i.e., an insurance policy where the payout is determined in part by the performance of certain investments).
- Finally, the insurance company forms a new “segregated account” on its books to hold the assets in which your policy is invested. The segregated account insulates your investments from the insurance company’s creditors and any down-side associated with investments held in other segregated accounts.
You’re not subject to US tax on any income or gain from the investments in the segregated account while you hold the policy. On your death, the policy beneficiaries would also receive the assets free of U.S. tax. Additionally, if the policy is structured properly, you can even receive distributions of cash during the term of the policy without paying tax.
So, tax-free asset appreciation and access to cash—what’s not to like?
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Complications . . . and More Complications
Well, here’s what—several complexities and complications. Here’s a sampling:
- The terms of the life insurance policy must be negotiated while you are outside the United States.
- The life insurance company will only be interested in writing you a policy if you are extremely healthy (verified by a physical) and have at least $2 million to put into the policy.
- The assets held in the account must meet numeric “diversification requirements” designed to insure that the overall value is not too heavily concentrated in a small number of assets.
- You cannot select the investments in the account—they must be chosen by an independent investment manager appointed by the insurance company.
- If you want the ability to access cash on a tax-free basis, the policy premium must be paid in slowly over a number of years on a pre-determined schedule designed to meet certain actuarial tests.
A Better Way to Invest in Mutual Funds
Offshore life insurance structures are a popular choice for holding assets where the holder cannot otherwise control taxable events. One example is mutual funds—a direct holder of mutual fund shares realizes taxable income every time the fund manager decides to sell an underlying security. Holding that same mutual fund through an offshore life insurance structure either defers that tax liability or eliminates it entirely.
So, there’s still an actual tax shelter that really works for those with the means to take advantage of it and the stomach to weather the initial complications.
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