Use of U.S. Life Insurance Policies By Non-Resident Aliens

International families who have some connection with the United States seek out U.S. life insurance policies to provide favorable tax treatment, flexibility, liquidity and certainty in their wealth planning. The U.S. life insurance industry offers these non-resident aliens (NRAs) competitive advantages not found in their home countries. There are, however, strict solicitation and eligibility requirements imposed by U.S. carriers in writing coverage for this specialized market. U.S.-based insurance can provide a more flexible alternative to a qualified domestic trust (QDOT), long-term tax benefits and asset protection for an international family with children or grandchildren permanently residing in the United States or provide estate tax liquidity or future cash flow when a foreign national owns an expensive vacation home in the United States.

Reasons for Purchase

There are a number of mostly non-tax reasons why NRAs purchase U.S. life insurance policies rather than policies issued in their home countries. 

Competition/costs. The pricing and product design in the U.S. life insurance industry is the most competitive in the world. There are over 2,000 U.S. life carriers, including many of the largest top-rated carriers in the world, some backed by international holding companies. NRAs from less-developed countries often have little confidence in their home countries’ life insurance industries. Due to advances in medical technology and access to top medical care, U.S. mortality tables are lower than in most less developed and many developed nations. State regulators regularly require U.S. carriers to periodically adjust their mortality tables to reflect increasing longevity in the United States, pegged to the most recent census. Greater longevity results in reduced premiums and higher internal rates of return on cash value and death benefit.

Privacy/confidentiality. Privacy and confidentiality are vital to many wealthy individuals residing in less developed countries. For security reasons or, perhaps, due to local tax concerns, NRAs who operate local businesses in their home countries may be reluctant to disclose personal financial information to local advisors and domestic life carriers. Often, professional financial advisors with detailed knowledge of an NRA’s financial situation reside outside the NRA’s home country.

Legal/forced heirship. Many civil law countries have forced heirship rules. For NRAs who own U.S.-based property or who have family members permanently residing in the United States, life insurance provides an estate tax-free liquid asset that can be distributed disproportionately or exclusively for certain heirs or property located in the United States. Otherwise, forced heirship rules will require that an NRA’s assets be divided according to civil law, which gives a spouse and all children certain fixed rights in an NRA’s assets. Life insurance can provide liquidity to pay any U.S. estate tax or to fund a disproportionate or exclusive bequest to U.S.-based beneficiaries. 

Dollar denominated assets. The U.S. dollar is the world’s reserve currency of choice and will likely remain so for the foreseeable future. NRAs typically find the U.S. dollar to be a safe place to reserve and hold cash, especially if their home country currency is volatile. Life insurance issued in the United States may offer higher fixed yields than short-term Treasuries, and the death benefit will be paid in U.S. dollars.

Economic and geopolitical.The United States remains a political and economic safe haven for individuals located throughout the world. Many NRAs purchase residences in the United States as a contingency in the event of turmoil in their home country. Some want the comfort of owning a U.S. policy because they sense greater financial security for their family members in the United States or to use a U.S. asset to protect a U.S. business interest or home.

Reputation and financial stability/regulation. The U.S. life insurance industry is the most stable, long lasting and highly regulated in the world. Many carriers date their roots back over 150 years, and no U.S. life insurance company has failed to pay a death benefit claim due to financial insolvency. By adhering to state regulation, U.S. insurers are required to be very conservative in their permissible general account investments, which usually require fixed income, medium duration obligations over equities. Even during the financial meltdown of 2009, policyholders of U.S. insurance subsidiaries of large holding companies that engaged in unrelated higher risk non-insurance business activities were protected by state insurance commissioners.

Tax efficiency. For nearly a century, the U.S. tax laws have accorded life insurance very favorable tax treatment. Cash value accumulates income tax-free. If the funding is structured properly (so the policy isn’t a modified endowment contract (MEC) from inception), the policyholder can withdraw against basis in the policy and borrow against the cash value without income tax. The death benefit is paid income tax-free. If an irrevocable life insurance trust (ILIT) owns a policy, the policy death benefit will also be free of estate tax. In a world where basis step-up is a critical consideration, the leverage of premiums to income tax-free death benefit essentially creates an asset with very positive basis step-up attributes.

Residence and Domicile

The tests for U.S. residency for income tax purposes are objective. The “green card” test is satisfied if the NRA secures permanent residency during the year. The “substantial presence” test is satisfied if the NRA spends

30 days during the current year and 183 days or more over a several year period in the United States, applying a weighted average. An NRA who becomes a U.S. resident is taxed on worldwide income.

The U.S. Tax Code imposes U.S. transfer tax on a worldwide basis on transfers by an individual who’s a citizen or resident of the United States. For gift tax purposes, an individual is a resident if he’s domiciled in the United States at the time of the gift. For estate tax purposes, a person is a resident decedent if he’s domiciled in the United States at the time of death.

The tests for U.S. residency for transfer tax purposes are subjective because they’re based on domicile and intent. Domicile is the place where an individual intends to remain indefinitely with no plan to leave. The Internal Revenue Service considers the facts and circumstances surrounding the individual’s contacts with the United States, including the amount of time spent in the United States, location of banking and business activities, location and relative size of family residences and location of other family members and the center of the individual’s social contacts. 

Resident aliens are, generally, subject to the same gift and estate tax laws applicable to U.S. citizens. There are some distinctions. The full applicable credit amount against U.S. estate tax is available the same as for U.S. citizens. For 2015, the amount is $5.43 million. Resident aliens can make present interest gifts to anyone in the United States, which will qualify for the $14,000 (in 2015) gift tax annual exclusion. Gifts made to non-U.S. citizen spouses aren’t eligible for the unlimited gift tax marital deduction. A spouse can make a present interest gift to a non-U.S. citizen spouse that qualifies for a larger annual exclusion amount ($147,000 in 2015).

Tax Overview of Life Insurance

NRAs can make gifts of foreign or U.S. life insurance policies, whether on their own lives or on the lives of other individuals, without being subject to U.S. gift tax. Life insurance is an intangible asset for U.S. gift tax purposes, and, generally, only gifts of U.S. real estate and tangible property located in the United States are subject to gift tax.

The IRS has taken the position that U.S. or foreign currency located within the United States at the time of the gift will be treated as a tangible asset. Cash drawn by check or wire transfer on a U.S. bank account located at a branch outside the United States is also considered a tangible asset located in the United States. However, the IRS has also ruled that the transfer of cash drawn on a personal foreign bank account in the NRA’s sole name but payable by a U.S. bank isn’t subject to gift tax because it’s considered an asset outside the United States. While no U.S. gift tax is imposed on the NRA, if a U.S. recipient receives gifts from NRAs that total more than $100,000 in a year, the gifts need to be disclosed on Form 3520.

An NRA is subject to U.S. estate tax on his U.S. situs property. The current exemption equivalent amount for NRAs is only $60,000. Life insurance is treated as intangible personal property and considered non-U.S. situs property for U.S. estate tax purposes. The death benefit from life insurance on the life of the NRA isn’t subject to U.S. estate tax. If the NRA owns a life insurance policy on the life of another person, or is the co-insured with a spouse on a second-to-die policy, the fair market value of the policy at the NRA’s death (perhaps, the cash value on a non-guaranteed policy) will be included in the NRA’s estate. If the surviving spouse-insured on a second-to-die policy is also an NRA, there would be no U.S. estate tax on the death benefit.

U.S. Carrier Guidelines

Some foreign countries restrict or prohibit their citizen residents from purchasing outside life insurance policies. Some countries may not have any legal or government restrictions preventing the sale of U.S. life insurance to their residents, but the carrier may determine that the risks present in those countries, such as crime, health, safety and political instability, are too significant to permit issuance of a U.S. policy.

Apart from requiring that the individual reside outside the United States more than 183 days a year, each carrier imposes its own criteria on NRAs who will qualify for U.S. life insurance coverage. 

Every carrier requires the NRA to have a minimum level of nexus to the United States, that is, U.S. connections/or meaningful ties.  Each carrier prescribes its own set of nexus rules. For example, a carrier may require a minimum 15-day stay annually in the United States, as well as existing U.S. financial presence, including a U.S. bank account and U.S. assets held for a minimum of six months. Some carriers require that 25 percent of the assets needed to justify the amount of coverage must be U.S. assets. Most carriers require a minimum $5 million (USD) global net worth. In addition, the carrier may require the NRA to own real estate in the United States, own a business in the United States, have a United States tax liability or have an immediate family member residing in the United States or some combination of these ties to the United States. Some carriers require that a U.S. entity, not the NRA, own the policy. Offshore trust ownership is prohibited. Coverage isn’t available for NRAs traveling to countries where the U.S. State Department has in place a travel warning advisory or alert. The carrier makes the decision at the time the policy is issued, based on the information available to it. Some carriers impose a prohibition on politicians, public figures, journalists or judicial personnel purchasing a U.S. policy.

All solicitation must take place in the United States. “Solicitation” covers the entire life insurance transaction, including illustrations, application and completion of underwriting, including medical examinations and policy delivery. In addition, the life insurance policy must be paid for from a U.S. bank account. No specific insurance products can be discussed in the NRA’s home country of jurisdiction or residence.

Planning for Multinational Families

Non-U.S. citizen spouses. Most NRAs with a significant U.S. estate tax and a non-U.S. citizen spouse will want to avoid using a QDOT due to its restrictive rules and limited benefit. For most wealthy NRAs with a non-U.S. citizen spouse, if trust assets exceed $2 million, there must be a U.S. bank serving as trustee, or a bond or letter of credit must be posted. The surviving spouse must be the sole beneficiary to qualify for the marital deduction, further limiting flexibility to benefit other family members while the spouse is alive. The QDOT must prohibit distributions of principal to a non-citizen spouse, unless the U.S. trustee withholds U.S. estate tax on each such distribution. Only QDOT income can be distributed estate tax-free to the surviving spouse. When the surviving non-U.S. citizen spouse dies, assets are subject to U.S. estate tax as though they had been included in the estate of the first spouse to die. Establishing a QDOT merely postpones payment of U.S. estate tax; it doesn’t reduce or avoid the tax. The U.S. estate tax will be increased if the value of the QDOT property increases during the intervening period between the first and surviving spouse’s deaths. The surviving non-U.S. spouse can’t easily spend down the QDOT assets to reduce the future tax, as is customary with a typical domestic marital trust.

In many non-U.S. citizen spouse situations, the use of life insurance can be an effective means to provide flexible support and estate liquidity for the surviving spouse and other family members without the restrictions and limitations of a QDOT. 

When the NRA contemplates becoming a permanent or temporary resident of the United States or the U.S. carrier requires a U.S. entity own the policy, having a U.S. tax-compliant ILIT own the policy is a strong consideration. The ability of NRAs to fast-track permanent residency by funding a new business creating at least 10 new jobs in the United States under the EB-5 program (that is, a method for foreign nationals to obtain a green card by investing in the United States) has increased the incentive for NRAs to move to the United States. For this group, funding a tax-compliant U.S. ILIT for a non-U.S. citizen spouse has appeal. This ILIT must have Crummey withdrawal powers to qualify gifts for the gift tax annual exclusion, and the trustee must purchase the policy and establish a U.S. bank account. The spouse and children could be permissible beneficiaries, there’s no requirement that a U.S. bank serve as trustee and, most importantly, trust principal can be distributed without imposing estate tax.

As an alternative to a QDOT, a spousal life access trust (SLAT) that owns a policy on the life of the NRA can provide flexibility and liquidity for the benefit of a non-citizen spouse. A SLAT is similar to an ILIT in that the grantor (NRA) is typically the insured, and it’s irrevocable. Both of these trusts remove the life insurance death benefit from the estate of the insured (NRA). The difference is that the SLAT is designed to allow the spouse of the insured easier access to trust assets during his lifetime. For non-U.S. citizen spouses of NRAs, this access provides a key advantage over a QDOT, in which principal distributions made to the spouse are subject to U.S. estate tax. Also, there’s no need to have a U.S. bank serve as trustee of a SLAT because there’s no withholding responsibility. In a SLAT, the spouse can be the primary beneficiary before the children during his lifetime, perhaps by being granted the exclusive right to annually receive trust income or the annual option to withdraw the greater of $5,000 or 5 percent of the trust’s assets. In addition, if discretionary trust distributions are limited to “health, education, maintenance or support,” the spouse could serve as trustee. When an ILIT or SLAT is designed to assist a spouse as the primary beneficiary during his life, a cash accumulation policy (such as indexed universal life (UL) or variable UL) should be selected to make sure early distributions of cash can be obtained without seriously jeopardizing long-term death benefit performance.

Leveraging gifts for U.S. family members. Children of NRAs regularly come to the United States for school and then decide to remain here. Many children of NRAs marry U.S. citizens, have children who are U.S. citizens and then themselves become either permanent residents or citizens of the United States. The parents remain in their home country.

Perhaps the easiest solution for an NRA is to own a policy on his own life and designate a U.S. ILIT as the beneficiary. There’s no U.S. gift tax consequence because there’s no transfer of ownership. The NRA can retain incidents of ownership in the policy because the life insurance death benefit isn’t U.S. situs property for estate-tax purposes. The NRA could transfer money from his foreign personal bank account to a U.S. bank account in the NRA’s name from which to pay the premiums. The NRA would have to come to the United States for a medical exam and otherwise satisfy the NRA nexus requirements, as well as solicitation rules. One major disadvantage, however, is that the NRA can change the beneficiary during life and disinherit the U.S. child and his family.

To add more certainty, the NRA might create and fund a U.S. ILIT in a state such as Delaware, New Hampshire or South Dakota, which permits perpetual trusts; doesn’t have a state income tax; and provides asset protection and other favorable state trust laws. The NRA might fund the ILIT with U.S. stocks and bonds, which are intangible assets for U.S. gift tax purposes. Alternatively, the NRA could write a check drawn from his local personal foreign bank account solely in his name payable by the local U.S. bank account of the U.S. ILIT. The ILIT trustee uses the trust assets to pay premiums on a policy insuring the NRA’s life. The investment inside the policy grows without U.S. income tax. The trustee can take tax-free withdrawals up to basis in the policy or loans up to cash value in the policy, from which to make distributions to beneficiaries without U.S. income tax. At the NRA’s death, the trust can receive the policy death benefit, which isn’t subject to U.S. income or transfer tax. After the death of the NRA, the reinvested death benefit proceeds can be held for the U.S. beneficiaries without further transfer tax.

If the NRA might move to the United States, perhaps to sponsor an EB-5 program or to become closer to U.S. family members, the ILIT should be drafted like any compliant domestic ILIT containing Crummey withdrawal powers and grantor trust powers. Provisions should be included to ensure the NRA-insured can’t become a trustee of the ILIT, which would run afoul of the incidents of ownership rules.

If the NRA is unhealthy or can’t come to the United States, he could create and fund an ILIT to purchase life insurance on the life of his child who’s a permanent resident or a citizen of the United States. If the NRA transfers foreign wealth, such as a check drawn on a personal foreign bank account solely in his name, to an irrevocable trust for the benefit of U.S. beneficiaries, there should be no U.S. gift tax due, regardless of the amount transferred. However, there may some tax reporting by the U.S. trust if the amount transferred exceeds $100,000 annually. For creditor protection reasons, a gift in trust of a large amount of wealth is preferable to an outright gift to the child. The trustee could then pay the premiums on a policy on the life of the child over a period of years. There would be no income tax due by the trust if the only asset is a life insurance policy. Note that the NRA would have to make sure that there are no currency controls in his home country that would prevent a very large one-time transfer of currency outside of his home country.

Owning real estate in the United States. Investors from all over the world are purchasing second homes and investment real estate in the United States as a hedge against the geopolitics and economies in their home countries. However, NRAs are subject to U.S. estate tax on U.S. situs assets in excess of $60,000.

Lifetime gifts of U.S. real estate and tangible property located in the United States are subject to U.S. gift tax. If the NRA wishes to transfer a U.S. home to his son who’s a permanent resident or citizen of the United States, the NRA could avoid both U.S. gift tax and estate tax by establishing a foreign corporation (taxed as a U.S. company) to buy the home. This transaction would convert the real estate into an intangible asset, and the NRA could make a gift of the shares in the foreign corporation to his son. Use of the foreign corporation is also suitable if the NRA wishes to transfer the home to his son at the NRA’s death. 

While use of the foreign corporation can avoid U.S. estate tax, it may require undertaking a complex offshore structure to solve the potential U.S. transfer tax issue. Life insurance not only could solve the estate tax problem, but also provide the future cash flow needed to maintain the home for the U.S. heirs. This use may be compelling when the NRA has post-death liquidity needs in his home country yet would like his U.S. child and family to enjoy the home located in the United States. If the U.S. child will lack personal resources to maintain the home in the future or there are multiple U.S. children, it may be more appropriate for a domestic trust to eventually own the home by using death benefit proceeds to purchase and maintain the home. The NRA may also decide to solve the estate tax problem by transferring ownership of the home to a foreign corporation during life and using the life insurance death benefit as a funding source for capital necessary to cover future expenses of the home.

Pre-immigration planning. Before immigrating to the United States and becoming a permanent resident, an NRA may want to explore how to use a combination of an irrevocable trust and life insurance to prevent income tax on existing foreign assets. Before becoming a U.S. resident, the NRA would transfer appreciated portfolio or other income-producing foreign assets to a self-settled irrevocable trust for the benefit of the NRA and his family located in a state where creditors can’t reach the trust assets. The trustee could invest the assets in a U.S. compliant private placement life insurance policy that’s not a MEC, so funds withdrawn during life receive favorable income tax treatment, and the death benefit isn’t subject to estate tax at the death of the NRA-now-U.S. resident.

If the NRA will only be in the United States temporarily, he may decide to opt for simplicity and use his foreign portfolio assets to purchase a foreign variable annuity prior to arrival in the United States. While the NRA is in the United States and treated as a U.S. resident for income tax purposes, there should be no U.S. income tax on the accumulation inside the annuity. The disadvantage of the annuity is that the favorable life insurance policy withdrawal rules don’t apply, and withdrawals from the annuity while in the United States would generate some ordinary income. The individual should only fund the annuity with assets he knows he won’t need while in the United States. When the individual departs the country and resumes NRA status, he can cash out the annuity without U.S. income tax on the appreciation in value. When considering this strategy, assess the tax consequences in the home country to the returning individual on reacquiring U.S. NRA status and cashing out the annuity.