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Foreign Life Insurance Taxation

Houston Tax Attorney

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Foreign Life Insurance Taxation

Life insurance can be good way to ensure that loved ones are taken care of in the event of an unfortunate situation. However, owning a foreign life insurance policy with cash value can prove to be more of a headache than it’s worth. We’ve come across such types of investments regularly in our offshore compliance cases; the reporting and tax obligations can be burdensome. Hopefully, this article will help foreign insurance policy owners understand their U.S. tax obligations.

How U.S. Life Insurance Policies are Taxed

A whole life insurance policy is part investment and part life insurance. Such policies have two basic financial components – cash value and death benefit. Insurance companies take policy premiums and invest them. The investments in turn are used to pay death benefits and “cashed out” policies. The cash value of the policy increases as premiums are paid and as the investment grows. This investment portion of it is tax-deferred – no tax will be paid on the cash value unless the policy holder cashes out the policy. The policy holder will pay a tax on the investment gain. The death benefit, or face value of the policy, is paid to the beneficiaries tax-free.

Insurance companies in the U.S. are heavily regulated as stock or mutual companies. Additionally, they pay taxes on the investment income they earn from investing policyholders’ premiums. A foreign life insurance company, on the other hand, cannot be regulated by the U.S. nor taxed by the U.S. unless they happen to have U.S. source income. They may have few regulations and possibly pay little or no foreign taxes. Many foreign life insurance policies are more investment oriented than actually life insurance policies and potentially have a huge advantage over U.S. life insurance companies. In order to level the playing field and close this loophole, Congress enacted the Tax Reform Act of 1986 and passed subsequent legislation to even the playing field.

Since the U.S. has no authority to tax the foreign life insurance companies directly, they imposed onerous reporting requirements for U.S. policy holders of such investments.

Tax and Reporting Requirements of Foreign Life Insurance Policies

As indicated above, a whole life insurance policy is part investment and part insurance product. Taxation of such policies is determined based on the primary function of the policy.

Is it a Life Insurance Policy or an Investment?

IRC Code §7702 contains a two-pronged test.  An insurance policy is non-taxable if it meets either (i) the cash value accumulation test or (ii) the guideline premium requirement and the specified cash value corridor.

Cash Value Accumulation Test (CVAT)

The CVAT requires a fairly straightforward determination: does the cash value of the insurance policy exceed the present value of all future premium payments on the policy?

Guideline premium requirement

A contract meets the guideline premium requirements of section 7702(c) if the sum of the premiums paid under the contract does not at any time exceed the greater of the guideline single premium or the sum of the guideline level premiums as of such time.

The guideline single premium is the premium that is needed at the time the policy is issued to fund the future benefits under the contract based on the following three elements:

  1. Reasonable mortality charges that meet the requirements (if any) prescribed in regulations and that (except as provided in regulations) do not exceed the mortality charges specified in the prevailing commissioners’ standard tables (as defined in section 807(d)(5)) as of the time the contract is issued;
  2. Any reasonable charges (other than mortality charges) that (on the basis of the company’s experience, if any, with respect to similar contracts) are reasonably expected to be actually paid; and
  3. Interest at the greater of an annual effective rate of six percent or the rate or rates guaranteed on issuance of the contract.

Specified Cash Value Corridor

A policy falls within the cash value corridor if the death benefit of the contract at any time is not less than the applicable percentage of the cash surrender value. The applicable percentage is determined based on the attained age of the insured as of the beginning of the contract year, as follows:

APPLICABLE PERCENTAGE   
In the case of an insured with an attained age as of the beginning of the contract year of:The applicable percentage shall decrease by a ratable portion for each full year:
More than:But not more than:From:To:
040250250
4045250215
4550215185
5055185150
5560150130
6065130120
6570120115
7075115105
7590105105
9095105100

Tax on the Inside Buildup

If the policy does not meet either of the above tests, IRC Code §7702(g)(1)(A) becomes applicable: “If at any time any contract which is a life insurance contract under the applicable law does not meet the definition of life insurance contract, the income on the contract for any taxable year of the policyholder shall be treated as ordinary income received or accrued by the policyholder during such year.” In other words, the policy holder is subject to a tax on the increase in cash value of the policy each year, even if the policy isn’t actually cashed out.

Reporting Requirements

U.S. Excise Tax: This may be one of the more ridiculous parts of the Internal Revenue Code. IRC §4371 requires policy holders to file a quarterly excise tax form (Form 720) to report and pay a 1% excise tax on insurance premiums paid to foreign life insurers.

Form 720 was meant for businesses to fill out for miscellaneous taxes such as transportation of persons by air, kerosene use, aviation gasoline, liquefied hydrogen, and other arcane items. IRS sneaked in “foreign insurance taxes” near the top of the 2nd page of the form. Because the form was designed for businesses to fill out, it cannot be filed using an SSN. Policy holders must apply online for an EIN, solely for purposes of filling out this form and paying the excise tax!

Form 720 Foreign Life Insurance Excise Tax

 

 

 

 

 

 

 

 

 

 

FinCEN 114 “FBAR” and Form 8938 “FATCA”

U.S. persons owning foreign financial accounts with values in excess of $10,000 at any point during the year are require to file FinCEN 114, commonly known as FBAR with the Financial Crimes Enforcement Network (“FinCEN”) on a yearly basis. “Foreign financial account” includes an account that is an insurance or annuity policy with a cash surrender value.

Foreign life policies are also considered “specified foreign financial assets” for Form 8938 purposes and must be reported annually if the value exceeds the applicable threshold.

Form 8621 “PFIC”

If there’s any good news coming from this, it’s that foreign life insurance policies are usually not considered to be passive foreign investment companies. There is no Form 8621 filing requirement if the holder of a life insurance contract does not have control over the available investment accounts. IRC §1297(b)(2)(B)(3), Treas. Reg. §1.367(a)-2T.

Conclusion

Foreign life insurance policies can be tricky for tax and reporting purposes, and those that are not compliant can face numerous penalties. For instance, a non-willful failure to file Form 114 and 8938 carry maximum penalties of $10,000 per form, per year. Where a person willfully fails to file an FBAR, the IRS may impose a penalty equal to the greater of $100,000 or 50 percent of the account’s highest balance. While these can be poor investment choices due to the burdensome reporting requirements and should probably be avoided, for those who do own such policies, it is important to fully disclose them and pay all applicable taxes.

IRS Tax Amnesty & Voluntary Disclosure Practice

Houston Tax Attorney

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IRS Tax Amnesty & Voluntary Disclosure Practice

What do you do if you have committed a serious tax crime but the IRS has not yet discovered it? Tax amnesty has been a longstanding practice of the IRS Criminal Investigation division whereby taxpayers are allowed to make timely, accurate, and complete voluntary disclosures to avoid criminal prosecution.

Taxpayers are given tax amnesty for “coming clean” regarding their tax crimes. There are two such programs depending on whether the tax evasion involves domestic or foreign income:

  1. Domestic Voluntary Disclosure Program (not to be confused with streamlined domestic offshore procedures which is a completely unrelated program)
  2. Offshore Voluntary Disclosure Program (OVDP)

Domestic Voluntary Disclosure

The domestic voluntary disclosure program has been around since the 1950s. It is used by persons who have two specific types of tax issues – those who have seriously delinquent (unfiled) tax returns and those with significant unreported income. Read more about how the IRS discovers unreported income.

Delinquent Returns

Taxpayers who have many years of delinquent tax returns can be subject to criminal prosecution. A well-known example is actor, Wesley Snipes, who was sentenced to federal prison for 3 years for willfully failing to file his tax returns.

It is important to note that not all cases involving delinquent returns require making a voluntary disclosure. The other option is to simply file up to 6 years of previously unfiled tax returns. 6 years (and not further) is recommended because the IRS’ Policy Statement 5-133 requires the filing of returns for the last 6 years, with prior managerial approval required to pick up more or less than six years of returns. The IRS recognizes that records tend to become unavailable or unreliable further back than 6 years. Also there is a 6 years federal statute of limitations period for prosecuting persons for failure to file a tax return.

Domestic Tax Evasion

When taxpayers have knowingly omitted income on their tax returns, they have committed tax evasion. Whether the IRS will discover the tax evasion or will refer it for prosecution is another matter. A large number of taxpayers probably underreport some income, accidentally or knowingly. Those that have significantly omitted income and do not have a valid reason for the under-reporting should consider entering into the domestic voluntary disclosure program.

How much is significant? It depends on various factors as well as the local criminal investigations group. Usually each local group has a threshold for deciding whether to refer a case to the DOJ for criminal prosecution. Cases referred for prosecution usually involve over $100,000 of total tax loss (not income).

For cases where the unreported amount is not as significant, the tax returns may simply be amended for a period of 3 or 6 years, depending on the situation.

Pros and Cons

Entering into the domestic voluntary disclosure program isn’t simply a matter of filing late taxes or amended returns for 6 years and calling it even with the IRS. The IRS may assess a 75% fraud related penalty on the balance due.

So if you file your tax return and owe $100,000 in taxes, a 75% fraud penalty would increase that total to $175,000. And you’ll still pay failure-to-file and failure-to-pay penalties, and interest on top of that.  If you have a low level risk of criminal prosecution, you might be well-served by simply filing the returns or correcting the omission, whatever the case may be.

On the other hand, almost all tax crimes can be cured through a voluntary disclosure, which means not having to face criminal prosecution and potential jail time.

Offshore Voluntary Disclosure Program

The Offshore Voluntary Disclosure Program (OVDP) has been available since 2009. It’s based on the same principles as the Domestic Voluntary Disclosure Program. It’s available for taxpayers who have unreported foreign income and assets.

The OVDP is a very structured program with specific requirements. Taxpayers are required to amend or file 8 years of the most recent tax returns and FBARs.

This program is for those who have criminal exposure for unreported foreign income. It should be used by individuals who have significant unreported foreign-sourced income and where there is evidence of willfulness.

Pros and Cons

A successful OVDP disclosure protects the taxpayer from criminal prosecution for failing to report their offshore income and assets. However, it comes at a very steep price. The taxpayer will be subject to a 27.5% miscellaneous Title 26 penalty on the highest aggregate value of their unreported financial assets during the 8 year look-back period. In addition, the taxpayer will be subject to a 20% accuracy-related penalty on the additional income tax.

Requirements for Tax Amnesty

In order to qualify for tax amnesty under the voluntary disclosure programs, the disclosure must be truthful, timely, and complete.

  • Truthful and complete: The taxpayer shows a willingness to cooperate (and does in fact cooperate) with the IRS in determining his or her correct tax liability.  The taxpayer makes good faith arrangements with the IRS to pay in full, the tax, interest, and any penalties determined by the IRS to be applicable.
  • Timely: A disclosure is timely if it is received before:
    • The IRS has initiated a civil examination or criminal investigation of the taxpayer, or has notified the taxpayer that it intends to commence such an examination or investigation.
    • The IRS has received information from a third party (e.g., informant, other governmental agency, or the media) alerting the IRS to the specific taxpayer’s noncompliance.
    • The IRS has initiated a civil examination or criminal investigation which is directly related to the specific liability of the taxpayer.
    • The IRS has acquired information directly related to the specific liability of the taxpayer from a criminal enforcement action (e.g., search warrant, grand jury subpoena).

How to make a Voluntary Disclosure

Domestic Voluntary Disclosure

Note that a voluntary disclosure will not automatically guarantee immunity from prosecution. However, it has been IRS’s practice to not refer voluntary disclosure cases for prosecution except where the income comes from illegal sources.

Taxpayers or their representatives initiate a voluntary disclosure by contacting IRS Criminal Investigations. Examples of voluntary disclosures include:

  • A letter from an attorney which encloses amended returns from a client which are complete and accurate (reporting legal source income omitted from the original returns), which offers to pay the tax, interest, and any penalties determined by the IRS to be applicable in full.
  • A disclosure made by a taxpayer of omitted income facilitated through a widely promoted scheme that is the subject of an IRS civil compliance project. Although the IRS already obtained information which might lead to an examination of the taxpayer, it not yet commenced any such examination or investigation or notified the taxpayer of its intent to do so. In addition, the taxpayer files complete and accurate returns and makes arrangements with the IRS to pay in full, the tax, interest, and any penalties determined by the IRS to be applicable. This is a voluntary disclosure because the civil compliance project involving the scheme does not yet directly relate to the specific liability of the taxpayer.
  • A disclosure made by an individual who has not filed tax returns after the individual has received a notice stating that the IRS has no record of receiving a return for a particular year and inquiring into whether the taxpayer filed a return for that year. The individual files complete and accurate returns and makes arrangements with the IRS to pay, in full, the tax, interest, and any penalties determined by the IRS to be applicable. This is a voluntary disclosure because the IRS has not yet commenced an examination or investigation of the taxpayer or notified the taxpayer of its intent to do so.

Offshore Voluntary Disclosure

A person desiring to enter the OVDP program must take the following steps:

  • Obtain a preclearance: Prior to making a disclosure, taxpayers may request a preclearance letter from the IRS Criminal Investigation Lead Development Center. If the IRS has already learned of the taxpayer’s noncompliance then the preclearance letter will be rejected. A decision can take up to 30 days. If a preclearance letter is granted, the taxpayer has 90 days to fully comply with all the provisions in the letter.
  • Submit an application: After the initial letters are submitted to the IRS, the IRS will respond back with a letter stating that if the taxpayer completely and truthfully submits documents required under the OVDP, the IRS will not recommend prosecution by the Department of Justice for noncompliance. Taxpayers have 90 days from the date of the IRS letter to submit the required documents. Additional time may be requested.

The OVDP submission will then be reviewed by the IRS and at the completion of the review, the IRS will propose a closing agreement (Form 906). The taxpayer must then sign the agreement or decide to opt out of the OVDP. If the taxpayer cannot full pay the additional tax, penalties, and interest, an installment agreement may be requested.


Sources:

IRS.gov, How to Make a Domestic Voluntary Disclosure

IRS.gov, 2012 Offshore Voluntary Disclosure Program

Internal Revenue Manual (IRM) 19.5.11.9

IRS Policy Statement 5-133, IRM 1.2.14.1.18