Offshore Insurance: The Last Great Loophole of Privacy%2C Tax Deferral and Asset Protection Customized Tax-Deferred Annuity
Originally Published in December 2001
A customized-single premium variable annuity that allows the holder a virtually unlimited choice of private investment funds and managers and still qualifies for the favorable tax deferral accorded annuities under the Internal Revenue Code is one of the last, yet best remaining tax deferral mechanisms left to offshore passive investors. These annuities are available only to persons who are "accredited investors" as that term is defined in the Rules and Regulations of the United States Securities and Exchange Commission, and are intended only for substantial investors who are U.S. taxpayers and desire to accumulate capital on a tax deferred basis for retirement or other long-term purposes.
Variable Annuity
A variable annuity is based upon a separate account established by an insurance company, generally referred to as a "segregated" investment account and invested at the general direction of the policyholder in one or more private investment funds (including hedge funds) or with an independent investment manager. Note, the independent investor may not make his own "investment decisions" and buy and sell specific stock pursuant to IRS regulations and still have the policy qualify as a legitimate "deferred" annuity. The investor may, however, select the investment advisor and discuss general "planning" with both the investment adviser and the insurance company. If the investment advisor or insurance company do not follow these "general instructions" of the policy holder, the holder may change advisers or insurance companies without tax implications.
The return on the annuity is keyed to the performance of the assets in the separate account, and not to the performance of the insurance company. The investor bears the risk of the performance of the variable account and there is no guaranteed rate of return. The tax courts have held that dispositions of the underlying assets by the insurer, including capital gains and dividends are not taxable events to the policy holder, since the policy holder has not disposed of the policy itself and has not received any "income", or other taxable benefit. This is the exact opposite of how the tax courts have treated closely held offshore corporations where they have imputed the income and gain of the corporation to the underlying shareholder. These types of policies are therefore the last great loophole for tax deferred growth of passive investment income.
You Set the Investment Objectives
The ability to indirectly set the investment objectives of the underlying investment account highlights an important distinction between "Offshore" and "On-Shore" insurance. The On-Shore companies are heavily regulated and therefore want to control both the management of the underlying "risk" being insured, as well as the management of the assets themselves. Offshore insurance has recognized that while insurance companies are expert at managing risk (just take a look at the gleaming office towers of most US and European cities. Chances are they bear the names of companies such as Prudential, AIG, John Hancock, Northwest Mutual and NY Life), but they are not experts at managing money itself. If you examine some of the worst performing mutual and retirement funds over the last decade, you'll notice funds managed by some of the same "big name" domestic insurance companies.
Offshore insurers have the ability to recognize this distinction and (in the absence of burdensome regulation,) they can offer flexible products that bring together their competitive advantages of managing risk, together with the ability of others to manage the client's underlying investment dollars. The ability to "segregate" client accounts and generate custom-tailored investment returns, has given the relatively newcomer jurisdictions such as the Turks and Caicos, Belize and the Cayman Islands the ability to compete most effectively with older "international" jurisdictions as well as the well established domestic insurance carriers.
In these favorable jurisdictions, the law requires that separate accounts are segregated and are subject only to the claims of the policy holder. They are not subject to any other liabilities of the company, even in the event of the company's bankruptcy or insolvency. Even though these foreign carriers are prohibited by law from advertising their products and services in the United States, it is not illegal for a US person to seek them out, although they usually will have to travel outside the US to execute and put one of these types of annuity contracts into place.
Private Annuity Contract
The Private Annuity contract gives the policy holder the ability to carry out his or her investment strategy on a tax-advantaged basis, with far more investment options than are currently available with conventional variable annuities in the United States. As long as the policy holder's funds remain invested in the annuity, there is no current U.S. tax liability to the investor and no current tax or regulatory reporting requirements (as in the case of foreign bank and brokerage accounts).
A withdrawal from the annuity is taxable to the holder as ordinary income to the extent gains have been realized in the account, with the remainder generally being treated as a tax free return of capital. As with all annuities, any withdrawal before age 59½ is subject to a 10% penalty tax on the gains in the account. The policy holder is permitted to direct that the separate account be invested in a number of private investment funds or through one or more independent investment managers. Again, the policy holder is not permitted to make specific investment decisions for the separate account, but may redirect the investment strategy of the account at any time to another fund or manager, with no tax consequences. Under current law, deferred annuities may grow tax free until the 85th birthday of the policyholder, when compulsory payments must begin.
Copyright 2002 Nagel & Associates, LLC