Law Office of Thomas J. Swenson
U.S. and International Wealth Building and Wealth Preservation
Legal and U.S. Tax-Law Compliant

DYNASTY TRUSTSCAPTIVE INSURANCE COMPANIESESTATE PLANNINGELDER LAW

OFFSHORE ASSET PROTECTIONINTERNATIONAL LLCsPRIVATE PLACEMENT LIFE INSURANCEMEDICAID TRUSTS

INTELLECTUAL PROPERTYSMALL BUSINESS START-UPS

Tel. 303-440-7800
or Click Here to
send message
Click Here to see diagrams of model structures

Summary: An irrevocable life insurance trust (ILIT) comprises two main parts: (1) an irrevocable asset protection trust; and (2) a life insurance policy owned by the trust. An international ILIT is better than a domestic ILIT because it is more flexible and less expensive. Private placement life insurance (PPLI) serves as a “wrapper” around a global, variable investment portfolio that grows free of income and capital gains taxes. At the trustee’s discretion, the trust may access policy cash value by withdrawals and tax-free loans during the life of the insured. The trust settlor (grantor) may also be a beneficiary. Upon death of the insured, PPLI proceeds are paid into the ILIT free of income and estate taxes.

For US persons, an irrevocable life insurance trust (ILIT) is arguably the most efficient structure for integrating tax-free investment growth, wealth transfer and asset protection. An ILIT comprises two main parts: (1) an irrevocable trust; and (2) a life insurance policy owned by the trust. An international (or offshore) ILIT is a trust governed by the law of a foreign jurisdiction that owns foreign-based life insurance. An offshore ILIT is better than a domestic ILIT because it is more flexible and less expensive. Regarding US tax laws, a properly designed international ILIT is treated virtually the same as a domestic ILIT.

An ILIT becomes a dynasty trust (or GST trust) when the trust’s settlor (or grantor, the person who establishes and funds the trust) applies his lifetime exemption for the generation skipping transfer tax (GSTT) to trust contributions. Once a dynasty trust is properly funded by applying the settlor’s lifetime exemptions for gift, estate and GST taxes, all distributions to beneficiaries will be free of gift and estate taxes for the duration of the trust, even perpetually. The individual unified gift and estate tax exemption and the GSTT exemption are both $5 million ($10 million for a married couple) during 2011 and 2012, which are the highest amounts in decades.

Under the US tax code, no income or capital gains taxes are due on life insurance investment growth, and no income tax is due when policy proceeds are paid to an insurance beneficiary upon death of the insured. When a dynasty trust purchases and owns the life insurance policy and is named as the insurance beneficiary, no estate tax or generation skipping transfer taxes are due. In other words, assets can grow and be enjoyed by trust beneficiaries completely tax-free forever. Depending on how a trust is designed, a portion of trust assets can be invested in a new life insurance policy each generation to continue the cycle.

Private placement life insurance (PPLI) is privately negotiated between an insurance carrier and the insurance purchaser (e.g., a dynasty ILIT). Private placement life insurance is also known as variable universal life insurance. The policy funds are invested in a separately managed account, separate from the general funds of the insurance company, and may include stocks, hedge funds, and other high-growth and/or tax-inefficient investment vehicles. Offshore (foreign) private placement life insurance has several advantages over domestic life insurance. In-kind premium payments (e.g., stock shares) are allowed, whereas domestic policies require cash. There are few restrictions on policy investments, while state regulations restrict a domestic policy’s investments. The minimum premium commitment of foreign policies typically is US$1 million. Domestic carriers demand a minimum commitment of $5 million to $20 million. Also, offshore carriers allow policy investments to be managed by an independent investment advisor suggested by the policy owner. Finally, offshore policy costs are lower than domestic costs. An election under IRC § 953(d) by a foreign insurance carrier avoids imposition of US withholding tax on insurance policy income and gains.

Whether domestic or offshore, PPLI must satisfy the definition of life insurance according to IRC § 7702 to qualify for the tax benefits. Also, key investment control (IRC § 817(g)) and diversification (IRC § 851(b)) rules must be observed. When policy premiums are paid in over four or five years as provided in IRC § 7702A(b), the policy is a non-MEC policy from which policy loans can be made. If policy loans are not important during the term of the policy, then a single up-front premium payment into a MEC policy is preferable because of tax-free compounding.

An offshore ILIT provides much greater protection of trust assets against creditors of both settlor and beneficiaries. Courts in the US have no jurisdiction outside of the US, and enforcement of US court judgments against offshore trust assets is virtually impossible. Although all offshore jurisdictions have laws against fraudulent transfers, they are more limited than in the United States. In any case, an offshore ILIT is necessary to purchase offshore life insurance because foreign life insurance companies are not allowed to market and sell policies directly to US residents. An international trust, however, is a non-resident and is eligible to purchase life insurance from an offshore insurance carrier.

An international ILIT may be self-settled, that is, the settlor of the trust may be a beneficiary without exposing trust assets to the settlor’s creditors. In contrast, in the United States, the general rule is that self-settled trusts are not honored for asset protection purposes.
In Private Letter Ruling (PLR) 200944002, the IRS ruled that assets in a discretionary asset protection trust were not includable in the grantor’s (settlor’s) gross estate even though the grantor was a beneficiary of the trust. The trustee of a discretionary trust uses his discretion in making distributions to beneficiaries consistent with trust provisions. Previously, it was questionable whether a settlor could be beneficiary of an ILIT without jeopardizing favorable tax treatment upon his death. The new ruling gives some assurance to a US taxpayer who wants to be a beneficiary of a self-settled, irrevocable, discretionary asset-protection trust that is not subject to estate and GST tax. As a result, the trustee can (at the trustee’s discretion) withdraw principal from the PPLI or take a tax-free loan from the policy’s cash value and distribute it tax-free to the settlor, as well as to other beneficiaries. In other words, a settlor need not sacrifice all enjoyment of ILIT benefits in order to achieve preferred tax treatment.

An offshore ILIT is designed to qualify under IRS rules as a domestic trust during normal times and as a foreign trust in case of domestic legal threats to its assets. The offshore ILIT is formally governed by the laws of a foreign jurisdiction and has at least one resident foreign trustee there. As a “domestic” trust under IRS rules, the trust also has a domestic trustee who controls the trust during normal times. If a domestic legal threat arises, control of the trust shifts to the foreign trustee, outside the jurisdiction of US courts, and the trust becomes a “foreign” trust for tax purposes. A domestic trust “protector” having negative (or veto) powers may be appointed to provide limited control over trustee decisions. An international ILIT protects trust assets against unforeseen lawsuits, bankruptcy and divorce.

The objective of PPLI is to minimize life insurance costs and to maximize investment growth. The life insurance policy acts as a “wrapper” around investments so that they qualify for favorable tax treatment. Nevertheless, PPLI still provides a valuable life insurance benefit in case of an unexpected early death of the insured.

Initial costs of setting up an ILIT are high, but are recouped after a few years of tax-free investment growth. Initial legal and accounting fees are typically in a range of $25,000 to $50,000. Premium “loading” charges are in a range of about 3% to 5% of premiums paid into offshore PPLI (compared to 8 – 10% in domestic PPLI). Annually recurring charges depend on policy value and vary widely among PPLI carriers, so careful comparison shopping is advised. For example, annual asset charges should be in a range of about 40 to 150 basis points (0.4% to 1.5%) of the policy’s cash value. The annual cost of insurance is not substantial and declines over time. Annual costs for maintaining an offshore trust are several thousand dollars. Finally, investment manager fees are paid regularly out of policy funds.

Cash may be contributed to the ILIT, which then purchases PPLI. If asset protection of vulnerable fixed assets in the US is a concern, then equity stripping can be used to generate cash, which is then contributed to the offshore ILIT. Of course, stocks and bonds and other assets may also be contributed to the ILIT and used for investing in PPLI. Various value-freezing and valuation discounting techniques can be used to leverage the GSTT exemption.

An offshore “frozen cash value” policy is a variation of PPLI governed by IRC § 7702(g). The minimum premium commitment is about $250,000. During the life of the insured, the cash surrender value is fixed at the sum of the premiums paid. Withdrawals up to the amount of the paid-in premiums are tax-free, but cash value in excess of the premium amounts is inaccessible until after death of the insured.
Another alternative investment for an ILIT is a deferred variable annuity (DVA). There is no cost of insurance, so investment growth is faster. Tax on appreciation is deferred, but DVA distributions are taxed as income.

Generally, for public policy reasons and because the insurance industry possesses strong political influence, life insurance has long enjoyed favorable tax treatment. Over the past two decades, numerous IRS rulings have clarified the tax treatment of PPLI and irrevocable discretionary trusts. At the same time, strong, new asset protection laws and reliable service providers in numerous foreign jurisdictions have enabled safe, efficient and flexible management of international trusts and insurance products. As a result, an international irrevocable, discretionary trust owning PPLI can provide tax-free growth of a global, variable investment portfolio managed by a trusted financial adviser in full compliance with US tax laws. At the discretion of the trustee, trust assets (including tax-free insurance policy loans and withdrawals) are available to the settlor during his lifetime. Upon death of the insured, policy proceeds are paid tax-free to the trust. Thus, a well-managed life insurance dynasty trust perpetually secures the financial well being of settlor, spouse, children and their descendants.

Download the PDF Article Here

Warning & Disclaimer: This is not legal advice.

Copyright 2011 – Thomas Swenson

Captive Insurance – Basics

On May - 3 - 2012

A captive insurance company (CIC) is an insurance company that insures the risks of operating business entities within the same “economic family”.

1. A CIC benefits its owner(s) generally through a combination of factors.

1.1 As with any conventional insurance premium, premiums paid from a business to the CIC are tax deductible expenses under IRC § 162(a).

1.2 A CIC that elects treatment under IRC § 831(b) is exempt from income taxation of premiums received up to $1.2 million annually. There is a public policy rationale for this favorable tax treatment. By including this provision in the tax code in 1986, the US Congress intended to increase competition among insurers and increase the range of choice for insurance consumers.

1.3 An 831(b) CIC is taxed only on its investment income. The “dividends received deduction” under IRC § 243 provides additional tax efficiency for dividends received from its corporate stock investments.

1.4 Policy premiums paid to the CIC stay in the economic family. Roughly 35–50% of premiums paid for conventional “retail” insurance go to overhead, administration and profit. A CIC reduces those costs. Further, since a CIC invests its reserves and surplus in its own investment accounts, investment gains benefit the CIC’s owner(s) (not an outside insurer).

1.5 A CIC customizes insurance policies directly to the needs and preferences of a business to improve insurance coverage and/or decrease premium costs.

1.6 A CIC customizes policies to insure risks that are otherwise uninsurable or too expensive to insure using conventional insurance. Thus, a CIC is a tax-efficient substitute for “self-insurance” (i.e., no insurance). Instead of using post-tax dollars to make a “rainy-day” fund, up to $1.2 million no-tax dollars can be shifted as insurance premiums to the 831(b) CIC annually.

1.7 A CIC is particularly well-suited for insuring “business loss” risks; for example, loss of business revenue resulting from loss of key employee or customer, change in government regulations, loss of operating license, etc. (see Section 6 below).

1.8 A CIC has access to reinsurers. For a high-premium policy (e.g., $1 million), a CIC can negotiate directly with a reinsurer for favorable “wholesale” insurance rates.

1.9 A CIC established in an offshore jurisdiction incurs no state income tax liabilities.

1.10 Although a non-831(b) CIC must recognize premiums as income, deductions under IRC § 832(b)(5) for IBNR (incurred but not reported) loss reserves provide arbitrage opportunities to the CIC. The “dividends received deduction” under IRC § 243 also applies.

1.11 A CIC offers flexible financing of annual premiums (and capitalization requirements), accommodating a business’s cash flow problems. For example, a significant portion of annual premiums may be paid at the end of the premium year.

1.12 CIC reserves and surplus are not exposed to general creditors of the operating business. Insurance reserves are available for paying insurance claims only. At the end of a policy term, corresponding insurance reserves become surplus. CIC surplus is not subject to claims and can be invested to maximize return.

1.13 When owned by one or more asset protection trusts, a CIC is a valuable part of an integrated asset protection, wealth accumulation and generational wealth transfer structure.

2. A well-designed CIC managed by a “turnkey” service provider can be operated and properly reinsured for about 15% of annual premium payments. For example, if premiums of $1 million were paid to the turnkey CIC, total management costs including the cost of reinsurance could be less than $150K, potentially resulting in a profit of $850K at the end of the year if there were minimal non-reinsured claims.

Generally, a CIC makes good economic sense when the CIC receives about $250K or more in premium payments annually. The insurance licensing agency in the jurisdiction of formation requires initial capitalization of a CIC, typically about 20 percent of the first year’s premiums.

Generally, formation of a CIC is less expensive in one of the traditional foreign jurisdictions than in one of the states in the US. In any case, an 831(b) CIC usually elects to be taxed as a domestic company under IRC § 953(d), its operating account is located in the US, and its investment account (holding the bulk of its assets) can also be located in the US and controlled by its owner(s).

Unrelated owners of businesses (i.e., owners from different “economic families”) can form a multi-owner CIC, a so-called “group captive”. For example, four unrelated owners of businesses having similar types of risk could form a group captive that insures some or all of their operating business entities.

3. CIC assets can be accessed in several ways.

3.1 Dividends. Unfortunately, beneficial tax rates for qualified dividends are scheduled to expire in 2013.

3.2 Direct investments. The CIC can invest directly in new business ventures.

3.3 Shareholder loans. Loans should be transacted only with strict formalities at arms length to avoid problems with the IRS and licensing agency.

3.4 Liquidation of the CIC will be treated as a long term capital gain.

4. To qualify as insurance, an insurance policy must shift a genuine risk from the insured to the insurer. A rule of thumb used by actuaries is that there should generally be a 10% chance of a 10% loss of the policy limit. In any case, a good CIC manager employs underwriting and actuarial skills to provide sound insurance coverage, satisfy statutory and IRS requirements, and maximize profits for a given set of circumstances.

To avoid scrutiny by the IRS concerning the appropriateness of deducting insurance premiums under § 162, total annual premiums paid by a business entity to an 831(b) CIC should not exceed 10% of the business’s gross revenue. For example, if a business has annual gross revenues of $3 million, insurance premium payments should not exceed $300,000.

For discussion purposes, risks can generally be characterized as follows.

4.1 Low-frequency/low severity risks. A CIC can issue a policy that is efficiently priced and avoid paying overhead costs of retail insurers.

4.2 High-frequency/low severity risks. Conventional insurance for such risk can be expensive because of high administration costs. The operating business can purchase a low-cost high-deductible (stop-loss) conventional policy and pay the numerous small claims up to the deductible amount. The CIC can then issue an indemnification policy to the business that covers the high deductible.

4.3 Low frequency/high severity risks. A CIC is well suited to insure this type of risk. Operating businesses often pay high insurance premiums for high severity events that rarely if ever occur. Other businesses are completely exposed to such high severity events because they do not insure against them, simply because they occur so rarely. Such risks are efficiently covered when the operating business purchases a conventional low-cost stop-loss (catastrophic) policy and the CIC writes an indemnification policy to cover rare, high-severity events.

4.4 Premiums approach policy limits of insured risk. There is little benefit from conventional insurance if premiums paid are close to policy limits. A CIC can underwrite risks more efficiently by reducing overhead costs and investing the premiums in its own accounts.

4.5 Risks that the business manages better than the industry average. A CIC enables the operating business to customize its insurance to meet its own risk profile, rather than indirectly subsidizing other companies having high claims histories.

5 Business Liability Policies. Liability policies cover claims made against the operating business by third-party claimants.

Direct policies directly pay claimants and pay legal fees and expenses. They could create an asset for plaintiffs to pursue and, therefore, are not preferred for a CIC.

Indemnification policies indemnify, or reimburse, the business for third-party claims that the business pays. The business decides whether it will pay third-party claims. In other words, an indemnification policy could cover the risk for the business without offering an asset for plaintiffs to pursue.

Litigation expense policies pay only legal defense fees and expenses. These are good policies for a CIC because they do not create any rights in favor of third-party claimants.

Business liability risks commonly exist in the following exemplary areas:

Vehicle use
Construction and design defects
Performance liability
Structural defects
Title insurance
Environmental impacts
Product liability
Professional malpractice
Advertising liability
Copyright and trademark infringement
Antitrust
Unfair trade practices (e.g., Lanham Act violations)
Director and officer liability
Errors and omissions
Sarbanes-Oxley violations
Employee relations (e.g., discrimination, sexual harassment)
Failure to investigate/control employees and agents
Libel and slander
Workers Compensation (subject to limitations)
Employee Health Insurance (subject to limitations)

6 Business Casualty Policies. A good type of policy for a CIC to issue is a business casualty (i.e., business loss) policy because only the business can assert a claim and no third-party claimant is involved. Most businesses consciously or unconsciously self-insure many potential business casualty risks.
Business casualty risks commonly exist in the following exemplary areas:

Unforeseen administrative action of a governmental body
Changes in state or federal law
Judicial or administrative delays
Extortion (even if not provable legally)
Market volatility
Inability of key individual to work
Loss of professional or business license
Loss of key client or investor
Business credit (e.g., credit loss, delayed or withheld loans)
Labor cost or strike
Property damage
Unfair calling of guarantees
Litigation costs
Tax audit defense
Business interruption (e.g., due to computer, supply chain, weather)
Lawsuit interruption (i.e., interruption by lawsuit into business operations)
Consequential damages
Contract frustration
Advertising and marketing failure
Business reputation
Commercial crimes (e.g., theft of trade secret)
Currency risks

7. Bonds. CICs are also suitable in some circumstances to underwrite surety, performance and other types of bonds.

Warning & Disclaimer: This is not legal or tax advice.

Internal Revenue Service Circular 230 Disclosure: As provided for in Treasury regulations, advice (if any) relating to federal taxes that is contained in this communication is not intended or written to be used, and cannot be used, for the purpose of (1) avoiding penalties under the Internal Revenue Code or (2) promoting, marketing or recommending to another party any transaction or matter addressed herein.
Copyright 2012 Thomas Swenson

An irrevocable life insurance trust (ILIT) is a 100% tax-efficient structure that builds and preserves wealth, while eliminating all taxes legally.  In addition to providing a life insurance benefit, private placement life insurance (PPLI) enables tax-free investment growth and tax-free family wealth transfer in complete compliance with U.S. tax law.  When PPLI is owned by an ILIT (or dynasty trust), PPLI policy proceeds are paid free of estate and GST taxes upon death of the insured.  To protect your business and build wealth, click CAPTIVE INSURANCE on the menu bar above.

Private placement life insurance (PPLI) allows tax-free investment growth in separate  policy accounts, especially investment portfolios holding hedge funds or other short-term high-return investments. Because assets in PPLI are in separate accounts, they are protected against insolvency of the insurance company.  When an irrevocable life insurance trust owns the policy, the policy and its proceeds are protected against unforeseen future creditors of the insured and beneficiaries.  Foreign PPLI typically has a minimum premium commitment of $1 million.

Captive insurance companies, life insurance and deferred variable annuity (DVA) policies in Liechtenstein, the Bahamas, and other offshore jurisdictions can be designed for full compliance with U.S. tax laws to maximize tax saving and investment growth. Offshore vehicles generally have greater funding and investing flexibility than US-based counterparts. Fees and minimum premium commitments are less than in the US. Asset protection is stronger, especially when an offshore trust owns the asset.  Offshore structures combine benefits of legal tax shelters with enhanced protection and growth.

Summary: An IRS ruling provided some clarity and reassurance to US taxpayers who want to be beneficiaries of a self-settled, irrevocable, discretionary asset protection trust. In Private Letter Ruling (PLR) 200944002, the IRS ruled that assets in an asset protection trust were not includable in the grantor’s gross estate even though the grantor was a beneficiary of the trust.

In these times of eroding property rights, punitive tax rates, and financial insecurity, a U.S. taxpayer can use an irrevocable life insurance trust to protect trust property against creditors, legally avoid all future U.S. taxes, and also enjoy trust assets. Generally, a carefully-designed irrevocable life-insurance dynasty trust (or GST trust) provides tax-free growth of policy assets, and proceeds of the life insurance policy are paid to the trust free of income and estate taxes.

Previously, some uncertainty still existed whether the person who settled and funded a trust could also be a trust beneficiary without loss of estate-tax advantages. Private Letter Ruling (PLR) 200944002 ruled that the grantor (or settlor) of the trust may be a discretionary beneficiary (i.e., subject to the discretion of the trustee), but trust assets will not be taxed in his estate when he dies. A private letter ruling is applicable only to the taxpayer to which it is addressed. It has no precedential force for other tax cases. Nevertheless, a private ruling is a good indicator of the IRS’s general position. Furthermore, PLR 200944002 is consistent with the case law and revenue rulings that have treated related issues over past decades. For example, Revenue Ruling 77-378 clarified Revenue Ruling 62-13 to remove any implication that an entirely voluntary power
held by a trustee to distribute all of the trust assets to the grantor is sufficient to render a gift to the trust incomplete in whole or in part.

Thus, a U.S. taxpayer can fund an irrevocable trust that buys a life insurance policy insuring his life, the policy assets can grow tax-free, he can benefit from trust property during his lifetime, and when he dies, the insurance policy proceeds are paid to the trust free of income and estate taxes.

In the past, some U.S. taxpayers used secret offshore companies and numbered offshore bank accounts to avoid taxes. Now, similar benefits can be achieved in complete compliance with U.S. tax laws, and with the peace of mind that everything is completely legal.

An offshore trust holding an offshore private-placement life insurance policy provides virtually unassailable asset protection, in addition to tax-free growth and tax-free wealth transfer in the family legacy trust – a nice solution to the problem of high taxes and precarious property rights. A deferred variable annuity owned by a trust can provide some of the same benefits. Advice on these and other wealth-building and asset-protection techniques is available to clients of The Law Office of Thomas J. Swenson, at 303-440-7800, and at www.swenlaw.com.

Download This PDF Article and Learn About Self Settled Discretionary Asset Protection

Warning & Disclaimer: This is not legal or tax advice.

Internal Revenue Service Circular 230 Disclosure: As provided for in Treasury regulations, advice (if any) relating to federal taxes that is contained in this communication is not intended or written to be used, and cannot be used, for the purpose of (1) avoiding penalties under the Internal Revenue Code or (2) promoting, marketing or recommending to another party any transaction or matter addressed herein.

Copyright 2011 – Thomas Swenson