By:   Leslie A. Share, Esq.

Packman, Neuwahl & Rosenberg, Coral Gables, Florida

Reprinted with Permission, Panel Publishers, Asset Protection Journal, Vol. I Issue I (Winter, 1999)      

For the intrepid individual, these tax and wealth preservation attributes may be further enhanced through establishing the trust offshore to hold a foreign life insurance product. However, as will be explored in this article, there are significant legal and practical differences between domestic and foreign ILITs which mandate a detailed review of the prospective settlor's individual situation and dispositive wishes before making the determination of which trust vehicle will be appropriate. The complex and onerous U.S. tax-related filing rules now applicable to foreign trusts with a U.S. settlor or U.S. beneficiaries may by themselves keep the faint-hearted within domestic boundaries. However, practitioners should not necessarily allow these compliance requirements to dissuade them from utilizing the foreign ILIT as an estate and asset protection vehicle in appropriate circumstances.

Why Go Offshore? 

            In general, the use of a foreign ILIT should be considered under one or more of the following circumstances:

1.     Enhanced asset protection, depending in part upon the selected foreign jurisdiction. Notwithstanding the built-in asset protection advantages of an irrevocable domestic trust, the uncertainty of a U.S. court's application of local law, coupled with the more debtor-friendly laws of a number of foreign countries, arguably make the use of an offshore entity most advantageous.

2.     Foreign life insurance products may offer increased investment options and flexibility. Offshore insurance policies may provide the ability to acquire a broader range of securities in various world markets than their domestic counterparts, along with a potentially more desirable choice of the investment manager(s).

3.     Potential avoidance of restrictive state laws controlling the disposition of property. Foreign courts are more likely to adhere to the law of the jurisdiction of the trust, rather than the law of the settlor's domicile, in the event of a challenge to the trust by a disgruntled family member, barring special circumstances.

4.     Privacy considerations, other than with respect to required related government compliance.  Although, as discussed below, a considerable amount of U.S. government-related compliance will be required for a foreign ILIT,  the trust should remain an entirely private document, outside of the jurisdiction of a U.S. court. This does not mean, of course, that the trust's existence will remain forever a secret in the event of actual or threatened litigation.

5.     The use of a trust Protector as a "check and balance" technique to watch over the trustee and the trust assets. The concept of a protector with the power to remove and replace the trustee, along with possibly other direct and indirect controls, is still far more commonly found in offshore trusts. However,  the 1997 Act clarified that a U.S. person may be treated as the trust fiduciary if such person has the power ordinarily held by a trustee to control one or more substantial decisions of the trust. [1]

6.     The use of a Letter of Wishes to stipulate certain nonbinding dispositive requests.  The Letter of Wishes is also more likely to be utilized with a foreign entity, and may provide additional "beyond the grave" comfort for a settlor, so long as she understands their  entirely precatory nature.

7.     The ability to have the settlor as a discretionary beneficiary, notwithstanding state laws prohibiting the use of self-settled trusts to shield assets from creditors. Notwithstanding the inability to create an effective "spendthrift trust" for such purposes in many jurisdictions, a number of foreign jurisdictions allow them. In this regard, the Service has confirmed that the settlor may be deemed to have made a completed gift for U.S. estate tax purposes while being a permissible discretionary income and principal beneficiary. [2]

8.     Pre-immigration planning for nonresident alien individuals [3].   The settlor would make offshore transfers of non-U.S. situs property to the trust while the settlor is a nonresident alien individual for U.S. income tax purposes and a non-U.S. domiciliary for U.S. estate and gift tax purposes. This type of trust is generally established as a grantor trust, although such status may change or be required depending upon the settlor's ultimate residency intentions.[4]                       

9.     Hedge against U.S. economic fluctuations. The foreign ILIT can act as a "nest egg" of foreign investments to diversify the settlor's overall investment structure.

10.  The desire to utilize a particular foreign institutional trustee without a U.S. presence. The settlor may wish to have one of the many highly respected international banks, trust companies or other financial institutions act as trustee where they are not qualified to so act (and often do not wish to serve in such capacity) for a U.S. trust.

11.  The ability to indirectly make offshore portfolio investments without current U.S. income tax consequences or the application of certain complex U.S. tax and compliance rules.  These attributes are often significant motivations for U.S. individuals to form a foreign ILIT. U.S. companies, of course, offer life insurance products similar to those found overseas, which also provide for internal growth without current U.S. income tax consequences to the policyholder under certain circumstances.  As stated above, however, domestic policies may not be suitable for any number of reasons in a particular situation. If a prospective U.S. settlor is looking to a foreign trust as an offshore asset holding vehicle, a foreign ILIT appears to have an important advantage over direct investments by U.S. persons or by the trustee, because the foreign life insurance company and any investment advisors will acquire such foreign properties through and within the policy. As a result, although the issue is not entirely free from doubt, the policy's offshore holdings may not be subject to reporting by or cause a potential U.S. income tax liability to the foreign ILIT settlor or beneficiaries as interests in offshore financial accounts[5], passive foreign investment companies, foreign partnerships, or other foreign property otherwise falling within the scope of the U.S. tax and compliance laws.  In this regard, the foreign ILIT trustee should generally not acquire the policy through a foreign holding company owned by the trust, as this arrangement may by itself create U.S. income tax consequences and concurrent reporting obligations.

The above list is, of course, non-exclusive, and the applicability and magnitude of each factor will vary based upon each person's own unique facts and circumstances. 

Practical Considerations 

In choosing between a domestic or foreign ILIT,  the prospective settlor should be aware of certain differences between them from a formation and operational standpoint: 

	Foreign trusts are often more expensive and cumbersome to maintain than domestic trusts.
	Offshore-based trustee fees are generally higher, in part because institutional trustees are more prevalent for foreign than domestic ILITs.
	Although ILITs in general by their nature require little activity on the part of the trustee during the insured's lifetime, communications are subject to time differences and greater expense, although the Internet and e-mail have somewhat leveled the playing field.
	Offshore trustees are often not as knowledgeable regarding the nuances of U.S. tax law, and the "form" ILIT documents that they utilize often require extensive review and modification by U.S. tax professionals to properly account for U.S. income, estate, gift, and generation-skipping transfer tax considerations which may affect the settlor and any U.S. beneficiaries.
	Premium payments to foreign insurance companies for a policy on the life of a U.S. citizen or resident are subject to a 1% federal excise tax.[6] The payor is responsible for the payment of the tax and filing Form 720. If a U.S. tax treaty exempts the premium payments from this tax,[7] Form 8833 should be attached to the Form 720.
	The settlor and the settlor's U.S. professionals must perform appropriate due diligence. Along with obtaining a sufficient level of comfort regarding the selected foreign life insurance company, they must be satisfied that the policy to be acquired actually qualifies a "life insurance contract" for U.S. tax purposes [8] through obtaining a related opinion of U.S. counsel. In addition, professionals should be consulted in the home jurisdictions of the foreign life insurance company and the foreign ILIT to confirm the potential effects of local law.

Foreign or Domestic Trust Status 

            A foreign ILIT may be established as either a "domestic" or "foreign" trust for U.S. tax purposes. Until the enactment of the Small Business Job Protection Act of 1996 (the "1996 Act"), as modified by the Taxpayer Relief Act of 1997 (the "1997 Act"), there was a great deal of uncertainty in determining such status.[9] A "foreign trust" for U.S. tax purposes is presently one which does not have both: (a) a U.S. court that is able to exercise primary supervision over its administration (the "Court Test"), and (b) one or more U.S. persons with the authority to control all substantial decisions of the trust (the "Control Test").[10]  The terms of the trust instrument and the applicable law as specified therein, must each be considered in determining whether the Court Test and the Control Test were met.  In general, if a foreign ILIT is drafted and maintained as a "domestic" trust for U.S. tax purposes, (for example, there are co-U.S. and foreign trustees with the U.S. trustee having administrative control, and the applicable law of the trust is that of a U.S. state), the burdensome foreign trust compliance requirements described below may be avoided while the trust retains such status. Section 6048(c)(2) indicates that a "domestic" trust of this nature may nevertheless be deemed a "foreign" trust for compliance purposes if it has "substantial activities" or holds "substantial property" outside of the United States (which presumably could apply to a foreign ILIT). To date, the Service has declined to issue the related legislative regulations, and indicated in Notice 97-34[11] that until further guidance is issued, domestic trusts will not be treated as foreign trusts pursuant to that section.           

Planners should be aware that an ILIT will be deemed a foreign trust for U.S. tax purposes if the trust instrument contains an automatic "flee clause," whereby any attempt by a United States court to assert jurisdiction over the trust or otherwise supervise its administration directly or indirectly, would cause the trust to migrate from the United States.[12]  As a result, a practitioner attempting to avoid foreign ILIT treatment may unknowingly cause the trust to be foreign for U.S. tax purposes through making the "flee clause" automatic rather than discretionary.  

Foreign ILIT Characteristics 

      In many ways, a foreign ILIT is quite similar to its domestic cousin, depending upon the motivation and intentions of the settlor. Foreign ILITs may be established through one or more completed gifts from the settlor to the trust or to the beneficiaries through the trust vehicle, although the use of Crummey powers in a foreign ILIT is generally discouraged, as noted below. In this manner, the proceeds of the policy or policies held by the foreign ILIT will escape U.S. estate tax upon the death of the settlor. In the alternative, particularly if the settlor wishes out of paramount asset protection concerns to transfer an amount to the trust in excess of the remaining available unified estate and gift tax applicable credit amount,[13] the settlor could instead make an incomplete gift to a trust in which he retains one of more "tainted" powers.  For example, the settlor may either reserve the right to add one or more new beneficiaries to the foreign ILIT, or to change the interests of the beneficiaries as between themselves so long as the power is not a fiduciary power limited by a fixed or ascertainable standard.[14] Retention of this type of power would not ultimately remove the life insurance proceeds or any other trust assets from his taxable estate, but the loss of 55% of the trust corpus to the U.S. government as estate tax, however painful, is far better than potentially losing 100% to a creditor. 

Funding Foreign ILITs 

          If the settlor of a foreign ILIT follows the traditional ILIT path, the settlor may make one or more completed gifts to the trust, which the trustee then will use in part to pay policy premiums on a policy applied for and owned at all times by the trust. As with domestic ILITs, if the settlor transfers an existing life insurance policy to the trust, he will have to survive for three years for the policy proceeds to escape tax.[15] A lump-sum transfer to the trust would be potentially eligible for the settlor's unified estate and gift tax applicable credit amount.  For example, in 1998, the settlor could transfer up to $625,000 tax-free to the foreign ILIT to be utilized for the acquisition of a single-premium life insurance policy or other trust investments.

        For a number of reasons, practitioners may choose not to include Crummey powers in foreign ILITs:

	Due to asset protection concerns, many such trusts are utilized for single premium policies or are otherwise funded through a single lump sum contribution.
	Where the settlor has a significant privacy concern, he may not wish for the trustee to send periodic written notices of trust additions to the trust beneficiaries.
	Foreign trustees are likely not as accustomed to the Crummey letter procedure as domestic institutional trustees, and they may not wish to assume the related administrative burdens, and, in the best of situations, may not be as prepared to handle them on a timely, periodic basis.
	As further discussed below, the use of Crummey powers may lead to unintended and cumbersome U.S. income tax results for U.S. power holders/beneficiaries.

Beneficiary Withdrawal Powers May Be U.S. Income Tax Traps 

            Domestic ILITs commonly provide two distinct withdrawal powers over trust corpus. As an alternative to "one-shot" funding, such trusts are often funded with transfers intended to qualify for the $10,000 per donee annual U.S. gift tax exclusion[16] through the use of so-called Crummey[17] withdrawal powers held by one or more trust beneficiaries. A Crummey power effectively allows a settlor to make transfers to the trust which are deemed to be completed gifts to the power holders for U.S. gift tax purposes, but which in fact may be used by the trustee for other purposes (e.g., payment of policy premiums) should the power not be exercised.

In addition, one or more beneficiaries (other than the spouse of the settlor) may be provided with a limited power to annually withdraw the greater of $5,000 or 5% of the trust principal (a "5 and 5 power").  This limitation prevents the power holder from facing potentially adverse U.S. estate or gift tax consequences relating to the holding or lapse of a 5 and 5 power.[18] Although the use of Crummey and 5 and 5 withdrawal powers allow for planning flexibility, they may cause unanticipated U.S. income tax results which are exacerbated in the foreign ILIT context after the death of the settlor/insured.

Pursuant to Section 678(a)(1), a person other than the settlor is treated as the owner of any portion of a trust with respect to which such person has a power exercisable solely by himself to vest trust principal or the income therefrom in himself.  In addition, Section 678(a)(2) treats a power holder as such an owner where the power holder has previously partially released or otherwise modified such a power, and after the release or modification retains such control as would, within the principles of the domestic income tax grantor trust rules, subject a settlor of a trust to treatment as the owner thereof.  Thus, for example, the holder of a 5 and 5 power over the principal of a foreign ILIT following the settlor's death will be treated as the owner of a 5% portion of such principal, and taxable on that proportion of the trust's annual income regardless of whether the power is exercised or the related trust income is distributed to the power holder or another trust beneficiary.

Although  Section 678(a)(2) uses the terms "release" and "modified" rather than "lapsed," the IRS nevertheless takes the position that the lapse of a withdrawal power causes an income tax problem for the power holder which grows progressively more severe over time.[19] There is no 5 and 5-type exception of the nature found in Sections 2041 and 2514, which would prevent this adverse result in the U.S estate and gift tax context, respectively, upon the lapse of a 5 and 5 or Crummey power. Thus, the IRS position is that every year a 5 and 5 power lapses (whether cumulative or non-cumulative), the power holder is treated as contributing the amount subject to the power to her own foreign grantor trust. This position has been criticized by commentators.[20] Because the "lapse" or "release" issue has yet to be settled by Congress or the courts, there remains a continuing concern that the power holder's portion of the foreign ILIT's corpus will continue to grow over time, and that he could be subject to U.S. income tax on all of the income and capital gains of such portion.

Section 678 is not a factor during a U.S. settlor's lifetime in a foreign ILIT because the settlor remains subject to tax under Section 679,[21] and is often not of major concern at any time in the domestic context since someone or something will always be currently be subject to tax on the trust's income. After the death of a U.S. settlor in a foreign ILIT, the continuing existence of a 5 and 5 power held by a U.S. beneficiary could give rise to a significant income tax problem that only grows worse with the passage of time.[22] 

Potential Effects of New Section 684 

Under Section 684, which was added by the 1997 tax act, except as provided in yet unissued regulations, in the case of any "transfer of property" by a U.S. person to a foreign estate or trust, gain (but not loss) must be recognized in the amount of the excess of the fair market value of the transferred property over its adjusted basis in the hands of the transferor.[23] Although Section 684(c) provides that a domestic trust which becomes a foreign trust is treated as having transferred all of its assets to a foreign trust immediately before the status changeover, it appears that a foreign ILIT set up as a "domestic" trust for U.S. tax purposes could later convert to a "foreign" trust under certain circumstances without the imposition of a U.S. income tax toll charge.[24]

In the foreign ILIT context, although transfers of cash to the trust by the settlor should not trigger Section 684, the primary issue raised by this rule relates to the death of the U.S. settlor of a trust treated as a "foreign" trust for U.S. tax purposes. The death of the settlor causes the effective end of Section 679 grantor trust status for the trust, and it has been suggested that Section 684 in effect causes a deemed taxable disposition of the assets of the foreign ILIT (including any life insurance policies) immediately prior to the moment of death.[25] Revenue Ruling 87-61[26] held that the former Section 1491 35% excise tax applied to a foreign grantor trust at such time as it was no longer a grantor trust.  Because Section 684 was enacted in conjunction with the repeal of Section 1491, the new statute thus may cause a similar taxable event from an income tax standpoint upon the death of the U.S. settlor/insured. 

On the other hand, one commentator has stated that Section 684 does not apply and was not intended to apply to situations where a foreign grantor trust has such status from its inception.[27]  The legislative history is not particularly illuminating, and no actual offshore "transfer" of property generally occurs in a foreign ILIT upon the death of the settlor.  Until this issue is resolved by the Service or otherwise, one or more of the trust's U.S. beneficiaries could be given an appropriate Section 678 withdrawal power,[28] if such power can be effective simultaneously with the moment of death. In the alternative, the foreign ILIT could be "domesticated" to the United States prior to the death of the settlor by utilizing trust instrument provisions which thereafter in effect allow the trust to satisfy the Court Test and the Control Test. 

Compliance Considerations

The compliance requirements for U.S. settlors and beneficiaries of foreign trusts, which were extensively modified and increased by the 1996 Act and subsequent Service activity,[29]  have been extensively reviewed and dissected.[30] In the foreign ILIT context, the application of the reporting rules depends upon whether the trust is a domestic or foreign trust for U.S. tax purposes. If it has foreign status, its settlor, its U.S. beneficiaries, and the trustee each have there own potential reporting obligations. Any failure to meet these compliance requirements in the absence of reasonable cause is subject to potentially draconian penalties.[31] However, these compliance considerations, although sometimes viewed as the primary reason not to venture into the foreign trust arena, may not be too onerous a burden with respect to a foreign ILIT. 

          In general, Forms 3520 and 3520-A are due annually from a U.S. settlor and the trustee, respectively, for an ILIT treated as a foreign trust for U.S. tax purposes. Notwithstanding Section 679, a U.S. settlor will likely have little or no income to report due to the internal build-up within the policy owned by the trust. The  U.S. beneficiaries of the foreign ILIT will have no Form 3520 reporting obligations so long as they do not receive any direct or indirect distributions from the trust. In this regard, in addition to actual principal and income payments, "distributions" include constructive transfers such as non-arm’s length sales of property or performance of services arrangements, credit card charges paid by the trust or guaranteed or secured by its assets, checks written on a trust bank account, and loans not treated as "qualified obligations."[32]

          Once the settlor has deceased and the life insurance policy paid off, the U.S. tax and compliance focus shifts to the U.S. beneficiaries. If a U.S. person is the owner of any part of the foreign ILIT assets under the grantor trust rules (e.g., through possessing a withdrawal power over trust income) or receives an actual or constructive distribution, such beneficiary must file Form 3520 and ensure that the trustee files Form 3520-A.

Continued Existence of the Trust After Death of Insured

      If the foreign ILIT is to carry on as a non-domestic trust for U.S. tax purposes following the receipt of the policy proceeds, its U.S. beneficiaries should be aware of the potential U.S. tax consequences. If income is accumulated rather than paid annually, it will eventually be subject to the throwback rules[33] and the Section 668 interest charge, which is now the Section 6621(a)(2) underpayment rate rather than fixed at 6% as it was before the 1996 Tax Act. Along with the concerns relating to the compliance rules described above, the high future U.S. tax cost of accumulating income offshore may make such a plan impractical. However, this situation may be avoided or alleviated through mandatory income distributions, annual discretionary distributions of the entire amount of the trust's income, or withdrawal or grantor trust-type powers.[34] To simplify the tax and reporting issues while still offering asset protection for the beneficiaries, the trust (assuming it is a spendthrift trust) could also be redomiciled into the United States as a domestic trust, keeping in mind the Service's position that income accumulated while the trust was offshore is not "cleansed" thereby.[35] In the alternative, the foreign ILIT principal could be reinvested in growth assets to minimize U.S. income and reporting concerns. 

Conclusion 

      Notwithstanding the U.S. tax and compliance legislation of the 1996 and 1997 Acts directed at foreign trusts with U.S. settlors or U.S. beneficiaries, the foreign ILIT remains a viable consideration for utilization in an overall wealth preservation planning structure. Although the benefits of post-death offshore income accumulation have in effect been reduced, there are still situations which dictate its use, particularly where an additional degree of asset protection is desired. The factors and legal issues described in this article are by no means a complete discussion of all potentially relevant facts and circumstances regarding foreign ILITs, and each person's own situation and overall estate plan must be taken into account in determining whether to go offshore.