Volume VIII, Number 1 – January 1999
© Donlevy-Rosen & Rosen, P.A.
INTRODUCTION. Contractual arrangements which qualify as annuities for U.S. income tax purposes provide a tax-deferred (not tax-free) environment within which investments can grow. “Tax-deferred” means that, as long as certain statutory and regulatory requirements are satisfied, no U.S. income tax will be imposed on the earnings and gains generated within the annuity contract. Annuities are available in a variety of “shapes and sizes”. In the following discussion, we will be describing a deferred variable annuity product offered by a Swiss company we recommend to our clients. A variable annuity provides the investor with a choice of investment alternatives under the annuity contract. A deferred annuity is an annuity under which the commencement of payments is deferred until a specified date/event.
HOW ANNUITIES ARE TAXED. The United States imposes income tax when a distribution is made from an annuity contract. Distributions from annuity contracts are of two types: annuity distributions and non-annuity distributions.
When annuity distributions are received, our tax law provides that a portion of each payment will represent a return of the amount paid into the contract (and be received tax-free) and a portion of each payment will represent the previously tax-deferred earnings on the contract (and be subject to current taxation as ordinary income). Annuity payments will be fully taxable after the amount paid into the contract has been received under the above formula.
When non-annuity distributions are made from the annuity contract, they are generally treated as consisting entirely of previously deferred income on the contract (to the extent thereof) and are taxable as ordinary income. There are traps for the unwary here: for example, merely pledging an annuity contract as collateral for a loan will be treated as a non-annuity distribution of the amount pledged, fully taxable to the extent the amount pledged is not greater than the then deferred income on the contract.
Another pitfall arose in 1998, when the Internal Revenue Service issued final regulations which classified certain annuity contracts as debt instruments, subject to the original issue discount (“OID”) rules. A discussion of the OID rules is beyond the scope of this newsletter. However, the negative impact of that classification will be not only to cause current taxation of ordinary income earned on the contract, but also to possibly convert capital gains earned on the contract into current ordinary income (all annuity contracts convert capital gains into ordinary income, but usually the deferral feature makes this worthwhile). Solution? Always obtain a written opinion from a qualified U.S. tax attorney that your offshore annuity will be treated as an annuity for U.S. income tax purposes.
ADVANTAGES OF OFFSHORE ANNUITIES. U.S. annuity companies typically offer investment alternatives under a variable annuity in the form of mutual funds offered by the insurance company issuing the annuity contract. Substantially greater investment flexibility is available under a carefully chosen offshore annuity. For example, the client’s chosen investment advisor can direct the annuity investments in any type of security (subject to reasonable diversification requirements): IBM, Intel, General Motors, etc. — not restricted to “in-house” mutual funds of the issuer. The investment advisor can be the client’s existing U.S. investment advisor or any other unrelated person chosen by the client.
The return generated within the offshore annuity will be entirely dependent upon the performance of the investments in the client’s underlying segregated account (i.e., no ceiling, no floor – but tax deferred). One of the available benefit payment options is a lump-sum payment. If this option is selected, the beneficiary (e.g., the client or his offshore trust) will receive the full value of the segregated account at the payment date. An additional benefit of such a segregated account will be that the client’s assets are not included in the balance sheet assets of the issuer, and will not, therefore, be subject to the debts of the issuer.
Another advantage, from an asset protection perspective, is that the offshore payor of the annuity described in this issue is a company not subject to U.S. court jurisdiction. This means that a garnishment or attachment order issued by a court in the United States will be ineffective with respect to the offshore annuity issuer. A U.S. claimant would be required to obtain an order from an appropriate court in the country where the corporate payor is resident in order to effect a garnishment.
Finally, the United States requires its citizens and residents to report foreign financial and bank accounts. Annuity contracts do not fall within either classification, and thus are not subject to the foreign account reporting requirements.
ADDING MORE PROTECTION & FLEXIBILITY. The strongest asset protection can be structured where an offshore trust is the owner of the offshore annuity contract. By holding the annuity contract in the properly structured offshore trust, it will derive the added benefits of the protection afforded by the offshore trust (See, AP NEWS, Vol. IV, No.2).
Another benefit of holding the annuity in the offshore trust is the added flexibility of the dispositive provisions of the trust. For example, the trust can authorize the trustee to withhold direct distributions to a drug-addicted, alcoholic, or otherwise impaired beneficiary, and it can provide the trustee with the means by which to utilize the trust assets/income for the impaired beneficiary without making a direct distribution to that person. The annuity contract cannot provide that degree of flexibility. Along these same lines, a properly drafted trust instrument can authorize the trustee to withhold a direct distribution to a beneficiary who is going through a divorce, who is involved in litigation, and the like. As in the case of the impaired beneficiary, the trustee can be authorized to utilize trust assets and income indirectly for the benefit of a beneficiary in such circumstances; an annuity contract alone cannot provide such flexibility.
Lastly, an income tax advantage. Although annuity payments received by an offshore trust during the life of the U.S. grantor of the trust will be taxable on the U.S. income tax return of the U.S. grantor in the manner described above, payments from an offshore annuity made to an foreign trust after the death of the grantor/annuitant will only be taxable to the U.S. beneficiaries of the trust when distributed to them by the trust. Thus, an additional deferral benefit is available for the surviving beneficiaries.
CONCLUSION. The annuity described in this issue is not for everyone. The issuer requires a minimum initial investment of $2,000,000. However, where appropriate, combining a carefully selected offshore annuity with a properly designed offshore trust (See, AP NEWS, Vol. VII, No. 2) can provide a powerful planning option. Note: the subject addressed in this issue has been covered in an overview fashion, necessarily omitting many details.