As a US tax lawyer, I see ghosts. Poltergeists, actually – the ghosts who cause real damage. The poltergeists are certain types of foreign financial assets which are perfectly normal outside the US. But they wander the separate dimension of US tax regulations and haunt the US citizens who brought them to life.
Some of these poltergeists I’ve written about before include non-US mutual funds (the dreaded PFICs), non-US retirement plans (usually cursed to be foreign trusts without tax benefits), and non-US property mortgages (which disappear into thin air in foreign disclosure penalty calculations).
Life insurance, however, is the foreign asset poltergeist with the most fiendish combination of scare tactics. It gives US citizens false hope of tax benefits, dangles them over the Passive Foreign Investment Company (PFIC) precipice and sucker punches them with an excise tax, all while creating a heavy reporting burden.
Tempting US Life Insurance Tax Breaks Usually Don’t Apply
The basic concept of life insurance, to provide a benefit to loved ones or associates after someone passes away, is a great concept to begin with. Political lobbyists for the US life insurance industry have also managed to attach tax benefits to certain life insurance policy structures that meet a strict set of guidelines. Non-US life insurance policies rarely meet those guidelines. After all, why would they? The foreign insurance companies’ target markets are outside the US. Those US tax breaks typically offer false hope to US expatriate insurance buyers. In the rare – maybe even “unicorn” – cases where a non-US life insurance policy does provide those tax breaks, it is because it
- passes the US Cash Value Accumulation Test
- meets the US Guideline Premium Requirements and
- falls within the US Cash Value Corridor.
These three requirements are, in summary, designed to ensure that the cash in the policy and benefits payable do not exceed the premium payment(s) by too great an amount. In other words, tax planners should not build up too many assets in a tax-advantaged policy. Don’t expect a foreign life insurer to know – or be overly concerned with – qualifying for special treatment under these US regulations.
Foreign Life Insurance and the PFIC Precipice
Passive Foreign Investment Companies (PFICs) rules are about as bad as they come in the realm of foreign asset disclosure. I wrote all about them here. Foreign life insurance policies almost always involve assets invested in foreign mutual funds aka PFICs. If you have a foreign life insurance policy, therefore, one of the first things to check is if you have PFIC exposure. You probably do, and in all likelihood you should be paying tax every year on the value of the policy assets.
The Excise Tax on Foreign Life Insurance
According to Internal Revenue Code Sections 4371 and 4372, you must pay an excise tax of 1% on premiums you pay for foreign life insurance. If you ever wondered what protectionism looked like, now you know! This relatively obscure excise tax is designed to encourage you to buy a US policy (with no such tax) as opposed to a foreign one.
You may be able to avoid this tax if the foreign insurer has an exemption based on an international tax treaty concluded with the US. Tax treaties are notoriously tricky. Please consult a specialist when in doubt.
Reporting Requirements Triggered by Foreign Life Insurance
Apart from having to pay tax on your foreign life insurance policy, you will also have to report that you have to pay tax on it and report your ownership of it. That means submitting:
- Form 720 for the excise tax described above
- Form 8833 for when Form 720 does not apply, thanks to a treaty-based exemption
- Form 8621 for each PFICs associated with the policy
- Form 8938 for “specified foreign financial accounts” such as the policy
- FinCen Form 114 for foreign financial accounts, such as the policy
Who You Should Really Call with Foreign Life Insurance Issues
If you have a foreign life insurance policy and have not kept it compliant under the US regulations outlined above, you will owe back taxes and face penalties and/or criminal prosecution from the IRS. You should really call a specialist to help with damage control. I’m afraid there aren’t really any happy endings for PFIC stories, whether connected to foreign life insurance or not. PFIC tax treatment is just too harsh. You can, however, reduce the risk of penalties and criminal prosecution by taking part in the Offshore Voluntary Disclosure Program (OVDP) or the Streamlined Offshore Procedures.
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