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Foreign Life Insurance: Taxable Income? FBAR reportable?

by: Anthony Parent   2013-08-01

 

There are many benefits of having life insurance. Life insurance is most commonly used as a means to make sure loved ones have financial security in the event of the sudden demise of the insured person. Different types of life insurance products have different features. Some of the products offer a fixed death benefit for a certain number of years and at the end of the term of the policy, the insured and insurer can go their separate ways. The downside for those who have foreign life insurance policies, is that there may be punitive FBAR tax penalties imposed by the IRS for not reporting the life insurance policies correctly.

 

There is one type of policy that is intended to protect the insured for life. This type of policy has a cash surrender value. These policies collect premiums from the policy-holders that are in excess of the actuarial cost to insure the insured person. The life insurance company then invests the difference in various financial instruments. Over time, the policy-holder continues to make premium payments and the actuarial cost to insure the insured person’s life is continuously deducted from the cash value. In the process, the financial instruments are expected to grow in value and in this process so does the cash value of the policy. These policies can become an investment and potentially a tax-free legacy gift to one's heirs.

 

This second type of policy is heavily regulated because Congress did not want life insurance policies to be a huge loophole to avoid taxes. Can you imagine an individual who in the hospital with less than 24 hours to live deciding to buy a $10 million life insurance policy and funding it with $10 million so that the life insurance money is paid out to his heirs tax free? This is exactly why congress has lots of regulations. Congress did not want to enable life insurance companies to design products with the sole intent helping American taxpayers avoid taxes.

 

How the IRS controls the life insurance "loophole"

Life insurance companies can retain and grow these cash values without the tax burdens felt by the insured or its beneficiaries. This is a tremendous benefit to taxpayers. No tax on capital gains or dividends on the financial instruments managed by the life insurance company. In order to maintain all these tax benefits, life insurance policies are held to very strict standards and requirements.

 

Life insurance policies with cash values in the United States are designed so that the insured and its beneficiaries do not pay taxes on the growth of the cash value. This can make them an incredible investment vehicle. When cash value life insurance policies are purchased in the United States, the insurance company and their representatives are aware of the regulations. 

 

How the IRS controls affect foreign life insurance policies

A complication occurs when policies are purchased overseas. When taxpayers have more than $10,000 in foreign accounts they must file FBAR reports. Taxpayers must report life insurance policies and the cash surrender value.  When an individual takes out a life insurance policy overseas, one issue that arises is that these policies are not held to the same regulations.

 

This doesn’t make these policies any less financially sound, they just were not designed with the intent of complying with the Internal Revenue Code. Foreign life insurance policies that don’t meet the strict criteria as defined in are not considered life insurance and may be considered by the IRS a taxable financial account. This means the growth of the cash value may be considered taxable and may subject policy-holders to tax penalties in the United States.

 

Life insurance policies that do not meet the strict requirements of the Internal Revenue Code are taxable and may be subject to penalties. In order for foreign life insurance treated as a non-taxable life insurance policy, the policy must meet 1) Cash Value Accumulation Test, 2) Guideline Premium Requirements, and fall within the IRC’s cash value corridor.

 

First, a foreign life insurance policy qualifies as a nontaxable life insurance policy for purposes of FBAR if it meets the Cash Value Accumulation Test. In order to meet this test, the cash surrender may not exceed the net single premium to fund the future benefits of the life insurance contract. This section of the internal revenue code was designed to prevent savvy financial planners from stashing assets in life insurance vehicles and abusing the benefit tax-free growth. Not all foreign insurance products meet this requirement. In addition to this requirement, there are a number of computational rules found in the Internal Revenue Code that congress included to limit abuse of the tax benefits.

 

Second, a foreign life insurance policy qualifies as a nontaxable life insurance policy for purposes of FBAR if it meets the Guideline Premium Requirements and falls within the Cash Value Corridor.



 

The guideline premium test requires that the aggregate of premiums paid to date under contract do not, at any time, exceed the greater of the guideline single premium or the sum of the guideline level premiums. 

 

The second part of the test requires the cash value of the policy not exceed a specific percentage of the death benefit. Looking at this chart, if someone 40 years old purchased a life insurance policy, the death benefit must be at least 250% of the cash value.

 

If a life insurance policy fails to meet either the Cash Value Accumulation Test of the Guideline Premium Requirement/Cash Value Corridor Test, the IRS will treat the life insurance contract as an investment and the interest or growth of the cash value may be subject to FBAR penalties if left undisclosed on various schedules of Form 1040 and FBAR forms.

 

Conclusion: If the IRS make such a determination that a Life Insurance policy is subject to FBAR reporting, and FBARs have not been filed, the results could be devastating for the policy-holder. As the IRS may be able to assess FBAR penalties three-times the value of the Cash value of the property --- causing the policy-holder not only to have to go outside the value of the life insurance policy but, from external sources --- other assets --- in order to pay in full assess FBAR penalties. 

 

NOTE: An international/foreign insurance company can elect to be treated as a domestic insurance company under tax code 953d, to avoid being treated as a CFC. Since 2014, the rumors are IRS is getting hard on this. There is a risk that the IRS will not recognize the election, thus treat the insurance company as CFC, which a lot of filing requirement will come.

 

If you need assistance filling out or amending your FBAR, or if you have questions or concerns about past FBARs you may have misfiled or not filed, contact us at 888-727-8796 or email info@irsmedic.com. We can help. 


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