FUNDING THE OFFSHORE STRUCTURE

 

A U.S. citizen or resident ("U.S. person") forms an FNGT, the FNGT forms an IBC. The IBC isminimally capitalized by the FNGT. The officers and directors of the IBC must not be the Settlor of the FNGT. Transfers to a foreign trust include:

1. Gifts. The Settlor or transferor must use his lifetime exemption for making transfers to the FNGT.⁵³ Such transfers will cause a gift tax return to be filed in addition to Form 3520, and the Settlor must pay gift taxes to the extent that the gift exceeds his lifetime exemption;

2. Loans. From a tax point of view, loans to the IBC are counterproductive. Interest the IBC pays the Settlor is deductible to the IBC against its 0% bracket and includable by the Settlor in his high bracket;

3. Investing into the Foreign Corporation. Generally a risky idea. Be sure the IBC does not become a CFC, PFHC or a PFIC.

4. Annuity. Sell the IBC assets in return for a Private Annuity.⁵⁴ The Private Annuity is an arrangement whereby an annuitant can transfer property to a Payor in exchange for an unsecured promise to pay to himself periodic payments for his life.⁵⁵ The installments can start immediately or at some future point in time. It does not matter if the Payor is easily able to make the annuity installments with or without the assets transferred. Installments are calculated with reference to the amount of the assets transferred, the date when they start, and the annuitants actuarial life expectancy.

The private annuity with the IBC is an exchange for equal value, as such the annuitant need not use his lifetime exemption or pay the IRC §684 tax (the successor to IRC §1491 Excise Tax).⁵⁶ The private annuity has the following advantages:

a. Asset Protection. Assets transferred are not available to creditors, nor can the right to future payments be accelerated.

b. Capital Gains Deferral. Capital gains is payable on each installment of the annuity as the installments are received.

c. No Gift or Estate Tax and No Tax on Future Growth. The value of the annuity is calculated on the fair market value of the assets transferred. If the Annuity is based upon a lesser value, the excess value is subject to gift tax. The transfer of assets to the Payor is not a taxable transaction because the unsecured promise to make lifetime payments has no determinable value.⁵⁷ Future appreciation is also transferred to the Payor.

By using the Private Annuity an annuitant reduces the size of his estate by the value of the assets transferred less the annuity payments which the Annuitant receives, without incurring gift or estate tax (since the annuity terminates upon his death).⁵⁸

d. IRC §684. IRC §684 imposes a tax on the transfer of appreciated property to a foreign entity. The terms of any annuity must be based on the IRS' actuarial tables.⁵⁹ Gain realized under §684 would be the difference between the "amount realized" (determined as the present value of the annuity) and the "adjusted basis" of the property transferred pursuant to IRC §1001(a). For the calculation of gain, the amount realized will be deemed equal to the present value of the private annuity.⁶⁰ The character of the gain is dependent upon the type and the holding period of the property. Upon the creation of the Annuity the Payor receives the assets at their FMV which in the hands of the Payor has a basis for tax purposes equal to the amount of the actuarial value of the annuity payments to be made. Accordingly if the annuity payments are properly calculated, no immediate gain will result.

e. Taxation of the Annuity Installments.⁶¹ IRC §72 relates to the taxation of private annuities. When the Annuitant receives each annuity installment the Annuitant will receive:

i. A return of part of his original basis, there is no tax on this part;

ii. Some of the deferred capital gain (if any) which will be taxable, and

iii. The balance is interest income.

Ninth Circuit Upholds Private Annuities With Foreign Trust. In Stern vs. Commissioner,⁶² the court of appeals approved an arrangement that allowed a couple to avoid more than $2.5 million dollars in taxes by transferring stock of their closely-held business to an offshore trust in the Cayman Islands in exchange for a lifetime annuity. It is the IRS’s position that the purchaser (in this case the offshore trust) should be adequately capitalized or the annuity transfer may not be deemed effective. The 9th Circuit (in Stern), disagrees.

Potential Estate Tax Savings. On the annuitant’s death no estate taxes are payable. On the other hand, if the Annuitant lives beyond his life expectancy he may receive in annuity installments more than the value of the property originally exchanged for the annuity. This is one of the risks of an annuity, namely that the Annuitant may receive in return for his assets more than he expected and so may put a financial strain upon the Payor (the IBC).

The annuity contract must be unsecured. If the annuity installments are secured, then upon the transfer of assets to the Payor any capital gain will be recognized at once instead of ratably as and when each annuity installment is received.⁶³

 

  

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