Domesticating a FNGT vs. Using PPLI

Why PPLI Can Be A Better Choice

When the grantor of a foreign trust dies that has U.S. beneficiaries, the trust becomes a Foreign Non-Grantor Trust, (FNGT) for U.S. tax purposes.  If distributions are then made to U.S. beneficiaries, the trust is exposed to a draconian tax regime. For our discussion, we will refer to this section of the tax code (ss665-669) as the throwback rules.

Briefly, the throwback rules are special rules that can result in adverse tax consequences when a foreign non-grantor trust earns distributable net income (DNI), which accumulates and becomes undistributed net income (UNI), before being distributed to US beneficiaries in later years.

Two common ways of dealing with this issue are domesticating the trust to a low tax jurisdiction in the U.S. like South Dakota, Nevada, or Delaware, and using a Private Placement Life Insurance (PPLI) policy to shield the trust from these significant taxes.  We will briefly discuss and contrast these two solutions.

Amidst this discussion, we will add a little levity in the form of two poems that you hopefully will find amusing and on point.

The Happy Niece

U.S. beneficiaries pay hefty tax,

Those FNGT assets get the axe.

PPLI structuring shows the way,

With a great solution to save the day.

Clients will receive a well-deserved peace,

Desired assets can even pass to their niece.

The PPLI solution is a clear winner when there are both U.S. beneficiaries and non-U.S. beneficiaries, and when there are both U.S. investments and non-U.S. investments.

If the trust is domesticated, adverse tax consequences arise when U.S. beneficiaries are attributed ownership of certain foreign assets held by the trust, such as passive foreign investment companies. The domesticated trust’s U.S. status may increase the administrative burden of establishing and maintaining banking relationships outside the U.S.  Non-U.S. beneficiaries may not find domestication the ideal solution if they would otherwise have little or no U.S. ties.

The PPLI solution does involve fees and the cost of the death benefit on the insured life in the policy.  Usually the tax and privacy advantages of using insurance outweigh these costs.  Although there are less tax benefits, using an annuity instead of life insurance reduces the costs and simplifies the transaction.

Domestication is attractive because the throwback rules have limited application to U.S. trusts.  As with the PPLI solution, domestication rarely reduces existing UNI, it prevents further accumulation of UNI. This makes sense, because undistributed income of a U.S. non-grantor trust is taxed currently, rendering moot the throwback rules’ anti-deferral purpose. Still, without additional planning tools, such as a life insurance or annuity contract, domestication generally subjects ‘domesticated’ income to current U.S. taxation, regardless of the income’s source or whether or not it is distributed.

Foreign investments within the now-domesticated US trust could also raise controlled foreign corporation and passive foreign investment company considerations, making such investments less attractive and indirectly restricting the trust’s investment universe.

Once investments are part of a properly constructed PPLI policy none of the following are treated as taxable income:

  • The income and investment returns inside the policy;
  • Withdrawals up to premium;
  • Policy loans, and;
  • Death benefit proceeds.

Therefore, these items are also not considered DNI and cannot add to the FNGT’s UNI.  Furthermore, trust assets can be used to pay the life insurance premiums on the policy, depleting the existing source of trust DNI.

Prized Relief

Pre-immigration PPLI is wise,

To guard against U.S. taxes will be your prize.

If minimizing taxes is what you conceive,

Your find reward you will surely receive.

Assets grown tax-free will be your motif,

To achieve this goal is a true relief.

Please give us your thoughts, comments, and suggestions.  We hope our brief overview brings into focus how these two methods of dealing with the throwback rules can serve you.

 

 by Michael Malloy, CLU TEP, @ Advanced Financial Solutions, Inc