Investment Tax Planning: Private Annuity – Life Insurance

March 20, 2017  |   Posted by :   |   International Tax Planning   |   0 Comments

The “mechanics” are as follows:

1) For clients with over $3m (investable) have them consider funding a Private Annuity (“PA”) (Nassau, governed under Puerto Rico law) for asset protection, investment diversity (including closely held companies) and confidentiality. The PA funds a non-modifed endowment contract (“non-mec”) Private Placement Life Insurance (“PPLI”) over 5 separate years so then policy withdrawals are either tax-free (return of basis) or tax-free loan proceeds (i.e. earnings over basis are borrowed out and repaid from policy death benefit on a leveraged basis i.e. policy premiums which pay for the death benefit are on a leveraged basis)

2) Tax and other advantages include: under the PA, tax deferred compounded earnings (not subject to tax until withdrawn as annuity payments, the annuity policy is collapsed, or the annuity is used for a loan to the annuitant). Under the PPLI, tax-exempt earnings withdrawn as either basis recovery or received as a tax-free loan.

3) Under either the PA and/or PPLI no annual reporting for earnings to the IRS (which minimizes audit risk);

4) Under either the PA and/or PPLI no 3rd party creditor attachments (absent a fraudulent conveyance) since under the governing law (Puerto Rico) annuities and life insurance are exempt from creditor attachment.

5) Complete confidentiality (very important for asset protection) since in Nassau disclosure of financial information is a crime subject to jail.

In addition, the funds may be held in the US, in an account with a major company, under the direction and control of the designated investment advisor and invested accordingly (included selecting a Depository US bank, and Custodian).

For tax compliance purposes, a Puerto Rico annuity or life insurance policy is not considered a foreign jurisdiction for FBAR reporting (i.e. foreign accounts over $10k re: FinCEN Form 114). Since the annuity and life insurance policies are not owned by an individual (they are owned by a California Limited Liability Company, one-member disregarded entity, which is wholly owned by a California trust; CA has very favorable asset protection laws for Trusts and LLCs) there is no requirement to file Form 8938: FATCA annual filing (attached to Form 1040 Individual Tax Return) for annual disclosure of foreign financial assets over $50,000 (see IRS instructions to Form 8938 which confirms the filing is only due for an individual not a limited liability company or other entity).

For estate and gift tax savings:

1) If the California trust is irrevocable, the assets contributed up to $10.98m (2017) husband and wife are exempt from gift tax and if the trust has additional beneficiaries under the withdrawal provisions (known as “Crummey” withdrawal rights, under the federal case of the same name) each beneficiary listed will increase the withdrawal rights by $28k per done (“gift splitting” husband and wife”). So if there are 5 beneficiaries of the trust, an additional $140k per year may be contributed estate and gift tax-free.

2) The estate and gift tax advantages of funding the trust (irrevocable) with the maximum $10.98m (2017) is that the future appreciation (after asset contribution) is excluded from 40% federal estate and gift tax upon death of trust settlors. For example, if $11.38m is contributed in 2017 (e.g. trust with 5 beneficiaries) and the trust is worth $21.38m at death the $10m in appreciation escapes 40% estate tax (i.e. a $4m estate tax savings.

3) In addition, estates over $10m have a nearly 100% audit tax rate. While gift tax returns have a 1.42% current audit tax rate for Form 709 Gift tax returns.

In the IRS 2012 Data Fact Book, reported during fiscal year 2012 (through 9/30/12), latest publicly available report, Estates between $5m and $10m audited nearly 60% rate, estates over $10m, 100% audit rate compared to Form 709 gift tax returns 1.42% audit rate i.e. of 223,090 tax returns filed, 3,164 audited).

The estate and gift tax planning are for the maximum allowable estate and gift tax free contribution of $10.98m (plus annual donee gifts). For assets over $10.98m they may be sold tax free to the trust under
the grantor trust rules.

The trust is an intentionally defective grantor trust (i.e. the income is taxed to the Settlor/Grantor and does not require a separate annual Form 1041/541 Fiduciary Income Tax Return filing, rather than income may be reported on Schedule E attached to the Settlor’s Form 1040). The tax status as a grantor trust means there is a tax bifurcation: the income is annually reported and subject to income tax by the grantor. The assets in the trust are exempt from estate and gift tax on the grantor’s death (saving a 40% estate and gift tax on the Settlors’ death on the value in excess of $10.98m (2017).

Grantor trust status is secured by including prohibited administrative powers in the trust: unsecured loans, power to substitute assets). Any assets over $10.98m may be contributed by a sale i.e. assets are “sold to the trust” under a Promissory Note. Since the trust is a grantor trust, there is no capital gain tax (due to the Seller/Grantor) by the sale of assets to the trust. The “interest” paid to the grantor, for sale of the assets, from the trust is also not a taxable transaction and does not have to be reported to the IRS on the Grantor’s Form 1040 annual income tax returns.

For more information please see an article I recently wrote for, Tax Planning for US Investors – Doubling Net Return on Investment.

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IRS Tax Audits – Criminal Tax (2017)

March 16, 2017  |   Posted by :   |   IRS Tax Audits   |   0 Comments

The IRS reported that in fiscal year 2016 they initiated 3,395 federal criminal tax cases thru the IRS/Criminal Investigation Division (which is the only federal law enforcement agency with jurisdiction over federal tax crimes). The focus of these cases included: money laundering, public corruption, cyber-crimes. For FY 2016, the IRS/CI conviction rate was 92%.

The IRS/CI investigates criminal violation of the Internal Revenue Code, which overlaps into related financial crimes e.g. money laundering which are subject to criminal prosecution by the US Dept. of Justice.

As stated by Commissioner of the IRS, John Koskinen: The IRS continues to work to ensure that everyone is playing by the same rules and paying their fair share (of tax)…. The IRS is committed to fairly administering and enforcing the tax code, and our criminal investigation division plays a critical role in that effort”.

Regarding IRS Civil Tax Audits, the audit rate has declined for individual taxpayers (in 2007: 1.38m taxpayers audited, 2010: 1.58m, 2016: 1.03m taxpayers were audited which is 0.7% i.e.1 in 143 risk) and for business taxpayers (Corporations, Partnerships and S-Corporations audit rate was 0.49% lowest level since 2004 (0.36%).

High Income Earners also saw a decline in IRS tax audits for taxpayers making over $200k (1.7% audit rate), over $1m in income (5.8% audit rate).

The decline in IRS audit rates is due to a reduced IRS budget (2010: $12.2B; 2016: $11.2B) and less employees in the IRS (between 2010-2016 the IRS lost more than 17,000 employees so now a little more than 80,000 people work at the IRS).

However, due to 3rd party information reporting, there is less opportunity for taxpayers to cheat on their taxes. The IRS collects information to verify taxpayer’s tax reporting including: Employers report wages, Banks report interest, Brokerages report sales/capital gains, and Lenders report mortgage interest.

As stated by the IRS Commissioner, “the IRS still audits over 1m tax returns per year… spinning the roulette wheel and risking an audit can be an expensive bet… considering unpaid tax, penalty and interest from an audit”.

IRS budget cuts may be illusory since the IRS collects 93% of US tax revenue. As stated by Tony Reardon (President of the National Treasury Employees Union, which represents IRS workers: “You cannot increase defense spending (as proposed by the new administration to increase defense spending by $54B) and cut IRS funding at the same time. It does not add up…” which was echoed by Steven Mnuchin the new Secretary of the Treasury in his confirmation hearings.

For US taxpayers concerned with either IRS civil tax audits/ or criminal tax issues the keys are to maintain good records, have legal authority in the form of a tax opinion citing favorable law which supports the Taxpayer’s tax returns, and be professionally represented.

In the words of Mark Twain: “Do the right thing. It will gratify some people and astonish the rest.”

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New IRS Tax Rules (2017)

March 15, 2017  |   Posted by :   |   IRS Tax Audits   |   0 Comments

In IR-2016-139 (10/25/16) for tax year 2017 the following new IRS tax rules apply:

1) Standard Deduction:

Singles: $6,350 (2016: $6,300)

Married: $12,700 (2016: $12,600)

2) Personal Exemption

Singles: $4050 (2016: same)

This exemption is subject to a phase out and is reduced by 2% for each $2500 of Adjusted Gross Income over threshold AGI levels, as follows:

Single over $261,500 (phased out at $384,000);

Married over $313,800 (phased out at $436,300)

The phase out of may add as much as 1.05% to marginal tax rates.

3) Itemized Deductions

These deductions are reduced by 3% of Adjusted Gross Income (AGI) over $287,650 for singles, $313,800 for married couples filing jointly and are fully phased out for Single Taxpayers at $418,400 (2016: $415,050) and Married Taxpayers at $470,700 (2016: $466,950).

The itemized deductions are reduced by 3% of adjusted gross income not to exceed 80% of total itemizations (medical expenses, investment interest deductions, and casualty losses are all exempt).

The phase-out in itemized deductions is based on the amount of AGI and net taxable income (ie. what is left after itemized deductions). The phase-out in itemized deductions may add up to 1.19% to marginal tax rates.

4) Alternative Minimum Tax Exemption

Single: $54,300 (phase out begins at $120,700)

Married: $84,500 (phase out begins at $160,900)

5) Foreign Earned Income Exclusion:

Single $102,100 (up from $101,300/2016)

6) Estates

Decedents who die during 2017 basic exclusion amount is $5.49m/Husband and Wife $10.98m (up from $5.45m/$10.90m/2016)

In addition Federal Payroll Tax planning (FICA/Medicare) has become more complex as these tax rates continue to increase.

In 2017, the Social Security Tax (“FICA”) aka Old Age, Survivors and Disability Insurance (OASDI), taxable wage base (on which the 7.65% tax is computed i.e. FICA 6.2%/Medicare 1.45%) increased from $118,500 (2016) to $127,200 (2017). This $8700 increase in the taxable wage base is more than double most previous wage base increases.

The maximum 2017 OASDI portion of the Federal Insurance Contributions Act (FICA) tax is payable by each employee and is $7886 (6.2% of $127,200/2017 taxable wage base);the Medicare tax is 1.45%(with no wage tax base ceiling). In tax year 2017, the first $127,200 would have a Medicare tax of $1884.

For 2017, the total payroll tax for employees (FICA/Medicare) is $9730. For employers of closely held companies who pay themselves a salary the Employer/Employee combined tax is $19,460.

The taxable wage base in excess of $127,200 remain subjects to an unlimited 1.45% Medicare tax on wages. For taxpayers whose wages are over threshold amounts ($200k/individual & $250k husband and wife) there is an additional 0.9% Medicare tax on earned income (which is in addition to 3.8% Medicare tax on investment income); the tax is then 2.35% so high earners who have closely held companies pay an additional combined 4.7% tax.

Tax Planning Strategy (Closely Held Companies)

To the extent possible, investment income (as compared to wages/earned income) should not be paid out as wages (by the owners of closely held companies). Otherwise the wages are subject to $19,460 in Social Security Taxes (Employer/Employee share) and Medicare taxes up to 2.35% (4.7% Employer/Employee share).

Instead, consider segregating investment assets into a CA limited liability company owned 99% by an S-Corporation, which is also the Manager (and 1% by a California Revocable Trust, which trust owns the S-Corporation /100%).

In this scenario, the LLC receives the investment earnings, distributes net income (after expenses) to the S-Corporation (99% Member/ Manager). The S-Corporation may allocate a portion to salary, fund a profit sharing or defined benefit plan creating a “tax-shelter for the investment earnings” or make a net distribution (after payment of a reasonable salary to officers) as S-Corporation income to the S-Corporation Shareholders (S-distributions do not have payroll taxes due).

This tax planning has both income tax and asset protection benefits as follows:

1. Unlike an LLC, S-Corporation distributions do not have payroll taxes imposed, which saves $19,460 on $127,200 of S-distribution (as well as a combined 4.7% on distributions received by S-shareholders in excess of the $127,200);

2. The S-Corporation may shelter LLC distributions from tax by making profit-sharing plan/pension contributions in allowable amounts based on salaries (with the excess over salary available as an S- Distribution);

3. Tax audit risk is reduced eg. IRS audit risk is approx. 1% for all taxpayers (and higher for taxpayers who earn more income). The IRS audit risk for S-Corporations is approx. 4/10 of 1% so an S- Corporation has a much lower risk of audit. At the highest income levels i.e. over $1m IRS audit risk is over 10%, over $5m is nearly 20%, over $10m is nearly 35%.

In addition the California/US Income tax “blended tax rates for wage earners is nearly 52% (Federal Tax Rate 44.3% with Medicare taxes; California tax rate: 13.3%); this 51.7% tax rate applies to wage earners.

For investors, the top rate on net investment income is 50.92% (Federal Tax Rate: 43.4%; California Tax Rate: 13.3%).

For taxpayers the phase-outs for personal exemptions and itemized deductions may increase the “blended tax rates” to up to 55%.

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The Panama Papers: Street Protests in Panama

February 22, 2017  |   Posted by :   |   Panama Papers   |   0 Comments

On 2/19/17 thousands of Panamians protested in the streets carrying signs “No More Governments of Thieves and the Corrupt”. They were demonstrating over the most recent scandal emerging from the Panama Papers the Brazilian firm, Odebrecht who paid $788m in bribes to win construction contracts in 12 countries (including $59m in bribes in Panama). Odebrecht has agreed to pay the largest fine ever ($3.5b) to the US Dept of Justice.

Panama has requested Interpol issue “wanted alerts” for the sons of the former Panama President, Ricardo Martinelli, who was President during 2010-2014 when the $59m in bribes were paid in Panama.
In Panama, prosecutors raided the offices of Mossack Fonseca, the law firm at the center of the scandal, seeking evidence of their links to Odebrecht.

In the words of one of the street protestors: “The goal of the protests is to demand that all those corrupt in all the parties and businessmen are investigated so they return the money and go to jail”.

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IRS Offshore Voluntary Disclosure Program: Declines and Withdrawals

February 21, 2017  |   Posted by :   |   OVDP   |   0 Comments

Taxpayers with undisclosed offshore holdings who applied for the IRS Offshore Voluntary Disclosure Program (OVDP) through the pre-clearance process but were either denied access to the OVDP, or later withdrew from the program face increased risks.

On February 1, 2017 the IRS Large Business and International Division of the IRS released a 13-item list for issue-based examinations and concerns for tax compliance, which included IRS/ OVDP Declines/Withdrawals.

Under these new IRS/OVDP rules:

1) Anyone who opts out of the IRS/OVDP is subject to an immediate IRS civil tax audit of his or her tax returns and FBAR filings. Information that the taxpayer submitted in either the pre-clearance process or to the IRS/OVDP (subsequent to the pre-clearance but prior to withdrawal) may be evidence used against them.

The IRS filing was submitted without either transactional or use immunity. Upon submission, the Taxpayer waived constitutional objections including: the 5th amendment right against self-incrimination, 4th amendment right against unreasonable searches and seizures.

2) Increased IRS tax audits are portended for continued tax non-compliance if the IRS receives information (not disclosed by the taxpayer) from 3rd parties including: foreign banks, foreign facilitators, or under treaty requests.

Much of this information is coming to the IRS based on implementation of the provisions of the Foreign Account Tax Compliance Act (“FATCA”) by foreign financial institutions, or from listed foreign financial institutions who are either under settlement agreements with the US Department of Justice or are in settlement discussions (e.g. in Switzerland as of 1/25/17 145 foreign financial institutions have been “listed” by the IRS and if a taxpayer has an account with them their penalty includes a 50% account balance penalty paid up front upon submission of their IRS/OVDP offer along with tax, interest and other penalties).

Please see my recent newsletter on this topic.

3) Those US taxpayers who applied through for the IRS/OVDP through the pre-clearance process but were either denied access or withdrew from the program face a heightened risk of IRS civil tax audit, criminal tax investigation or IRS referral for US/DOJ criminal prosecution.

The IRS/OVDP for submissions made on or after July 1, 2014 require that all payments due be made up front at the time of the submission of the IRS/OVDP (see IRS Offshore Voluntary Disclosure Program Frequently Asked Questions and Answers 2014 (“IRS FAQ”). See IRS FAQ #1.1

Under the “7/1/14 IRS OVDP” (7/1/14 forward) a 50% offshore penalty applies if either a foreign financial institution at which the taxpayer has or had an account or a facilitator who helped the taxpayer establish or maintain an offshore arrangement has been publicly identified as being under investigation or as cooperating with a government investigation. See IRS FAQ #7.2 for a complete list of all 145 foreign financial institutions/facilitators as of 1/25/17 (published 1/31/17).

Under IRS FAQ #7.2, 23, 24:
For those taxpayers who request preclearance before they submit their offshore voluntary disclosure, under #23, the taxpayer must send detailed information to the IRS Criminal Investigation Lead Development Center (LDC) which includes:

1) Applicant identifying information including complete names, dates of birth, tax identification numbers, addresses and telephone numbers;

2) Identifying information of all financial institutions at which undisclosed OVDP assets (see FAQ # 35) were held including complete names (including DBAs and pseudonyms), addresses and telephone #s;

3) Identifying information of all foreign and domestic entities (e.g. corporations, partnerships, limited liability companies, trusts, foundations) through which the undisclosed IRS/OVDP assets were held by the taxpayer seeking to participate in the OVDP; this does not include any entities traded on a public stock exchange. Information must be provided for both current and dissolved entities. Identifying information for entities includes complete names (including all DBAs and pseudonyms), employer identification numbers, addresses and the jurisdictions in which the entities were organized.

4) In the case of jointly filed tax returns, if each spouse intends to apply for the OVDP, each spouse should request preclearance.

5) Criminal investigation will then notify taxpayers or their representatives via fax whether or not they are eligible to make an offshore voluntary disclosure. It may take up to 30 days for Criminal Investigation to notify taxpayers or their representatives of the decision.

It should be noted that IRS pre-clearance does not guarantee a taxpayer acceptance into the IRS/OVDP. Taxpayers pre-cleared for OVDP must follow the steps outlined in IRS/FAQ #24 within 45 days from receipt of the tax notification to make an offshore voluntary disclosure. Taxpayers must truthfully, timely and completely comply with all provisions of the OVDP.

Under IRS FAQ #24, Taxpayers who make an offshore, voluntary disclosure must submit their Offshore Voluntary Disclosure Letter (and attachment) to the IRS (address as designated in Philadelphia, PA). IRS Criminal Investigation will review the Offshore Voluntary Disclosure Letter and notify taxpayers or their Representatives whether the offshore voluntary disclosures have been preliminary accepted as timely or declined (usually within 45 days of receipt of a complete Offshore Voluntary Disclosure Letter).

Once a taxpayer’s disclosure has been preliminarily accepted by IRS Criminal Investigation as timely, the taxpayer must complete the submission and cooperate with the civil examiner in the resolution of the civil liability before the disclosure is considered complete.

Under IRS FAQ #24.1, where spouses both desire to participate in the OVDP, they may do so jointly or separately. If spouses make a joint submission, they must include all required information and documents for each spouse and clearly indicate the intention to disclose jointly. If spouses make separate submissions each spouse must complete and submit all required information and documents.

Under IRS/FAQ #25, if the Voluntary Disclosure is accepted, the IRS Criminal Investigation Division will instruct the taxpayer or his representative to submit the full voluntary disclosure to the IRS Austin campus within 90 days of the date of the timeliness determination. The Voluntary Disclosure submission must be sent in two separate parts:

1) Payment;

2) All documents as required under IRS/FAQ #25.

Under IRS/FAQ #7, the terms of the Offshore Voluntary Disclosure Program require that the taxpayers must:

1) Provide payment, documents

2) Co-operate in the voluntary disclosure process, including providing information on foreign accounts and assets, institutions and facilitators, and signing agreements to extend the period of time for addressing Title 26 liabilities and FBAR penalties.

Regarding payment it is now due with the submission of the disclosure. Under IRS FAQ #25, the payment to the Dept. of Treasury is in the total amount of tax, interest, offshore penalty, accuracy-related penalty, and if applicable, the failure-to-file and failure-to-pay penalties, for the voluntary disclosure period. These payments are advance payments; consequently any credit or refund of the payments is subject to the limitations of IRC Sec. 6511 (see IRS/FAQ #25). These total tax, interest and penalty payments are due up front with the application submission.

Under IRS/FAQ #7, the up front payment includes the following penalties which may in the aggregate with tax and interest “wipe out” the account:

1) Pay 20 percent accuracy-related penalties under IRC Sec. 6662(a) on the full amount of the offshore-related underpayments of tax for all years;

2) Pay failure to file penalties under IRC 6651 (a) (1), if applicable;

3) Pay failure to pay penalties under IRC 6651 (a) (2), if applicable;

The big penalty is the Title 26 Misc. penalty. The payment, in lieu of all other penalties that may apply to the undisclosed foreign accounts assets and entities, including FBARS and offshore-related information return penalties and tax liabilities for the years prior to the voluntary disclosure period, a Misc. Title 26 offshore penalty equal to 27.5%, or 50% for those listed in FAQ #7.2, of the highest aggregate value of OVDP assets as defined in IRS/FAQ # 35 during the period covered by the Voluntary Disclosure.

The suspension of interest provisions of IRC Sec. 6404(g) do not apply to interest due under the OVDP.

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