Tax strategies for foreign nationals using life insurance

Nationality, residence, and US taxes

Most countries tax people based on their residence and where their income is earned, not citizenship¹. The United States is an exception to the rule, and bases taxation on both citizenship and residence, which complicates matters for expat Americans and foreign nationals who have assets and earn income in different countries, including the US.

Different rules for taxing income and estates

Depending on their residency status, foreign nationals (also called aliens) have specific US federal tax obligations, based on a fairly straightforward "substantial presence" measure:

Resident aliens are typically subject to tax on their worldwide income, much like US citizens - including expat Americans who live abroad and never set foot in the US.

Non-resident aliens, however, are typically only taxed on US-sourced income.

However, the US Internal Revenue Service has a different set of seemingly contradictory “domiciliary” rules for estate tax purposes. For example, individuals present in the US on nonresident visas (such as G-4 visas) may be considered US-domiciled for estate and gift tax purposes, even though they are considered nonresidents for US income tax purposes. Why does that matter? Because when the time comes to transfer US assets to other family members, there’s a significant estate tax disparity¹

Generally speaking, a US citizen or foreign national domiciled in the United States tax gets a $12,920,000 million exemption; after that amount, their estate is responsible for up to a 40% tax.

Non-domiciled foreign nationals get just a $60,000 exemption -- and are responsible for up to 40% of estate taxes above that amount.

So for example, if you own a house in the US that your son or daughter lives in with their family, your estate can typically pass it on to them without paying any estate taxes (unless the exemption is used for other assets) – as long as you are domiciled. However, the estate of a non-domiciled foreign national will be responsible for estate taxes up to 40% on the value of that house over $60,000.

State taxes

To further complicate matters, each US state has its own set of taxes and rules regarding both income and estate assets. Some have state income and/or estate taxes, while others don't. Foreign nationals should be aware of the varying tax rates and rules in each state they have ties to, as residency criteria and tax treatments differ. That's why it's important to consult with qualified professionals familiar with all the applicable rules, and who can help mitigate risk and maximize advantages.

Some personal and business taxation issues to consider with your financial advisors

Residency and domiciliary rules: Make sure you understand which set of rules applies to your specific residency situation, and measures you may need to take to establish or prove US presence (or disprove presence, if needed).

Timing of asset sales: If you are considering selling an asset or property as your residency status is changing (e.g., because you are about to get a green card or you are leaving the US), find out whether it is in your interest to complete the transaction before or after your status changes.

• Foreign tax credits: Find out if you can offset taxes paid to a foreign country against your US tax liability.

• Qualified dividends: If held for a minimum specified period, dividends from shares in domestic and certain foreign corporations may be taxed at a preferential long-term capital gains rate.

• Tax treaties: The US has tax treaties in place with over 60 countries.² Provisions vary by country, but generally speaking, these treaties can reduce double taxation and lead to savings for foreign nationals.

• FATCA compliance: The Foreign Account Tax Compliance Act mandates reporting by US taxpayers about certain foreign financial accounts and offshore assets.

• Reporting requirements and forms: The Report of Foreign Bank and Financial Accounts (FBAR) requires reporting of foreign accounts exceeding $10,000.⁴

FIRPTA - The Foreign Investment in Real Property Tax Act: Generally, the law imposes US income tax on foreign nationals who sell US real estate, which can have complex effects that mitigate potential tax advantages. United States residents are not subject to FIRPTA requirements.

US Corporate Anti-Inversion Rules: In the past, high-net-worth foreign nationals not residing in the United States could hold real estate assets through US corporations, which were, in turn, owned by a foreign corporation. This strategy could, in simple terms, function as a "blocker" for US estate and gift tax liabilities on nonresident investors. Recent federal legislation nullified these "inversion" or corporate "blocker" moves.

Other rules, regulations, and issues may apply to your situation, which can be quite complicated. They should be discussed with qualified financial planning professionals and legal advisors to ensure compliance as you look to minimize tax losses.

Using US life insurance to overcome the estate tax disparity

While US residency may or may not be advantageous when it comes to taxing income, there is a definite advantage when it comes to estate taxes: residents enjoy a significant $12,920,000 exemption on estate taxes and lifetime gifts. The nonresident exemption is limited to just $60,000, so any significant US assets may be subject to estate taxes of up to 40% as they are passed on to the next generation.

Nonresident life insurance can help minimize or eliminate these tax consequences because death benefit payments are generally exempt from federal estate taxes. That also means that money is transferred to beneficiaries without going through the probate process, which can be time-consuming for a large estate. These features could make life insurance an attractive wealth-transfer vehicle for many foreign nationals with US-based assets. Permanent universal or whole life insurance that builds cash value can also provide a number of other advantages when it comes to tax and estate planning and preserving family wealth:

Covering potential estate taxes with life insurance

The US government imposes estate taxes on US-situated assets for nonresidents. Still, US-denominated life insurance can provide the liquidity needed to cover potential estate taxes without having to sell all or a portion of these holdings, helping preserve the estate's value for heirs.

Portfolio diversification and risk mitigation

Permanent, whole life insurance builds cash value at a guaranteed life insurance rate and is among the more conservative financial products available. A policy can build US-denominated cash value* that can be accessed while the policyholder is still alive, acting as a potentially effective hedge against economic downturns in one's home country, fluctuating exchange rates, and other forms of geopolitical risk.

Asset protection

Life insurance policies are generally protected from creditors and bankruptcy. This can provide an additional layer of protection for foreign nationals' assets.