Foreign Life Insurance Taxation (IRS Summary 2020)
Foreign Life Insurance Taxation: The foreign life insurance taxation rules are complicated. In general, a foreign life insurance policy is an important component of an investment portfolio. When a U.S. person owns a foreign life insurance policy, there may be tax issues to consider. In addition, if the foreign life insurance policy has a surrender value or cash value, and/or is considered a ULIP there may also be IRS reporting requirements on the FBAR and 8938. In recent years, the IRS has taken an aggressive position involving foreign accounts compliance — which includes Foreign Life Insurance Policies.
Foreign Life Insurance Taxation
The IRS rules for foreign life insurance Taxation of policy income complex. A Foreign life insurance policy has to two components to it: taxation of foreign income and offshore reporting on forms such as . In addition, when the foreign policy is ULIP (unit-linked), then there is a significant investment component, which further complicates the tax rules and may ignite the PFIC (Passive Foreign Investment Company Rules).
What is a Foreign Life Insurance Policy?
Foreign Life Insurance Policies are life insurance policies that are based overseas. They are very popular investment vehicles abroad.
Common examples we represent clients with, include:
- Prudential or ICICI policy in India
- AIA policy in Singapore
- Part of your Australian Superannuation
Different Types of Policies
While life Insurance policies do not generally have an investment component, whereas a Unit Linked Life Insurance Policy combines life insurance with an investments component as well. Either policy is reportable on your U.S. Tax Return.
Foreign Life Insurance Policy
A Foreign Life Insurance Policy does not always have an investment component, or earn any income. Sometimes, it is just a regular term policy, which may or may not have a surrender value or “cash value,” and it pays out at death or disability.
Unit Linked Insurance Plans
As the name implies, the Unit Linked Insurance Plans combine the investment component, with the insurance component (not always life insurance). As with most insurance policies, the “pay-in” is via premiums.
But, unlike pure insurance policies — there is a second “investment component” as well, which is commingled with the investment, to provide an investment component along with the life insurance coverage.
Example of a Unit Linked Insurance Plan
Some common examples of Unit Linked Life Insurance, include:
Friends Life (aka Aviva)
Personal Pension in the UK or UK Offshore, such as Guernsey.
It generally will contain funds and shares, so at the end of the day, this may be considered a PFIC.
These are common life insurance policies, but they are not necessarily linked to an investment per se. There many flavors (linked and non-liked) and while some tend to take the shape more of “Life insurance” with some accrued interest — others are more investment focused linked insurance policies.
India LIC or Prudential
These may or may not have an investment component to it.
They can vary greatly depending on the type of policy.
When a U.S. Person is invested in these types of policies, and subject to U.S. Tax, they are referred to as “Expat Life Insurance.”
The failure to report the policy may result in offshore penalties, but the Internal Revenue Service has developed FBAR Amnesty and other amnesty programs, collectively referred to as offshore voluntary disclosure.
The Foreign Life Insurance Taxation analysis involves all different types of foreign income, including gains, dividends, bonus, and reporting (FBAR & FATCA). In general, foreign life insurance income is taxed when earned or accrued (even if it is not distributed).
Common examples of foreign life insurance policy income, includes:
- Capital Gains
(General) Foreign Life Insurance Policy Tax Rules
With a foreign life insurance policy, there is less room for tax-deferral. In other words, the Internal Revenue Service requires insurance policy holders to pay tax on the income growth and accruals — even if the income is not distributed (subject to PFIC rules).
The timing and rate of tax will vary based on the category of income, type of foreign life insurance policy and whether PFIC issues are involved (common when the policy is “unit-linked”).
IRS Tax on Foreign Life Insurance Policy Income
When it comes to foreign life insurance proceeds, it is important to distinguish between a return of basis and proceeds. When a person pays a life insurance premium, and the premium is returned to the investor — that is not taxable. Why? because it is not earned income. Rather, the post-tax invested money is simply returned to the investor.
Conversely, if the foreign life insurance policy pays or accrues income, then the income is taxable — since those are “gains” on the investment. Whether the income is taxable now or later is dependent on the PFIC (Passive Foreign Investment Company) status of the foreign life insurance policy.
Here are the basics summarized for you:
Payments & Investments into the Policy
At the most basic level, the money invested into the policy used to pay the premiums is not taxed when it is distributed.
While the income generated from the foreign life insurance policy is taxable, the amount invested into the policy, or policy payments made on the policy are not taxable when distributed back out form the policy.
This is because the payment back of the policy payments or investments is merely a “return of basis.”
When the investment into the policy results in the foreign life insurance policy generating income, the income is reported and taxed. This is similar to income earned from a bank account (interest); income earned from a dividend, or income earned from capital gains.
Reporting the Policy
In addition to U.S. tax requirements for life insurance proceeds, interest and dividends, there are also numerous informational reporting required. Some common foreign life insurance policy reporting forms include: FBAR and FATCA reporting, Form 3520, 3520-A, 8621, 8938, 720 and more.
Common types of income generated by a foreign life insurance policy, include:
Foreign Life Insurance Dividend payments are generally taxable as foreign passive income.
Foreign Life Insurance Interest payments are generally taxable as foreign passive income.
Foreign Life Insurance Capital Gains payments are generally taxable as foreign passive income.
Some Foreign Life Insurance Policies earn interest or dividend equivalents, which are referred to as“bonus” payments. The bonus is taxable as foreign passive income.
Surrender Value “Cash Out”
A Surrender Value is generally defined as what price the insurance company will pay the policyholder if there is a voluntary termination or other cancellation of the policy before it becomes due.
Depending on how much the surrender value is vs the amount of premiums will impact if the cash-out is taxed, or just considered a return of basis.
How to Report Foreign Policy Values
Reporting a foreign life insurance policy: When a foreign life insurance policy has a cash value, surrender value and/or is “unit-linked,” there may be an immediate tax liability on the income proceeds, growth and distributions.
The reporting rules of a foreign life insurance policy primarily involve FBAR, FATCA, PFIC and more.
We have a separate article on the requirements for Reporting a foreign life insurance policy.
Out of Compliance?
If you have not properly reported the foreign life insurance policy to the US government and/or include the income in your tax return, you could be subject to extensive fines and penalties.
What Can You Do?
Presuming the money was from legal sources, your best options are either the Traditional IRS Voluntary Disclosure Program, or one of the Streamlined Offshore Disclosure Programs.
Golding & Golding Specializes in Safely Disclosing Foreign Money
We have successfully handled a diverse range of IRS Voluntary Disclosure and International Tax Investigation/Examination cases involving FBAR, FATCA, and high-stakes matters for clients around the globe (In over 65 countries!)
Whether it is a simple or complex case, safely getting clients into compliance is our passion, and we take it very seriously.
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Sean holds a Master's in Tax Law from one of the top Tax LL.M. programs in the country at the University of Denver. He has also earned the prestigious IRS Enrolled Agent credential. Mr. Golding's articles have been referenced in such publications as the Washington Post, Forbes, Nolo, and various Law Journals nationwide.