What is the best tax policy? Most might answer one that taxes them less and others more.
Now that answer falls apart on its own logic, since if applied to everyone, there would be no "others" to tax more. But the answer does bring up a point. The fairness and utility of taxes - and fairness and utility are key ethical concerns - those items are often in the eye of the beholder. So as I described in a companion article ("Taxes: A Calculation in Ethics") establishing an acceptable, and ethical, tax policy involves blending perspectives from across the social and economic spectrum to achieve a common consensus. Almost by definition no one individual can determine the optimum solution.
So, being consistent with my own words, I will add to that blending process by offering a few suggestions of my own.
Principles
What are the goals of a good, dare say ethical, tax policy? Here is what I would say. Taxes should be 1) fair to the individual, while they also 2) promote the general welfare, and 3) augment economic performance. They should also 4) gather sufficient revenue for the government we desire, and 5) be simple, efficient and minimize evasion.
How do I think we best accomplish those goals? Certainly a complete discussion could run not just a number of pages, but a whole book, or several books. But here would be a few ideas.
Credits verses Deductions
Like it or not, America uses taxes to promote social welfare. We promote home ownership by allowing deduction of mortgage interest; we subsidize state and local governments through the tax exclusion for municipal bond interest; we support non-profit institutions through charitable deductions.
Many an argument has been made over what should or should not be excluded or deducted from income for taxes purposes. I won't add to that here. Rather, the focus here is on the manner in which these exclusions or deductions are applied.
For deductions (like home mortgage interest) or exclusions (like municipal bond interest) we apply them as offsets to income, not to the income tax. Deductions and exclusions lower taxable income.
What is the ethical implication? Higher income individuals, in higher tax brackets, receive a greater benefit than the much larger group of individuals in the middle and lower brackets. A wealthy person donates several thousand dollars to their faith, they save twenty to thirty cents on the dollar. The everyday person donates an equivalent amount, they save either nothing, or maybe ten of fifteen cents on the dollars.
By what mechanism do upper income individuals receive greater benefit? First, obviously, upper income individuals are in higher tax brackets, so each dollar excluded or deducted saves a higher percentage. Second, there is the standard deduction. Higher income individuals most often exceed that standard amount, and thus their deductions actually reduce their taxes. Moderate and lower income individuals generally do not have sufficient deductions to exceed the standard amount. Thus, when they give to the church, or the local food bank, or make some expenditure that is deductible, those contributions or deductions save them nothing.
My suggested remedy would be to change deductions and exclusions into credits. Deductions and exclusions would no longer lower taxable income, but rather directly lower taxes, i.e. they would in whole or part become a direct credit against taxes. Thus, if one gives a dollar to charity, taxes are reduced the same regardless of income. If one receives a dollar of municipal interest, the tax savings are the same for everyone.
Minimum Tax Rates
A related step, for fairness, would be minimum tax rates. As income rises, the ability of individuals to participate in tax favored activities increases. Take the mortgage interest deduction. A good percentage of average income individuals might need to rent, while the wealthy can more likely buy a large home. Thus, while under the above "deductions become credits" approach above, mortgage interest credits would benefit all incomes equally, the average person has less financial ability to actually buy a home, much less a large home, and thus take advantage of the "deduction becomes credit".
The approach for this, to maintain fairness, would be a minimum tax. Such a minimum tax would say that when all is said and done, an individual must pay a minimum percentage in income taxes. This would apply to one's straight income, all sources (I would allow the personal exemptions, but that is all), regardless of credits, or anything else.
Credits and Minimum Tax Rates
How would these two ideas work together? Let's take a simple example.
For our example, our regular tax rate will be 25 percent for income above $75 thousand, and our minimum tax rate for the same bracket will be 15 percent. In terms of credits, an individual can take a credit against taxes equal to 50% of eligible expenditures, i.e. the items that are deductible or excluded today, for example charities, mortgage interest, extraordinary medical expenses, municipal interest, and so on.
Let's now take an individual making $175 thousand, with $30 thousand in eligible expenditures. The income amount in the 25 percent bracket is $100 thousand, i.e. $175 minus $75. The regular tax on that amount is $25 thousand (i.e. 25 percent of the $100 thousand), and the credit is $15 thousand (50 percent of the eligible expenditures, which amount to $30 thousand). So the tax, so far, is $10 thousand (i.e. $25 thousand minus the $15 thousand credit).
But we have a minimum tax, set at 15 percent for the bracket, and 15 percent of $100 thousand is $15 thousand. The individual would pay no less than $15 thousand.
Below $75k, our regular tax rate for this example will be 10 percent, and the minimum 5 percent. We will also have a $10K per person exemption. A person earning $40K, married, would pay $2 thousand in taxes before credits; that is $40 thousand minus the exemption for two people, leaving $20 thousand, times the 10 percent. The minimum tax would $1 thousand. The couple rents, so has no mortgage interest deduction, but gives a thousand dollars to the local church. Under current tax regulations, the couple receives no benefit, but if deductions were turned to credits, that contribution would save the couple $500 dollars in taxes, off the $2 thousand.
Our turning deductions into credits thus spreads out the base of individuals who benefit from tax advantaged expenditures, and the minimum rates prevent any one individual from excessively benefiting from the credits.
Abolition of Cash
An unavoidable part of taxes is that individuals seek to avoid them. Each of us actually becomes part of that when we pay a contractor in cash to receive a reduced price, or pay for a restaurant meal and tip with cash. We suspect, and in cases we are correct, that the cash payments are not fully reported for tax purposes. Significant amounts of transactions occur on a cash basis, and some percent, maybe very large, escape taxes.
Is that okay? Possibly, in that within industries with large amounts of cash transactions, say tips, the lack of taxes likely is offset by lower pay. So the waiter's actual pay scale, as well as tip expectations, have been adjusted down, an implicit and tacit recognition that tip income can escape taxation. If this changed, if 100% of tips were suddenly taxed, tip levels would likely, through various social and subtle signals, gradually adjust themselves up, and waiters themselves would argue for a higher base pay.
That being said, a general principle is that all income should receive equal consideration. While we accept the leakage that cash transactions create, fairness indicates that leakage should be minimized or eliminated.
But how?
I would argue for the eventual abolition of cash.
Now this idea is neither new nor unique. In the United States, regulations require reporting cash transactions over $5,000. Beyond that, governments worldwide have and are considering, and have implemented, various limitations and prohibitions on cash transactions.
And controversy exists. Cash transactions provide a mechanism for privacy. We certainly are in an era where our electronic footprints - what we buy, what websites we visit, even our current location - are of substantial and increasing interest to marketers, law enforcement and the like. Abolition of cash thus raises privacy concerns, and privacy concerns are not trivial.
Cash also provides choice, at times necessary. Not everyone desires to use credit or debit cards, and some can't readily obtain them, due to social status, credit issues, etc.
So why suggest this abolition?
Because over the coming years cash will increasingly abolish itself. We see the trend clearly already. Increasing numbers of outlets accept credit cards, including cabs, fast food restaurants, convenience stores, parking meters, and transit systems, along of course with the normal large chain stores. That acceptance will continue to grow, as numerous firms are competing for a breakthrough to convert Smartphones into transaction accepting devices that even the corner hot dog stand can use.
At some point, electronic transactions will become so efficient, so available, so socially expected, so quick, that those wanting to use cash will increasingly be those who do so for a nefarious purpose, i.e. to avoid taxes, to commit a crime, to embezzle funds, to immigrate illegally.
At the same time, privacy issues over electronic information will need some resolution other than cash. If one needs to use cash for privacy, then what would that say concerning the privacy of thousands of non-financial electronic bread crumbs one leaves. These include medical records, employment records, emails, drivers license records, voting registration, social media postings, and on and on.
So fast forward a decade or two or even three. It is not inconceivable that kids will grow up not knowing what cash is. Thus abolition of cash at some point will not hurt the common person, but will create added fairness in taxation by preventing those looking to evade taxes from using cash to do so.
Assessment
At the beginning, I listed five principles: 1) increase fairness, 2) promote social welfare, 3) augment the economy, 4) collect revenue and 5) operate efficiently. How do the ideas above stack up? Let's see.
I would claim that changing deductions and exclusions from income, into credits against taxes, combined with true minimum tax rates, would achieve the first two goals, in spades. Those two changes make available to all income levels tax advantaged expenditures. That promotes fairness across the base of tax payers and widens the reach of the social benefits that accrue from the tax advantaged expenditures.
The abolition of cash achieves the last two. That step allows capture of cash transactions now lost to the tax base, and reduces the enforcement and compliance efforts needed to combat cash-based tax evasion.
The ideas are likely neutral to economic activity. Economic stimulus involves steps like capital investment, or business formation, or job creation. And admittedly, in this short piece, those item aren't directly addressed.
But impacting four out of five goals isn't bad.
So there we have it, a few suggestions to improve and make more ethical our tax structure. Some may agree, others not, but most might concur these ideas are worthy to put on the table as part of the ongoing discussion of the despised reality of taxes.
By: David Mascone
Sunday, May 12, 2019
Friday, April 26, 2019
US Tax Planning for Passive Investments
In her 10/18/06 Wall St. Journal article, Insuring Against Hedge-Fund Taxes, Rachel Emma Silverman stated:
"A small but growing number of wealthy investors have discovered a legal way to invest in hedge funds without paying income taxes on the gains. It's called "private placement" life insurance. These special insurance contracts allow policyholders to invest in a wide range of products, including hedge funds. The main attraction: Because the investments are held within an insurance wrapper, gains inside the policy are shielded from income taxes - as is the payout upon death. What's more, policyholders may be able to access their money during their lifetimes by withdrawing or borrowing funds, tax-free, from the policy... "
"Private-placement insurance policies are essentially variable insurance policies, which allow policyholders to invest a portion of their premiums in separate investment accounts... "
"The strategy's chief advantage is the tax benefits that all life-insurance policies offer: Assets inside a life insurance policy can grow tax-free, and the death benefit can also be paid out free of income tax... "
Tax Planning Strategy for Passive (Portfolio) Investments
U.S. taxpayers can achieve greater net-after tax returns and superior asset protection for their domestic or international investment portfolios by using a tax planning strategy utilizing private placement life insurance. The benefit is perhaps greatest when combined with investments like hedge funds that are taxed at ordinary income rates and also where taxable unrealized income tax and gains are flowed out annually to fund shareholders.
A summary of the benefits are as follows:
1) Taxable ordinary income and short-term capital gains (taxed at 35% federal tax rate) now wholly tax exempted.
2) For Foreign Trusts, investment portfolio income now compounds tax-free annually with no accumulation tax.
3) Pre-empts IRS tax audits on investment portfolio income since there is neither any income tax nor any reporting due on the investment portfolio income.
4) Absent a fraudulent conveyance, investment portfolio assets are immediately exempt from creditor seizure once held by the policy.
5) U.S. tax compliance is minimized for filings: that is, no TDF 90-22.1 ("FBAR" filing), or IRS Form 8938 (Statement of Specified Foreign Financial Assets).
For U.S. taxpayers, the strategy requires that the investments are owned and held by a Puerto Rico issued Life Insurance policy- Puerto Rico is a US Commonwealth Territory and considered "US" for many practical purposes, but with design and investment flexibility typically found "offshore". In turn, the policy could be owned by a U.S. Grantor Trust, domiciled say, in the Bahamas. The Bahamas is particularly well suited in that under local law, insurance is expressly exempt from the claims of creditors, provided that premium(s) used to fund the policy are not subject to any prior claim at the time of transfer.
The tax planning strategy is particularly appropriate to international investors (who are treated as U.S. resident taxpayers) who invest in U.S. hedge funds, but also a very wide variety of portfolio investments.
Reporting Benefits
U.S. Taxable Residents with offshore structures ordinarily must file the following annual U.S. tax compliance:
a) Annual Form 1040: report worldwide income (including hedge fund income)
b) Foreign Financial accounts over $10,000 file form TDF 90-22.1, Report of Foreign Bank and Financial Accounts, "FBAR Filing," due June 30th following tax year (separate tax filing)
c) Foreign Financial Assets valued in excess of $50,000 file form 8938, "Specified Foreign Financial Assets" attached to form 1040 (Foreign Account Tax Compliance Act: "FACTA Filing"
Note: Filing form 8938 (with form 1040) does not relieve U.S. taxable residents of the requirement to file "FBAR," Form TDF 90-22.1 if FBAR filing is otherwise due.
In contrast to these reporting obligations, the aforementioned strategy is not only compliantly tax exempted, but also relieves the taxpayer of all the reporting obligations listed above and thus diminishing the likelihood of IRS audit.
In Greater Detail: U.S. Tax Compliance/Tax & Asset Protection Benefits
1) Income Tax (Form 1040)
Under IRC§72(e)(5), income from assets held under a qualifying life insurance policy (i.e. Puerto Rico Life Insurance policy), is not subject to income tax, nor is there tax reporting. Effectively, the investments otherwise taxable income and gains are not subject to U.S. income tax or tax reporting.
2) Report of Foreign Bank and Financial Account ("FBAR": TDF 90-22.1)
The "FBAR filing" is a financial disclosure for U.S. taxpayer foreign financial accounts (i.e. a report of taxpayer's foreign financial accounts if the account value is over $10,000). As a U.S. territory, an account in Puerto Rico is not considered a foreign account so no "FBAR filing" is due for the Puerto Rico life insurance policy.
3) Statement of Specified Foreign Financial Assets (IRS Form 8938)
The Puerto Rico life insurance policy may be classified as a foreign financial asset (i.e. a foreign financial account maintained by a foreign financial institution, subject to reporting under IRS Form 8938. Since the U.S. taxpayer (IRC§679(a)(1) Foreign Grantor Trust (i.e. Bahamas Discretionary Trust) owns the policy, the U.S. taxpayer may file an abbreviated Form 8938 (only completing Parts 1 and IV) confirming that the specified foreign financial asset (i.e. Puerto Rico Life Insurance policy with more than $50,000 cash value) was reported on the Foreign Grantor Trust (Nassau Trust) tax filings (Forms 3520, 3520-A)
4) Policy lifetime withdrawals may be tax-free and not subject to tax reporting (as either a return of premium/basis or a loan). The Modified Endowment Contract ("MEC") rules may or may not apply depending on policy design.
5) IRS Private Letter Ruling 200244001 (May 2, 2002): IRS audit risks are minimized since assets held under a qualifying life insurance policy are neither subject to investor income tax, nor is there any required income tax reporting (under IRC § 72(e)(5)), reference: Rev. Rul. 81-225 (situation #5), Rev. Rul. 82-54, 1982-1 C.B.11.
In addition to the substantive tax and reporting benefits, for audit purposes there would be no presumed IRS tax avoidance, due to the fact that life insurance has been granted an "angel exception" (i.e., is an IRS approved transaction) (IRS Revenue Procedure 2004-65, 2004-66, 2004-67, 2004-68).
6) As a U.S. territory, Puerto Rico life insurance policies do not require filing of "FBAR" Form TDF 90-22.1 (Report of Foreign Bank and Financial Account). Since taxpayer's foreign Grantor Trust (i.e. Nassau Trust) owns the Puerto Rico Life Insurance policy an abbreviated Form 8938 may be filed (only Parts I and IV).
In contrast, foreign life insurance issued to U.S. persons is subject to "FBAR filings" annually (if valued at more than $10,000) with the report filed directly with the IRS (Treasury Department), and disclosure as a specified foreign financial asset (over $50,000) with the annual filing of Form 8938, a separate tax compliance form filed with annual income tax returns (Form 1040).
7) Additional income tax benefits:
a) Assets inside a life insurance policy grow and compound income tax free.
b) Death benefit paid income tax free. (IRC§101)
8) Short-term capital gains exempt from income tax (41% Federal/California income tax, i.e. Federal 35% tax rate over $379,150, California: 9.3% tax rate over $48,029)
9) Bond interest exempt from income tax (taxed at 41% ordinary income rates Federal/California)
10) Under Puerto Rico law, the cash value benefits of a life insurance policy are expressly exempt from seizure by creditors (absent fraudulent conveyance funding of the policy). Act No. 399 of Sept. 22, 2004, as amended by Act No. 98 of June 20, 2011.
Under Act No. 98 (6/20/11), which amended Act no. 399 (9/22/04), the policy owner and policy beneficiary are statutorily protected from seizure.
In summary, a properly structured US compliant private placement life insurance as issued by a duly licensed Puerto Rican carrier, and as owned by a Bahamian Foreign Grantor Trust is very legitimate and tax effective way to hold portfolio investments (especially hedge funds), while at the same time having a minimal reporting burden associated with it, as well as providing significant asset protection.
By: Gary Wolfe
"A small but growing number of wealthy investors have discovered a legal way to invest in hedge funds without paying income taxes on the gains. It's called "private placement" life insurance. These special insurance contracts allow policyholders to invest in a wide range of products, including hedge funds. The main attraction: Because the investments are held within an insurance wrapper, gains inside the policy are shielded from income taxes - as is the payout upon death. What's more, policyholders may be able to access their money during their lifetimes by withdrawing or borrowing funds, tax-free, from the policy... "
"Private-placement insurance policies are essentially variable insurance policies, which allow policyholders to invest a portion of their premiums in separate investment accounts... "
"The strategy's chief advantage is the tax benefits that all life-insurance policies offer: Assets inside a life insurance policy can grow tax-free, and the death benefit can also be paid out free of income tax... "
Tax Planning Strategy for Passive (Portfolio) Investments
U.S. taxpayers can achieve greater net-after tax returns and superior asset protection for their domestic or international investment portfolios by using a tax planning strategy utilizing private placement life insurance. The benefit is perhaps greatest when combined with investments like hedge funds that are taxed at ordinary income rates and also where taxable unrealized income tax and gains are flowed out annually to fund shareholders.
A summary of the benefits are as follows:
1) Taxable ordinary income and short-term capital gains (taxed at 35% federal tax rate) now wholly tax exempted.
2) For Foreign Trusts, investment portfolio income now compounds tax-free annually with no accumulation tax.
3) Pre-empts IRS tax audits on investment portfolio income since there is neither any income tax nor any reporting due on the investment portfolio income.
4) Absent a fraudulent conveyance, investment portfolio assets are immediately exempt from creditor seizure once held by the policy.
5) U.S. tax compliance is minimized for filings: that is, no TDF 90-22.1 ("FBAR" filing), or IRS Form 8938 (Statement of Specified Foreign Financial Assets).
For U.S. taxpayers, the strategy requires that the investments are owned and held by a Puerto Rico issued Life Insurance policy- Puerto Rico is a US Commonwealth Territory and considered "US" for many practical purposes, but with design and investment flexibility typically found "offshore". In turn, the policy could be owned by a U.S. Grantor Trust, domiciled say, in the Bahamas. The Bahamas is particularly well suited in that under local law, insurance is expressly exempt from the claims of creditors, provided that premium(s) used to fund the policy are not subject to any prior claim at the time of transfer.
The tax planning strategy is particularly appropriate to international investors (who are treated as U.S. resident taxpayers) who invest in U.S. hedge funds, but also a very wide variety of portfolio investments.
Reporting Benefits
U.S. Taxable Residents with offshore structures ordinarily must file the following annual U.S. tax compliance:
a) Annual Form 1040: report worldwide income (including hedge fund income)
b) Foreign Financial accounts over $10,000 file form TDF 90-22.1, Report of Foreign Bank and Financial Accounts, "FBAR Filing," due June 30th following tax year (separate tax filing)
c) Foreign Financial Assets valued in excess of $50,000 file form 8938, "Specified Foreign Financial Assets" attached to form 1040 (Foreign Account Tax Compliance Act: "FACTA Filing"
Note: Filing form 8938 (with form 1040) does not relieve U.S. taxable residents of the requirement to file "FBAR," Form TDF 90-22.1 if FBAR filing is otherwise due.
In contrast to these reporting obligations, the aforementioned strategy is not only compliantly tax exempted, but also relieves the taxpayer of all the reporting obligations listed above and thus diminishing the likelihood of IRS audit.
In Greater Detail: U.S. Tax Compliance/Tax & Asset Protection Benefits
1) Income Tax (Form 1040)
Under IRC§72(e)(5), income from assets held under a qualifying life insurance policy (i.e. Puerto Rico Life Insurance policy), is not subject to income tax, nor is there tax reporting. Effectively, the investments otherwise taxable income and gains are not subject to U.S. income tax or tax reporting.
2) Report of Foreign Bank and Financial Account ("FBAR": TDF 90-22.1)
The "FBAR filing" is a financial disclosure for U.S. taxpayer foreign financial accounts (i.e. a report of taxpayer's foreign financial accounts if the account value is over $10,000). As a U.S. territory, an account in Puerto Rico is not considered a foreign account so no "FBAR filing" is due for the Puerto Rico life insurance policy.
3) Statement of Specified Foreign Financial Assets (IRS Form 8938)
The Puerto Rico life insurance policy may be classified as a foreign financial asset (i.e. a foreign financial account maintained by a foreign financial institution, subject to reporting under IRS Form 8938. Since the U.S. taxpayer (IRC§679(a)(1) Foreign Grantor Trust (i.e. Bahamas Discretionary Trust) owns the policy, the U.S. taxpayer may file an abbreviated Form 8938 (only completing Parts 1 and IV) confirming that the specified foreign financial asset (i.e. Puerto Rico Life Insurance policy with more than $50,000 cash value) was reported on the Foreign Grantor Trust (Nassau Trust) tax filings (Forms 3520, 3520-A)
4) Policy lifetime withdrawals may be tax-free and not subject to tax reporting (as either a return of premium/basis or a loan). The Modified Endowment Contract ("MEC") rules may or may not apply depending on policy design.
5) IRS Private Letter Ruling 200244001 (May 2, 2002): IRS audit risks are minimized since assets held under a qualifying life insurance policy are neither subject to investor income tax, nor is there any required income tax reporting (under IRC § 72(e)(5)), reference: Rev. Rul. 81-225 (situation #5), Rev. Rul. 82-54, 1982-1 C.B.11.
In addition to the substantive tax and reporting benefits, for audit purposes there would be no presumed IRS tax avoidance, due to the fact that life insurance has been granted an "angel exception" (i.e., is an IRS approved transaction) (IRS Revenue Procedure 2004-65, 2004-66, 2004-67, 2004-68).
6) As a U.S. territory, Puerto Rico life insurance policies do not require filing of "FBAR" Form TDF 90-22.1 (Report of Foreign Bank and Financial Account). Since taxpayer's foreign Grantor Trust (i.e. Nassau Trust) owns the Puerto Rico Life Insurance policy an abbreviated Form 8938 may be filed (only Parts I and IV).
In contrast, foreign life insurance issued to U.S. persons is subject to "FBAR filings" annually (if valued at more than $10,000) with the report filed directly with the IRS (Treasury Department), and disclosure as a specified foreign financial asset (over $50,000) with the annual filing of Form 8938, a separate tax compliance form filed with annual income tax returns (Form 1040).
7) Additional income tax benefits:
a) Assets inside a life insurance policy grow and compound income tax free.
b) Death benefit paid income tax free. (IRC§101)
8) Short-term capital gains exempt from income tax (41% Federal/California income tax, i.e. Federal 35% tax rate over $379,150, California: 9.3% tax rate over $48,029)
9) Bond interest exempt from income tax (taxed at 41% ordinary income rates Federal/California)
10) Under Puerto Rico law, the cash value benefits of a life insurance policy are expressly exempt from seizure by creditors (absent fraudulent conveyance funding of the policy). Act No. 399 of Sept. 22, 2004, as amended by Act No. 98 of June 20, 2011.
Under Act No. 98 (6/20/11), which amended Act no. 399 (9/22/04), the policy owner and policy beneficiary are statutorily protected from seizure.
In summary, a properly structured US compliant private placement life insurance as issued by a duly licensed Puerto Rican carrier, and as owned by a Bahamian Foreign Grantor Trust is very legitimate and tax effective way to hold portfolio investments (especially hedge funds), while at the same time having a minimal reporting burden associated with it, as well as providing significant asset protection.
By: Gary Wolfe
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