In a previous post, we went over the basic eligibility for foreign nationals applying for life insurance in the U.S. Essentially, their eligibility depends on their country of citizenship, where else they travel, and whether they have a physical and financial presence in the U.S. In this post, we’ll go over a few planning concepts that can help them protect their loved ones and preserve as much of their wealth as possible.
Tax Implications: The Basics
One of your client’s first questions about life insurance will probably be this: "What happens if I pass away while I'm outside the U.S.?" The good news is that as long as the policy is in force, it doesn't matter where they are when they pass away. Their beneficiary is entitled to the death benefit whether or not your client was living in the U.S. at the time of death. Better still, that money isn't subject to U.S. income tax, even if your client is classified as a nonresident alien.
It’s important that your client tells his or her beneficiary about the policy, and what to do when they pass away. It will be up to the beneficiary to contact the carrier and file a claim for the death benefit. Make sure your client has the carrier's contact information, along with the steps required to file a claim. Your client should leave a copy of that information with each of his or her beneficiaries. This is especially important if your client's beneficiary doesn't speak English, or spends time outside the U.S.
Foreign Nationals & U.S. Tax Classifications
In the U.S. tax code, there are two distinct classifications: resident aliens or non-resident aliens. A resident alien has a green card or meets a residence requirement: 31 days during the current calendar year, or 183 days during the preceding 3-year period (with a specific number of days required for residence during each of those three years). You can find the specific days-per-year requirement below, at the substantial presence test link.
If your client doesn’t meet this residence requirement, they will be classified as a non-resident alien. There are occasional exceptions for a non-resident spouse, or citizens of a country whose U.S. tax treaty specifies a particular classification. Keep in mind that these exceptions could change based on updates to our laws and tax codes.
References to keep on hand or provide to your clients, all from IRS.gov:
Income Tax Implications
Your discussion probably won’t get far before your client asks about the tax implications of a life insurance policy. We’re not CPAs, so we can’t give specific tax advice – but we can provide general guidelines to help set your client’s expectations. Be sure your client knows they need to consult their accountant and/or attorney to get specific questions answered.
In general, resident aliens must follow the same income tax rules as U.S. citizens:
- They must declare all their income, from sources inside and outside the U.S., and decide whether to file as single, head of household, married filing jointly, or married filing separately.
- They may be taxed on their worldwide property and income, with a lower exemption than U.S. citizens.
If, however, your client is classified as a non-resident alien, the rules are different:
- The IRS will usually only tax income from U.S. sources. That income is separated into two types. First, they'll look at fixed or annual income (a salary, for example). Second, they'll look at income from a business your client owns or a service they provide. This is called ECI, or effectively connected income. Their ECI is taxed at the same rate as an American citizen’s, while their fixed/annual income is subject to flat rate of 30% (unless their country of residence has a tax treaty with the U.S.).
- They will be responsible for the tax on any income they make from non-U.S. sources in their country of residence. When it comes to estate, gift, and generation-skipping transfer taxes, they will only owe taxes on “U.S. situs” assets (asset located in the U.S.).
References to keep on hand and provide to your clients, all from IRS.gov:
Gift & Estate Tax Implications
Your client’s gift and estate tax responsibilities will depend on their status as a resident or non-resident alien. This is determined a bit differently than their status regarding income tax.
For gift and estate taxes, the IRS will determine whether your client was domiciled in the U.S. at the time of the gift or their death. This is tricky, because being domiciled requires “no definite present intention of later removing therefrom,” according to the U.S. Treasury.
If you’re scratching your head, you’re not alone.
It’s hard to legislate intent, but that’s what this statement boils down to. If your client had no intention of leaving the U.S. at the time of the gift or their death, they're considered domiciled here. Of course, a country with a tax treaty might have its own rules established. The tax treaty would take precedence in that case. Your client should have an advisor and/or attorney in their home country to advise on the issue.
If your client is classified as a resident alien, they must usually follow the same gift and estate tax rules as U.S. citizens. Most importantly, their entire estate is subject to the U.S. estate tax when they pass away. They may also have to pay tax in their country of citizenship, unless a tax treaty removes this obligation.
- In 2017, the U.S. estate tax threshold is $5,450,000.
- All their property, no matter where in the world it’s located, is subject to U.S. estate tax.
- The estate tax marital deduction is not available unless their spouse is a U.S. citizen, becomes a U.S. citizen before the estate tax is due, or your client had a Qualified Domestic Trust.
- A life insurance death benefit will not count toward the estate total if it’s owned in an Irrevocable Life Insurance Trust (ILIT).
- Your client will owe gift taxes if they are domiciled in the U.S. at the time the gift is made.
- In 2017, the annual gift tax exclusion is $14,000 per person per year.
If the IRS classifies your client as a non-resident alien, their gift and estate tax will depend on where they're domiciled. To be domiciled somewhere, the IRS will look at things like your client’s driver’s license state of issue, home bank, voter registration records, and how much time they spend traveling abroad. If your non-resident alien client is not domiciled in the U.S.:
- Only their U.S. situs property will be subject to the estate tax. This includes tangible and intangible property, including the stock of U.S. corporations. If a county's tax treaty specifically excludes stock or other property types from U.S. estate tax, the tax treaty takes precedence.
- In most cases, the life insurance death benefit will not be subject to estate tax.
- They can only use the estate tax marital deduction if their spouse is a U.S. citizen, becomes a citizen before the tax is due, or they have a Qualified Domestic Trust.
- In 2017, the U.S. estate tax transfer exemption is $60,000 for non-resident aliens.
- Only real estate and tangible property (including cash) in the U.S. will be subject to the gift tax.
- In 2017, the annual exclusion limit is $14,000 per person per year.
References to keep on hand and provide to your clients:
That’s our look at the estate and gift tax implications for foreign nationals with life insurance.
In a future post, we’ll share some marketing ideas for reaching the foreign national market. If you missed our first post on eligibility, click here to check it out.