AND PAY NO TAXES . . .
AND I’M AMERICAN!
By Mark Smallwood, Smallwood & Company

It had been a glorious weekend, dinner with friends on Friday night, game of golf on Saturday, and Sunday spent idling on beautiful Grace Bay beach. The warm glow of the sun seemed a distant memory as another week started, and Bob Geldorf’s “I don’t like Mondays” reverberated in my mind as I welcomed Harry into my office.

Harry had been introduced to me by some clients who described him as a highly successful orthopedic surgeon, living in Atlanta with his wife and two children (who were at college). They said that he made a large amount of money, paid his taxes, went to church every Sunday, and was essentially a nice guy. Like many successful Americans, however, Bob had a couple of problems that he was more than aware of.

Firstly, his occupation was very high-risk. Patients recognized that he was worth a lot of money, but, in tandem with their contingency-fee lawyers, failed to appreciate that not all operations are 100% successful. The result was a steady spate of rogue
litigation, and the constant dread that one day he might lose everything that he had built up for himself and his family.

Secondly, whilst Bob considered himself a loyal American, paid his taxes, and abided by the law, he still believed that it was his duty to minimize his tax liabilities to enable himself to choose where his money went, rather than the government deciding for him.

Sitting down at the boardroom table it was fairly easy for me to identify these characteristics, and I was fully prepared to meet the intensive questioning and attention to detail that I would expect from a successful medical professional and businessman.

Having gone through the preliminaries and having told Harry a bit about myself, it was now my turn to ask the question:
“So, Harry, what are you trying to achieve?”

Harry looked directly back at me, and with a grin growing on his face laid his cards on the table: “I want to protect my assets from would-be creditors, pay no taxes, and I’m American!!”

By the time he had finished his sentence the grin had turned to a broad smile. I could read his mind–despite the introduction through friends I got the feeling he was a bit skeptical that I could do anything, and here was his challenge for me to prove him wrong.

In America I would have kept a poker face, but being a Brit, it was more about keeping that upper lip stiff, as I responded, “Yes, I think we can achieve that.”

The smile subsided, “But not legally!” he queried.

Harry then explained to me what he had learnt from reading a couple of books and talking to some lawyers in the United States who were friends of his. The net result of his research was that asset protection in the U.S. required the use of an Alaskan trust. U.S. courts had a dismal view of any offshore structure, and certainly that the only way not to pay tax was to lie on your tax return, which is not something he was prepared to do.

Harry seemed fairly typical of the inquisitive prospective clients that I had been coming across in the last few years. There was a clear desire to do something, but confusion over misleading information was leading to lack of action, and in many situations inappropriate action. It was time to put him out of his misery.

“Well, Harry. Let me explain how it can be done. What you are looking for are two things. Firstly, a legal asset protection vehicle, and secondly, a legal tax avoidance vehicle. Am I right?”

“That’s right,”–the smile was replaced with an enquiring frown.

“Okay, so let us first look at asset protection. The reality of litigation is that if it does happen, you will be hauled up in front of a court, you will have to declare all your assets on pain of perjury, and when the court decides to relieve you of these assets, they will transfer them to your creditors. The problem that you have with assets held in the United States is that despite domestic structuring, if the court rules against you it has the power to ignore these structures and take away the underlying assets. Have you ever heard of a limited liability company limiting liability?”

“Guess not,” he replied.

I continued, “The problem you have is that you cannot move all your assets and yourself out of the jurisdiction of a U.S. court. After all you are American, you live and earn your living in the United States, your family is there, and you have no desire to leave. So what you need to do are two things. Firstly, look at your fixed assets in the U.S., such as property, your business and other immovables, and speak to your lawyer about setting up a domestic structure, such as a limited life company or other domestic asset protection structure to hold these assets. Then look at your liquid assets, your bonds, stocks, cash holdings, these are the ones that we can help you with.”

He was all ears, so I continued.

“Firstly, you must give up control of these assets, so that a U.S. court cannot direct you as to how the assets are handled (and thus paid out to a creditor). Secondly, you need to get these assets out of the United States and have them managed in a foreign country where the U.S. courts have no jurisdiction.”

Harry must have done quite a lot of research, because he came back very knowledgeably. “So you are telling me to set up an offshore trust. That way I give up direct control of the assets, the foreign trustee holds the assets for future purposes (such as a retirement fund), and if a U.S. court gives me instructions on this, because I have given up control I cannot direct the trustees as to how to handle the assets, and therefore cannot tell them to repatriate the assets to my creditors.”

I sat back somewhat stunned–he had grasped things immediately. “Yes, that is it.”

“I’m afraid I have a couple of problems with that.” My heart sank, but I was prepared.

“What are they?” I asked, knowing pretty well what they would be.

“Well, first of all, the trustee has complete control of my assets, and I am not sure if I trust you Mark. And worst of all, if I set up an offshore trust, I have to complete several Internal Revenue Service Forms–you know, Form 3560 and the rest of them.”

Harry had clearly done some sound research, and yes, he would have to complete these forms, but the underlying investments I had in mind for him would mean that the forms would be very easy to complete. Nevertheless, I had to show him that there was a way to mitigate both of these concerns if they really were a big problem for him.

“You are absolutely right,” I retorted, “but we can get around those issues if you wish. If you set up the offshore trust as a foreign trust, with a foreign trustee, it becomes what is referred to as a Foreign Grantor Trust for U.S. tax purposes. What that means is that whilst you have given up control of the assets for asset protection purposes, your friendly agent from the IRS will still want to collect the tax on the income that is being generated. So it is just as if you still owned the assets for tax purposes, which is why you have to fill out Form 3560 and Form 3560A every year. Then, as you rightly point out, I as the trustee have control over your assets. So if I were a crook I could run off with your money. There is one solution which mitigates both these problems.” Harry looked very interested.

“What we do,” I continued, “is we maintain the trust as a U.S. trust for tax purposes. We appoint two trustees, one who is resident in the U.S., and one who is resident here (i.e., myself). The result of this is two-fold. Firstly, as the trust is no longer a foreign grantor trust, you do not need to fill out all those nasty IRS forms. Secondly, because you appoint a domestic trustee (who might be your lawyer), you have a second trusted party involved in the control of the funds.”

Harry picked this up immediately but thought he saw a potential flaw in the plan. “But if we do that, then a U.S. court can direct the domestic trustee, so we might as well not bother.”

“On the contrary,” I replied. “The trust must be set up and the assets settled to the trust prior to you having creditor problems. You must show that there was no intent to defraud anyone. What would then happen in practice is that, say three years down the line someone sued you, there would be a clause in the trust deed that subject to certain conditions (such as a major judgment against you or a domestic attempt to attack the trust), the U.S. trustee would be by default removed from their position as trustee. The trust would then be controlled solely by the foreign trustee. It would become a Foreign Grantor Trust and you would have to fill out those forms, but your creditor would have to go overseas to seek a judgment from a court in the foreign trustee’s home jurisdiction to force the trustee to release the assets.”

Harry sat back, he was nodding up and down. “Good sign,” he smiled. “Very good sign.” He understood.

“Okay, so it sounds as if you can resolve the asset protection issue after all, but if the trust is in the United States and is a grantor trust, how can I save any taxes if all the income and capital gains liabilities pass through to me?”

“Insurance!” I said, awaiting the traditional response that normally comes across when introducing insurance products as a tax planning solution.

“Oh no, not insurance, you are just trying to sell me an insurance policy. I know the commissions involved, they are ridiculous!”

It was clearly important for me to tackle the cost element, as this was the only objection that Harry was raising, although I suspected that he did not understand what vehicle to use, and how it would work for him.

“Let me explain,” I remarked, trying not to appear condescending. Having been involved in wealth management using insurance for over 12 years, I had learned that most people have a void in understanding the role of life insurance in tax planning.

“When you settle the money into your trust, the trustees will then purchase a variable life insurance policy from a major offshore insurance company, which ensures that the policy conforms to Section 7702 of the Internal Revenue Code. The policy can be structured as either a modified or non-modified endowment contract. The death benefit will be free of income and capital gains taxes, you might be able to take tax-free loans, and if you have a smart lawyer in the U.S., we can also look at the possibility of structuring the trust as an irrevocable life insurance trust, or just a credit shelter trust or even a generation skipping transfer trust.”

Blank! That is the only way to describe the expression on Harry’s face, but I had achieved my aim. It was important for me to make Harry feel confident that I knew my subject, even if he did not understand it fully himself.

“Go on,” he said nervously.

“Okay, what happens is this. The trustees will invest the capital of the trust in a foreign variable life policy, which meets U.S. rules. The policy will be based on your life, as the Settlor of the trust. You can achieve this in one of two ways: firstly, you could simply put one large tranche of cash into the policy–this will create a modified endowment contract (MEC)–or alternatively, you could make regular payments over a number of years–this would create a non-modified endowment contract (non-MEC).”

“So which one should I do?” Harry enquired.

“Well, if you do an MEC, the death benefit will be free of income and capital gains taxes, but if you want to gain access during your lifetime, you would be better off with a non-MEC, as this will allow you to take tax-free loans from the policy before you die, and the death benefit will be as per the MEC. You will therefore create a portfolio of investments under the umbrella of the contract which can be managed with no tax liabilities, and which you can draw down on in the future on a tax-free basis.”

Harry’s jaw was starting to quiver. “Is that legal?” he asked incredulously.

“Absolutely,” I replied. “The contract is structured to be in conformance with U.S. law, it is based on the variable life policies that are issued in the United States, it is issued by a major U.S. insurer through its foreign subsidiary, and all the necessary legal opinions have been obtained.”

“But why use a foreign insurer?” he asked.

“Well, for a number of reasons. Firstly, you have the contract outside the jurisdiction of the U.S., which helps with the asset protection issue. Secondly, you have much greater investment flexibility than that offered by domestic contracts, so for example, you can invest in a broad number of sophisticated funds, such as hedge funds or fund of fund hedge funds which provide ideal diversification in these volatile markets. And thirdly–in answer to your initial objection on charges–I can guarantee it will be cheaper to purchase than a typical domestic U.S. contract.”

“Cheaper?”

“Yes, the policies we use are issued by private placement to sophisticated investors. The result of this is that you do not pay the very high expenses associated with the typical retail market in the United States.”

Harry looked at me and paused. “So what you are saying is that you can protect my assets from future creditors, invest my money tax-free legally, provide me with a tax-free ‘income’ in the form of loans from the policy, and when I die the balance of the capital is paid out free of income and capital gains tax to my wife or children?”

“That’s it,” I replied, “but that is not all. In addition to the tax-free accumulation of investments, you will also obtain substantial insurance at very competitive rates, which will provide a large sum to your wife and/or children if you were to die prematurely. For example, you are a 50 year old male, in good health who does not smoke. If you put in $250,000 per year for five years to qualify as a Non-MEC, then if you died in the first year your beneficiaries would get nearly $4.5 million.”

Harry looked at me, and I could see he was impressed. “I would like you to join my wife and me for dinner tonight. I think it is important that she understands what I am considering doing. Oh, and by the way, could you leave out the $4.5 million bit? That might be too tempting!” Harry grinned.

Mark Smallwood is Managing Director of Smallwood Trust Company Ltd. and Smallwood Insurance Company Ltd., based in Providenciales since 1994. He can be reached at smallwd@tciway.tc.