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THE ACTUAL POTENTIAL CRITICISM OF OFFSHORE MECHANISMS I wish to set forth below, from the IRS’s point of view, some of the strategies they could try to utilize to negate your charitable plan. It is quite imperative that the issue of “control” be understood. BACKGROUND You may be advised to establish a domestic or offshore insurance trust as part of the overall planning mechanism. The trustee of that insurance trust will purchase a variable life insurance policy (“Policy”) from a non-U.S. carrier, located in Belize or another jurisdiction which respects the IRS’s concept of segregated accounts. After the ILIT (Irrevocable Life Insurance Trust) is established and the Policy purchased, the Policy will invest its cash value into a diversified group of investments. One of the investments of the Policy will be an international business corporation (“IBC”). Assets of the IBC are irrevocably owned and managed by the IBC. The IBC owns the assets and you should not be involved with the IBC’s management or its investment strategy. (In other words, if you tell your friends about “your” investments, then there is an incident of ownership and you could easily be legally defrauding the IRS. ASSUMPTIONS However, defensible is not the same thing as saying that there is a guarantee that you will prevail if challenged. If the VUL is not operated properly, then the Structure may not survive challenge. We are available to assist in advising you regarding these issues in conjunction with our international tax and legal counsel. The Structure is not intended as a device to allow you to continue ownership of the assets in the VUL. If this is your goal, then the Structure is doomed to failure and we do not wish to be involved. The mere completion of “documentation” is not determinative of the Structure being respected for tax purposes. The critical key to the success of the proposed Structure is that at all times the Structure will be truly independent of you. That is, from the earliest inception through the last payment. The areas of concern are the degree of dealing you have with the VUL. Set forth in the ensuing sections is a brief analysis of some, but not all of the ways the IRS may attack the proper structure. POTENTIAL CONSEQUENCES If the IRS were to disregard the Structure based upon one of the theories described below, or upon other theories, then serious issues will arise, including the possible taxation on all income that was deferred through the Structure, and the imposition of various penalties provided for under the tax laws. 1. Control by You. A principal area of IRS concern is the degree of involvement you have with the investments made by the Structure. In cash value of an insurance policy there are two essential elements: first; you part with something and second; you receive something. It is imperative that when you purchase a VUL policy it is a complete and absolute purchase and this is not a “back door” for you to continue to assert ownership or personal use over assets transferred. It is imperative that you respect the insurance Strugture and not treat its assets as though they were still your assets. B. Constructive Receipt: If you continue to manage the assets either directly or C. Economic Realty/Substance v. Form: A taxpayer has the right to minimize taxes by any means which the law permits. However, this rights does not bestow upon the taxpayer the right to structure a paper entity to avoid tax when the entity does not stand on a solid foundation of economic reality. When the form of the transaction ahs not, in fact, altered any cognizable economic relationship, the IRS looks through the form and applies the tax law according to the substance of the transaction. This is also known as the substance versus form attack. The courts have held that: “A transaction will be accorded tax recognition only if it has ‘economic substance’ which is completed or encouraged by business…..realities (and) is imbued with tax-independent considerations.” Assets in the policy are irrevocably dedicated to the Policy. Accordingly, all of your actions in dealing with Policy assets, need to be consistent with the fact that those assets belong to the Policy. D. Agency: Agency is a situation in which someone is acting on our behalf. This The IRS may argue that the insurance company or the IBC is in reality an “agency” for federal tax purposes and is acting on your behalf. This is especially true if you direct the investments and/or you effectively control the IBC’s property or the management thereof. 2. Business Purpose. The IRS has successfully challenged corporations, foundations, trusts and other entities for a lack of any valid business purpose. Presently, there is case law which supports three different levels of required business purpose: (1)minimal business purpose, (2)a “reasonable amount” of business purpose, or (3)the business purpose must exceed the tax purpose. There is no consistent position as to just how much “business purpose” is required for a transaction to be considered viable. At the very least, you should plan on having a “reasonable amount” of business purpose for every aspect of the Structure and the transaction—especially if the transaction is between you and the Structure. In part, the business purpose will depend on, and be a function of how the Structure operates in the future. It is critical to engraft substantial non-tax purposes for each step of those transactions. Sometimes the courts have intertwined and overlapped the concepts of business purpose, sham, conduit and substance vs. form arguments without making any distinction. The ultimate effect of the application of any of these principles is to disregard the transaction. For instance, if the Structure was to make you a loan at 12% interest when you can get 8% interest locally, what business purpose did you have in paying more than you had to. Didn’t the tax purpose of deducting interest on a portfolio interest loan outweigh the “business” purpose? On the other hand, if the structure makes a loan to you and requires negligible collateral, what was the IBC’s business purpose? A. Sham. The IRS can ignore the Structure as a sham (this may be in addition to, or as an alternative to the substance v. form argument. C. Substance v. Form (aka Economic Substance). The substance of the transaction, rather than the form in which it is cast, is determinative of the tax consequences. In performing the substance-over-form analysis, the Courts have “looked to the objective economic realities of the transaction rather than to the particular form of the parties employed.” The courts try and determine the intent of the parties involved by analyzing all of the surrounding facts and circumstances. This analysis includes the arms length nature of the arrangement, proper documentation and the transaction must have “…economic substance separate and distinct from the economic benefit achieved solely by tax reduction.” In determining the tax nature of the transaction, the IRS will view the entire transaction and its overall economic effect rather than one or a few elements of the plan. 2. Classification. Tax consequences are dependent upon the proper classification of the Structure. If it is classified as a trust for tax purposes, then one type of reporting regime must be complied with. If it is a corporation, then there is another regime. In the case of a charitable offshore entity, the corporate structure is often used. 3. A. Assignment of Income. Income should be taxed to the person or entity who earned the income. This is one of the fundamental tenants of United States taxation. The IRS has challenged corporations, foundations, trusts and other entities, and business arrangements based upon assignment of income concepts; that is the income was truly earned by someone other than the entities. This concept has been used to challenge gifts of stocks to charities when there has been arrangements (contracts, letters of intent, etc) in place relating to selling the stock to another party. B. Step Transaction. In viewing a transaction as a dynamic whole, the courts often say that an integrated transaction must not be broken into independent steps, or conversely, that the separate steps must be taken together in attacking the tax consequences. The step concept is frequently employed where there agreements or understandings in place that various transactions are to take place. For example, in the case of charitable contributions, the IRS has often challenged such contributions where there has been some prearrangement relating to the assets contributed. C. Code Section 269. The Code provides that if a corporation, be it domestic or foreign , is “formed or availed of” to obtain a benefit that would otherwise not be obtainable, the IRS has the right to disregard the corporation. This section may come into play and be used to disregard and collapse the Structure and/or the related arrangements. Therefore, the Structure must operate so that it will be respected as a true insurance policy. It is critical to engraft substantial non-ta purposes for each step of the contemplated transactions.[1] D. Code Section 482. The Code also provides that in the case of two related taxpayers, the IRS has the right to reallocate income, deductions and expenses between them. If the IRS were to view you as having the requisite control over the investment of Policy assets, and the policy enters into a transaction with any entity or business owned by you or under some type of common “control,” the IRS may seek to reallocate all of the income and deductions to reflect a true arm’s length transaction. E. Debt. In certain circumstances, the IRS has successfully re characterized certain entities as a debt arrangement, rather than an equity. The IRS may seek to challenge the establishment of the Structure as some type of loan arrangement. This would require that interest be “imputed” to you annually, so that the benefits of deferral would be limited. F. Due Diligence. It would be helpful for you to meet with the people from whom you are purchasing the policy from, if the structure is such that you are purchasing a policy. This is a factor in demonstrating that you consider the Structure to have importance and independent significance. In a recent case, the Tax Court notes that it cold not believe that the taxpayer transferred property to an offshore entity without knowledge of the business and operations of the foreign entity and disregarded the taxpayer’s Structure. G. Reporting and the Statute of Limitations. We advise our clients as to the initial reporting requirements relating to the Structure. If, however, the IRS were to recharacterize the Structure or its ownership, then additional reporting would have been required—which reporting would not have been complied with. If the IRS were to prevail, in addition to imposing certain penalties, the IRS could claim that the statute of limitations has not run, allowing it additional time to propose assessments. 4. Consequences of the IRS disregarding the Structure Allegations by the IRS which if successful ignores the Structure, or attributes the action/income to you, could result in (1) a substantial increase in your income and the tax liability related thereto, (2) the imposition of civil penalties and interest; and (3)may result in criminal prosecution and penalties if there is a fraudulent or .conduct. We do not provide any guarantee or assurance that any of the tax or other benefits that you might anticipate from the Structure will ultimately be realized, particularly if the IRS deems you in control of the Policy’s or IBC’s assets. The results, in part, are based upon their being substance to each and every aspect to the Structure, and that the “Structure” itself is separate and independent of you. We have made arrangements with a tax law firm which specializes in tax opinion letters on your Structure should you decide to have one. 5. Potential Change in Tax Law. Tax Law is continually evolving and changing both in legislation and through action of the IRS and the courts. These changes may affect the analysis and consequences of the Structure. We assume no obligation to update you as to any change in the law. However, please do be advised that the IRS is seeking to attack these types of policies based on “control”. In conclusion, the client should initially see that it is not always possible to eliminate taxes—but it is always possible to plan for them. A well thought-out estate plan minimizes taxes to the greatest extent possible and then provides liquidity for taxes that cannot be eliminated. It is assumed that the reader will easily see that offshore planning which includes a charitable structure will provide significant elimination of estate and other taxes. 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