If you have a foreign life insurance policy that has or will have a surrender value, let me begin by saying I’m sorry that these clearly unfair and unnecessarily burdensome rules apply to you.
In the U.S., qualified life insurance policies are tax advantaged and there are a number of benefits to investing in this type of policy. The most noteworthy benefit is the tax free growth of the underlying funds. To receive this benefit, a life insurance policy must meet the requirements outlined by U.S. tax law, and if these requirements are not met, the policy will lose many of its tax advantages and the taxpayer who opened the policy will be subjected to tax annually on the growth of the plan. This unfortunately brings us to the tax treatment of foreign life insurance. Foreign financial institutions generally do not concern themselves with the life insurance laws of the United States, and this often results in foreign life insurance policies being nonqualified.
Now you’re probably thinking - alright, so my insurance policy is nonqualified which means I’ll be taxed on the growth annually but that’s not too bad - and I wish that was where this particular story ended, but unfortunately the tax laws that govern the taxation of nonqualified life insurance policies are written in a uniquely shortsighted fashion that very often result in taxable income that greatly exceeds the actual income on the policy. I don’t want to dive too thoroughly into the mechanics of these computations, but it is important to understand that if your foreign life insurance policy’s cash value grows in any way other than incremental annual increases, you will very likely not be getting credited for the premiums you paid into the policy. There are many life insurance policies (particularly Indian life insurance policies) that increase dramatically every 5, 10, or even 20 years, very often having cash values that jump from $0 to large values based on a percentage of the ultimate payout of the policy upon maturity. When this happens, most of that value increase, despite the fact that most if not all of that increase stems from premiums paid in earlier years, needs to be included in your income for the year of the increase.
Alas these unjustifiable income tax consequences are still only the beginning of the reporting obligations in relation to foreign life insurance. Foreign life insurance policy cash surrender values must be counted toward both FBAR and Form 8938 thresholds and must be included on both of those forms.
At this point the IRS has effectively robbed your insurance policy based on poorly conceived tax laws and has required you to disclose your ownership of these policies on two separate informational returns (presumably so they can be alerted to the fact that you own foreign life insurance and that an audit could result in a significant amount of tax) but this is not the conclusion of the outrageous reporting requirements. The IRS next requires you to pay an excise tax on all the amounts that you pay into foreign insurance policies, but of course there aren’t yet enough hoops to jump through for your foreign life insurance policy, so the IRS also requires you to acquire an EIN (that’s right, an employer identification number that you have to acquire for yourself, a single person) in order to be able to file the excise tax return to pay an excise tax on the premiums that you paid into the policy, premiums that you very likely will never receive full credit for when performing the associated tax computations for policy growth. This excise tax is reported on Form 720, a form that is supposed to be filed quarterly (because it’s actually designed for businesses engaged in business that gives rise to excise taxes).
The IRS having metaphorically compelled you to tell them your blood type and then forcibly extracting several liters of blood, has the audacity to tell you that you have to pay a fee for the tools used to extract your blood.