Life insurance planning for US citizens in the UK

A common strategy for managing potential inheritance tax exposure on death is taking out life insurance.

This is true in both the US and the UK, but for those with connections to both jurisdictions (such as US citizens living in the UK) it is crucial to make sure that policies are structured appropriately for both countries.

References to “inheritance tax” or “IHT” in this article are to UK inheritance tax whereas references to “estate tax” are to US federal estate tax.

The premise of life insurance planning and potential pitfalls

There are a number of different types of life insurance products on the market.

Traditionally, products have been split between “whole of life” and “term” policies. A whole of life policy pays out the insured amount on death regardless of when that occurs (assuming premiums are paid) whereas a term policy will only pay out if the insured passes away during the insured term.

Term insurance can, for example, be used to provide cover for the inheritance tax (“IHT”) that would be payable if an individual dies within 7 years of making an outright gift of capital. Whole of life insurance, by contrast, is usually used to provide liquidity to meet tax liabilities on the insured’s passing.

Both the UK and the US operate beneficial tax regimes for insurance policies but also have punitive anti-avoidance regimes which can catch out the unwary.

In practice, this means that US citizens in the UK need to consider:

• Whether any given policy will receive beneficial tax treatment in both jurisdictions.
• Whether policies should be held in trust and, if so, how the trust should be drafted so as to operate effectively in both jurisdictions.
• How to fund the premiums of policies which are held in trust without triggering immediate tax liabilities in either country.

Ensuring that a policy qualifies for beneficial tax treatment in both jurisdictions

UK tax law distinguishes between “pure” life insurance policies and those with an investment element.

The latter are then further divided into:

• Offshore bonds
• Personal portfolio bonds ¹

Offshore bonds benefit from a favourable tax regime which can allow investments held by the policy to grow tax-free until maturity, and permit tax-free access to the originally invested capital over time.

Personal portfolio bonds are taxed much more harshly and are generally to be avoided for anyone who is tax resident in the UK.

The key distinguishing feature which causes a policy to fall into one category or another is the choice of investments it offers. Offshore bonds limit choice to a number of investment categories permitted by UK statute (mostly particular forms of collective investment scheme and certain types of bonds). Any insurance policy with an investment element which allows a wider range of choice than that is likely to be considered a personal portfolio bond.

US insurance policies often have an investment element and, unless they have been prepared with the UK market in mind, the investment choice on offer is likely to make them personal portfolio bonds for UK tax purposes.

For this reason, anyone moving to the UK should arrange for their existing policies to be reviewed by a UK adviser (and for changes to be made to those if necessary) and should factor the UK tax code into any new insurance that they take out after their move.

Conversely, UK policies do not automatically qualify as “insurance” for US federal tax purposes and care must be taken that any such policy will benefit from US tax deferral on underlying investment profits.

Trust ownership

Assuming that a policy is put in place which meets the relevant criteria in both the UK and the US, thought must be given to how it will be owned.

The benefit of a life insurance policy is itself an asset and so would be subject to IHT and/or US Estate Tax on the death of the insured if it is included within their estate (which can materially reduce the amount of any payout which is actually available to support the surviving family).

In order to address this, it is common for such policies to be written into trust. Where this is properly drafted, the insurance proceeds should be excluded from the estate of the insured on their death and so can be paid out gross.

It is possible to structure such a trust such that it is compliant in both the US and the UK, but a typical UK insurance policy trust will not be sufficient.
Similarly, any trusts which an individual has already established prior to moving to the UK should be reviewed to ensure that they will have the desired effect in the UK (for example, it is often necessary to exclude the person who funded the trust from benefit; otherwise UK tax law can deem the assets held by the trust to remain in that person’s estate for IHT purposes).

Funding the trust

If a trust is in place, care must be taken as to how premiums are funded. In particular, it is imperative that the contributions to the trust do not cause an immediate tax charge in either jurisdiction.

For example, someone exposed to UK inheritance tax might face an immediate 20% IHT charge if they make a capital contribution of more than their available nil-rate band (currently a maximum of £325,000) to a trust.

US persons might also lose part of their gift tax exempt amount.

There are various options for dealing with this:

New arrivals in the UK

• The UK tax exposure may be a moot point, at least initially, for new arrivals.
• Broadly speaking, they will initially only be subject to UK inheritance tax on UK situated assets and so can simply fund the premiums from a non-UK account in order to avoid any risk of an IHT charge.
• However, once a person has been UK tax resident for ten or more tax years, they usually become “long-term UK resident” such that their inheritance tax exposure extends to worldwide assets. At that point they need to consider other options.

Regular gifts out of surplus income

In the UK, the most common way to fund a life insurance trust is by relying on the regular gifts out of surplus income exemption from IHT. Where this exemption applies the transfer to the trust is exempt from IHT for the donor and therefore does not use up any of their nil-rate band – currently set at £325,000 per individual – or give rise to an immediate 20% IHT charge.

The conditions for the regular gifts out of surplus income exemption are as follows:

• The gifts must be made out of income and not out of capital.
• The gifts must be made as part of the donor’s “normal expenditure”. This means that there must be a pattern or element of regularity to the gifts. One-off gifts will not qualify.
• The donor must be left, after the gift, with sufficient income to maintain their normal standard of living.

Provided these conditions are met, there is no limit on the value of gifts which can rely on this exemption. In addition, a gift that qualifies will be immediately exempt from IHT for the donor (rather than only being outside of the scope of IHT once the donor has survived for seven years, as is usually the case).

Care is needed when income drops (such as in retirement) as this can materially impact the availability of the exemption. Premium terms may be agreed to pre-empt this (such as front-loading payments whilst the insured is still in employment).

Crummey power

A US citizen has two potential exemptions available to them: the annual exclusion amount and their lifetime exempt amount.

The annual exclusion currently allows a US citizen to make tax free gifts of up to $19,000 per recipient each year without using any of the lifetime exempt amount.

The lifetime exempt amount is currently set at $15m per donor. Where a gift to an individual exceeds the donor’s annual exclusion amount it will generally use up part of the lifetime exempt amount (leaving less of this for future lifetime gifts and/or transfers of assets on death).

Clearly it is preferable to use an individual’s annual exclusion amount rather than reducing their lifetime exempt amount where possible.

For a gift to qualify for the annual exclusion, it must be made to another individual. A gift to a trust can qualify provided a named beneficiary of the trust has a “present interest” immediately following the gift. In practice, this is often satisfied by using specific withdrawal rights and notice arrangements. So, for example, a beneficiary might be given a right to withdraw any contributions made to the trust within 30 days (a so-called “Crummey power”).

It is partly for this reason that trusts holding US/UK policies require careful drafting.

Combining US and UK considerations in funding the trust

Taking these rules together, a typical trans-Atlantic strategy for funding a trust might be as follows:

• The donor calculates the amount they need in order to sustain their normal standard of living. They use income above this amount to make regular gifts to the trust so as to qualify for the UK “regular gifts out of income” exemption.
• Care is also taken to ensure that the premium amounts make full use of the US annual exclusions:
  • The amount gifted is planned so as not to exceed the US annual exclusion amount per beneficiary with a present interest in the trust.
  • The trust is drafted such that a named beneficiary has a withdrawal right and they are notified of this right.
  • The trust holds the premiums for a period of at least 30 days so that the withdrawal right can be exercised.
  • Once this time period has expired, the trustees pay the funds to the insurance company as premiums.
• The donor continues to fund premiums in the same way each year.

Conclusion

For US citizens living in the UK, life insurance can be a valuable tool but must be handled carefully.

Policies should be checked to ensure that they qualify for the desired tax treatment in both jurisdictions.

It will often be appropriate to write them into trust and those trusts should also be checked for suitability in both countries.

As part of that, a plan should be put in place so as to allow premiums to be paid without triggering any immediate tax in either the US or the UK.

The Burges Salmon international private client team is well placed to guide US connected clients through these issues.