Estate planning for US persons in the UK: A practical guide

US citizens who have settled in the UK are in the difficult position of having to balance estate taxes on both sides of the Atlantic – Inheritance Tax (“IHT”) in the UK and Gift and Estate Taxes in the US.

With a headline rate of tax at 40% in each jurisdiction, missteps can lead to a very high effective tax rate. With the right advice, however, it is possible to align the point at which tax arises in both jurisdictions so that tax credits can be claimed under the US/UK Estate Tax Treaty.

In this guide we explore some of the issues which can arise and how we can help clients avoid them.

Key points to note are:

• The UK and the US operate different tax thresholds before IHT/estate taxes begin to apply.
• UK and US spouse exemptions have different criteria and thresholds.
• The core goal of US/UK tax planning is often to ensure that tax is triggered at the same time, on the same asset and for the same person so that credits can be claimed under the treaty and double taxation can be avoided.

UK Inheritance Tax (IHT)

Territorial scope

In the UK, IHT is charged on the basis of:

1. The long-term residence (“LTR”) status of the donor
2. The situs of the assets

An individual who has been UK tax resident for at least 10 out of the previous 20 UK tax years will be long-term resident and therefore exposed to IHT on their worldwide assets.

By contrast, an individual who is not long-term resident will generally only be exposed to IHT on their UK situs and deemed UK situs assets.

In something of a trap for the unwary, it is possible to be “long-term resident”  in the UK (and so exposed to UK IHT on worldwide assets) at a time when a person is not tax resident here, so the status needs to be tracked carefully from year to year.

Spouse exemption and thresholds

There are a number of important reliefs from IHT.

One of the most important in the context of transatlantic couples is the spouse exemption. This provides 100% relief from IHT on assets which pass to an individual’s spouse (or into certain forms of trust for the benefit of the spouse).

However, it is restricted (to £325,000) if the assets are passing from a spouse who is long-term resident to one who is not (the logic being that the assets are effectively leaving the UK IHT net). In such cases, the receiving spouse can choose to elect to be treated as long-term resident and careful thought should be given to the pros and cons of this to determine if it is desirable.

Note that the full, unlimited, spouse exemption is available if neither spouse is long-term resident, or where assets pass from one who is not to one who is.

Regardless of long-term residence status, an individual is entitled to a tax-free amount of £325,000 (the “nil-rate band”). A married couple can effectively pool their nil-rate bands so that they have a combined allowance of £650,000. In certain circumstances the “residence nil-rate band” is also available which can allow a married couple to pass on up to £1m tax-free.

US Estate Tax

Territorial scope

In the US, Estate Tax is charged on the basis of:

1. Citizenship or domicile
2. The situs of assets

A US citizen or domiciliary is generally subject to US Estate Tax on their worldwide assets.

An individual who is neither a US citizen nor a US domiciliary is generally only subject to US Estate Tax on their US situs assets.

Spouse exemption and thresholds

The US version of the spouse exemption is the “marital deduction” which can allow full relief from US Estate Tax for assets passing from one spouse to another. However, where the recipient spouse is not a US citizen, this is restricted.

The US Estate Tax exemption for US citizens and domiciliaries is currently set at $15m, significantly more than the UK’s nil-rate band. Individuals who are not a US citizen or a US domiciliary are restricted to an Estate Tax Exemption of only $60,000.

The UK/US estate tax treaty

The UK/US estate tax treaty seeks to avoid double taxation by determining which jurisdiction will have primary taxing rights in relation to any given asset and then requiring the other jurisdiction to either forgo tax on those assets entirely or to allow a credit for the other country’s taxes.

Nationality is a key consideration under the treaty.

For example, it includes an important “saving” provision which essentially provides that the US cannot be prevented from taxing its citizens. This means that for US citizens it generally operates as a “credit” treaty (i.e. everything remains reportable in the US but foreign taxes may be allowed as credits against US tax where the treaty gives primary taxing rights to the foreign jurisdiction).

The treaty also allows the creation of trusts which can provide indefinite protection from UK inheritance tax (but only for non-UK citizens who satisfy certain key criteria).

Practical implications

A single Will can generally be used to cover assets in both the UK and the US, but it must be drafted with care to ensure that a tax efficient result is achieved in both jurisdictions.

In the context of a married couple, this generally means:

• Checking the tax status of the couple (and in particular identifying whether there are any mismatches which could restrict the availability of the spouse exemptions).
• Checking the value of the estates in question (and in particular identifying whether they exceed the relevant thresholds).

If the tax statuses are the same, estate planning on the first death at least is usually quite straightforward (because the spouse exemption can be used in both countries to defer tax until the second death).

Where there is a mismatch in tax statuses, and particularly where one or both estates might exceed the US exempt threshold, careful planning may be required to avoid double taxation.

This can include, for example, using a special form of US trust known as a Qualified Domestic Trust (QDOT). A QDOT essentially allows a US person to leave assets in trust for their non-US person spouse, without any tax on the first death, but in such a way as to trigger estate tax when the non-US person spouse later dies. This is only a tax deferral, but it generally allows the UK and US tax points to be aligned on the second death so that tax credits can be claimed under the treaty.

Similarly, it is often sensible to structure gifts from a non-US person spouse so that they are not pulled into the US tax net unnecessarily (particular forms of life interest trust can be used to leave assets in such a way that they can benefit a surviving US person spouse without being treated as part of that person’s estate for US estate tax purposes).

Case studies

In this section we outline two common scenarios that arise in practice and the issues that they can present.

US citizen leaving assets to a non-US spouse and US citizen children

• Jane is a UK citizen and not a US person
• Bob is a US citizen
• Both are tax resident (and long-term resident) in the UK
• Their children are dual nationals
• They each hold roughly $20m of assets
• They want to leave assets to each other on the first death and then in trust for their children

Some of the issues that arise in this scenario are as follows:

• As Bob is a US citizen but Jane is not, he will not be entitled to the marital deduction on any assets that he passes outright to Jane. Instead, careful structuring will be required to ensure that assets passing from Bob to Jane do not suffer an immediate US Estate Tax charge. Bob’s Will could leave a figure equivalent to the exempt amount to Jane outright, with the rest in a Qualified Domestic Trust for her benefit, that way no estate tax or IHT should be triggered if he dies first.
• As Jane is neither a US citizen nor a US domiciliary her estate is currently outside the US Estate Tax net except on certain US situate assets. However, if she were to leave assets outright to Bob, those assets would be within his estate for US Estate Tax purposes on his subsequent death. She could leave assets to him in a form of life interest trust so that he is not deemed to own them for US estate tax purposes.
• Their children could be exposed to taxation in both the US and UK so any trusts established for their benefit will need to factor in the tax regimes of both countries. With proper advice it should be possible to align tax charges in each jurisdiction so that tax credits are available for income tax and capital gains tax purposes.

Two US citizens move to the UK

• Michael and Henrietta are both US citizens
• They buy a property in the UK to be nearer their children and grandchildren
• They intend to split their time between Florida and London

Some of the issues that arise in this scenario are as follows:

• The new property in London will be subject to UK IHT regardless of Michael and Henrietta’s tax status in the UK as it is physically situated in the UK.
• Michael and Henrietta should ensure their estate plan is structured such that the UK spouse exemption is available in connection with the property on the first death.
• If Michael and Henrietta spend enough time in the UK, they may become long-term resident and therefore subject to UK IHT on their worldwide assets. Provided they do not acquire UK citizenship, it may be possible to use the UK/US treaty to give the US exclusive taxing rights over their estate (with the exception of the London property). This would give them the benefit of the significantly higher US exempt amount – rather than being limited to the UK’s nil-rate band of £325,000 – but requires careful planning to execute.
• If Michael and Henrietta do intend to settle in the UK long-term there is a limited opportunity to shelter their estate from IHT by setting up a “treaty protected trust”. Such a trust would ideally be set up soon after their arrival in the UK but could offer them considerable long-term flexibility as the assets in it would not be subject to UK IHT even if they become long-term resident.

Conclusion

IHT and US Estate Tax are deceptively similar.

Both have headline rates of 40% and an exemption for assets passing between married spouses.

Below the surface, however, there are important differences which can trip up the unwary. None of the issues are insurmountable and the Burges Salmon international tax team is well placed to assist with estate planning documents for those navigating the complexities of UK/US planning.