Advising clients with UK and US connections: traps and pitfalls
Camilla Wallace and Harriet Ballard explore certain considerations in cross-border estate planning for US and UK individuals
This article is designed to highlight some of the potential estate planning issues and risks for UK residents and/or domiciled individuals with US connections. An appreciation of US estate planning ‘red flags’ is essential for UK professionals advising these types of clients. An absence of awareness could result in the client or their estate being subject to adverse or double taxation and their estate may not devolve as they desire.
It is important to identify at the outset whether a client or any of their family has US connections of relevance in an estate planning context. This will be so where that individual:
- is a US citizen or green card holder.
- is tax resident in the US.
- is married to a US citizen.
- has beneficiaries of their estate or any trusts that they have created (such as their own children) who are US citizens or reside in the US.
For those with a US and UK connection, US tax codes and UK tax legislation should be considered in conjunction to ensure the preservation of wealth during lifetime, and after the death for the eventual beneficiaries of the estate.
US citizens are required to file US tax returns in respect of their worldwide income and gains, and are subject to various reporting requirements. If a US citizen is a tax resident and domiciled in the UK, they will also be subject to UK income tax and capital gains tax (CGT) on their worldwide assets. Coordinated US/ UK legal and accounting advice will be essential to make sure full advantage is made of tax exemptions in either jurisdiction and double taxation relief.
The concept of ‘domicile’ determines liability to inheritance tax (IHT) in the UK, and estate tax in the US. Unsurprisingly, the definition is not synchronised so it is feasible that a US/UK individual could, at the same time, be domiciled in a UK jurisdiction for UK purposes, as well as a US state for US purposes; which could have double taxation consequences.
In the UK, married couples or those in a civil partnership who have matching domiciles will usually benefit from an unlimited spouse exemption. A mismatch between their respective domiciles generates an IHT and estate tax trap with regards to the availability of this exemption. In the UK, where assets pass from a UK to a non-UK spouse (triggering IHT), the spouse exemption is limited to the nil-rate band (currently set at £325,000 and frozen until 2028). Analogously, in the US, the annual estate tax marital exemption for transfers to a non-US spouse is also limited – to $175,000. These limitations can have a negative effect on estate planning options.
Wills and succession planning
An awareness of the above limited spouse exemptions is crucial when preparing wills for a couple with mismatched UK/ US domiciles. To mitigate IHT if the UK spouse dies before the US spouse, the UK spouse could leave guidance to their executors to consider whether an election is made for the US spouse to be treated as UK domiciled for the purposes of IHT (thus securing the full spouse exemption and postponing the IHT until that spouse's death). To contend with the estate tax consequences of the US spouse dying first, a qualified domestic trust (QDOT) could be included in their will for the benefit of the UK spouse. If this is correctly drafted (and there are essential terms that should be included), the estate tax will be deferred to the death of the UK spouse.
UK property ownership is another risk area for UK residents who are US citizens as this can elicit unexpected and unsolicited US tax consequences. For example, UK residents disposing of their main home should benefit from Principal Private Residence Relief (PPR) for CGT purposes at 100 per cent. However, the position is not the same in the US: any gain realised by the US citizen in excess of $500,000 will be subject to US federal income tax. Consequently, while no CGT is due in the UK, a substantial US tax bill may be lurking in the shadows. With prior knowledge, it is possible to mitigate this.
How a US person and non-US person couple owns or co-owns their marital home can have inadvertent and undesirable consequences in the US and / or the UK. The couple's respective equity divisions (and those of other assets in their estates) will need to be considered. For example, jointly owning a home where only the US spouse has provided the funding and/ or attempting to adjust the split of assets between them through the US spouse gifting their share in the property to the UK spouse could initiate US gift tax.
Whether contemplating setting up a new trust structure, or continuing with an existing trust as a UK tax resident, if a US settlor (referred to as a ‘grantor’ in the US) or US beneficiary is involved, careful consideration will need to be given to ascertain the tax implications from both a US and a UK perspective.
For example, it is common US estate planning for any US assets to be transferred into a ‘revocable living trust’ or ‘grantor trust’ during the asset-holder's lifetime. This should evade the necessity for probate of the trust assets on the grantor's death (a protracted and expensive process in the US), as well as the requirement for the trust document to be made public (unlike a will).
The trust should not trigger UK IHT for as long as the grantor is not UK domiciled, but if this changes, UK advice will be necessary to ensure the trust is not regarded as a ‘relevant property trust’ for IHT purposes and subject to decennial IHT charges. The trust deed should be reviewed by a UK lawyer and, if necessary, powers under the trust exercised to amend the terms of the trust so that it is construed by HM Revenue & Customs as a UK ‘bare’ trust.
Another risk area to be aware of in the context of trusts correlates to those set up outside of the UK or US (‘offshore’ trusts) with one or more US beneficiaries. These trusts are classified as ‘foreign non-grantor’ trusts for US purposes and can be subject to the US ‘throwback rules.’ If the creation of the trust is being overseen by a UK lawyer, it is imperative that there is awareness of this potential US tax trap. Under the ‘throwback rules,’ distributions out of the trust to a US beneficiary could be taxed at penal rates of US tax if the distributed income and gains arose in a prior US tax year. The impact of these rules can be mitigated provided US advice is taken from the start.
Powers of Attorney
In the UK, there are two types of LPA (one for health and welfare, and one for finance and property). The equivalent powers in the US are known as ‘Durable Powers of Attorney.’ Like UK LPAs, Durable Powers also appoint an attorney, who is referred to as the ‘agent’ or ‘attorney-in-fact.’ The agent has potentially wide powers and can take any action permitted in the document for the benefit of the donor of the Durable Power.
If individuals spend time in, and/or have assets in both the UK and US, there is a possibility, they may require both UK LPAs and US Durable Powers of Attorney. It is important to be mindful of the US state system when drawing up Durable Powers. In the US, a Durable Power of Attorney is accepted in all states, but the rules and requirements do differ from state to state.
Camilla Wallace is a partner and head of the private client group and Harriet Ballard is a solicitor at Wedlake Bell LLP wedlakebell.com