Planning for Inheritance Tax as an American in the UK
Many people don’t like to think about what will happen in the event of their death. For US persons living in the UK, the subject of inheritance tax is one that can be very important due to the large differential in the nil rate inheritance tax bands available in the UK as compared to the US. A lack of understanding about how inheritance tax works can end up costing loved ones hundreds of thousands if not millions of dollars. However, proper planning can help minimise the amount of inheritance tax payable and help ensure that loved ones are left with an estate that will provide for their needs after death. Proper strategies will largely depend on whether an individual is deemed to be UK domicile or non-UK domicile at the time of death.
What is inheritance tax?
Inheritance tax is a levy that is assessed by the government based on the net value of an estate. In its simplest definition, the net value of an estate is based on the fair market value of all assets on the date of death less any debts. Includable assets are most often, among others:
• Cash in the bank
• Any personal property
• Any real property or businesses owned
• Life insurance policy pay-outs
In the UK everyone is currently allowed a net estate valued up to £325,000 before any inheritance tax is assessed. This is called the nil-rate band. Any estate valued above this threshold is subject to tax at 40% (or 36% if at least 10% of the residual assets are left to a HMRC qualified charity).
Generally, at death, any assets left to a spouse or civil partner, are exempt from inheritance tax as long as they are considered to be UK-domicile (it is possible to make an election to be treated as UK-domicile, if appropriate). This means that together a couple can currently pass on up to £650,000 before being subject to UK inheritance tax.
During an individual’s lifetime, the UK allows gifts to be made to individuals free of tax, if it meets certain conditions. This is known as a potentially exempt transfer, or PET. A gift will be free of inheritance tax as long as the individual giving the gift does not die within seven years of giving. If the individual who makes the gift does die within seven years then part or all of the gift will be added back to the taxable estate.
Domiciled versus non-domiciled for UK inheritance tax purposes
Many Americans living in the UK are considered to be non-domiciled for UK inheritance tax purposes. Currently, a non-domiciled individual becomes deemed domicile for inheritance tax purposes when they have been resident in the UK for 17 out of the last 20 years. Beginning in April 2017 this threshold will change to 15 out of the last 20 years. When an individual is deemed domicile for UK inheritance tax purposes, the UK will generally apply its inheritance tax rules on an individual’s worldwide assets.
Until an American meets the UK deemed domicile rules, it is likely that they will be considered non-domiciled in the UK and will remain domiciled in the US for inheritance tax purposes. There are a number of important considerations when this is the case. First, while an American remains non-domiciled the UK inheritance tax threshold and associated rules remain relevant for any assets that are held inside the UK. Assets held outside of the UK generally remain outside of the UK inheritance tax net.
While a US person remains domiciled in the US, they are generally subject to the US inheritance tax rules on their worldwide assets. A US domiciliary resident for gift and estate tax purposes enjoys a lifetime allowance of $5.45 million (2016, adjusted annually). During an individual’s lifetime, money can generally pass freely between two US citizen spouses without any limitations applying (if one spouse is not a US citizen, lifetime transfers to the non-citizen spouse is currently limited to $148,000 per year before reducing the US citizen’s lifetime allowance). Any gifts to individuals other than a spouse in excess of the annual gifting allowance ($14,000 in 2016) will reduce the individual’s lifetime allowance that will be applied to their residual estate value at death.
How planning for becoming deemed domicile in the UK for inheritance tax purposes can help
Once over the threshold for being considered deemed domicile in the UK for inheritance tax purposes, one would generally continue to fall under the UK domiciliary resident rules if either of the following apply:
• Had a permanent home in the UK at any time in the three years before death
• Was resident in the UK for at least 17 of the 20 income tax years up to death
As noted earlier, these rules will change in April 2017 and an individual will reach deemed domicile status earlier and will subsequently also need to have left the UK for a longer period of time before their UK deemed domicile status will cease.
Given the modest thresholds present in the UK for inheritance tax, in the lead up to becoming deemed domicile, it becomes especially important to review the planning opportunities available. One option open to non-domiciled individuals prior to becoming deemed domicile in the UK is the ability to fund an excluded property trust for assets that are held outside of the UK. Generally any assets held within this type of trust, while remaining offshore, will be excluded from UK inheritance tax even after becoming deemed domicile. For some this could be a way to equalise the differential between the US and the UK inheritance tax bands.
The opportunity to fund an excluded property trust ceases when the deemed domicile threshold has been crossed. So, what else can be done? Developing a lifetime gifting strategy remains a viable option provided the requisite seven years has been outlived, to be considered an exempt transfer. For some people a strategy of passing on wealth during their lifetime may be a very effective way to meet long-term priorities and objectives. It is essential to work with an adviser to put together an appropriate and individual strategy as everyone has differing needs and requirements. Additionally, an adviser can help determine the best way to go about implementing the lifetime transfer of wealth. What will remain of utmost importance, is understanding precisely when the rules will begin to apply and take any relevant action appropriately.
For more wealth planning tips and tidbits from MASECO read our 39 Steps to Smart Living in the UK.
Risk Warnings and Important Information
The value of investments can fall as well as rise. You may not get back what you invest.
The above article does not take into account the specific goals or requirements of individual users. You should carefully consider the suitability of any strategies along with your financial situation prior to making any decisions on an appropriate strategy.
MASECO LLP trading as MASECO Private Wealth is authorised and regulated by the Financial Conduct Authority, the Financial Conduct Authority does not regulate tax advice. MASECO Private Wealth is not a tax specialist. We strongly recommend that every client seeks their own tax advice prior to acting on any of the strategies described in this document.