Principles of Investing for American Citizens Living in the UK: Principle 7 – Plan for the next generation

Written by Kyle McClellan & Ollie Cutting

“Each generation will reap what the former generation has sown” ~ Anonymous

Although winning the title of the “richest person in the graveyard” is an accolade few of us will care for or personally benefit from, estate planning is a crucial component of many of our client’s financial plans, especially for those who have both US and UK inheritance tax (IHT) to contend with. Unfortunately, even though death and taxes are fates all of us must inevitably plan for, formalising our estate plans can commonly be left as an afterthought until goals in our own lifetimes are met, such as purchasing our first home, putting our children through university, or investing for retirement. While this behaviour is perfectly understandable, getting a head start on estate planning can allow us to maximise the “excess wealth” (i.e. capital that is highly unlikely to be spent in our lifetime) that is passed on to the next generation and available to support our philanthropic goals.

If you, like many of our readers, have connections to both the US and UK, your estate plan may need to consider the rules on both sides of the Atlantic. Understanding the dynamics at play in both jurisdictions can therefore be a good starting point for beginning the estate planning process.

Inheritance Tax (IHT) Considerations:

UK IHT

Any UK non-domiciled individual living in the UK for more than 15 of the last 20 years is deemed to become ‘domiciled’ in the UK. This matters because the UK assesses IHT based on an individual’s domicile status. ‘Domicile’ is a long-term, sticky tax status in the UK (not to be confused with ‘residence’), and those who are domiciled (or deemed to be domiciled) in the UK have their worldwide estate fall into the UK inheritance tax net (‘non-doms’ who do not yet meet the deemed domicile threshold are subject to UK inheritance tax on UK-situs assets only).

The UK offers a paltry IHT allowance in comparison to the US.  If you are domiciled (or deemed domiciled) in the UK, your individual IHT allowance for worldwide assets (i.e., the estate value you can pass on without tax) will be £325k under the current rules.  Some individuals can benefit from an additional £175k allowance should their main home be passed on to an immediate family member, but this benefit begins to be phased out for individuals who have estates worth more than £2mn.  In most instances, the value of your estate above the allowed threshold  would be exposed to IHT at a rate of 40% – yikes! 

US Estate Tax

The US has far more generous allowances  but chooses to tie its’ estate and lifetime gifting rules together.  While the US also charges IHT at a rate of 40%, under the current rules, an individual has a “lifetime gift and estate tax exemption” of just over  $12mn.  This, however, is due to sunset back to an inflation adjusted amount of the previous allowance of $5mn (c.$6mn) at the end of 2025.  Therefore, even after the US’s lifetime gifting and estate tax exemption reverts back to the c. $6mn threshold, the UK’s IHT regime remains incredibly important to manage appropriately.

Once you have a broad understanding of your IHT obligations, we naturally begin to consider strategies to reduce our exposure and increase the excess wealth we can pass on. Some of those strategies may include:

1.)    Gifting 

a.    With the need to closely manage and navigate the differences between the UK and US rules and available thresholds, many turn to the possibility of making gifts during their lifetime.  The impact of doing so is very different in the US and the UK, so it is key for clients to understand what making a gift will mean for their estate when they die.

b.    In the UK, while you are alive, you can consider making a potentially exempt transfer (PET) gift to reduce your UK taxable estate.  Providing it meets the relevant criteria for a PET, it will be fully exempt from UK IHT if you (the donor) survive seven years from the date of the gift.  If you pass away within the seven-year window, the gift, or a portion of it may remain taxable within your estate.  Gifting assets that are unlikely to be used within your lifetime can therefore be very effective for reducing your exposure to UK IHT.

c.    Although the US’s lifetime gifting and estate tax exemption is more generous than the UK’s, their gifting rules are less flexible.  Generally, any gift above the annual gifting exclusion ($16k per individual in 2022) would reduce your lifetime exemption available to offset future gifts as well as your US estate at death.

2.)    Trusts

a.    Trusts can often be used to achieve numerous objectives and can be particularly useful in managing a non-domiciled individual’s exposure to UK and/or US IHT.  In our experience, the most common uses of Trusts within estate plans for US-UK connected families are:

i.    Excluded Property Trusts (EPT)

1.    If you are neither domiciled nor deemed domiciled in the UK, an EPT can be settled to shield offshore assets from UK IHT.  Many of our clients consider this strategy with their estate planning attorneys, who should be consulted to advise on the tax and IHT implications, to meaningfully lower their exposure to UK IHT alongside their broader goals and objectives.

ii.    Qualified Domestic Trust (QDOT)

1.    If you are a US citizen married to a non-US citizen (or vice versa) and have an estate valued above the lifetime gift and estate exemption, US estate tax may be liable at your death when assets pass to your non-US citizen spouse. QDOTs can be used to defer that tax charge until the non-US spouse passes away which can also generally align the timing of estate tax being payable in both jurisdictions.

iii.    Irrevocable Life Insurance Trust (ILIT)

1.    If you are considering taking out a life insurance policy as part of your estate plan, creating an ILIT to own that policy may offer numerous IHT and legacy planning benefits including ensuring that the insurance proceeds ¬¬themselves remain outside of your taxable estate.

3.)    Charitable donations

a.    Charitable donations are a complex topic (that probably demands a dedicated article for US-UK connected individuals!) because donations must be carefully planned to enjoy the full benefit in both the US and UK.  Fortunately, if you have philanthropic goals, charitable donations are generally a tax-efficient means of reducing your taxable estate (in the US and UK) that can also offer additional income tax benefits.

These are just some of the strategies you can consider within your estate plan.  As you may have guessed, the strategies discussed within this principle are complex and should be discussed with the relevant tax and legal professionals.  If you would like an introduction to an estate planning attorney or tax advisor that can opine on your unique IHT position, please contact Kyle McClellan or Ollie Cutting from our Private Wealth Team.

Please email masecocommunications@masecopw.com to receive the full copy of our Principles of Investing whitepaper.

The Legal Stuff

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