Case study - an everyday situation?
Scott Kesselring is a US citizen who has lived in London since the late 1990s (having moved following graduation from university in the US). Now aged 37, Scott is employed by a City-based private equity fund.
He is married to Anne aged 36, who is English. They have two young children, Finn and Esme, aged three and five respectively, who were both born in the UK. Now that she is caring for Finn and Esme, Anne no longer works. She has never held a green card.
Scott and Anne met in the UK and have been married for about six years. Although Scott has a notion that he would like to go back to the US on retirement, both he and Anne are happily settled in London and plan to continue living in the UK for the foreseeable future and at least until the children start to think about tertiary education.
Scott has investments worth in the region of US$10m, including an investment portfolio which is run out of the US. He and Anne own their London home (which they purchased with a mortgage for £2m) as beneficial joint tenants. The mortgage has been paid off and (after a little renovation) the house is now worth in the region of £5m. Anne inherited some assets from her parents when they passed away, although the bulk of her parents' £1.5m estate is now held in trusts for Finn and Esme.
Scott's parents are both still alive and are still living in the US. They have assets in the region of US$3m which they intend to leave to Scott and his two brothers. Both Scott and Anne have low value term life insurance policies - taken out when they took out their mortgage. Scott has recently taken out some whole of life cover to provide for Anne and the kids should something happen to him.Neither Scott nor Anne have made a will. They both considered doing so when the children were born, and then again after Anne's parents passed away, but have never got around to it.
For Scott and Anne, the overriding priority is to secure the financial well-being of their family - as tax-efficiently as possible. They have heard about the ways in which US and UK tax and regulation can impact the finances of people in their situation, including the drive by the US Treasury to ensure that it receives the correct amount of tax from US persons living overseas. Scott has already considered expatriating from the United States as a possible course of action. But the issues seem so complex that they have repeatedly postponed seeking advice.
Focusing on the issues
Scott and Anne consider themselves to have a simple situation. In our experience their situation is far from unusual but - as can be seen from some of the issues identified below - there are a number of complexities that lurk behind this apparently everyday situation. They do therefore need early, tax and estate planning advice.
Set out below are some of the main areas on which Scott and Anne need to focus. The aim is to safeguard their family's financial well-being and prevent their hard-earned wealth being unnecessarily depleted by avoidable double taxation.
Buying property in the UK
Like Scott, many Americans own real estate in the UK. Unfortunately, many of them unwittingly fall foul of US estate, gift and income tax laws because they omitted to take US tax advice before buying the property. Scott's situation is, in our experience, one of the most common problems.
Estate agents and conveyancers in the UK frequently advise married couples to buy homes as beneficial joint tenants - on the basis that if one of the couple dies the other will inherit the home automatically and without the complications of probate. However, where one of the couple is a US person, this can give rise to a myriad of tax issues.
US federal gift tax
When two Americans are married, they can simply transfer assets between them without triggering any US federal gift tax (there is an unlimited marital deduction for transfers to a US citizen spouse). This deduction does not apply to transfers to a non-US citizen spouse. Instead there is a limited annual exclusion.
As a result, when an American buys property jointly with his or her non-US citizen spouse, there might be gift tax implications on the initial purchase, or more likely on the later sale of the property. Any gift over and above the amount of the annual exclusion will be reportable in the US and the amount of the excess will absorb at least part of the US citizen's lifetime gift tax allowance. In circumstances where that allowance has already been fully absorbed this will result in gift tax being payable.
US federal income tax
In the UK a relief is available to exempt from tax the gain arising when someone sells their home. In the US, however, a person generally can only exclude up to US$250,000 of capital gain from the sale of a main home. Consequently, Scott may find that, although there is no UK tax to be paid when he and Anne sell their home, there could be substantial US tax on the gain. Further issues arise when there is an outstanding UK mortgage.
This means that for US income tax purposes, it may often be better for a couple to buy their home in the non-US spouse's name. However, simply giving the property, or the money to buy the property, to the non-US spouse could trigger US gift tax. An alternative might be to loan the non-US spouse the money (the US tax code allows such loans to be non-interest bearing). Care is needed to ensure that the IRS does not assert that the transfer is a gift.
Qualified Domestic Trusts (QDOTs)
If, like Scott, an American owns property jointly with their non-US spouse, the full fair market value (ie not just half) of the property is included in the American's taxable estate, except to the extent that the non-US spouse can show that they contributed to the purchase or to mortgage payments. As a result, US federal estate tax may apply on the American's death, with UK inheritance tax due when the non-US spouse dies. This mismatch can result in double tax.
Property bequeathed outright to a US citizen spouse qualifies for a full US federal estate tax marital deduction. However, property left to a non-US citizen spouse does not qualify for the deduction unless it is left in a special type of trust known as a Qualified Domestic Trust (‘QDOT'). This trust can often be an essential tax-planning tool and should be considered in all US/UK estate planning scenarios. Without it there is a real risk of assets being taxed both in the US and in the UK with no tax credit being given in either country.
Expatriating from the United States
Every year, many US citizens and green card holders renounce their citizenship or lawful permanent resident status. However, before expatriating, Scott needs to be aware of a number of issues affecting him and his children.
Under US tax law, certain US citizens and green card holders are subject to a special tax regime when they expatriate.
These individuals are referred to as ‘covered expatriates'. Generally, a covered expatriate is any US citizen or longterm green card holder (ie held a green card for eight years) who expatriates and either has a net worth of US$2m or more, exceeds a US income tax liability threshold or fails to certify that he has satisfied all US tax obligations for the previous five tax years. As Scott's net worth exceeds US$2m, he would be considered a covered expatriate and thus would be subject to the special tax regime if he were to expatriate (and, as explained below, Scott's children - who are automatically US citizens - would be taxable on assets they received from him).
Under this special expatriation regime, Scott would be treated as if he sold all his assets when he expatriated and US taxes would be due on the gains from the deemed sales. Further, Scott's children (as US citizens) would be subject to tax at the applicable gift or estate tax rate when they received a gift or bequest from him.
There are exceptions and planning methods that may enable people to avoid these harsh rules.
Tax compliance - ‘voluntary disclosure'
Scott moved to the UK to continue his studies and had no significant income when he did so. When he did start earning in the UK he always ensured that he filed any UK tax returns on time. He did not realise until the recent publicity surrounding the US ‘Voluntary Disclosure Program', however, that he had an ongoing duty to file US tax returns in addition to the UK returns. Further, he had no idea at all that he had an obligation to make a separate return detailing his non-US bank accounts (FBARs). This was a mistake. As a US citizen, he should have been filing a tax return with the IRS each year. Even green card holders are under an obligation to file US tax returns each year as they are subject to tax on their worldwide income even after moving from the US and even beyond expiry of the green card!
Scott needs to take immediate action to rectify the position. We will be able to advise him as to the various alternative routes to US tax compliance and are well positioned to conduct negotiations with the IRS as necessary.
Leaving assets to US heirs
As Finn and Esme are both US citizens they too are subject to US tax law. This raises significant estate planning issues that must be addressed, particularly where the trusts set up by Anne's parents are concerned.
Assets held in a properly drafted trust for the benefit of US persons are not subject to US federal estate tax. However, if the trust has not been properly drafted, over one half of all the assets could be unnecessarily lost to the US government - not just once, but at each successive generation. It is essential, where possible, that trusts set up to benefit US children should qualify as ‘grantor trusts' during the settlor's lifetime. Grantor trusts are disregarded for federal income tax purposes, with any income, gains or losses attributed directly to the donor. After the donor's death non-US trusts could be subject to the confiscatory tax and interest charges under the US ‘throwback' rules. These rules can cause virtually the entire distribution from a non-US trust to a US person to be payable to the US government in tax where the trust has previously accumulated income or gains. The fact that the trusts for Finn and Esme were established under Anne's parents' wills means that they are not grantor trusts and that action will need to be taken to mitigate against the impact of the ‘throwback' rules.
And finally... a proper estate plan is the last - and essential - piece of the puzzle
Anne and Scott's tax profiles are not aligned. Anne is a UK domiciliary but Scott is a US citizen who is not yet ‘deemed' domiciled in the UK.
If Scott dies first leaving his estate outright to Anne US estate tax would be payable unless Anne transfers a substantial portion of the assets of Scott's estate to a QDOT. However, because Anne is a UK domiciliary, her transfer of the assets to a QDOT would trigger an immediate UK inheritance tax. Either way, the amount that Anne would have at her disposal to support her and the children would be significantly less.
Worst of all the balance of whatever is left at Anne's death would then be taxed again in the UK - this time to inheritance tax at 40% with no credit given for the tax already paid in the US on the same assets. The table below sets out how that tax might look - assuming that Scott dies leaving $12.5m at a time when the US estate tax rate is 45%, the US ‘credit shelter' amount is $3.5m and that no QDOT is established on Scott's death.
Similarly, suppose Anne dies first and leaves her estate (of £2.5m) outright to Scott. As their UK domiciles do not match, only a limited spouse exemption would be available (assuming they do not want to take advantage of the limited provisions under the US/UK double tax treaty or make an election for Scott to be treated as UK domiciled for inheritance tax purposes). The table below again sets out the potential outcome in that scenario - with the UK estate being taxed first in the UK on Anne's death and then again in the US on Scott's death.
As a result of poor planning, the children could end up with only 40% of their parents' gross estates. If, on the other hand, Scott and Anne instructed Withers to produce US/UK integrated estate plans, tax would only be paid once in relation to each of their estates as illustrated below - potentially saving the children millions.