A brush with death taxes

The US and the UK each impose their own tax regime regarding transfers of wealth to future generations. Due to the differences in the rules of each system, planning for only one regime could have detrimental consequences. When drafting a will for a married couple, where one is a US citizen or otherwise domiciled in the US for US estate tax purposes (based on a facts and circumstances analysis) and the other is domiciled in England or Wales for UK inheritance tax (IHT) purposes (or one or both are domiciled in both jurisdictions), the challenge is to draft a document that takes advantage of the benefits available under both tax systems.

Through the creation of a number of separate sub-trusts in a will, it is possible to (1) defer US estate taxes and UK IHT (collectively, death taxes) until the second spouse’s death, and (2) allow the maximum amount possible to pass free of death taxes upon the second spouse’s death. First, a trust would need to be created on death that consists of assets that are completely exempt from both US estate taxes and UK IHT (usually the UK nil-rate band amount). An appropriately drafted will would then enable the trustees to have the flexibility to divide the remaining assets into the following sub-trusts.

First sub-trust

The first sub-trust would be equal to the amount by which the US estate tax exemption (currently USD5,340,000 for 2014 and indexed for inflation in future years) exceeds the UK nil-rate-band amount. This trust could also be drafted to be an immediate post-death interest trust (IPDI trust) for UK purposes so that the trust fund is treated as forming part of the surviving spouse’s estate. During the surviving spouse’s lifetime, the trustees could have the power to create trusts overriding the IPDI trust provisions that give all the income to the surviving spouse. If the trustees did decide to exercise this power, for example, to appoint the trust fund to the US person’s children outright, this would be treated as a potentially exempt transfer for UK tax purposes by the surviving spouse.

Second sub-trust

The second sub-trust would consist of the remaining assets of the estate. In order to defer US estate taxes otherwise due on the US person’s death, this sub-trust should be either a trust of qualified terminable interest property (QTIP), or a qualified domestic trust (QDOT). A QTIP trust will be used when the surviving spouse is a US citizen and a QDOT will be used when the surviving spouse is not a US citizen. QTIPs and QDOTs must be drafted with certain provisions as required by US tax law, and also require the executors of the US person’s estate to make an affirmative election with the US Internal Revenue Service.

Third sub-trust

It is possible that a further subdivision of the sub-trusts could be achieved by the trustees to take advantage of the US person’s US tax exemptions, so as to minimise the eventual tax consequences to grandchildren or more remote issue. The US generation-skipping transfer tax (GSTT) is imposed at the maximum US estate tax rate (currently 40 per cent) whenever property is distributed to or passes in trust for the benefit of grandchildren or more remote issue. Each US person is currently allowed a USD5,340,000 exemption (indexed for inflation in future years) from the GSTT. This exemption could be allocated between the nil-rate-band trust and the first sub-trust.

By giving the trustees the power to further subdivide trust property into additional, separate, parallel trusts, it would be possible to take advantage of the US person’s GSTT exemption by holding GSTT-exempt property separately from non-GSTT-exempt property. This planning makes the best use of the US person’s GSTT exemption with respect to the eventual distributions to grandchildren.

Final comments

While, on the testator’s death, the trustees will require specialist advice to achieve the best tax treatment in both jurisdictions, a well-drafted will should give the trustees sufficient flexibility to utilise applicable tax reliefs and exemptions, and deal with the various factors they may face in the future, including a beneficiary’s personal needs, marital status, residence and changes in applicable tax laws.