If you hold a US passport you will hopefully be aware that you are subject to US tax and reporting obligations in relation to your worldwide assets, regardless of where you are resident, and you will be reviewing your tax and estate planning to prepare for President Biden’s proposed tax changes.
You should be doing the same if you are not a citizen or resident of the US but are married to one, or if you own assets in the US. However, if you are also resident, domiciled or deemed-domiciled in the UK, or if you own assets in the UK, then you should check that any US planning does not have adverse effects in the UK. This is something which we, as UK advisors, see all too often.
The American Families Plan
On 28 April 2021 President Biden announced the American Families Plan, which included significant tax changes impacting wealthy individuals and corporations. The proposals evolved further on 13 September when the House of Ways and Means Committee released its proposed tax plan and again later when the House Budget Committee advanced the reconciliation bill to the House floor.
We understand that the current draft legislation is expected to be subject to further changes before it becomes law. However, whilst uncertainty remains, some of these proposals would take effect on the date of enactment and others on 1 January 2022. Therefore advisors could be left with very little time to implement planning.
A few of the key proposals affecting individuals are considered below.
A reduction in the Federal Estate and Gift Tax Exemptions
Both the UK and the US impose an estate tax - referred to as inheritance tax in the UK – at 40 per cent. For those unfortunate enough to be subject to both UK inheritance tax and US estate tax, it is essential to be able to offset one against the other. The ability to do so is not a foregone conclusion and double taxation is a real risk in many cases. A classic example is where a US citizen dies leaving assets to a spouse who is a UK domiciliary and not a US citizen. In this case the assets may be subject to estate tax, as the marital exemption, which would normally relieve inter-spousal transfers, is not available for transfers to a non-US spouse. When the UK spouse subsequently dies, the assets (now in his or her estate) will then be subject to inheritance tax in the UK. This scenario can be mirrored if the UK spouse dies first.
There are various planning tools which can be used to avoid double taxation. However, for many individuals it has not been a practical concern, as the US has a very substantial lifetime exclusion from estate and gift tax. Whilst the UK has a modest 'nil-rate band' free from inheritance tax - which can be as little as £325,000 and also takes into account gifts within seven years of death – the US offers a whopping $11,580,000 free from estate tax. To the extent that a US citizen’s estate falls below this amount, he or she does not need to worry about estate tax, even absent the marital exemption.
The exclusion was due to be reduced to $5,000,000 (adjusted for inflation) in 2026, but the House of Ways and Means Committee propose to bring forward the reduction so that it takes effect from 1 January 2022. Whilst this is still very significant compared to the UK’s nil-rate band, the reduction will bring more people within the estate tax net. They will need to take advice on how to mitigate estate tax and avoid being taxed in both the US and the UK.
It is worth mentioning that individuals who are not US citizens, but who hold investments in the US which are subject to US estate tax, do not have the benefit of the sizeable lifetime exclusion and must pay estate tax on US assets worth in excess of $60,000.
Changes to the taxation of grantor trusts
A significant amount of US gift and estate planning relies on the use of various forms of 'grantor trust'.
Grantor trusts are trusts in which the grantor (or 'Settlor' in British parlance) is treated as the owner for income tax purposes. This is something of an oversimplification, but with the correct implementation grantor trusts can be used as a vehicle for transferring wealth free from estate tax.
Significant changes to the treatment of grantor trusts have been proposed. For example, grantor trusts established after the enactment of the legislation - or any contribution to an existing grantor trust after this date – could be included in a taxpayer’s gross estate on death, with distributions to a third party being treated as a gift. In addition, sales to a grantor trust may be fully taxable and distribution in kind treated as triggering capital gains.
If these changes come into effect a substantial amount of estate planning will need to be revised.
Trusts are taxed quite differently in the UK than the US. Individuals who are resident or domiciled in the UK and who are implementing US planning involving trusts should take advice on the UK tax implications of such planning. For example, the transfer to a trust may be a 'non-event' in the US, but subject to an immediate 20 per cent inheritance tax charge in the UK if the transferor is domiciled or 'deemed-domiciled' in the UK.
Increased tax on capital gains
As with estate tax/inheritance tax, it is vital that individuals who are subject to capital gains tax in both the US and the UK ensure that they can set one off against the other to avoid double taxation. Careful planning is required to ensure that the 'tax points' in the two countries match and that the base cost used to determine the gain (called 'basis' in the US) is the same. This is not always the case. For example, in the US a gift of an asset does not necessarily result in tax on any gain in the asset and, consequently, does not increase the basis of the asset. Therefore if the recipient subsequently disposes of the asset, he or she will be subject to tax on the gain by reference to the donor’s basis. By contrast, a gift in the UK is treated as a disposal which can give rise to capital gains tax and the recipient will then receive the asset with a new base cost – with any subsequent sale only subject to tax by reference to that value.
The rate of tax is also a relevant consideration when coordinating tax planning between the UK and the US. Currently UK capital gains tax for higher-rate taxpayers stands at 20 per cent (28 per cent for residential property which is not a main residence). The US also taxes long-term gains at up to 20 per cent.
It is proposed that, from 13 September 2021, the US tax on capital gains be increased from 20 per cent to 25 per cent.
Another common pitfall relating to tax on gains can arise on the disposal of main homes. Principal Private Residence Relief means that a UK resident will not pay capital gains tax in the UK when they sell their main home. However, there is no such relief in the US – only an exclusion for the first $250,000 of gain. Therefore a US citizen who is living in the UK and sells his or her home may have a tax liability in the US.
Other tax changes
Other proposals include the following:
- From 1 January 2022 trusts which receive income in excess of $100,000 (which is many trusts in practice) will be subject to a 3 per cent surcharge.
- From 1 January 2032 conversions from traditional, tax-deferred IRA’s to tax-exempt Roth IRAs will be prohibited for taxpayers with income exceeding $400,000 and married taxpayers with income over $450,000. From 1 January 2022 all taxpayers will be prohibited from converting after-tax IRA contributions to Roth.
- From the date of enactment, it will no longer be possible to obtain a valuation discount for gift tax purposes on the gift of a minority interest in a closely-held entity made up of 'non-business assets' (i.e. passive investments rather than the assets of a trade or business). Currently it is possible for both UK inheritance tax and US gift tax purposes to obtain a discount to take into account the lack of control, liquidity and marketability of the interest in the entity which is being gifted. This may no longer be the case in the US.
Takeaway
If you have tax and filing obligations in the US and the UK you should consult with advisors in both jurisdictions to ensure that you are ready for the US tax changes and that your planning also works in the UK. We can help you with the UK aspects and we work closely with US advisors to achieve this.