Inheritance and Tax Issues for Property in

the United States

CLT Conference:Will Drafting and Succession

for Clients with Foreign Assets

or Overseas Connections

25 March 2010

Ian Watson

Overview1. US Estate Tax Update and Overview

2. Cross-Border Will Planning

3. Avoiding US Situs for Probate and Tax

4. US Real Property Investments

5. Non-Tax Issues

6. Trust Issues for Settlors and Beneficiaries

1. US Estate Tax Update and Overview

Before 2001 “repeal”, estates (including aggregate post-1976 lifetime gifts) taxed at graduated rates from 18% to 55%

“Unified credit” effectively exempted an amount from tax -- $675,000 for US citizens or domiciliaries; $60,000 for non-US citizens domiciled abroad (taxed on US situs assets only).

Assets passing to grandchildren (et al.), also subject to generation-skipping transfer tax at top estate tax rate, with $1 million (inflation indexed) GST exemption

“Repeal” was in stages from 2001 to 2010 – raising unified credit for US citizens or domiciliaries and decreasing the top rate of tax every few years.

By 2009, the unified credit sheltered $3.5 million for US persons but still only $60,000 for non-US persons, with a top rate of 45%

1. US Estate Tax Update and Overview

In 2010, estate and GST taxes repealed but reappear in 2011 with $1 million “exemption” at old graduated rates

During repeal in 2010, gifts taxed at flat 35% with $1 million “exemption” for US persons

Note that many states still impose death taxes (based on domicile or situs)

Stepped-up basis at death also repealed for 2010 only

Legislation may yet alter the “exemption”, make repeal permanent (unlikely) or re-impose tax before 2011 – several recent proposals have come close to passing

What Will We End Up With?

Default: Reversion to 2001 rates and $1 million “exemption”

Continuation of 2009 flat 45% rate and $3.5 million “exemption”

Something in between

Something entirely different, or

A series of temporary extensions of the status quo before settling

on one of the above

Mechanics of US Estate Tax

1. Add up gross estate

2. Subtract deductions (marital, etc.)

3. Apply tax rates to net taxable estate

4. Apply credits against tax

The Gross Estate Includes aggregate post-1976 lifetime gifts

Settled assets included if settlor retained any interest or power of control (as trustee, by power of appointment, etc.)

Assets of trust settled by someone else not included in beneficiary’s estate (even if “IIP”) unless he has general power of appointment

For US citizens or domiciliaries, worldwide assets included

Domicile rules generally similar to law of E&W, but generally no reversion to domicile of origin.

Green card is strong indicator of US domicile

Treaty tie-breaker may override domicile, but not citizenship

No concept of deemed domicile, but long residence likely to suggest domicile

For non-US citizens not US-domiciled, only US situs assets included

US Situs Assets

Generally:

Real property and chattels situated in the US at death

Shares of companies incorporated in the US

Certain US debt obligations

Business-related assets owned by a sole proprietor and usedin a US business activity (including land, machinery and equipment, patents, accounts receivable and goodwill)

Section 2104(b) – Trust assets includible in non-US person’s estate if US situs when settled or at death

(Note: For lifetime gifts, intangible assets do not have US situs)

US/UK Estate and Gift Tax Treaty: If testator is domiciled in UK

US real property

Business assets (business property of a permanent establishmentand assets pertaining to a fixed base used for the performance of independent personal services)

Not US shares or chattels

US Situs Assets

Deductions

Debts, estate administration expenses, losses during administration

For non-US persons, debts are apportioned pro rata among worldwide assets except non-recourse mortgage

Qualifying marital dispositions

Qualifying charitable dispositions

Basic Marital Deduction Rules

If surviving spouse is a US citizen:

Outright bequest, or

If in trust,

All income to spouse for life

Spouse may require change of unproductive investments

No power to pay income or capital to anyone other thanthe spouse during her lifetime (so no OPOA), and

Either

Qualified Terminable Interest Property (QTIP) Election is made to qualify (and subject trust assets to estate tax at spouse’s death), or

Spouse given general power of appointment (which also subjects assets to estate tax at spouse’s death)

If surviving spouse is not a US citizen:

Qualified Domestic Trust (QDOT)

All the requirements of a QTIP or GPOA trust plus:

A “US Trustee” must have power to pay US estate tax

US bank or bond if more than $2M

Estate tax payable on spouse’s death or lifetime distribution of capital to spouse

May be created under the will, or

Settled (before estate tax return is filed) by the surviving spouse from assets passing from deceased

Not required to be US resident for US income tax

Basic Marital Deduction Rules

Basic Charitable Deduction Rules

If testator is a US citizen or domiciliary:

Legacy to foreign charity deducible for estate tax (unlike corresponding income tax rule) provided:

Section 170(c) purposes (religious, charitable, scientific, literary, educational, etc.)

No earnings inure to benefit of any individual; and

Section 4945 – no self-dealing or political lobbying or campaigns.

If legacy intended for US charity needs to qualify for IHT relief, CAF or dedicated dual-qualified charity

Basic Charitable Deduction Rules

If testator is non-US person leaving US assets:

Only legacies to US charities deducible for estate tax

Overridden by some treaties, but not US/UK treaty

If legacy intended for UK charity, again consider CAF or dedicated dual-qualified charity

Between … and … Tax on lower amounts

Rate on excess over

column 2

0$10,000$20,000$40,000$60,000$80,000

$100,000$150,000$250,000$500,000$750,000

$1,000,000$1,250,000$1,500,000$2,000,000$2,500,000$3,000,000

$10,000$20,000$40,000$60,000$80,000

$100,000$150,000$250,000$500,000$750,000

$1,000,000$1,250,000$1,500,000$2,000,000$2,500,000$3,000,000

–

–$1,800$3,800$8,200

$13,000$18,200$23,800$38,800$70,800

$155,800$248,800$345,800$448,300$555,800$780,800

$1,025,800$1,290,800

plusplusplusplusplusplusplusplusplusplusplusplusplusplusplusplus

18%20%22%24%26%28%30%32%34%37%39%41%43%45%49%53%55%

US Federal Estate and Gift Tax Graduated Rate Schedule

Credits

“Unified Credit”

For US citizens or domiciliaries, a moving target

For non-US citizens not US-domiciled, still $60,000

Not transferable

5% surcharge on estates between $10 million and $17,184,000 (designed to phase out benefit of credit and lower graduated rates for large estates)

Foreign tax credit

US and UK death taxes generally may be offset under domestic rules or treaty

State death tax credit

Credit for gift taxes paid (so gifts not taxed twice, but they increase total estate and therefore rate of tax)

Generation-Skipping Transfer Tax

Repealed for 2010 but reappears in 2011 with $1 million exemption and 55% rate

Imposed on dispositions to or for the benefit of “skip-persons”

Relatives more than one generation younger, or

Unrelated persons more than 37 ½ years younger

Once exemption applied to trust, it remains exempt forever

Does not apply on event subject to estate tax – such as death of settlor’s child who is given general power of appointment

Similarities:

Basic planning goal for married couple involves making use of first spouse’s allowance, and deferring tax on the balance until the second death

Trust can qualify as both IPDI and US marital trust

Both countries try to approximate full tax at each generation

Both penalise legacies to “foreign” spouses

2. Cross-Border Will Planning:Comparing US and UK Death Taxes:

Differences:

Discretionary trust at first death will not work in US for marital or charitable legacies (but OK after 2nd death)

Must qualify from death by terms of will or operation of law

Flexibility must be written into will – e.g., partial QTIP election or disclaimer trust

No PETs in US

No provision for civil partners in US

No BPR or APR in US – only a provision for payment over ten years

No transferrable allowance in US at first death – usually requires trust similar to NRB DT

Comparing US and UK Death Taxes:

Points of tension:

UK limit on relief for non-domiciled spouse – US tax may be deferred but UK tax may not

Consider triggering US tax early to use foreign tax credits

Conversely, US limit on relief for non-citizen spouse unless QDOT

QDOT for non-US citizen spouse prevents successive trusts for children (unless QDOT is bare trust)

New relevant property regime v. trusts required to for efficient unified credit and longer-term GST planning in US

Mitigate by advancing capital to grandchildren as soon as feasible

Consider lifetime settlement of NRB amount every 7 years up to US exemption amount

Comparing US and UK Death Taxes:

Typical Estate Plan for US Citizen Domiciled in UK

Spousal IPDI(not exempt in US)

Balance of US$1 million exemption

Marital ResiduaryFund

absolutely (A), orIPDI+QTIP trust (B)

Death of spouse

Trust for children,then grandchildren

(GST exempt, but relevant property)

To children; if (A),spouse may create IPDIs (with GPOA);

if (B), to childrenabsolutely

NRB DT

£325,000

Typical Estate Plan for US Citizen Domiciled in UK

NRB DT

£325,000

Spousal IPDI(not exempt in US)

Balance of US$3.5 million exemption

Marital ResiduaryFund

absolutely (A), orIPDI+QTIP trust (B)

Death of spouse

Trust for children,then grandchildren

(GST exempt, but relevant property)

To children; if (A),spouse may create IPDIs (with GPOA);

if (B), to childrenabsolutely

Typical Estate Plan for US Citizen Domiciled in UK

NRB DT

£1 million?$1.5 million?

?

Marital ResiduaryFund

absolutely (A), orIPDI+QTIP trust (B)

Death of spouse

Trust for children,then grandchildren

(GST exempt, but relevant property)

To children; if (A),spouse may create IPDIs (with GPOA);

if (B), to childrenabsolutely

Discretionary Trust

US assets up to $60,000

US & UK Marital Trust (QDOT)

Other US assets upto GST exemption

To Spouse absolutely(transferring

balance of NRB)

Non-US assets

Typical Estate Plan for Non-US Person Domiciled in UKWith Non-US Citizen Spouse

Death of spouse

Trust for children,then grandchildren(GST exempt, but relevant property)

IPDIs for children(or absolutely)

US & UK Marital Trust

(QDOT)Balance of US assets

To childrenabsolutely

3. Avoiding US Situs for Probate and Tax

Consider lifetime gifts of US situs intangibles

Not necessary for UK domiciliaries (as intangibles not taxed under treaty)

Revocable trusts – touted to avoid probate, but beware UK tax consequences

Relevant property regime for UK domiciliaries

Settlor-trustee who becomes UK resident

Unfunded revocable trust still useful for confidentialityand ease of changing trustees

Non-US holding company – not necessary for UK domiciliary

} Unless bare trust

4. US Real Property Investments Whether complex company or trust structures beneficial depends

on expected difference between US and UK tax, levels of income produced (if any) and gains, residence of beneficiaries, length of intended ownership, etc.

Consider simple solutions first:

Non-recourse mortgage

Insurance for estate tax (or differential over IHT)

Proceeds not included in non-US resident insured’s taxable US estate

Generally avoid joint ownership – tenancy in common gives effect to will provisions, and avoids presumption that a non-US spouse paid no consideration

4. US Real Property Investments

(continued) Acquire through non-US holding company – but beware of

complex and expensive taxes on income and gains (including FIRPTA and branch profits tax) and PFIC or CFC rules for future US beneficiaries, as well as imputed income for UK purposes

US corporation works as well for a UK domiciliary (because US shares not taxable under treaty) – avoids FIRPTA and branch profits tax, and no estate tax for UK domiciliary, but corporate rate on capital gains (up to 39%) instead of individual maximum (15% in 2010, 20% thereafter) – and consider imputed income for UK purposes

Irrevocable trust (in which settlor retains no interest and beneficiary does not have GPOA) sometimes recommended – may work for non-UK domiciliary – or pre-existing Will trust

5. Non-Tax IssuesTake advice on state law specific matters:

Will appropriate to state of domicile

State death taxes

Community property (Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington and Wisconsin – optional in Alaska)

Inheritance rights of spouses in other states

Execution formalities

Durable powers of attorney

Health care directives

Prenuptial agreements

6. Trust Issues for Settlors and Beneficiaries

From 18 March 2010, rent-free use of real property by US settlor or US beneficiary of a non-US trust is taxed as distribution in amount of the fair market rent

Allow flexibility as to residence – change of trustees and jurisdiction, depending on residence of beneficiaries, to avoid accumulation penalties on income and gains

Be alert to changes of residence among beneficiaries, trustees and settlor and take advice in time

For more information please contact:

Ian Watson3 Stone BuildingsLincoln’s InnLondon WC2A 3XLTel: 020 7242 4937Email: iwatson@3sb.law.co.ukDX 317 Chancery Lane

3 Stone Buildings, Lincoln's Inn, London. WC2A 3XLtel: +44(0)20 7242 4937 fax: +44(0)20 7405 389610 Rockefeller Plaza, 16th floor, New York. NY 10020-1903tel: (1) 212 713 7680, fax: (1) 212 713 7679

3stonebuildings.com