The benefits of life policies in estate planning exercises for individuals with US and UK connections

The use of life policies is a well-established and effective strategy in estate planning exercises for clients whose estates are likely to be subject to UK inheritance tax ("IHT") on their death, or who are considering making substantial gifts during their lifetime. US life assurance products, in particular, can be beneficial for US citizens who reside in the UK and who are, therefore, potentially exposed to the tax regimes in both countries. 

A fictional case study seeks to illustrate this in more detail:-

Case study

Michael and Mary are US citizens, resident in the UK, both aged 60 and with 3 adult children all of whom are US/UK dual citizens. They have been UK resident for over 20 years and so will be subject to UK inheritance tax ("IHT") on their worldwide assets. They intend to remain in the UK, and specifically Scotland, with their children.

Finances

Michael and Mary jointly own a £4 million castle in Scotland, a $2 million investment portfolio and they have a joint bank account with $5 million in Jersey. Michael has a £1 million UK pension, a $1 million 401K and $5 million company shares in a large international company listed on the NYSE. Their total joint annual income is $700,000.

UK IHT

The UK nil-rate band ("NRB") is £325,000 per individual but any unused nil rate band can be transferred to the surviving spouse, giving a combined NRB on the second death of up to £650,000. If certain conditions are satisfied, the residence nil rate band ("RNRB") of £175,000 per individual may also apply and this can also be transferred to the surviving spouse on the second death. IHT is charged at 40% above the available NRBs and RNRBs.

Issue

Michael and Mary's joint estate is below the current US federal estate tax threshold of $27,980,000 per married US couple. However, on current values, their joint estate would be exposed to quite considerable UK IHT. What might be done by them to plan for this potential tax liability?

Solution

One possible solution would be for Michael and Mary to take out a $10 million US sourced permanent life insurance policy (similar to UK "Whole of Life") that is written on a Joint Life Second Death basis. This amount would cover the anticipated IHT bill and also allow room for growth in assets and the related tax liability. Assuming the couple are in good health and do not smoke, the indicative annual premiums would be in the region of $108,000. The policy would be owned by a US Irrevocable Life Insurance Trust, treated as a discretionary trust in the UK, ensuring the proceeds are not subject to UK IHT or US federal estate tax.

Benefits

Some of the benefits of this arrangement would be as follows:-

• US permanent life insurance products offer flexibility, allowing individuals to fund life insurance policies over a timeframe that best suits their circumstances: the USD premiums can be paid annually or the policies can be fully funded in an accelerated period.
  
  
• The USD premiums payable to the trust can be structured as gifts out of normal expenditure from income for UK IHT purposes and should therefore be exempt from IHT. Separate US provisions also mean that tax-efficient funding can be achieved from the US perspective.
  
  
• When the policy pays out, the funds can be used to settle the UK IHT obligation on the death of the second spouse, within HMRC's 6 month deadline, avoiding delays and associated interest on unpaid IHT and ensuring the full value of existing assets are passed down to the next generation including the family home.

For US citizens, however, it should be noted that a specific US compliant solution is required in order to be considered life insurance for US tax purposes with the death benefit structured outside the US, as well as UK, taxable estate.

Additional considerations

Whilst the example above relates to US citizens, it is worth noting that non-US citizens may also be able to access the US life insurance market by demonstrating a qualifying US nexus, which can include having US family members or US financial ties. In these cases, it is important to engage a dual US/UK authorised and regulated independent life insurance advisor to investigate the US market as it may offer more suitable policy terms.

In passing, it should also be noted that there are two common scenarios which often arise that can be problematic and merit a review:-

1. US persons with UK trust held policies; and
   
2. UK residents who have permanent life insurance policies with high internal cash values. Whilst these are popular in the US, they are largely unsuitable for UK residents.

This highlights the importance of instructing a dual US/UK authorised life insurance advisor who is qualified to provide advice in both jurisdictions.

Key takeaways

For US citizens who reside in the UK and who are likely to be caught within the net of UK IHT, a US life insurance policy written in trust could be part of the wider solution. However, with any estate planning exercise for clients with financial connections to more than one country, it is essential for professional advisors in each jurisdiction to work collaboratively to ensure that the proposed solution addresses the client(s) financial, tax and legal objectives.

Brodies' wills and estate planning lawyers can advise on Scottish matters, as well as English wills and probate. Our personal law team is highly experienced in working with individuals who have connections in the US and UK. To speak with a member of our team, please get in touch.