US citizens and green card holders living in the UK generally face the same estate tax exposure as if they were living in the US and can also be subject to the UK inheritance tax (‘IHT’) regime. The acquisition of a US compliant life insurance policy (hereinafter ‘life policy’), whether issued by a US or non-US life insurance carrier, via a properly structured irrevocable life insurance trust (ILIT) is the next estate planning step for many such individuals to consider after implementing a Will and health and financial care directives. ILIT planning can:
- exempt life policy death benefits from US estate taxes and generally from IHT (whether funded annually or via a larger one off gift)
- provide liquid cash that can be loaned to the executors so as to mitigate the need to sell family assets to pay estate taxes and IHT due with respect to whatever family assets were subject to transfer taxes following the insured’s passing
- create an additional pot of funds to help provide for family members following the insured’s passing (e.g. where the insured is concerned that their existing assets may not be sufficient to provide for the family following their passing)
- eliminate probate with respect to the life policy death benefit
- allow a trustee to look after the life policy proceeds for the ongoing benefit of the family, where desired
What if the insured acquires a life policy without an ILIT?
If a life policy is instead owned directly by the insured, rather than by an ILIT, then the full amount of the death benefit would be included in their US taxable estate (and also their UK estate for IHT purposes if the policy is a UK situated asset, or if they were actually domiciled or deemed domiciled in the UK at the time of their passing).
- For individuals passing in 2021, the US gift and estate tax exemption amount is $11,700,000 ($23,400,000 per married US couple) which is the maximum amount that can be passed free of US gift and estate tax to or for the benefit of surviving family. Prior lifetime gift planning generally would reduce the available exemption amount. Amounts in excess of the exemption generally would be subject to estate tax at the rate of 40% of their value regardless of where located in the world.
- While President Biden has not yet acted on campaign pledges to increase estate taxes, several proposals have been put forward by Senators including one from Senate Budget Chairman Bernie Sanders which would reduce the exemption amount to $3,500,000 and increase estate tax rates to start at 45% and increase to 65%.
- Absent a change in law, the US estate tax exemption amount will automatically be reduced to $5,000,000 (indexed for inflation) from the beginning of 2026.
- The UK IHT exemption amount of £325,000 is far less than the US exemption amount and generally applies to UK situs assets of persons not domiciled or deemed domiciled in the UK and to the worldwide assets of individuals domiciled or deemed domiciled. Such assets in excess of this amount are generally subject to IHT at 40% of their market value on passing (potentially subject to deferral when passing to a surviving spouse).
ILIT planning allows the life policy death benefit to be received by the trustee free of US estate taxes and from UK IHT payable on death, although some IHT charges at a rate of up to 6% may apply in some circumstances (as discussed below).
How an ILIT Works – US Considerations
An ILIT is an irrevocable trust established by the settlor that generally purchases a life policy on the life of the settlor. The ILIT is funded by the settlor, typically via annual gifts to the trust. When the settlor passes, the life policy death benefit is paid to the ILIT trustee who can then use or distribute the funds for the family’s benefit taking into consideration any letters of wishes prepared by the settlor.
The trustee will need to undertake a number of activities including completion and submission of the life policy application form and maintenance of a bank account to receive periodic cash gifts from the settlor and timely pay these amounts over to the life insurance provider to keep the policy in effect.
Withdrawal Rights and Annual Gift Tax Exclusions
Assuming that the life policy is to be funded at least annually, in many cases, the trustee also will be responsible for notifying the beneficiaries of certain limited withdrawal rights they have been given so as to allow the settlor’s ongoing cash gifts to the trust to qualify for US ‘annual exclusion’ treatment. In this manner, it may be possible to fund the ongoing insurance premium payments without using any of the settlor’s estate tax exemption amount, thereby preserving that amount to be applied against the settlor’s personal assets upon their eventual passing.
For example, in 2021, the annual exclusion amount is $15,000 per beneficiary (other than non-US spouses). Thus an ILIT for a US spouse and two children would allow for up to $45,000 of annual withdrawal rights with the trustee writing to the beneficiaries periodically informing them of trust contributions. Assuming that the annual premiums due on the life policy were less than $45,000 then it should be possible for the settlor to annually fund the trust without utilising any of the settlor’s estate tax exemption amount.
In most cases, the beneficiaries will appreciate that if they were to exercise their withdrawal rights then it may not be possible for the trustee to maintain the life policy which generally would be against their broader interests. Where the beneficiaries are minors, it’s generally feasible to provide the settlor’s spouse with notice on behalf of the minor children.
Annual withdrawal rights up to the greater of $5,000 or 5% of the value of the trust’s assets per beneficiary per year can lapse in their entirety each year. Withdrawal rights beyond that amount require special attention and tracking by the trustee as the excess each year will accumulate and remain in existence until such time as contributions to the trust are no longer required to keep the policy in effect, at which time accumulated withdrawal rights will start to decrease at the rate of the greater of $5,000 or 5% of the then current value of the trust’s assets per beneficiary per year.
One-off Gifts and ILITs without Withdrawal Rights
Where the settlor does not wish for the beneficiaries to hold withdrawal rights or simply prefers to fund the ILIT with a larger one off gift, then ILIT planning can still be implemented albeit with gifts to the trust reducing the settlor’s gift and estate tax exemption amount.
In fact, in the run up to the 2020 US Presidential election, a number of clients looked to utilise substantial amounts of their gift and estate tax exemption amounts through one off funding ILITs which then acquired permanent cover life policies on their settlors. For example, if the one off payment cost of a $25,000,000 permanent cover life policy for an individual in their 50s was, say, $5,000,000 then such individual could settle an ILIT with a one off tax free gift of $5,000,000 (which would reduce their remaining gift and estate tax exemption amount) such that when they eventually passed, the ILIT would receive the entirety of the death benefit free of estate taxes (and without the settlor needing to make further gifts to the trust during their lifetime).
Normal expenditure out of income
Generally, once an individual becomes ‘deemed domiciled’ (or becomes actually domiciled) in the UK, transfers into trust which are in excess of an individual’s available annual reliefs and exemptions give rise to an immediate charge to UK IHT to the extent that such transfers are in excess of that person’s available nil rate band amount, currently £325,000 in any 7 year period.
However, it still may be possible for the settlor to fund the premiums for the ILIT without an immediate IHT cost by making transfers which qualify for the UK ‘normal expenditure out of income’ exemption. Transfers to the ILIT should qualify as an exempt transfer if, or to the extent that, they meet the following three conditions:
- they were made as part of the settlor’s ‘normal expenditure’ – i.e., expenditure which accords with a settled ‘pattern’ when made;
- they were made out of the settlor’s income, rather than capital; and
- after allowing for all transfers of value forming part of their normal expenditure, the settlor is left with sufficient income to maintain their usual standard of living.
There is no quantitative limit to the amount that can be claimed under the normal expenditure out of income exemption, though reporting of the transfers may be required.
Thus, where relevant, in many instances it should be possible for a settlor to avail themselves of the benefits of both US annual exclusion treatment and also UK normal expenditure out of income treatment for annual gifts to the ILIT.
Whole of life policies
Whole of life policies (i.e. policies other than term life policies) and some term policies in unusual circumstances present an additional UK IHT consideration under the ‘relevant property regime’ where either a UK situated policy is used, or the settlor is either deemed domiciled (or actually domiciled) when creating the ILIT or later becomes deemed domiciled (or actually domiciled) while still making transfers to the ILIT.
Under the ‘relevant property regime’, the trust can become liable for ten-yearly charges, currently at 6%, as well as exit charges at the then current rates against the value of the trust. Where an ILIT holds a whole of life policy, or in some (unusual) cases, a term policy, the value of the policy for IHT purposes is deemed to be the greater of (i) the policy cash surrender value and (ii) the aggregate value of historic premiums paid. To the extent the deemed value of the policy exceeds the then available nil rate band exemption amount, IHT charges would then apply under the relevant property regime.
Thus consideration may need to be given to both the projected build-up of cash surrender value within the policy as well as aggregate premium payments anticipated over time. Where relevant, it may be possible for the insurance agent to design the policy so as to limit cash surrender value build-up to help mitigate the position, though the future impact of the aggregate premiums paid might still create a tax charge in due course.
Potential application of the relevant property regime should though be evaluated in context. If the insured were to forego the use of an ILIT and instead own the life policy directly then the entire policy death benefit would generally be subject on death to IHT at 40% rates (potentially subject to deferral when passing to a surviving spouse). While each case should be evaluated individually, it is likely that the payment of ten-yearly charges and/or exit charges in connection with ILIT planning will represent a substantial saving as against policy ownership by the insured.
While acquiring a life policy via an ILIT can provide substantial US and UK tax savings, creating and administering the ILIT requires consideration of a range of US and UK tax and legal issues, some of which can be surprisingly complicated. Choosing experienced advisers and trustees to assist with the planning will help ensure that matters are dealt with practically and efficiently while maximising potential benefits to the family.