These individuals are referred to as ‘covered expatriates’. Generally, a covered expatriate is any US citizen or longterm green card holder (ie held a green card for eight years) who expatriates and either has a net worth of US$2m or more, exceeds a US income tax liability threshold or fails to certify that he has satisfied all US tax obligations for the previous five tax years. As Scott’s net worth exceeds US$2m, he would be considered a covered expatriate and thus would be subject to the special tax regime if he were to expatriate (and, as explained below, Scott’s children – who are automatically US citizens – would be taxable on assets they received from him).
Under this special expatriation regime, Scott would be treated as if he sold all his assets when he expatriated and US taxes would be due on the gains from the deemed sales. Further, Scott’s children (as US citizens) would be subject to tax at the applicable gift or estate tax rate when they received a gift or bequest from him (without the benefit of the credit shelter exclusion amount).
There are exceptions and planning methods that may enable people to avoid these harsh rules.
TAX COMPLIANCE – ‘VOLUNTARY DISCLOSURE’
Scott moved to the UK to continue his studies and had no significant income when he did so. When he did start earning in the UK he always ensured that he filed any UK tax returns on time. He did not realise until the recent publicity surrounding the US ‘Voluntary Disclosure Program’, however, that he had an ongoing duty to file US tax returns in addition to the UK returns. Further, he had no idea at all that he had an obligation to make a separate return detailing his non-US bank accounts (FBARs). This was a mistake. As a US citizen, he should have been filing a tax return with the IRS each year. Even green card holders are under an obligation to file US tax returns each year as they are subject to tax on their worldwide income even after moving from the US and even beyond expiry of the green card.
Scott needs to take immediate action to rectify the position. We will be able to advise him as to the various alternative routes to US tax compliance and are well positioned to conduct negotiations with the IRS as necessary.
LEAVING ASSETS TO US HEIRS
As Finn and Esme are both US citizens they too are subject to US tax law. This raises significant estate planning issues that must be addressed, particularly in relation to the trusts set up by Anne’s parents.
Assets held in a properly drafted trust for the benefit of US persons are not subject to US federal estate tax, (regardless of value) however, where trusts are not properly drafted, over one half of all the assets could be unnecessarily lost to the US government – not just once, but at each successive generation.
While transfer taxes may be of limited concern in the case of trusts below the credit shelter exclusion amount, the same cannot be said about income taxes. It is essential, where possible, that trusts set up to benefit US children should qualify as ‘grantor trusts’ during the settlor’s lifetime. Grantor trusts are disregarded for federal income tax purposes, with any income, gains or losses attributed directly to the donor. After the donor’s death non-US trusts could be subject to the confiscatory tax and interest charges under the US ‘throwback’ rules. These rules can cause virtually the entire distribution from a non-US trust to a US person to be payable to the US government in tax where the trust has previously accumulated income or gains. The fact that the trusts for Finn and Esme were established under Anne’s parents’ wills means that they are not grantor trusts and that action will need to be taken to mitigate against the impact of the ‘throwback’ rules.
Even where mitigation is put in place, there will be US reporting on any distributions from the trusts to the children, which can include deemed distributions via the use of trust property. In addition, consideration will need to be given to the FATCA reporting required in relation to these trusts. It is not unusual for US based CPAs to be unfamiliar with these reporting obligations and for American beneficiaries to find themselves unwittingly non-compliant.
A proper estate plan is the last – and essential – piece of the puzzle
Anne and Scott’s tax profiles are not aligned. Anne is a UK domiciliary but Scott is a US citizen who is not yet ‘deemed’ domiciled in the UK.
If Scott dies first leaving his estate outright to Anne US estate tax would be payable unless Anne transfers a portion of the assets of Scott’s estate to a QDOT. However, because Anne is a UK domiciliary, her transfer of those assets to a QDOT would trigger an immediate UK inheritance tax. Either way, the amount that Anne would have at her disposal to support her and the children would be significantly less.
Worst of all the balance of whatever is left at Anne’s death would then be taxed again in the UK – this time to inheritance tax at 40% with no credit given for the tax already paid in the US on the same assets. The table below sets out how that tax might look – assuming that Scott dies leaving $12.5m at a time when the US estate tax rate is 45%, the US ‘credit shelter’ amount is $310m* and that no QDOT is established on Scott’s death.
Similarly, suppose Anne dies first and leaves her estate (of £2.5m) outright to Scott. As their UK domiciles do not match, only a limited spouse exemption would be available (assuming they do not want to take advantage of the limited provisions under the US/UK double tax treaty or make an election for Scott to be treated as UK domiciled for inheritance tax purposes). The table below again sets out the potential outcome in that scenario – with the UK estate being taxed first in the UK on Anne’s death and then again in the US on Scott’s death.
If Scott and Anne instructed Withers to produce US/UK integrated estate plans, tax would only be paid once in relation to each of their estates as illustrated below – potentially saving the children millions. Without planning the children could end up with only around 53% of their parents’ gross estates notwithstanding the US10m US federal estate and gift tax unified credit exclusion amount.