US individuals living in the UK should consider their current family gift planning opportunities ahead of the possible enactment of a budget reconciliation package by the Democrats later this year. If the key gift and succession provisions of President Biden’s Green Book tax proposals are carried through into law then:
- transfers of appreciated property to non-US spouse or other family members, whether by gift or at death, would trigger capital gains tax on previously unrealised appreciation (subject to an aggregate $1 million exclusion amount). Under current US law,
- gifts generally can be made free of US capital gains tax with the recipient taking over the donor’s basis in the gifted asset (though UK capital gains tax is likely to apply); and
- inherited assets generally are received with a ‘stepped up’ basis such that they can later be sold with gains being calculated based on market value at the time of the decedent’s passing, rather than their original acquisition cost (which currently matches the UK position).
- capital gains tax rates (currently generally set at 20%) are proposed to be increased to the top ordinary income tax rates for taxpayers with gross income of more than $1 million (which includes capital gains amounts). This would adversely impact both high income individuals looking to make gifts and also individuals with lower incomes but looking to gift highly appreciated assets.
- Transfers of property into, and distributions in kind from, trusts, partnerships, or other non-corporate entities (other than a grantor trust deemed wholly owned and revocable by the grantor)—would trigger recognition of capital gains on unrealized appreciation (as well as potentially triggering UK capital gains tax and inheritance tax (IHT) as at present)
While decreases to the estate and gift tax exemption amount, currently at $11.7million per individual, and increases to the estate and gift tax rate, currently at 40% of asset fair market value, were widely discussed in connection with President Biden’s election campaign, these items were not included as part of the Green Book. There were though proposals earlier this year from Senators Sanders and Warren, among others, that would decouple the estate and gift tax and reduce the exemption amount to the $1million to $3.5 million range while also increasing gift and estate tax rates but these didn’t make it into the Green Book. In any event, even under current law, the unified exemption amount will automatically decrease to $5 million (plus an inflation adjustment) come January 1, 2026.
Further, on Monday September 13, the House Ways and Means Committee released draft budget legislation that would reduce the exemption amount back to 2010 levels – $5 million adjusted for inflation – effective January 1, 2022. Interestingly, the proposal to apply capital gains tax to gifts of appreciated property and appreciated property held at the time of passing were not included in this draft legislation.
Given that the capital gains tax provisions with respect to gifts of assets and inheritances are included in the Green Book and are proposed to take effect from January 1, 2022 and that the proposed decrease in the exemption amount to $5 million in the House Ways and Means Committee draft legislation also would not take effect until January 1, 2002, consideration should be given to gift planning opportunities under current law with the current $11.7 million exemption amount during the remainder of this calendar year.
For some, the simplicity of outright gifts direct to family members will be appealing. US individuals generally can gift any portion or all of their $11.7m exemption amount before triggering US gift taxation. For US couples, that would effectively allow for up to $23.4 million of gifts. Under current law, the recipient would take over the donor’s basis in the gifted assets.
Consideration will though need to be given to the donor’s UK position when it comes to gifts of appreciated assets. Gifts of appreciated assets by UK residents generally will be treated as taxable disposals for UK purposes unless the donor is neither domiciled nor deemed domiciled in the UK and pays UK tax on the remittance basis of taxation and the gift is of non-UK situated assets.
Gifts in trust
Others may have concerns over giving younger or less experienced family members direct access to substantial amounts or may otherwise feel that substantial benefits could be had from aggregation of assets and centralised investment management. In such instances, the use of gifts into trust for the benefit of family members can work well by allowing a trustee to look after the assets.
Again, care must be taken from a UK perspective as gifts into trust by domiciled or deemed domiciled individuals in excess of their available nil rate band exemption amount, currently £325,000 in any seven year period, generally will trigger an upfront 20% IHT charge (subject to certain exceptions) and further ongoing 10 yearly charges.
A one off gift to a trust structured to acquire a life insurance policy is another option. The trust could use the gifted funds to purchase a permanent cover insurance policy on the life of the settlor with the policy paying out a specific death benefit amount upon the settlor’s passing free of US federal estate tax and generally free of IHT. If instead of utilising the trust, the policy had been held by the insured, then federal estate tax and IHT generally would apply to the full amount of the death benefit either on the passing of the insured or their spouse depending on the details of their US and UK status.
As mentioned above, if the settlor were domiciled or deemed domiciled in the UK then a one off gift to the trust generally would trigger an upfront 20% IHT charge (subject to certain exceptions) and further ongoing 10 yearly charges and generally should be avoided.
However, while larger one off gifts into trust generally should be avoided by domiciled and deemed domiciled individuals, it still may be possible for such persons to make annual gifts to a trust without an immediate IHT charge arising on each payment by making transfers which qualify for the UK ‘normal expenditure out of income’ exemption – gifts made out of income which are part of a settled pattern after which the settlor is left with sufficient income to support the settlor’s usual standard of living. The UK IHT position will probably be further improved if the policy is a term, not whole of life, policy. In this manner, life insurance trust planning benefits frequently can still be provided for the family though an annual gifting plan.
Excluded property trusts
Many US individuals living in the UK will be aware of so called ‘excluded property trusts’ which, when funded with non-UK situs assets by individuals who are not yet deemed domiciled, generally allow the IHT charge which might otherwise have occurred upon the passing of the settlor and/or the settlor’s spouse to be legitimately sheltered. As these trusts are typically structured such that the individual settling the trust remains a beneficiary, they’re generally tax neutral from a US perspective but allow for trust assets to escape probate and provide an effective succession structure. So while not typically used as a US gift planning opportunity, excluded property trusts do allow US individuals to effectively remove non-UK assets from the scope of IHT so are well worth considering give the large difference in the UK exemption of £325,000 vs the US exemption amount.
For those deemed domiciled individuals wishing to make gifts in trust but effectively prevented from doing so because of the upfront IHT charges that would result, family limited partnerships offer a tax efficient alternative structuring vehicle.
Family partnerships are typically arranged to allow senior family members to contribute assets to a partnership in exchange for general partner and limited partner interests. The limited partner interests might represent the substantial majority of the value and can then be gifted to family members. The limited partner interests would allow the younger family members to receive distributions from the partnership but they would not generally be allowed to directly access the underlying partnership assets themselves.
Centralised investment management would be carried out through the general partner though, depending on the overall facts and circumstances, it may be necessary for the general partner to appoint an independent manager to address decisions such as distributions and liquidations.
From a UK perspective, the transfer of the limited partner interests is a potentially exempt transfer and does not trigger an IHT charge so long as the transferor survives the transfer by seven years. There may however be a UK capital gains tax charge if the underlying assets stand at a gain from when first acquired by the transferor. For US federal estate and gift tax purposes, the transfer (when structured properly) is respected as a gift and will diminish the transferor’s lifetime estate and gift tax exemption.
With interest rates remaining at low levels, loans to family members provide a simple but effective opportunity for wealth transfer. Intra-family lending allows an individual to assist family members without making a current gift.
In order to avoid the intra-family loan being treated as a gift for US transfer tax purposes, the loan needs to be documented and the family member providing the loan must charge interest at a rate greater than or equal to the applicable monthly AFR specified for the term of the loan. The family member providing the loan will report income on the interest received from the borrower, but as long as the borrower is able to invest the funds to generate an investment return in excess of the minimum AFR interest rate, the loan will be successful as a wealth transfer technique.
AFR interest rates are set monthly and determined by reference to actual Treasury rates. For example an intra-family loan made in September 2021 would need to charge interest at 0.17% for a loan term up to three years, 0.86% for a loan term up to nine years and 1.73% for a loan term in excess of nine years.
If the borrowing family member can earn a greater return on the amount being borrowed than the AFR, then such family member can keep that additional return without any gift tax consequences. Intra-family loans can also be used to enable a family member to purchase a more expensive residence or vacation home than they could otherwise afford.
While intra-family loans to individual family members generally work well for both US and UK purposes, additional care must be taken with respect to loans to or from trust structures as a number of US and / or UK tax and reporting considerations could arise depending on the overall facts and circumstances.