1. 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

2.  Overview 1. 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

3.  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%

4.  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 US Estate Tax Update and Overview  In 2010, estate and GST taxes repealed but reappear in 2011 with $1 million “exemption” at old graduated rates  During repeal in 2010, gifts taxed at flat 35% with $1 million “exemption” for US persons  Note that many states still impose death taxes (based on domicile or situs)  Stepped-up basis at death also repealed for 2010 only  Legislation may yet alter the “exemption”, make repeal permanent (unlikely) or re-impose tax before 2011 – several recent proposals have come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

5.  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

6.  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

7.  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

8.  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 used in 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)

9.  US/UK Estate and Gift Tax Treaty: If testator is domiciled in UK  US real property  Business assets (business property of a permanent establishment and assets pertaining to a fixed base used for the performance of independent personal services)  Not US shares or chattels US Situs Assets

10.  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

11. 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 than the 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)

12. 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

13.  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

14.  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

15.  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 plus 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

16.  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)

17.  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

18. 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:

19. Differences:  Discretionary trust at first death will not work in US for marital or charitable legacies (but OK after 2 nd 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:

20. 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:

21.  Typical Estate Plan for US Citizen Domiciled in UK Spousal IPDI (not exempt in US) Balance of US $1 million exemption Marital Residuary Fund absolutely (A), or IPDI+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 children absolutely NRB DT £325,000

22.  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 Residuary Fund absolutely (A), or IPDI+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 children absolutely

23.  Typical Estate Plan for US Citizen Domiciled in UK NRB DT £1 million? $1.5 million? ? Marital Residuary Fund absolutely (A), or IPDI+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 children absolutely

24.  Discretionary Trust US assets up to $60,000 US & UK Marital Trust (QDOT) Other US assets up to GST exemption To Spouse absolutely (transferring balance of NRB) Non-US assets Typical Estate Plan for Non-US Person Domiciled in UK With 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 children absolutely

25.  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 confidentiality and ease of changing trustees  Non-US holding company – not necessary for UK domiciliary } Unless bare trust

26.  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

27.  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

28.  5. Non-Tax Issues Take 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

29.  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

30. For more information please contact: Ian Watson 3 Stone Buildings Lincoln’s Inn London WC2A 3XL Tel: 020 7242 4937 Email: iwatson@3sb.law.co.uk DX 317 Chancery Lane 3 Stone Buildings, Lincoln's Inn, London. WC2A 3XL tel: +44(0)20 7242 4937 fax: +44(0)20 7405 3896 10 Rockefeller Plaza, 16th floor, New York. NY 10020-1903 tel: (1) 212 713 7680, fax: (1) 212 713 7679 3stonebuildings.com