It is common in the UK to hold life insurance policies in trust to shelter the proceeds from Inheritance Tax (IHT) and give the family quick access to the funds following death without the need for probate. Indeed, life insurance is often taken for the express purpose of lending to the executors to pay the estate’s IHT liability in order to allow probate to be granted.
Where a UK insurer issues the policy, any trust holding the policy will normally need at least one UK trustee, as well as a UK bank account. However, where the individual (the “life assured”) is a US person (a citizen or resident) using a typical English life policy trust would likely cause a number of issues, and extra care must be taken to ensure the life policy trust works efficiently for the purposes of US tax.
What is the issue?
Life policy trusts are perhaps one of the few examples of trust planning which is typically simpler and has fewer tax consequences in the UK than in the US, at least in the case of ‘term’ life policies.
US citizens are subject to US tax on worldwide assets, including federal income tax, estate tax and gift tax, regardless of where they are resident. It is therefore essential that any trust created to hold a life insurance policy is efficient not only for IHT but also for US tax where different rules apply to determine the tax outcomes.
Tax on the trust during lifetime
Many clients are advised by their US advisors to create Irrevocable Life Insurance Trusts(ILITs), but are surprised to discover that, if they were UK domiciled at the time (or if they later return to the UK as ‘formerly domiciled residents’) the ILIT is within the scope of UK IHT charges. This is not usually a problem for term life insurance policies but can arise for whole of life policies.
This problem is likely to be exacerbated under proposed new IHT rules expected to be implemented in April 2025 (see our recent article) which will cause many more foreign trusts to be brought into the scope of IHT.
Tax on the life insurance proceeds after death
In the UK, the trust assets held in virtually all trusts created in a person’s lifetime, are not considered part of the personal estate of any individual. The main exception is ‘bare trusts’ discussed later in this article. So long as the life assured or their estate is not named as a trust beneficiary, the existence of the trust will generally be sufficient to ensure that the life policy is not exposed to IHT on the death of the life assured. It is quite possible for the life assured to be a trustee, though it would be sensible to have at least one other trustee to ensure smooth access to the funds after death.
For US citizens, the generous estate tax allowance ($13.61mil or $27.22mil for a married couple in 2024) may mean that estate tax is not a concern. However, the allowance is due to reduce to $5mil (indexed for inflation) in January 2026 unless the current rates are extended by the US federal government. This would bring a greater number of clients (and their life policies) within the scope of US estate tax.
US life policy trusts typically require far more careful drafting than standard UK life policy trusts. The Internal Revenue Code sections 2041, 2042, 2036 and 2038 contain a number of traps which may cause a life policy to be exposed to US tax despite the existence of a trust. For example:
- The life assured should not be a trustee or, if they are, should have limitations on their trustee powers to ensure they have none of the “incidents of ownership” in the policy (such as the power to surrender or assign it or to change the beneficial ownership) which would expose the trust to US estate tax on their death. Independent trustees are preferable.
- If a US person funds an ILIT which is classified as a foreign trust for US tax (for instance, if the trustees are not US persons) it will very likely be treated as a foreign grantor trust for US tax purposes. This fundamentally changes the US tax treatment (and reporting obligations) of the trust and steps need to be taken to avoid a US tax charge on the proceeds of the life policy following death of the life assured. It is generally preferable to use a US domestic trust.
- The definition of “life insurance” for tax purposes differs in the US and UK. If the life assured or trustees are both US and UK connected it is important to ensure that the policy meets the definition in both countries.
Tax on the premiums
In both the UK and US, the premiums paid for a life policy which is not held personally by the life assured is taxed as a lifetime gift or transfer.
- Regular premiums
In the UK, gifts into trust are immediately chargeable to IHT (at 20%) subject to the rolling seven-year cumulative allowance of £325,000. However, regular life policy premiums are often exempt either under the annual exemption (£3000) or the ‘regular gifts from income’ exemption. The latter is particularly helpful as the exemption is limited only by the level of surplus income of the payer after payment of their other personal expenses.
In the US, ordinary gifts to individuals benefit from an annual allowance of $18,000 in 2024. However, gifts into trust do not qualify for the allowance unless named individuals attain a ‘present interest’ immediately following the gift. Life policy trusts must therefore be carefully drafted to provide such an interest, using what is known as ‘Crummey wording’ to provide a series of notification and withdrawal rights to trust beneficiaries. Generally, the premiums cannot be paid by the life assured directly but must first be paid to the trustees who are required to wait for a defined Crummey notice period before using the funds to pay premiums.
Where the premiums are considered to be paid from marital ‘community property’ as a result of the life assured’s connection with a US community property state, extra complexities arise to ensure that the surviving spouse is not considered to have a retained interest in the trust (given that the premiums are effectively considered to have been paid jointly by both spouses).
- Single premium
Different considerations apply where the life policy is funded by a single one-off premium. This avoids the need for Crummey withdrawal rights. The payment would use part of the life assured’s US lifetime tax allowance. This is attractive to many US clients seeking to make use of the current allowance before the anticipated reduction in 2026. If the settlor purchases the policy themselves before settling it in trust (as is standard practice in the UK) a three-year ‘look back’ period applies for US estate tax – if the settlor dies within this period, the policy is treated as taxed within the settlor’s personal estate.
For those subject to UK IHT, the much lower allowance of £325,000 is often problematic. For more valuable policies it is usually preferable to ensure the trust is treated for UK purposes as a bare trust for the intended beneficiaries. If it is, the premium is then taxed akin to an ordinary gift to an individual. There would be no IHT charge so long as the life assured survives a further seven years after paying the premium (or, if later, after assigning the policy into trust).
The Birketts view
Life insurance is a hugely valuable tool in the estate planning toolkit, but where the life assured is a US citizen, life policy trusts should be approached with caution to ensure they are fully compliant with both US and UK tax regimes.
Our US/UK Private Client Team specialises in providing UK tax advice to US connected clients. Please get in touch if you would like to discuss any of the issues raised in this article.
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The content of this article is for general information only. It is not, and should not be taken as, legal advice. If you require any further information in relation to this article please contact the author in the first instance. Law covered as at October 2024.