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Estate and Gift Tax Planning for Non-Traditional Families |
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Co-Authored with Jerry Simon Chasen, Esq. |
With increasing frequency, families are living in situations in which there has been no civil marriage, either because a couple chooses not to marry or because they do not have the opportunity to marry. According to the General Accounting Office of the federal government, approximately 1,200 rights and responsibilities associated with civil marriage exist. [Defense of Marriage Act, Letter Report, GAO/OGC-97-16 (Jan. 31, 1997).] Although many of these are relevant to a comprehensive estate plan, this article is most concerned with the unlimited gift and estate tax marital deduction under Code §§ 2523 and 2056 respectively. Because of the complexity of these issues and the importance of thoroughly examining several sophisticated estate planning paths, this topic will be dealt with in two parts, the second article appearing in the May/June 2001 issue of Probate & Property.
Without the “unlimited marital”, even the task of equalizing assets so that both halves of a legally unmarried couple can take full advantage of his or her lifetime exemption can be fraught with transfer tax issues. Although much can be said on the impact the marital deduction has in estate planning, the net result is that a married couple can generally postpone the impact of transfer taxes until after the death of the second to die. In fact, although there is much talk about a marriage penalty in the income tax situation, the “unmarriage penalty” of the transfer tax is arguably far more burdensome.
IDENTIFYING DOMESTIC PARTNERS
The usual model for estate planning involves the traditional family situation: husband, wife, kids—Ozzie & Harriet, or, depending on generation and income –Homer and Marge Simpson. The reality is that significant portion of the population does not fit this model. The Census Bureau estimates a sevenfold increase in number of unmarried partners' households since 1970, and this figure does not account for gay and lesbian couples. [Terry A. Lugalia, [Terry A. Lugalia, Given the current political climate, and particularly the passage of civil union laws in Vermont, societal visibility and acceptance of gay and lesbian couples are likely to rise, which will result in more “unmarried” couples in the eyes of the Code. [15 Vt. State. Ann. §§ 1201-1207 (2000)].
Although
the examples used in this article are largely drawn from the gay and lesbian
community, this is just one segment of nontraditional households.
More and more heterosexual couples who have been married but are no
longer are choosing to remain legally single while in committed relationships.
Whether they choose to stay single because they are concerned alimony will be terminated in the event of
subsequent marriage, or because they would like to keep things simpler for their descendants’
inheritance, these couples present many of the same planning opportunities and
challenges as their same sex counterparts.
Half of all baby boom marriages are expected to end in divorce, and
although 75% of those who divorce will probably remarry, 40% of those
remarriages will end in divorce. When New York established domestic partnership
registration, more than half of the couples that registered were heterosexual. [Mayor
Giuliani Signs Landmark Domestic Partnership Legislation, Press Release No.
319-98 (Jul. 7, 1998)].
In
a recent study, the American Association of Retired Persons Women’s Initiative defined a non-traditional family
as any family or household in which: (1) at least two or more people not related;
(2) if the household members are related, at least one is related non-lineally,
such as a sibling; or (3) one or more lineal generations are missing from the
household, such as when grandparents are caring for grandchildren with neither parent
present. [See Deborah Chalfie, The Real Golden
Girls: The Prevalence and Policy Treatment of Midlife and Older People Living in
Nontraditional Households, AARP (1995) at viii]. The
Initiative found that:
THE BASICS
Unless these nontraditional families avail themselves of at least basic estate planning services, the law of most states will presume that they want all of their property to go to, and medical decisions to be made by, their next of kin. In a nontraditional family setting, that is unlikely to be a client’s real intention. Practitioners must appreciate the unique needs of these clients and how best to accomplish the goals of making estate administration efficient and minimizing tax burdens with creative planning techniques.
A
recent study of the gay and lesbian community seemed to illustrate that use of the charitable deduction is one of the best ways available to do
tax-wise planning. This study has
found that the average gay or lesbian donor contributed 2.5% of his or her personal
income ($1,194) to nonprofit organizations. [M.V. Lee Badgett & Nancy
Cunningham, Creating Communities: Giving and Volunteering by Gay, Lesbian,
Bisexual, and Transgender People, Working Group on Funding Lesbian & Gay
Issues and the Institute for Gay & Lesbian Strategic
Studies (1998)]. Because many gay
and lesbian couples do not have children, the charitable deduction can be a big help in
reducing the size of a taxable estate. The examples in this article focus primarily on using the charitable
deduction as part of an estate plan.
In
the Badgett & Cunningham survey, although only 9% of the respondents reported personal income in
excess of $100,000, the household income of 26% exceeded $100,000. [Id.]. This
statistic suggests that the
likelihood of needing some significant asset transfers between partners is
essential to attempt to equalize wealth and maximize the use of each party’s
lifetime exemption. The following three
fact scenarios illustrate some of the possibilities in planning for alternative
families.
EVENING THINGS OUT
Harriet
and Marge are both in their mid-40’s and have been domestic partners, couples
who cannot avail themselves of civil marriage, for about
ten years. Before South Miami Beach became a hot spot, Harriet had bought a nice little apartment building with about 25 units right on the ocean.
She has handled all of the renovations and repairs on it herself, which
has also helped reduce her costs. Harriet
paid $70,000 for the building in the mid 1980’s, but it is worth about ten
times that now. Although Harriet has a nice little
business, the apartment building is her most significant asset by far.
It yields a tidy $80,000 in rental income annually, which is more than the couple needs when their salaries are taken into
account.
Marge
makes a decent living, but up until now hasn’t accumulated much. The two are interested in evening out their assets
so that the continued appreciation in the building can build in both of their
estates and so Marge will be able to take advantage of her lifetime exemption
amount. Harriet is willing for
Marge to have a 40% interest in the building, which would yield an annual income
(with present rentals) of $32,000. Harriet
also has a soft spot in her heart for a number of charitable organizations, and
she is planning to retire in a few years.
Simply using a pro-rata valuation, a 40% interest in the $700,000 building would be worth $280,000. Because the 40% interest is a minority interest, it would likely be discounted for gift tax purposes, which is not taken into consideration in this example. Obviously, if Harriet simply gives Marge a 40% interest, she will use $280,000 of her lifetime exemption. The trick is to get some of this interest into Marge’s column without Harriet's having to use any of her lifetime exemption.
Because the property is expected to continue to appreciate, because certainty about payment seems desirable and because the AFR is currently relatively low, a charitable lead annuity trust (“CLAT”) seems to be an appropriate vehicle. With the current AFR, Harriet could put the interest in a CLAT at 11% for 13 years, with monthly payments of $2,556.67 made to charity. There would be an annual charitable payout of $30,800, which would distribute nearly all of the income earned by the trust each year. At the end of that time, Marge would own the interest outright.
Even
though this planning would accomplish the client’s goal of not using any lifetime
exemption, it would not be a big surprise if Harriet were not particularly happy
about the term taking that long. Without the income from the gifted
share, Harriet would have difficulty retiring.
Of course, if Harriet is truly concerned about keeping the income "in the
family”, instead of a CLAT with the income going to charity, she could
establish an old fashioned GRIT because the parties are not legally related.
Another
solution would be to put the interest first into an LLC and
then put the LLC interest into the lead trust. Harriet
would then make a gift to Marge of a 40% interest of the LLC. Although
the IRS and legal commentators have paid a lot of attention to the
problems involved in family limited partnerships, most of those concerns are not
relevant because none of the parties here
are legally related. Because the LLC’s organizational documents will contain various
restrictions on transferability, and because of limited marketability, the value of the gifted
interest would likely be discounted significantly. If
the discount is 40%, instead of the interest being worth
$280,000, it would be valued for gift tax purposes at only $168,000.
The terms of the CLAT would be
different, however. Instead
of 11%, the annuity amount could be 19%. Annual
distributions to charitable beneficiaries would be $31,920, nearly the exact
amount of income, with monthly distributions of $2,600.
Best of all, it would take only 7 years—just slightly more than half the
time—to transfer the interest to Marge, and virtually none of Harriet’s
lifetime exemption amount will be used.
There would be income tax benefits of the CLAT to Harriet as well. The nature of the benefits would depend on whether Harriet has the CLAT constructed as a grantor trust. Because, under these facts, Harriet probably does not need a large deduction up front and probably would not want to pay tax on income she would not personally receive, she would not set this up as a grantor trust.
PROTECTING A DOMESTIC PARTNER'S ASSETS
Now
suppose that Harriet is
53, and Marge is 33. Harriet's previous 14
year relationship ended last spring
before she met Marge. For her part,
Marge is quite fond of Harriet and also is reasonably fond of the lifestyle
that Harriet can provide. Harriet
has requested Marge’s hand in domestic partnership because they live in a county that
has a domestic partner registry and domestic partner benefits, and there are some “prenup” conversations going on.
Suppose that Harriet has some other assets in addition to the apartment
building. Key among these is a
stretch of undeveloped beachfront in Hollywood, Florida.
Harriet bought the property when the beach was at
its lowest value and its value has already appreciated threefold, to a
present value of about $1 million. Harriet
has some other assets as well and is relatively well off.
Harriet
is willing to provide for Marge and make some gifts now in expectation of their
long life together,
but
she is not interested in providing for Marge if they do not stay together. She has long
been a supporter of a number of local charities, and she has established a
donor advised fund at her local community foundation.
One
choice for Harriet would be to place the beachfront property in a two-life flip
charitable remainder unitrust for Harriet’s life and then for Marge’s life.
The Taxpayer Relief Act of 1997 requires that the actuarial value of the
remainder that a charity will receive be
"at least 10 percent of the net fair market value of such property" as of the date
of the gift. [Code §
664(d)(2)(D)]. Because
of the parties’ relatively young ages, the only way that this planning will pass the
10% test is if there’s a relatively low unitrust rate.
With an AFR of 6.4%, a unitrust rate of 5.75% will pass the test for
parties at this age.
Harriet
is well aware of the tremendous tax savings she would get by avoiding the capital
gains tax, as well as the charitable deduction that would help shelter the
income from her other investments. To make sure that Marge is in for the long haul, Harriet was advised to
reserve a testamentary power to change the beneficiary. Therefore, Harriet would
not incur any
gift tax at this point.
Marge,
however, is a little sharper than that. She
knows that if Harriet can change the beneficiary, she’s will always be subject to
Harriet’s threats of “If you don’t do this, I’ll change my will.”
Marge has her own lawyer, who has proposed a solution.
Instead of a reserved testamentary power, the trust
agreement would provide that, if Marge and Harriet were no longer registered as
domestic partners, Marge’s interest would terminate.
In
a similar situation involving a heterosexual divorce, the IRS ruled that
the condition was acceptable. The IRS generally will not rule on whether a trust qualifies as a charitable
remainder unitrust under section 664 because it believes, apparently, that it
spoke clearly in Rev. Proc. 90-31, 1990-1 C.B. 539, by providing forms for
charitable remainder unitrusts. However, it will do so in certain circumstances. In PLR 9511029 the trust agreement provided that, in the event that the
donor and spouse were divorced, the spouse’s interest would terminate. The IRS
recognized that that trust agreement contained provisions that are not included in, or are different
from, the sample provisions outlined in Rev. Proc. 90-31, and so it agreed to rule
on whether those provisions complied with the requirements for a charitable
remainder unitrust under Code § 664.
Lawyers
may argue that all Harriet would have to do to avoid Marge’s interest
would be to “deregister” their domestic partnership.
That, however, is basically the same as arguing that someone would divorce
so as to affect the disposition of his or her assets.
Time and again, divorce has been deemed to be an event of “independent
significance”. As one court cogently states: "In
reality, a man might divorce his wife, but to assume that he would fight through
an entire divorce process merely to alter employee death benefits approaches the
absurd." [Estate of Tully v. United
States, 528 F. 2d 1401 (Ct. C1. 1976)
The
harder question is how to effect this in the majority of jurisdictions that do
not have domestic partner registries. It
is possible to create a domestic partnership agreement, and have the unitrust
interest dependent upon partnership’s continued existence and effectiveness.
Domestic partners may be defined as:
It must be recognized,
however, that legal, heterosexual marriage has tremendous
ramifications in terms of ownership of property that are
generally absent in the domestic partner situation.
And the consequences of proceeding with the right of termination without a
private letter ruling could be disastrous, since the IRS may fail to recognize
the trust as a CRUT. The problem,
of course, is that the Trust cannot qualify as a CRUT if it is a grantor
trust, which it would be if Harriet were deemed to have a power that was not
seen as having to do with an event of independent significance.
SELF-CREATED
RETIREMENT PLAN
The
following hypothetical will briefly address a creative approach for partners to
protect one another and benefit a charity as well. Homer & Ozzie live in a
beautiful home, currently valued at $700,000, in South Miami Beach. Ozzie
owns the home. Neither man has children; conversation about preserving the family homestead is
not necessary. Rather than continuing
to hold the full ownership interest of the house, it may be possible to provide
Homer with some additional flexibility and remove the asset and its
continued appreciation from Ozzie’s estate.
A likely vehicle would be a charitable gift annuity. In effect, Ozzie would be selling the remainder interest in the house after his and Homer’s deaths in exchange for an annuity that would be paid to them together and then to the survivor. If Ozzie has designated a charitable organization as the contingent beneficiary of his retirement plan, supplementing Homer’s available income may be useful. Ozzie would transfer the remainder interest in the house to his favorite large charity, reserving a life estate for Homer and Ozzie’s combined life expectancy. In exchange, the charity will agree to pay an annuity amount to Homer and Ozzie together and then to the survivor.
A
charity must be substantial to be able to offer this type of annuity. If the primary goal here is simply removing the asset from
the estate and the charity was unwilling to pay an annuity, Ozzie might simply
reserve a life estate for Homer and himself and deed the remainder interest to
charity.
Moreover,
the amount could be made flexible by establishing a deferred gift annuity, thereby
postponing the annuity starting date. [PLR 9743054].
This planning would give Ozzie and Homer some of the flexibility
that they are
eager to have in planning their estate. With
this type of annuity, Homer and Ozzie could defer the initiation of payments.
The amount of their current income tax deduction would be based on the
earliest time that they could elect to receive their annuity payments.
Although it would not increase the amount of their tax deduction, the
longer they defer the commencement of annuity payments, the greater each payment
would be, thereby reducing the amounts that they would have to withdraw from the retirement accounts for their
living expenses.
CONCLUSION
Working
with gay and lesbian families, as well as with other non-traditional families,
requires thinking outside the box. Although there are obstacles in
sophisticated estate planning for non-married couples - most significantly the lack of
an unlimited marital deduction - there are also distinct advantages. One
advantage is that the income tax burden is often reduced, depending on the individual tax brackets,
because filing jointly is not required.
Many gay and lesbian couples do not raise children,
which provides
greater opportunity for them to give charitably, both during life and at death.
The key is
for lawyers not to make any assumptions about the client's heterosexuality or homosexuality.
Lawyers should listen to cues and
pay attention to the client's conspicuous omission of a gender
pronoun in referring to a significant other.
In addition, lawyers should trust
their instincts and be as direct as possible without creating an
uncomfortable situation. Lawyers are trying to build a relationship of trust and are helping
their clients plan for their lives, so this is no time to dance around
matters that are directly relevant to estate planning.
Determining and coaching intentions means lawyers are doing their job well and
being sensitive to their clients’ concerns.
This article was originally published in Probate & Property, January/February 2001