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A Cautionary Tale Community Property Trusts
In his column “Where There’s a Will,” Dan Holbrook recently commented on the advantages of the new Tennessee Community Property Trust Act of 2010. While his characterization of the act as a potentially useful tool for estate planners is correct, lurking pitfalls await the unwary in addition to the reduced level of asset protection and the possible divorce issues discussed in his column.
For most Tennessee lawyers, community property is an unfamiliar concept forgotten after the 1L property exam. This act, however, will force both Tennessee practitioners and courts to become reacquainted with the concept. Community property is an ancient property ownership system derived from Spanish civil law that vests each spouse with a one-half interest in the couple’s community property. Under the system, generally all property of a married couple is held as community property except for property obtained in a manner excluded from such treatment, such as gifts, inheritances or under a separate property agreement. While the system varies by jurisdiction, community property may be subject to creditor claims of either spouse and may be divided other than equally in the case of divorce. Upon death, each community property asset is divided equally between the surviving spouse and the deceased spouse’s estate.
A particularly advantageous characteristic of community property exists under Internal Revenue Code section 1014. At the death of the first member of the community, each community asset receives a new basis equal, generally, to the fair market value of the asset as of the date of death. In sharp contrast, in a common law state upon the death of a member of a tenancy by the entirety, only half of the asset receives a fair market value tax basis. Because over time assets tend to appreciate in value, this adjustment in tax basis is frequently referred to as a “step-up” in basis and the asset said to have a “step-up” basis (although the heirs of those who died during the bear markets of the last decade might ruefully object to that label).
While community property is the inveterate default regime in nine states, 13 years ago Alaska adopted a community property system that allows married couples to “elect” community property treatment for certain assets. As discussed in Dan Holbrook’s column, Tennessee took a page from Alaska’s property laws by enacting legislation allowing for elective community property treatment of assets a couple contributes to a Community Property Trust (CPT). The unspoken purpose of the legislation was to permit a full basis “step-up” for appreciated assets. Thus, each practitioner should first consider whether a CPT will work for federal income tax purposes. The prudent practitioner should also consider several of the lurking pitfalls that wait for the unwary. The following hypothetical “worst case scenario” story illustrates several of these pitfalls along with the effectiveness issue.
The Munfords, a happily married, elderly couple, decided to face their inevitable demise and discuss their estate plan with their family lawyer, Mr. Pearson. Mrs. Munford, the bread-winner in the marriage, had held in her name alone almost all of the couple’s property, much of which was highly appreciated. The couple wanted to leave most of their property to their two industrious daughters who were both successful professionals. Yet, Mr. Munford also wished to provide for his free-spirited, artistic nephew in addition to his own children, in light of his daughters’ self-sufficiency.
Familiar with the appreciation in the Munfords’s assets, Mr. Pearson recommended that they transfer all of their assets to a CPT to position the entire property for a basis increase at the first spouse’s death. As part of an effort to ensure an interest for Mr. Munford’s nephew, the instrument Mr. Pearson drafted provided that the dispositive provisions in favor of his daughters and nephew were irrevocable and could not be amended upon the death of the first spouse. Shortly thereafter, the CPT was signed and funded.
Effectiveness of CPTs
Two years after creation of the CPT, Mrs. Munford died when driving in the wrong direction down I-40; she collided with a Porsche Cayenne full of doctors. In addition to the numerous wrongful death and personal injury lawsuits filed by the doctors and their families, the Munford family also faced IRS audits of the estate tax return and subsequently filed individual 1040s resulting in a challenge to the CPT’s effectiveness for basis purposes. After years of litigation, the United States Supreme Court held that elective CPTs were ineffective to convert separate property into community property for federal income tax purposes. Thus, the sole purpose for creating the CPT was defeated, and the Munfords lost the creditor protection that could have been achieved by using tenancy by the entirety and other ownership options.
A real potential exists for the new Tennessee act being declared ineffective for federal income tax basis purposes. In 1939, before the advent of married-joint returns, the Oklahoma legislature enacted an elective community property act intending to permit married couples to divide their income equally on their individual tax returns, thereby reducing the effective rate of taxation. In the only case confronting elective community property systems, the United States Supreme Court in Commissioner v. Harmon held the elective community statute ineffective to accomplish its federal income tax goals. The court found such contractually based divisions of property facilitated by Oklahoma’s elective law were ineffective to equalize income between spouses for income tax purposes.
According to the court, “[c]ommunities are of two sorts, — consensual and legal. A consensual community arises out of contract.” The court assumed that the state law status of elected Oklahoma community property was the equivalent to community property located in a traditional community property state, but found that the “important fact is that the community system of Oklahoma is not a system, dictated by state policy, as an incident of matrimony”; that is, it is not a “legal community.”
Proponents of the CPT will attempt to draw distinctions between the Harmon decision and effectiveness of CPTs for basis purposes. Proponents may argue that in the case of income tax basis, the requirement to receive the full “step-up” as expressly stated in the statute itself is that the property must be considered community property under state law. In a later revenue ruling, the IRS concluded that the conversion of separate property to community property by residents of a community property state would be effective for gift tax purposes while ineffective for the transmutation of income from such property. Those arguing for the effectiveness of CPTs may claim that such ruling reveals that the IRS will treat the underlying property as community property and will not distinguish between elective and default community property systems.
Still, Harmon is the only case law addressing the federal income tax consequences of transactions involving property treated as community property under an elective state law, despite the fact that Alaska’s elective community property statutes have been in effect for over twelve years. The IRS’s comprehensive Publication 555, Community Property (Rev. December 2010), specifically states that “[t]his publication does not address the federal tax treatment of income or property subject to the ‘community property’ election under Alaska state laws.” For nine community property states, the publication discusses not only who is subject to tax on income from community property but also the “step-up” in basis on death of one spouse. The clear implication of this publication, perfectly consistent with the holding in Harmon, is that the IRS will not recognize elective community property laws for federal income tax purposes.
The lead time for a definitive answer as to whether elective community property status for an asset is effective for federal tax basis purposes can be long. Unlike the situation in Harmon, where an income tax return was filed for the same year the Oklahoma statute became effective, tax basis does not become an issue until (a) one of the grantors dies and (b) a community property elected asset is subsequently sold. Even then, examination of an income tax return, where the tax basis of a sold asset would be reported, is neither automatic nor particularly likely to bring the tax basis issue to light. While more than 12 years is a long time, it is not so long as to make a practitioner comfortable that the issue will never surface.
Gift Tax Consequences Between Spouses upon Transfer
In addition to challenging the basis increases claimed on the individual 1040s, the IRS also asserted delinquent gift taxes at the conclusion of the estate audit. When Mrs. Munford contributed her assets to the CPT, she made a taxable gift to her husband of the amount by which the value of those assets exceeded the value of Mr. Munford’s contributed assets. While transfers between spouses failing to qualify for or exceeding the annual exclusion are taxable gifts, most gifts do not result in tax because of the marital deduction. Unfortunately, Mr. Pearson failed to ensure that the transfers to the CPT qualified for the marital deduction. Instead, Mr. Munford held only a terminable interest not qualifying for the marital deduction. Since Mrs. Munford owned most of the assets, the gift greatly exceeded the federal exemption. Of course, it also resulted in a Tennessee gift tax liability because of Tennessee’s lack of a lifetime exemption.
Mr. Pearson could have avoided the resulting gift tax in several ways. The simplest was to make the CPT revocable, thereby making the gift itself incomplete. However, by making the CPT revocable, arguments against the CPT’s effectiveness under the tax basis rules are bolstered. If the Munfords desired or required an irrevocable CPT, then the potential for a taxable gift could have been avoided by implementing one of the tax code approved alternatives. For instance, terminable interest property can qualify for the marital deduction if the property qualifies as “qualified terminable interest property” or QTIP, and a QTIP election is made on a timely filed gift tax return. If a timely gift tax return is not filed, the IRS’s position is the QTIP election is lost and a gift to the spouse occurs. The CPT also would have qualified for the marital deduction if Mr. Munford had held a right to all income and a general power of appointment over his one-half interest in the CPT.
Taxable Gifts to Others
During the audit, the IRS also determined that the dispositive provisions of the Munfords’s CPT, which became irrevocable at the death of Mrs. Munford, resulted in a premature gift. In the case of joint wills, a taxable gift occurs after the death of the first spouse if the surviving spouse may not alter the dispositive terms of the joint will. If a CPT agreement provides that the surviving spouse may not alter the dispositive provisions of the entire trust after the death of the first spouse, a similar result may occur. Mr. Pearson could have avoided this result by giving the surviving spouse the ability to amend his or her portion of the trust after the first spouse’s death. Moreover, taxable gifts could have been avoided by giving the surviving spouse unrestricted ability to withdraw or consume the property subject to the irrevocable dispositive provisions. Finally, inclusion of the QTIP provisions in the trust document along with a timely filed QTIP election could have eliminated the gift as well.
A ‘Step Down’ in Basis
Even if the CPT is declared effective for basis purposes and all gift tax traps are avoided, the CPT is not guaranteed to yield the desired result under the basis rules. As we have been made keenly aware in recent years, property appreciation is not a certainty. If assets depreciate in value after contribution to CPT, the sought after tax savings may be lost, and a reduction in basis may occur. A reduction in basis would place the client in a worse position than if the CPT had not been used. Such a result might be avoided by providing the grantors with the ability to change assets held in the CPT. However, such flexibility in contributing and removing depreciating assets may increase the argument against the effectiveness of the CPT for tax purposes. Thus, a prudent practitioner will be selective in advising which assets to contribute to a CPT.
It is not clear that a Tennessee CPT will accomplish the legislative purpose of giving a married couple a fair market value tax basis in assets held in the CPT at the time of the first death. Even if CPTs are effective for federal income tax basis purposes, practitioners should be careful to advise their clients of the asset protection benefits that may be lost by converting assets from tenancy by the entirety to community property by use of a CPT or giving up the opportunity to use other asset protection methods. Thus, practitioners should carefully gauge the opportunity costs of establishing a CPT with their clients. Given the state of the tax law, however, such trusts should only be used by clients if the perceived tax benefits outweigh the non-tax considerations. Moreover, if a CPT is desirable, special care should be undertaken to avoid any unintended gift tax consequences between the spouses and potentially with subsequent beneficiaries of the trust. While the CPT may be a useful tool of the experienced estate planner, it is a double-edged sword that must be wielded with care.
[The author would like to thank Susan Callison who provided insight and advice in editing the early drafts of this article.]
- Dan Holbrook, “Where There’s a Will: Community Property Trusts,” Tenn. Bar J., December 2010.
- Jurisdictional law varies. In some jurisdictions, earnings from separate property, proceeds from transfers of separate property, property acquired while living in common law states, personal injury proceeds, and commingled property are treated as separate property. Kathryn G. Henkel, Estate Planning and Wealth Preservation: Strategies and Solutions, §4.06 (Thomson Reuters/WG&L 1997 & Supp. Oct. 2010).
- Henkel, supra note 3, §4.06.
- States adopting a default community property system are Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington and Wisconsin. Puerto Rico also has a default community property system.
- Alaska adopted an elective system in 1998 allowing for community property ownership either through a trust or by agreement between the spouses. Only residents of Alaska may enter into community property spousal agreements. However, community property trusts are available to nonresidents as well as residents of the state.
- At the time of the case, married-joint returns did not exist. Married individuals in community property states held the income tax advantage of owning a one-half interest in their spouse’s income. Thus, each spouse could report one-half of the income. Such reporting was particularly advantageous to single bread-winner households.
- 323 US 44 (1944).
- Comm’r v. Harmon, 323 US 44, 46 (1944). The dissent criticized the court for drawing an arbitrary distinction between the ability of community property state residents to elect out of community property treatment by agreement, but not permitting common law state residents to opt into community property treatment by agreement. By combining the dissent’s criticism with the fact that Harmon was decided prior to the adoption of the current basis statute, there is an argument that the case should not be followed.
- Harmon, 323 US at 48.
- I.R.C. §1014(b)(6) (2010).
- Rev. Rul. 77-359, 1977-2 CB 24.
- Presumably it will be amended to include Tennessee’s legislation.
- Highly regarded commentators disagree on the effectiveness of elective community property laws for basis purposes. See David Westfall & George P. Mair, Estate Planning Law & Taxation, §4.01(1) (4th ed. 2001 & Supp. Feb. 2011) (arguing that an elective community property system such as adopted by Alaska will not be effective under Harmon); Jonathan G. Blattmachr, Howard M. Zaritsky & Mark L. Ascher, “Tax Planning with Consensual Community Property: Alaska’s New Community Property Law,” 33 Real Prop., Prob. & Tr. J. 614 (1999) (arguing that an election under the Alaska law will be effective for tax basis purposes); and David G. Shaftel & Stephen E. Greer, “Alaska Enacts an Optional Community Property System Which Can Be Elected by Both Residents and Nonresidents,” SD 36 ALI-ABA 1, 12-13 (1999) (arguing that such election will be effective for tax basis purposes).
- The Munfords could have equalized their assets prior to transferring them to the CPT. Doing so, however, may have subjected the transaction to the well-established step transaction doctrine. If this approach is used, clients should at least “age” the first transfer before making the contributions to the community property trust.
- I.R.S. Priv. Ltr. Rul. 2003-14012 (Apr. 4, 2003).
- Pyle v. U.S., 766 F.2d 1141 (7th Cir. 1985); I.R.S. Priv. Ltr. Rul. 79-44009 (July 10, 1979); I.R.S. Priv. Ltr. Rul. 81-05006.
WILLIAM CHAD ROBERTS is an associate attorney with Harris Shelton Hanover Walsh PLLC in Memphis, where his practice focuses on estate planning, business planning and tax litigation. He received his J.D. from the University of Memphis and his LL.M. in taxation from the University of Florida where he served as a graduate assistant editor for the Florida Tax Review. The author would like to thank Susan Callison who provided insight and advice in editing the early drafts of this article.