1. 1. ABA Tax Section Mid-Year Meeting Fiduciary Income Tax Committee January 25, 2014 Phoenix, Arizona Brian P. Tsu Melinda Merk Henderson, Caverly, Pum & Charney LLP SunTrust Bank Private Wealth Management San Diego, California Vienna, Virginia
2. 2. Agenda Community Property Overview Key non-tax characteristics Federal income and wealth transfer tax aspects Potential pitfalls using joint trusts Transmutation agreements/planning Increased use of Joint Revocable Trusts (JRTs) in Common Law Property States Common law property basics Typical design of JRTs for non-community property Federal income and transfer tax issues and pitfalls Other post-mortem administrative issues Using Community Property JRTs to convert common law to community property 2
3. 3. Overview of Community Property - Community Property Jurisdictions Community property principles apply to property acquired by spouses while domiciled in certain jurisdictions Community property also applies to same-sex couples if the state recognizes the same-sex marriage for state law purposes States differ as to whether community property applies to registered domestic partners Currently, community property jurisdictions include Arizona, California, Idaho, Louisiana, New Mexico, Nevada, Texas and Washington as well as many foreign countries In addition to the above jurisdictions, Wisconsin has adopted the Uniform Marital Property Act, in effect adopting a community property system unless spouses elect out The IRS has ruled that Wisconsin marital property is the equivalent of community property for income tax purposes [Rev. Rul. 87-13] Alaska has also adopted the Uniform Marital Property Act, except that spouses must elect to treat property as community property The IRS has not ruled on whether Alaskas system constitutes community property for federal tax purposes 3
4. 4. Overview of Community Property Categories of Property In general, there are two categories of property in a community property jurisdiction: Community property Separate property In some community property jurisdictions, such as California, a third category of property, known as quasi-community property exists Quasi-community property seeks to treat as community property, for purposes of disposition at death or at divorce, property acquired during marriage in a common law jurisdiction prior to the spouses domicile in a community property jurisdiction Quasi-community property does not constitute community property for federal tax purposes 4
5. 5. Overview of Community Property Working Definition What is separate property? Property (1) owned by a spouse before marriage, (2) any property acquired by gift, inheritance or bequest after marriage, and (3) property converted from community property by valid agreement What is community property? All other property acquired by spouses during their marriage while domiciled in a community property jurisdiction Note: Community property jurisdictions presume that property acquired by spouses is community property unless shown otherwise. The IRS acknowledges this presumption as well [IRS Publication 555] 5
6. 6. Overview of Community Property Key Characteristics Ownership: Each spouse owns one-half of community property Management: Each spouse has equal management rights over community property Each spouse can dispose of only one-half of the community property at death Also, in general, unless a transferring spouse has the consent of the other spouse, a spouse may only give away one-half of the community property during life Title: Title to community property is generally irrelevant to the interests of each spouse However, where the character of property is unclear, title may give rise to presumptions regarding the character of the property 6
7. 7. Tax Aspects of Community Property Federal Income Tax Inclusion: One-half of community income is included in the gross income of each spouse [Lucas v. Earl, 281 U.S. 111 (1930); Rev. Rul. 55- 726] Basis: At the death of either spouse, each spouses one-half interest in community property receives a basis adjustment equal to fair market value. [IRC Section 1014(b)(6)] Note that quasi-community property does not receive basis adjustment Grantor trusts: For grantor trust purposes, a grantor includes any personwho directly or indirectly makes a gratuitous transfer of property to a trust [Treas. Reg. 1.671-2(e)(1)] Accordingly, upon transferring community property to a trust, each spouse is treated as a grantor of that trust 7
8. 8. Tax Aspects of Community Property Federal Wealth Transfer Tax Community property equalizes estates between spouses as each owns one-half of such property Inclusion: Upon the death of a spouse only one-half of the value of community property is included in the gross estate under section 2033 Gifting: Accordingly, each spouse is also considered a donor of community property for gift tax purposes Split gifts: Because each spouse is considered a donor for gift tax purposes, gifts of community property are automatically split for gift tax purposes [Instructions to Form 709] 8
9. 9. Tax Aspects of Community Property Federal Wealth Transfer Tax Fractional discounts: A discount may be available for transfers of non-marketable community property. [See Propstra v. U.S., 680 F.2d 1248 (9th Cir. 1982)] The IRS has argued unsuccessfully that such property should be valued at 100% of fair market value less costs of partition. [See Estate of Cervin v. Commr, 68 T.C. Memo 1994-550] GST tax: The foregoing aspects of community property also apply to the generation-skipping transfer tax. They apply for purposes of determining: the transferor under section 2652(a); and the value of property transferred as such value is determined for gift or estate taxes 9
10. 10. Community Property Pitfalls Preservation of Community Property in JRTs As a general rule, transferring property to a revocable trust does not change the character of the transferred property That said, the revocable trust should provide, as to any community property: Property transferred to the trust shall retain its character as community property As long as both spouses are alive, they may at any time alter, amend or revoke the trust in whole or in part, provided that any part of the trust estate so withdrawn shall be transferred to them as community property Net income from the trust is community property, and is to be paid to or applied for the benefit of the grantors [Rev. Rul. 66- 283] 10
11. 11. Community Property Pitfalls Joint Irrevocable Trusts While many of the planning considerations present in planning for a gift of common law or separate property to an irrevocable trust overlap, the creation of an irrevocable trust that holds community property raises additional traps for the unwary Many pitfalls arise from the fact that each spouse is considered a donor/grantor as to gifts of community property for wealth transfer and income tax purposes 11
12. 12. Community Property Pitfalls Incomplete Gifts In many community property jurisdictions, the non- transferring spouse must consent a transfer of community property If that consent is not provided, the gift may be incomplete under Treas. Reg. 25.2511-2(b) as the donor has not ceded dominion and control Because it is sometimes possible for a spouse to have acquired a community property interest in separate property, it may be prudent to obtain the written consent of the spouse even when making a gift of separate property 12
13. 13. Community Property Pitfalls Retained Interests under IRC 2036 and 2038 Because each spouse is treated as a donor of community property, take care to ensure that the terms of the irrevocable trust holding such property do not create retained interests Spousal beneficial interests: Beware of gifts of community property to an irrevocable trust in which a spouse is a beneficiary if the intention is to exclude the trust assets from the gross estate of that spouse (for example ILITs and SLATs) Beware of community property funds used to fund premiums especially if the state is an inception from title state Fund such trusts with separate property Even if trust is funded with separate property, beware of states (for example Texas) where income from separate property is community property [But See Rev. Rul. 81-221 based on Federal Fifth Circuits conclusion re: Texas law] Spouse as trustee: Beware of gifts of community property to an irrevocable trust in which a spouse has control over a beneficial interest (for example as a trustee) Limit trustee discretion to ascertainable standard Fund trust with separate property 13
14. 14. Community Property Pitfalls Qualified Personal Residence Trusts The success of a QPRT as a wealth transfer vehicle success depends on the grantor surviving the term of the trust If a residence owned as community property is transferred to a QPRT, both spouses must outlive the term for the trust to succeed Alternatives to joint QPRTs The residence is commonly transmuted to create one-half separate property interests with the spouses creating separate QPRTs so that should one spouse predecease the term, the other trust may still succeed if the other spouse survives the term Separate QPRTs also allows for other benefits, not unfamiliar to practitioners in common law jurisdictions, including different terms tailored to the ages of each spouse and the availability of a fractional discount 14
15. 15. Community Property Pitfalls Sales to Intentionally Defective Grantor Trusts Typically, a sale is structured so that an individual is selling property to a wholly-owned trust under the grantor trust rules to avoid gain or loss on the sale [Rev. Rul. 85-13] If the grantor trust is seeded with community property, each of the spouses is a grantor of the trust However, as both of the grantors are spouses, gain on the sale to the trust is probably avoided under section 1041 Upon the death of the first spouse, a portion of the trust ceases to be a grantor trust [Rev. Rul. 75-267] As a result, complexities related to a partial grantor and partial non- grantor trust may arise as to the: income tax treatment of the payments on the note questions regarding gain recognition income tax reporting for the purchasing trust (part IDGT and part taxable trust) Similar issues may also arise upon the death of the first spouse as to joint ILITs 15
16. 16. Community Property Pitfalls Grantor Trusts Issues under IRC 674(c) and 675(3) Related or subordinate party status is relevant to powers possessed by independent trustees to distribute income or principal to certain classes of beneficiaries under IRC Section 674(c), and with respect to a grantor's borrowing of trust funds from the trust under IRC Section 675(3) In-laws may often be selected as independent trustees. If a trust is funded with community property, an in-law may be a related or subordinate party with respect to the other spouse 16
17. 17. Overview of Transmutation Agreements - Planning Opportunities Consider transmuting appreciating separate property into community property to obtain a basis step-up equal to 100% of the fair market value of the property Conversely, consider transmuting depreciating community property into separate property to limit the basis step-down to 50% of the value of the property Transmuting community property into separate property to create separate trusts for the purpose of: avoiding retained interests where a spouse has a beneficial interest or a problematic power Increasing the likelihood of success and customizing the terms of each QPRT to each spouse avoiding the problems associated with a partial grantor trust in the context of a sale to IDGT 17
18. 18. Overview of Transmutation Agreements - Pitfalls Transmutation have consequences far beyond income or wealth transfer taxation Inherent conflict between spouses Some states have a presumption of undue influence Potential for claim against attorney upon spouses divorce 18
19. 19. Overview of Transmutation Agreements - Best Practices Inform spouses of potential conflict Consider separate representation Put agreement in writing, specifically interests being transmuted But see Einim, T.C. Memo 1984-130 Transmutation must be permitted under state law [See Rev. Rul. 77-359] Both spouses are informed of the assets and liabilities of the other spouse Both spouses are given sufficient time to consider the agreement Consult family law counsel 19
20. 20. Common Law Property Basics In non-community property states, only 50% of any joint spousal property (JSP) is included in deceased spouses estate [IRC Section 2040(b)] Results in 50% (vs. 100%) stepped-up basis for JSP at the first spouses death Tracing rules apply if surviving spouse is a non-US citizen 100% stepped-up basis may be available for JSP created prior to 1977 under the so-called Gallenstein rule Traditionally, separate revocable trusts are created by each spouse and funded with the couples separate and/or JSP Often requires the severance of joint ownership/tenancy by entirety (TBE) protection to sufficiently fund bypass trust at first spouses death Some states (VA, MD, Missouri, Indiana, Illinois Hawaii and DE) preserve TBE character Deceased spouses 50% interest in any JSP can also be disclaimed by surviving spouse into bypass trust via qualified disclaimer 20
21. 21. Increased Use of JRTs in Common Law Property States Tax law changes made permanent under the American Taxpayer Relief Act of 2012 (ATRA) have eliminated or lessened the need to plan for the Federal estate and gift tax for many married couples Increased Federal estate/gift tax exemption ($5.34MM for 2014) Portability election allows for transfer of deceased spouses Federal estate/gift tax exemption amount to surviving spouse Not available for GST tax or state estate tax purposes In order to make the election, Federal estate tax return must be filed at the first spouses death JRTs are viewed as simpler estate planning solution One trust document vs. two separate trusts for each spouse Alleviates need to divide couples joint and/or separate property between two separate trusts Community property JRT (formed in AL and TN) may allow couple domiciled in common law property state to obtain 100% stepped-up basis at first spouses death 21
22. 22. JRTs Typical Design (Non-Community Property) Scenario #1 Estate Equalization JRT Each spouse owns or is deemed to own (via deemed gifts upon contribution of any separate property to the trust) an undivided 50% of the trust assets No separate shares are maintained Both spouses are co-trustees During their joint lifetime, spouses retain joint right to income and principal, and joint right to amend and revoke Upon revocation, trust assets are distributed 50/50 to each spouse May also provide for automatic revocation and 50/50 distribution upon divorce, unless decree of divorce directs or the spouses mutually agree otherwise Upon first spouses death, deceased spouses 50% share is directed to bypass trust (or to the surviving spouses share, with ability to disclaim into bypass trust) Surviving spouse retains right to income and principal, and right to amend/revoke, over surviving spouses share 22
23. 23. JRTs Typical Design (Non-Community Property) Scenario #2 Separate Share JRT Separate shares are created and maintained for joint property contributed to the trust, and for any separate property contributed by each respective spouse Both spouses are co-trustees Spouses retain joint right to income and principal with regard to the joint property share, and unilateral right to income and principal with regard to their respective share of separate property Spouses retain joint right to amend and revoke with regard to the joint property share, and unilateral right to amend and revoke with regard to their respective share of separate property Can be cumbersome to revoke/unwind upon divorce if separate shares are not maintained Upon first spouses death, deceased spouses 50% share of joint property, and of all of his or her separate property, is directed to bypass trust (or to the surviving spouses share, with ability to disclaim into bypass trust) Surviving spouse retains right to income and principal, and right to amend/revoke, over surviving spouses share 23
24. 24. JRTs Typical Design (Non-Community Property) Scenario #3 General Power of Appointment JRT Equalization or Separate Share plan designs are utilized during the spouses joint lifetime Upon the first spouses death, the deceased spouse has a testamentary general power of appointment over part or all of the trust assets In default of such exercise, the deceased spouses remaining estate tax exemption amount is directed to bypass trust, any excess is directed to surviving spouses share Surviving spouse retains right to income and principal, and right to amend/revoke, over surviving spouses share Goal is to obtain maximum funding of bypass trust and 100% stepped-up basis at first spouses death Can also be utilized using separate revocable trusts 24
25. 25. JRTs - Federal Gift Tax Issues (Non-Community Property) Potential gift to non-donor spouse upon contribution of unequal amounts of any separate property to JRT Donor spouses right to revoke does not make gift incomplete if only exercisable jointly with, or only with the consent of, a person who has a substantial adverse interest (i.e., non- donor spouse) Even if unilateral right to revoke over separate property is retained (Scenario #2), may be difficult to exercise if separate shares are not maintained Gift would a terminable interest (i.e., life estate) that may not qualify for the unlimited gift tax marital deduction under IRC Section 2523(e) or 2523(f) Should qualify as life estate with power of appointment under IRC Section 2523(e), if non-donor spouse has unilateral right to revoke (or power to appoint in favor of his or her estate) over gifted portion Would not be considered qualifying income interest eligible for QTIP treatment under IRC Section 2523(f), if trust principal from gifted portion can be distributed to the donor spouse (i.e., any person other than the donee spouse) Potential gift by surviving spouse to remainder beneficiaries when bypass trust portion of JRT becomes irrevocable at first spouses death Any such gift can be rendered incomplete if surviving spouse retains a testamentary special power of appointment over the bypass trust 25
26. 26. JRTs Federal Estate Tax Issues (Non-Community Property) May be unclear what portion of JRT is includible in deceased spouses estate Affects what portion of the trust assets would be eligible for stepped-up basis at first spouses death Qualified joint interest treatment under IRC Section 2040(b) only applies to property held by spouses as TBE or JTWRS To the extent spouse contributed property to the trust and retained a right to alter, amend, revoke, or terminate such interest (either alone or in conjunction with any other person), property would be includible in his or her estate under IRC Section 2038 To the extent spouse has general power of appointment over part or all of the trust assets, trust assets would be includible in his or her estate under IRC Section 2041 IRS says no stepped-up basis for portion of trust assets contributed by the surviving spouse, under IRC Section 1014(e) [PLRs 200101021 and 200210051] Tracing may be required to determine character/ownership of trust assets, if separate shares are not maintained Potential inclusion of bypass trust assets in surviving spouses estate under IRC Section 2036(a)(1) if he or she is treated as a contributor/transferor of these assets, particularly under Scenario #2 where separate shares for separate property are not maintained IRS ruled favorably on this (no inclusion) for JRT where general power of appointment was given to first spouse to die [PLRs 200101021 and 200210051] 26
27. 27. JRTs - Federal Income Tax Issues (Non-Community Property) Amount includible in deceased spouses estate/amount generally eligible for stepped-up basis, unless IRC Section 1014(e) applies Can trustee pick and choose assets upon division at the first spouses death, or does fractional interest of each asset have to be used? Other reporting issues common to joint spousal accounts Only one spouses SSN can be used during joint lifetime Separate EIN must be obtained for deceased spouses portion of trust at first spouses death (administrative trust) and for bypass trust Surviving spouses SSN should be used for remaining portion of trust assets 27
28. 28. Limited IRS Rulings on JRTs (Non-Community Property) PLR 200101021 Facts JRT funded solely with TBE property Either spouse had unilateral right to revoke; if exercised, an undivided 50% interest in the trust property was returned to each spouse as tenants in common First spouse to die had testamentary general power of appointment over all of the trust assets; upon failure to exercise, amount equal to remaining exemption amount passed to Credit Shelter Trust, any excess amount passed outright to the surviving spouse IRS ruled as follows: No completed gift upon funding due to unilateral right to revoke Deceased spouses one-half of the trust assets included in his/her estate under IRC Section 2038, surviving spouses one-half of trust assets included deceased spouses estate under IRC Section 2041 Completed gift of surviving spouses one-half of trust assets to deceased spouse at first spouses death qualifies for the gift tax marital deduction and prevents stepped-up basis in this portion under IRC Section 1014(e) Credit Shelter Trust not includible in surviving spouses estate because the property is treated as passing from the deceased spouse and not from the surviving spouse 28
29. 29. Limited IRS Rulings on JRTs (Non-Community Property) PLR 200210051 Facts JRT funded with JTWRS and/or separate property Either spouse had unilateral right to revoke; if exercised, trust property was to be distributed in accordance with the direction of both spouses Each spouse also had a unilateral power to withdraw principal (lifetime general power of appointment) Upon first spouses death, trust was divided into Credit Shelter Trust (up to deceased spouses remaining exemption amount) and Marital Trust IRS ruled as follows: Portion of trust property transferred to the trust by the deceased spouse was included in his/her estate under IRC Section 2038, portion contributed by the surviving spouse included in deceased spouses estate under IRC Section 2041 Completed gift of surviving spouses entire interest in the trust to deceased spouse at first spouses death qualifies for the gift tax marital deduction and prevents stepped-up basis in this portion under IRC Section 1014(e) Credit Shelter Trust not includible in surviving spouses estate because the property is treated as passing from the deceased spouse and not from the surviving spouse 29
30. 30. Other Post-Mortem Administrative Issues (Non-Community Property) Can be cumbersome/confusing having one trust document for deceased shares irrevocable portion and surviving spouses revocable portion after first spouses death Consider transferring surviving spouses portion into newly-created separate revocable trust 30
31. 31. Community Property JRTs Statutes in AL and TN allow nonresidents to establish a community property trust, and to potentially convert property transferred to the trust to community property At least one trustee must be a resident of the state See Alaska Stat. 34.77.020 - 34.77.995; 4.Tenn. Code Ann. 35-17-101, et seq. IRC Section 1014(b)(6) says the surviving spouses one-half share of community property held under the community property laws of any state shall be eligible for a stepped-up basis US Supreme Court ruled that a statute allowing spouses to elect a community property system under Oklahoma law would not be recognized for federal income tax reporting purposes. [Commissioner v. Harmon, 323 U.S. 44 (1944)] The Harmon decision should also apply to the Alaska system for income reporting purposes. [Internal Revenue Manual, Section 25.18.1.1.2] Case was decided prior to the allowance of joint returns IRS argued income should be included on husbands separate return under the assignment of income doctrine Rev. Rul. 77-359 - Washington couple agreed to convert their separate property to community property. IRS ruled that conversion was effective for federal tax purposes, but added To the extent that the agreement affects the income from separate property and not the separate property itself, the Service will not permit the spouses to split that income for Federal income tax purposes where they file separate income tax returns. See Blattmachr, Zaritsky and Ascher, Tax Planning with Consensual Community Property: Alaskas New Community Property Law, 33 Real Property, Probate and Trust Journal (Winter 1999). 31
32. 32. Contact Information Brian P. Tsu Partner Henderson Caverly Pum & Charney LLP 12750 High Bluff Drive, Suite 300 San Diego, CA 92130 Tel: (858) 755-3000, Ex. 130 Fax: (858) 755-9900 E-mail: btsu@hcesq.com Melinda Merk, JD, LLM, CFP Senior Vice President, Regional Trust Advisor Private Wealth Management SunTrust Bank 8330 Boone Blvd, Suite 700 Vienna, VA 22182 Tel: 703/442-1534 Fax: 703/859-7653 melinda.merk@suntrust.com 32
33. 33. Bios Brian Tsu is a partner in the Estate Planning, International Private Client and Taxation Groups at Henderson, Caverly, Pum & Charney LLP. Mr. Tsu advises clients in the areas of domestic and international estate planning, business succession planning, estate and trust administration and charitable planning. Mr. Tsu also advises clients on a variety of domestic and international tax matters, including federal wealth transfer, fiduciary income and business entity taxation. Mr. Tsu received his LL.M. in Taxation in 2009, from Northwestern University School of Law, received his law degree in 2004, from the University of Dayton School of Law, received his Master of Science in Professional Accounting in 2002, from Seton Hall University and his bachelors degree in Accounting in 2000, from Boston College. Mr. Tsu is admitted to practice law in California and Illinois and is also a registered certified public accountant (Illinois). Mr. Tsu is a regular speaker and contributing member of the American Bar Association, Tax and Real Property, Trust & Estate Sections; the Society of Trust and Estate Practitioners (STEP); the California State Bar Association, Taxation and Trusts & Estate Sections; the San Diego County Bar Association, Estate Planning, Trust & Probate Section. 33
34. 34. Bios Melinda Merk is a Senior Vice President and Regional Trust Advisor and part of the Greater Washington Private Wealth Management team at SunTrust Bank. She focuses on providing multi- generational wealth transfer planning advice and estate and trust services to high net worth individuals, families , and business owners. Melinda has over 18 years experience in the estates and trusts area. Her prior experience includes serving clients as a Tax Director in the Personal Financial Services group at PricewaterhouseCoopers LLP, and as a Tax Manager in the National Tax Department at Ernst & Young LLP. She was also engaged in the private practice of law as a Senior Counsel in the Private Wealth Services group at Holland & Knight LLP. She has significant experience advising clients with regard to domestic and foreign trusts, family limited partnerships, grantor retained annuity trusts, dynasty trusts and other wealth transfer strategies, charitable trusts, estate and trust administration, and asset protection planning. Melinda received a B.S. (cum laude) from Shepherd College, a J.D. from the Duquesne University School of Law, and an LL.M. in Taxation (with distinction) from the Georgetown University Law Center. She is also a Certified Financial Planner. 34