TRANSFER TAXES

Estate Planning for Nontraditional Couples, OSB, CLE, July 29, 2004

Presented By:  Donna R. Meyer, Attorney at Law, FITZWATER & MEYER, LLP
FITZWATER & MEYER, LLP is located in Portland, Oregon and can be found online at http://gaymarriagelawyers.com/Oregon.htm

INTRODUCTION

Transfer tax laws generally favor married couples.  There are some ways in which the transfer tax laws have the same application for both married and non-traditional couples.  However, in many ways the application of the laws is quite different, calling for different and varied strategies.^[1]

I.  TRANSFER TAX LAWS THAT APPLY THE SAME

A.  Federal Unified Credit

The unified credit against estate taxes of $345,800 for 2004/2005, gives each spouse or partner the ability to exempt $1,500,000 worth of assets.  The value of the credit will be increasing over the next six years until it is repealed in 2010 for one year.  It comes back into existence in 2011 at the exemption level of $1,000,000, unless changed by Congress before that time.  IRC §2010

B.  Annual Gift Exclusion

The annual gift exclusion allows any individual to make gifts of $11,000 per person per year.  IRC §2503(b).  Transfers paid on behalf of an individual as tuition to certain educational organizations or to a person who provides certain types of medical care to the individual are not treated as a gift transfer.  IRC §2503(e).  (See below with regard to gift-splitting.) 

C.  Oregon Inheritance Tax Credit

The state unified credit (tied to 1997 federal law levels) gives each spouse or partner the ability to exempt $850,000 of property from inheritance tax.  The exemption threshold rises to $950,000 in 2005 and then to $1,000,000 in 2006, where it is scheduled to remain indefinitely.  ORS 118.160.

D.  Charitable Deduction

Any property passing outright to a qualified charity receives a 100 percent deduction from federal estate tax.  IRC §2056.

II.  TRANSFER TAX LAWS THAT APPLY DIFFERENTLY

A.  Unlimited Marital Deduction—Generally

The most significant difference when planning for non-traditional partners rather than married couples is the inability to use the unlimited marital deduction for gifting during lifetime or at death.  IRC §2056(a); IRC §2523(a).

NOTE REGARDING SAME-SEX MARRIEDS:  The definition of "spouse" is controlled by the Defense of Marriage Act (DOMA), which provides that for purposes of federal laws, marriage is defined to be a "legal union between one man and one woman."  Defense of Marriage Act, H.R. 3396.  While on its face this may seem to be definitive for purposes of federal law, some commentators believe that the U.S. Supreme Court will find this law to be unconstitutional, or even that there is some interpretational wiggle room in the Internal Revenue Code.^[2]

For unmarried couples, the inability to use the marital deduction can cause a tax at the death of the first partner to die if he/she has assets in excess of the federal or state exemption, and makes it difficult for couples to split the assets between them to insure each partner uses his/her unified credit. The inability to use the marital deduction is one of the key problems in this type of planning. 

B.  QTIP

QTIP trust planning, in which one spouse gives the surviving spouse a terminable interest in property, such as a life estate or trust, still qualifying the property for the marital deduction, is not available for unmarried couples.

C.  Disclaimer Trusts

Among the requirements of a qualified disclaimer are that the person has not accepted the interest being disclaimed or any of its benefits, and that as a result of the disclaimer, the interest passes without any direction on the part of the disclaimant and passes either to the spouse of the decedent or to a person other than the person making the disclaimer.  IRC §2518(4).  While an unmarried partner can disclaim outright, unmarried couples cannot use commonly used disclaimer trust planning.

D.  Charitable Remainder Trusts

If an unmarried partner creates a charitable remainder trust naming his/her partner as a beneficiary, a gift is made.  This does not apply to married couples, for which a deduction is available for the value of the interest passing to the surviving spouse.

E.  Gift-Splitting

Unmarried partners cannot give twice the annual exclusion to a donee by utilizing gift-splitting.

F.  Joint Ownership with Right of Survivorship

The full value of jointly owned property held between nonspouses (as defined for federal purposes under DOMA) is included in the estate of the first joint owner to die, unless the executor can produce evidence of the surviving joint tenant's consideration toward the property in question.  IRC §2040; Treas. Reg. §20.2040-1(a)(2).  Contrast this with the rule for joint property held with spouses--only 50 percent of the value of the property is included in the estate of the first spouse to die.

G.  Community Property

In community property states, for married spouses the property receives a full step up in basis at the death of the first spouse.

H.  Chapter 14

Chapter 14 of the Code targets intrafamily transactions used to pass property to the next generation with a minimum of transfer tax.  Examples are GRITs, split-interest purchases, and other transactions intended to freeze value to the value at the time of the gift, while minimizing the value of the gift by retaining an interest or imposing restrictions.^[3]  Unmarried partners aren't legally "family" and so are not restricted by some of these rules.

III.  TRANSFER TAX TECHNIQUES FOR NON-TRADITIONAL COUPLES^[4]

A.  Credit Shelter Trust

A credit shelter trust can be used to hold assets in the amount of the exemption equivalent for the benefit of the surviving partner.  The credit shelter trust works to prevent the assets of the first partner to die from doubling up in the surviving partner's estate, similar to its use for married partners.  It has the additional effects of creditor protection and insuring that any assets remaining at the second death are distributed back to the family of the first partner.  The exemption equivalent can be tied to federal or state levels, depending on the overall goals of the client, and any excess could be distributed to charity.  Further, provisions can be made to allow distributions from the credit shelter trust to children or other family.

B.  Oregon QTIP for Same-Sex Marrieds

Oregon inheritance tax is "tied" to the federal tax calculation so that federal deductions are allowable for Oregon inheritance tax purposes, including unlimited marital/charitable deductions.  ORS 118.010(2).

QUERY:  will the definition of spouse be controlled by state or federal law? See ORS 118.007:  "Any term used in [the Oregon inheritance tax statutes] has the same meaning as when used in a comparable context in the laws of the federal Internal Revenue Code relating to federal estate taxes, unless a different meaning is clearly required or the term is specifically defined in the [inheritance tax statutes]."  Does the interpretation of the Oregon Constitution allowing same-sex couples to marry clearly require a different interpretation of the word spouse?  If so, Oregon same-sex spouses should receive the same privileges as federal spouses in the context of inheritance tax.

NOTE REGARDING CIVIL UNION:  If same-sex marriages do not survive the upcoming ballot measure or court challenge, it is still possible that civil unions will be formalized, giving same-sex partners many of the same rights under Oregon law as married couples.  It remains to be seen if the result will be that same-sex couples are treated as if federal tax law recognizes a civil union.  This is the Vermont solution for purposes of income tax law.

For same-sex married couples in which one spouse has assets in excess of the Oregon exempt amount, it may be wise to include an Oregon QTIP trust in the planning to be effective only in the event the exemption at the state level is available.  This is the approach used by some Massachusetts estate planners for same-sex married couples.

C.  Gifting in the Amount of the Annual Exclusion and for Medical and Educational Expenses

Nontraditional couples can use the same gifting techniques available to all individuals for gifting to third parties.  In addition to gifting in the annual exclusion amount, the wealthier partner can also pay directly for any medical or educational expenses qualified under IRC §2503(e).  The goal is to equalize the estates and bring both partners under the tax thresholds.  This is particularly true for those couples whose combined estates fall in between the Oregon and federal tax thresholds.  Because Oregon does not tax lifetime transfers of property, it may be possible to transfer property between partners to bring both partners under the Oregon threshold level with no tax consequences.  Gifts must be to individual title; gifts into joint names will not work because full value of asset (not one-half) will be included in first partner's estate.  Reg. §20.2040-1(a)(2).

NOTE:  It may be difficult to transfer enough wealth through annual gifting to successfully split the assets to minimize tax, but annual gifting can help minimize growth in the estate of the wealthier partner.

D.  Freeze and Discount Techniques^[5]

Traditional freeze and discount techniques may be appropriate for unmarried partners.  Further, several benefits that are not available to married couples may be available to nontraditional couples, because Chapter 14 rules, enacted to curb abuses in intrafamily transactions, do not apply.  In addition to benefiting partners, each partner can benefit the children or nieces and nephews of the other partner without triggering the intrafamily rules. Techniques include grantor retained interest trusts (GRITs), grantor retained annuity trusts (GRATs), valuation freezes, split-interest purchases, and other traditional freeze techniques.^[6]  Examples of freeze and discount techniques include the following:

1.      Gifting fractionalized interests in property to obtain valuation discounts.  Each partner can own a fractionalized interest as tenants in common of the property, perhaps achieving marketability discounts on some assets (real estate).  Or a properly drafted joint revocable living trust could provide that all property transferred is deemed to be held as 50 percent tenants in common.  (This technique is available to married couples as well.)

2.      Transfers of closely held business interests, such as an interest in a corporation or partnership.

3.      Nonfamily member grantor retained interest trusts (GRITs).  The GRIT is a method for making discounted gifts and removing future appreciation of assets from the maker's gross estate.  It "is particularly useful if the domestic partners function as an economic unit because the gifted property will provide an income stream to the partners during the retained trust term and the principal will remain within the economic unit at the expiration of the term."^[7]  The trust should be funded with assets that produce high appreciation potential.

4.      Grantor retained annuity trusts (GRATs).  A grantor retained annuity trust is a popular form of retained interest transfers used to limit gift tax exposure.  The grantor transfers assets to the trust, and retains the right to receive fixed payments for a specified term.  At the termination of the term, trust property passes to the remainder beneficiaries.  The taxable gift is reduced by the value of the grantor's annuity interest.

Note:  If the donor is unlikely to survive the term, an outright gift may be the better choice.

5.      Qualified personal residence trust (QPRT) and "house GRITS."  The usual qualified personal residence trusts are available to unmarried partners.  However, because partners are unrelated and thus not subject to many of the prohibitions described in Regs §§25.2702-5, a "house GRIT" can be established outside the usual §2702 valuation rules that apply to qualified personal residence trusts (QPRTs).  The partner who establishes the trust may purchase the residence from the trust just prior to the expiration of the retained term so that cash or other assets pass to the remainder partner, if that is desirable.  This may also be useful if the remainder beneficiary is the child or other relative of the partner.

6.      Form a family LLC, transferring substantial interest in the property to the donee partner but retaining a voting membership interest.  The gift thus lacks control and marketability and should be valued at a discount.  The agreement could also contain terms for buyout in the event of a breakup.

E.  Charitable Gifting Techniques

In the absence of the marital deduction, many unmarried partners take a more careful look at the charitable deduction.  Many of the usual charitable techniques are available.  However, with many of these techniques, a reportable gift will be made. 

1.      Leave the exemption equivalent at the first partner's death to the surviving partner, either outright or in trust, with the excess to charity.

2.      Disclaimer to charity.  The client can provide that all property would pass to the surviving partner but that any property disclaimed by the surviving partner would pass to a qualified charity.  This would allow the surviving partner the flexibility to analyze the estate taxes existing on the date of the decedent partner's death and decide whether to pay estate taxes (if any) by keeping the property or reduce/eliminate the taxes by directing a portion of the property to charity.

3.      Testamentary charitable remainder trust, benefiting the surviving partner for his/her lifetime.

4.   A nongrantor charitable lead trust, especially when the donee partner is significantly younger than the donor partner.

5.      Life estate to the partner, with remainder interest to charity.

6.      Charitable remainder trusts and gift annuities.

F.  Life Insurance

Life insurance is often even more important for unmarried partners.^[8]  First, there may be a transfer tax at the death of the first partner.  Second, the surviving partner will not be able to draw on the decedent partner's Social Security record.  If the higher earning partner dies first, the survivor may not have sufficient income to cover his/her needs.  Also, the surviving partner may not benefit from pension or health insurance benefits that a surviving spouse may have received in the same situation.

1.      Gifts of life insurance policies to the other partner can avoid taxability at the death of the first partner, if made three years before death.  This will not, however, shield the insurance from taxability at the death of the second partner to die.  Also, the interpolated terminal reserve value of the policy will be considered a gift to the other partner at the time of the transfer.

2.      Irrevocable life insurance trust (ILIT) may be preferable to an outright transfer for several reasons.  It can shield the assets from taxability at the death of both partners, it insulates the proceeds from creditor claims, and it avoids questions about whether the beneficiary has an insurable interest in the insured.  Again, transfer of an existing policy into an ILIT will trigger a gift to the trust beneficiaries.

G.  Tax Apportionment Clause

With the higher risk of transfer tax, it is even more important than usual to carefully review the tax apportionment clause in estate planning documents.

Presented By:  Donna R. Meyer, Attorney at Law, FITZWATER & MEYER, LLP
FITZWATER & MEYER, LLP is located in Portland, Oregon and can be found online at http://gaymarriagelawyers.com/Oregon.htm