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Estate and Gift Tax Planning for Nontraditional Families
By Jerry Simon Chasen and Elizabeth F. Schwartz
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 deduction, even the task of equalizing assets so that both halves of a legally unmarried couple can take full advantage of their lifetime exemptions can be fraught with transfer tax issues. Although much can be said about the effect the marital deduction has in estate planning, the net result is that a married couple can generally postpone the effect 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 and Harriet Nelson or, depending on generation and income, Homer and Marge Simpson. The reality is that a significant portion of the population does not fit this model. The Census Bureau estimates a sevenfold increase in the number of unmarried partners' households since 1970, and this figure does not account for gay and lesbian couples. Terry A. Lugalia, Marital Status and Living Arrangements: March 1997 (Update), Current Population Reports, Population Characteristics, Series P20-506, U.S. Dept. of Commerce, Economics & Statistics Adm., Bureau of the Census (June 1998). 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. Stat. 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 are not related; (2) if the household members are related, at least one is related nonlineally, 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 in a survey that:
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 determine 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 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 and Gay Issues and the Institute for Gay and Lesbian Strategic Studies (Feb. 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. 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-40s and have been domestic partners, couples who cannot avail themselves of civil marriage, for about 10 years. Before South Miami Beach became a hot spot, Harriet had purchased a nice little apartment building with about 25 units right on the ocean. She has handled all of the renovations and repairs herself, which has also helped reduce her costs. Harriet paid $70,000 for the building in the mid-1980s, but it is worth about 10 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 she has not 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, but this discount 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 in 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 seven years, just slightly more than half the time, to transfer the interest to Marge, and virtually none of Harriet's lifetime exemption amount would be used.
There would be income tax benefits of the CLAT for 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 is also 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 assets 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 to 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% 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 is a relatively low uni-trust 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 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 Code § 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, 1406 (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 to have the unitrust interest dependent upon the 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. Accordingly, 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 in the example 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 and 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 would 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 to remove the asset from the estate and the charity is 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.
Working with gay and lesbian families, as well as with other nontraditional families, requires thinking outside the box. Although there are obstacles in sophisticated estate planning for nonmarried 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 to not 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.
Jerry Simon Chasen and Elizabeth F. Schwartz are members of the firm SmithChasen, Lawyers, in Miami and Key West, Florida.