We live in an age of “nontraditional families.” This catch-all phrase includes unmarried couples, either homosexual or heterosexual, with or without children.
Although the number of nontraditional families is increasing, the laws governing inheritance and the taxation of inheritance still are generally designed to benefit the traditional family. In most states, unmarried couples do not have inheritance rights. Rather than relying on intestacy statutes, therefore, unmarried couples must prepare wills or other estate-planning vehicles to ensure distribution of their assets upon death to their partners.
A complete estate plan will include arrangements to: (1) provide for the desired distribution of property; (2) minimize transfer taxes; (3) provide for personal needs, such as appointment of financial and health care decision-makers, funeral arrangements, and guardianship of minors; (4) protect assets from creditors; and (5) minimize conflict. Many of these arrangements can be implemented through trusts.
PRIVATE LIVES, PUBLIC WILLS
The most common way to provide for the distribution of property at death is a will. Depending on the circumstances, however, wills may be problematic for same-sex couples.
After death, a will is a matter of public record, and it is relatively easy for disappointed relatives to challenge a will by filing an objection in the probate proceeding. If the couple want to preserve the privacy of their relationship or of their estate plan, or if a challenge by the decedent’s family is a concern, it may be preferable to establish a revocable living trust.
A revocable living trust is an arrangement by which a person can transfer assets upon death privately and without the need for probate.
The steps are simple. First, the person establishing the trust (the grantor) signs the trust instrument, which provides for the grantor’s use of the trust assets during his or her lifetime and for the disposition of the trust assets after his or her death. Second, the grantor transfers his or her assets to the trust. Typically, the grantor serves as his or her own trustee and names one or more successor trustees to serve after disability or death. The grantor can amend or revoke the trust until death. When the grantor dies, the trust governs the disposition of the assets.
If all of the grantor’s assets are in the trust at death, no assets will pass through the public and court-supervised probate process. Someone seeking to challenge a revocable trust after death has to file a lawsuit, which is a more cumbersome and expensive process than contesting a will.
One of the biggest areas of concern for domestic partners is the same planning issue that arises for married couples with “noncommon” children — that is, children from previous relationships. Although many domestic partners will raise common children, many do not.
With couples who do not share common heirs, one member typically leaves assets in trust for the survivor and gives the remainder after the death of the survivor to his or her heirs. This provides for a surviving partner while ultimately preserving the assets for the heirs of the deceased partner.
Life insurance is also an issue for domestic partners. Married couples can transfer assets to each other — both during their lifetime and at death — without any transfer taxes because of the gift- and estate-tax marital deductions. Because the estate-tax marital deduction is not available to unmarried couples, the estate-tax consequence of the death of an unmarried partner may be a concern. Unmarried couples may wish to obtain life insurance to care for the surviving partner and also, perhaps, to pay any estate taxes that may be due at the first partner’s death.
If the insured owns the life insurance policy at death, the proceeds will be fully included in the insured’s estate for purposes of estate tax. Depending on the value of the total estate, the insurance proceeds may be subject to substantial estate taxation.
Instead of owning the insurance policy, the insured should consider establishing an irrevocable trust to be the owner and the beneficiary of the policy. If the trust owns the policy from its inception, or if the policy is transferred to the trust more than three years before the insured dies, the policy proceeds will avoid taxation in the insured’s estate. This means that 100 percent of the proceeds will be available for the intended purposes.
Federal estate- and gift-tax planning for unmarried couples is complicated because, as mentioned, the unlimited marital deductions for estate and gift taxes are not available to unmarried couples.
Each individual, however, does have a federal estate-tax exemption amount (currently $1.5 million, but scheduled to increase over the next several years), which can be used to transfer assets to anyone, including a partner, free of federal estate tax. In addition, $1 million of this exemption can be used during an individual’s lifetime to make gifts not subject to estate or gift tax. Using the gift-tax annual exclusion, domestic partners also can transfer up to $11,000 per person per year (increasing to $12,000 in 2006) without using any portion of the $1 million gift-tax exclusion.
Unmarried couples also can take advantage of estate-freeze transactions. Generally speaking, an estate freeze is used to pass property from one person to another at a reduced transfer-tax cost by freezing the value of the transfer at the date of gift so that all future appreciation in value escapes taxation at the time of death.
Chapter 14 of the Internal Revenue Code deals with transfers among traditional family members and addresses perceived abuses with estate-freeze transactions. It provides very restrictive rules for certain transfers into trusts for family members. Because unmarried partners are not considered family members for purposes of Chapter 14, certain strategies that are limited or no longer available to married people under Chapter 14 remain available to unmarried couples.
These strategies include the common-law grantor retained interest trust (GRIT). For example, Partner No. 1 (the grantor) establishes and transfers assets to a GRIT and retains all income from the trust for a fixed term of years. At the end of the term, the remainder passes to Partner No. 2 (the beneficiary). The creation of the trust would be a gift equal to the fair market value of the assets transferred to the trust, less the grantor’s retained income interest.
The tax advantage of a GRIT is that if the rate of trust income is lower than the Internal Revenue Service’s assumed rate, there will be an overvaluation of the income interest and the remainder (i.e., the gift to Partner No. 2) will be undervalued.
Thus, a very low discounted value for gift-tax purposes will be obtained. Then, upon trust termination, the trust assets (including appreciation) will pass transfer-tax-free to the other partner.
Similarly, Chapter 14 restricts family members in the use of a qualified personal residence trust, which is a trust used to transfer a personal residence to intended beneficiaries at a reduced transfer-tax cost. But some of the restrictions on related parties do not apply to unmarried partners, so that an unmarried partner has a tax advantage in transferring a personal residence to his or her partner that a parent does not have in transferring a personal residence to a child.
For example, Partner No. 1 establishes a trust and transfers her residence to that trust for the benefit of Partner No. 2. The trust provides that Partner No. 1 has a beneficial interest in the trust (i.e., the right to live in the residence) for a specified period of years. After this, the house belongs to the beneficiary, Partner No. 2.
Partner No. 1 has made a gift to Partner No. 2, but the value of the gift is discounted because of Partner No. 1′s retained interest in the trust. The amount of the discount depends on the length of time Partner No. 1 retains the right to live in the residence — the longer the retained interest, the greater the discount on the gift to Partner No. 2.
Ideally, from a tax perspective, Partner No. 1 would purchase the residence from the trust just before the end of the term, without any recognition of gain or loss.
As a result, Partner No. 1 would have the residence back in her name, and Partner No. 2 would receive the purchase price Partner No. 1 paid to acquire the residence from the trust without any further gift-tax consequences.
The regulations applicable to qualified personal residence trusts set up within families prohibit the grantor from purchasing the residence back from the trust. Because these regulations do not apply to nonfamily members, the buyback arrangement is available only to unrelated parties, such as domestic partners and other unmarried persons.
Domestic partners face challenges with retirement benefits. Same-sex partners and other unmarried couples are not entitled to the federal spousal benefits accorded spouses in qualified retirement plans. A lump-sum death benefit payable to a plan participant’s partner will not be eligible for the spousal rollover to an IRA or for any of the special distribution options available to a spouse under Section 401(a)(9) of the Internal Revenue Code.
The unavailability of a spousal rollover is particularly troublesome in situations where the retirement plan provides that the lump sum is the only form of death benefit. In such a situation, the plan participant may want to consider designating a charitable remainder trust (CRT) for the benefit of the participant’s partner as the beneficiary of the death benefit.
A CRT is an irrevocable trust that makes distributions — at least annually — to one or more noncharitable beneficiaries for a term of years or for the life or lives of the beneficiaries. When the noncharitable interest ends, the remainder interest passes to one or more charitable organizations.
Leaving a large retirement account to a testamentary CRT — that is, a CRT that is created at the death of one partner — may be more beneficial than leaving the account outright to the surviving partner. The CRT will not be currently taxed on the lump-sum payment from the plan. Instead the surviving partner will be taxed only on the distributions actually received from the CRT. The estate of the deceased partner will receive a charitable deduction for the value that will eventually pass to charity.
Often, professionals, business owners, and corporate board members are interested in asset protection as part of their estate plans. Married couples have available to them the simplest form of asset-protection planning — ownership of assets as tenants by the entirety. Tenancy by the entirety, which is joint ownership between married persons with rights of survivorship, protects assets from the creditors of either spouse (except the IRS).
This form of ownership is not available to unmarried couples. The irrevocable trusts described here have the added advantage of creditor protection. Once a person has transferred assets to an irrevocable trust for the benefit of his or her partner, those assets may be protected against the claims of the transferor partner’s future creditors (depending on the terms of the trust) and will be protected against the claims of future creditors of the beneficiary partner.
The importance of trusts in estate planning for unmarried couples cannot be overstated. Privacy, control, tax savings, and asset protection — all important estate planning goals — can be achieved with the implementation of proper trust planning.
Nancy Fax, managing partner of Bethesda, Md.’s Pasternak & Fidis, concentrates in estate and trust law.