Unmarried But Protected

Originally published in Trust & Estates September 2003.

Unmarried But Protected

Planning for same-sex couples and other non-marital relationships

is certainly more difficult. But there are some basics all advisors must know

By Shari A. Levitan, partner and Ellen S. Berkowitz. associate,

Holland & Knight LLP, Boston, Mass.

Increasingly estate planners are asked to advise clients who are not husband wife. Such couples include, but are not limited to gays and lesbians and unmarried heterosexuals. There also are combinations of siblings and friends as well as parents who co-own property with children. For these clients, planning is more difficult because they cannot avail themselves of tax benefits reserved for transfers to a spouse.[1] Any couple also may own property together. They lack the legal protections generally afforded spouses and children under state laws governing intestacy, health care and financial decision-making, dissolution of the relationship, and preferences for who may serve as executor under a will and who may make funeral arrangements for a deceased person.

It seems legal protections for homosexual couples won't be coming anytime soon. While Vermont provides some measure of benefits to couples who've entered civil unions, those benefits are not generally recognized by other jurisdictions. In any event, civil unions do not provide the couple with preferential tax treatment. A recent judicial ruling in Ontario, Canada recognized the legal status of same-sex marriages; other Canadian provinces are expected to follow suit. But the United States is not required to give full faith and credit to the laws of other countries. President Clinton in 1996 signed the Defense of Marriage Act, which provides that marriage for the purpose of federal laws must be between a man and a woman, and permits states to deny recognition of same-sex marriages validly entered into under the laws of other states. President Bush recently made plain his hostility to same-sex marriages by calling on advisors to devise additional legal barriers.

Advisors therefore should be well-versed in knowing how to help clients in non-marital relationships. The task can be complicated by the fact that property is frequently co-owned, without consideration of the gift tax consequences and without a plan to unwind the economic relationship should the personal relationship end (by death or otherwise). Sometimes troubled family relationships make estate planning even more difficult.

When parties are unrelated, advisors tend to focus on the immediate negative tax and non-tax economic issues, including termination of the relationship. Many wrongly assume that unmarried clients will be reluctant to make significant irrevocable transfers during life because the relationship may not endure. This is a mistake, as such concerns are no different when a donor makes an irrevocable transfer to a spouse or to children and more remote issue. The desire and ability to make the transfer, and its irrevocability, must be explored. With care and thought, a tax-efficient estate plan can be constructed that will meet most, if not all, of clients' objectives.

TAXES

If the taxable estate is large, it may be insufficient to employ the usual techniques, such as using annual-exclusion gifting and exemptions from federal and, if applicable, state gift taxes. A case may call for a number of additional strategies. These could include:

• Leveraging the use of the annual exclusion and exemption from the federal gift tax. Because estate taxes can't be deferred by using the marital deduction at death, consider the ability to leverage value when making transfers during life and at death. Leveraged transfers include the traditional planning arsenal of transfers of partial interests, including minority interests; the creation of limited partnerships and limited liability companies; charitable remainder and charitable lead trusts; and transfers to irrevocable trusts that own life insurance. The leveraging results either from valuation discounts or, in the case of life insurance, from the ability to use the gifts to purchase death benefits exponentially larger than the gift.

To the extent additional leveraging is-required, loans might make sense. For example, in addition to making annual exclusion gifts, and perhaps larger gifts, to an irrevocable insurance trust, the donor also might make a significant loan to the trust, particularly in this low-interest rate environment. If structured properly, the loan will not be considered a split dollar arrangement.[2] The trustee can invest the borrowed funds and use both the principal and earnings of the trust to pay future premiums. Even after repayment of the outstanding loan balance to the donor's estate, the amount passing to beneficiaries may be increased substantially without payment of additional gift or estate tax.

To the extent that the irrevocable trust is funded by gifts and/or loans in excess of the annual insurance premiums, additional leveraging may be obtained if the trust is a grantor trust for income tax purposes. If the trust is taxed entirely as a grantor trust, the donor remains responsible for paying tax on income earned by the trust, with the result that the transferred assets are not diminished by the payment of income taxes.[3] If beneficiaries are unrelated, advisors should consider whether transfers will be subject to generation-skipping transfer tax.

• Considering a sale rather than a gift. A popular planning technique is to structure transfers as sales to intentionally defective irrevocable trusts, with the expectation that the asset sold to the trust for fair market value will not trigger capital gains taxes, at least provided the seller is living during the term of the note. It may make sense to structure the transaction as a sale rather than a gift, particularly if the donor holds an asset that has a current low value but potential for substantial appreciation. Important factors include the age and health of the donor; the size of the estate; the likelihood that the particular asset will increase in value; the donor’s view on whether estate tax repeal will be made permanent; the ability of the purchaser to fund the purchase and the asset’s cost basis.

Service has taken a heightened interest in these transactions. Therefore, given the newly-reduced capital gains tax rates, a garden-variety sale may be appropriate. In addition, recent low interest rates have made private annuities and self-canceling installment notes more popular than they have been in years because the purchaser's obligation is more affordable.

• Considering techniques that freeze the value of assets for transfer tax purposes. Techniques that freeze the value of assets–such as personal residence trusts, grantor retained annuity trusts (GRATs) and sales in exchange for promissory notes–can reduce exposure of the estate to additional transfer taxes on future appreciation. These strategies should be considered in addition to the leveraging techniques, particularly if the asset is expected to increase in value. In particular, the GRAT has the added advantage that at the end of the retained interest, which is usually of very short duration, the donor can see whether any value was transferred successfully, and, if necessary, can create another GRAT to achieve the desired benefit.
• Taking advantage of the tax code preferences for transfers to non-family members. Chapter 14 was added to the Internal Revenue Code more than a decade ago to prevent family members from crafting financial arrangements that were perceived as shifting too much economic value to certain relatives without adequate recompense. For unrelated beneficiaries, it is still possible to create tax-planning vehicles without the full measure of Chapter 14's restrictions using common law grantor retained interest trusts[4] (GRITs), personal residence trusts[5] and shareholder agreements[6] that reflect the desired economic arrangement of the parties.

With a GRIT, the donor retains an income interest (rather than the annuity interest required by a GRAT, which is fixed regardless of the actual income earned) in the transferred property during the retained interest term. Because the value of the income and remainder interests are computed using the IRC Section 7520 rates, in a low interest and dividend environment it is likely that the actual earnings of the GRIT will be lower than the value ascribed to the income interest, with the result that the remainder interest will have a lower value for gift tax purposes than its anticipated actual value.[7]

OUNCE OF PREVENTION

Estate plans enriching unrelated beneficiaries are more likely to be challenged. One way to protect the plan is to include a statement of intent in the client's will to confirm whom the client intends to benefit, and to state affirmatively that others are excluded intentionally and not through inadvertence.

Clients who co-own assets with others should consider including a similar provision in their wills to confirm the joint ownership, and explain that it was not entered into for convenience, but was intended to vest absolute ownership in the surviving co-owner. While jointly-owned property belongs to the surviving joint owner by operation of law, including such a statement may help defeat a challenge to the joint tenancy. A similar statement confirming all life insurance and qualified retirement account beneficiary designations should be included.

Unmarried couples should memorialize joint ownership arrangements with particular care.[8] The parties should clearly state their intention with respect to rights of survivorship in deeds and account registrations, particularly if a joint owner's estate plan benefits different individuals than the co-owner, so there is no claim that the arrangement was a co-tenancy without survivorship rights.

Estate planners also should encourage unmarried clients who co-own assets to keep track of their respective contributions to the jointly owned property. Under IRC Section 2040(a), the entire value of jointly-owned property will be included in the estate of the first joint owner to die, unless the parties can prove their respective financial contributions to the property–in which case only the proportionate value belonging to the decedent will be included in the gross estate. Depending on the nature of the asset, and whether there is any agreement confirming the ownership interests in the asset, unequal contributions also may result in an unintended taxable lifetime gift.

Even when the joint ownership is carefully formed and accurate records are kept, the rights and duties of joint owners may be memorialized contractually in a co-ownership agreement. The agreement should address the financial rights and responsibilities of the joint owners, including defining what, other than death, constitutes a termination of the relationship, triggering certain rights and obligations. The agreement also should allocate responsibility for real estate taxes and other property expenses between the joint owners, taking into account the benefit of real estate tax deductions, for example. If the joint ownership terminates for a reason other than the death of a joint owner, the agreement should specify whether an outstanding mortgage must be discharged, whether any transfer restrictions on the property will remain intact, whether either party will have a right to acquire the property and, if so, on what terms.

Different concerns may arise if the parties are unmarried but related. For example, if a parent jointly owns property with one of several children and the value of the jointly owned property is disproportionate to the value of the parent's entire estate, the agreement, as well as the parent's estate plan, should address the intention of the parties in the event of the parent's death, illness or if the co-owners become estranged. Similarly, when the identities of a joint owner and estate beneficiaries differ, apportionment of estate taxes should be addressed.

While there is an extensive body of law defining the rights of married couples, both during marriage and upon divorce, no comparable legal guidance exists for unmarried individuals. Unmarried clients, however, may protect their expectations through cohabitation agreements. The case law is still developing, but many jurisdictions have stated that express or implied contracts between unmarried parties should be upheld so long as such contracts are not based only on sexual services and conform to the ordinary rules of contract law.[9]

As with prenuptial agreements, cohabitation agreements may be particularly helpful when one partner has significantly more assets than the other or when one partner works outside of the home while the other supports the relationship without direct economic contribution. The cohabitation agreement should address the parties' financial expectations during the cohabitation, at the termination of the relationship and upon the death or disability of a party.[10] In the absence of a court filing or a formal divorce decree to serve as objective indicia of the end of a relationship, the agreement should define what constitutes evidence of the termination of the relationship. The agreement also should address property ownership and responsibility for liabilities such as mortgages and real estate taxes, as well as support obligations. Even in jurisdictions that recognize domestic partnerships, the agreement should set forth the parties' responsibilities to each other with respect to health insurance and other employment benefits both during the relationship and after it ends. Benefits available to domestic partners[11] generally terminate upon dissolution of the relationship. Some domestic partnerships apply only to same-sex couples and do not make benefits available to unmarried, heterosexual couples or other partnerships.[12]

BEYOND MONEY

All clients should provide for orderly decision-making in the event of their incapacity. Health care proxies and, in some states, living wills are standard components of most married clients' estate plans. These documents are even more critical when planning for unmarried clients. Without a health care proxy, health care providers are likely to turn to the patient's next of kin for critical health care decisions, or family members may bring a guardianship proceeding to obtain the legal authority to make such decisions. If appropriate, the client should advise family members that such a document exists and provide the name of the agent. Similarly, clients should have a durable power of attorney authorizing one or more individuals to manage the clients' financial affairs in the event of incapacity. In these documents, the client can nominate the agent as conservator or guardian, foreclosing the ability of family members to use the court system to name someone they deem more suitable.

Privacy also may be a concern for unmarried couples. They may prefer to name a trust for the benefit of a partner rather than name the individual as the beneficiary of retirement benefits or group life insurance.

START-PLANNING NOW

Many married couples initiate the estate planning process to address concerns about guardianship arrangements for their children and management of inheritance until children reach a suitable age. Their estate planning advisors then educate them about the opportunities available for tax planning. Unmarried clients, though, often fail to appreciate the need for estate planning. The result: Unmarried clients are likely to forfeit substantial tax savings available to them. Advisors must initiate discussions and provide comprehensive solutions.

[1] I.R.C. Sections 2056 (marital deduction), 6013(3) (ability to file joint income tax return), and 401(a)(9)(B)(iv) (ability of spouse to defer receipt of retirement benefits to age 70 1/2).

[2] Proposed Treas. Reg. Section 1.7872-15(e)(5).

[3] I.R.C. Sections 671-675, 677.

[4] I.R.C. Sections 2701(e)(2) for class of "applicable family members" for transfers in trust.

[5] I.R.C. Sections 2702.

[6] I.R.C. Sections 2703-2704.

[7] A donor also may create either a personal residence trust or a qualified personal residence trust if the remainder beneficiary is not related. While personal residence trusts are in some sense more restrictive (for example, the trust can't hold cash for improvements), there is no provision for the personal residence trust to convert to an annuity trust upon the sale of the property if no successor home is purchased and the personal residence trust may not sell the home during the term. There also is no prohibition against commutation of the term holder's interest.

[8] Gail E. Cohen, "Estate Planning for the Unique Needs of Unmarried Partners," Estate Planning, April 2003, Vol. 30/No. 4.

[9] For example: Doe v. Burkland, 808 A.2d 1090,1093-1094 (2002); Salzman v. Bachrach, 996 P.2d 1263, 1267-1268 (2000); Wilcox v. Trautz, 427 Mass. 326, 693 N.E.2d 141 (1998).

[10] Mary L Bonauto, "Advising Non-Traditional Families: A General Introduction," Boston Bar Journal, Sept/Oct. 1996.

[11] The employee generally will have to pay additional income taxes on the fair market value of the insurance received by his unmarried partner. PLR 96-03-011 (Oct 18,1995).

[12] “Employers May Refuse to Extend Domestic Partnership Benefits to Heterosexual Cohabiting Couples," 29 Tax Mgmt. Comp. Plan. J. 197 (July 6. 2001) (discussing the Seventh Circuit decision in Irizarry v. Board of Education of the City of Chicago, 251 F. 3d 604 (2001)).