Whether of same-sex or opposite-sex unions, unmarried couples face many estate planning issues (and opportunities). Although unmarried couples clearly face challenges that married couples do not, most are challenges that can be overcome with planning. However, because many of the issues discussed in this article are state-specific, it is important that unmarried couples preparing an estate plan seek the counsel of an attorney familiar with the laws of their states of domicile.
Unmarried couples (whether same-sex or opposite sex) have the same estate planning objectives as do married couples. They want to: avoid the costs, delays and publicity associated with probate; eliminate or minimize estate taxes; make certain their assets will pass to whom they want, when they want, and how they want; and protect heir assets from their heirs' inabilities, disabilities, creditors and predators.
Unlike married couples, unmarried couples do not benefit from many of the legal presumptions and default provisions under state and federal law. For example, unmarried couples: are not entitled to the federal unlimited estate and gift tax marital deductions; cannot utilize the tax free "rollover" of retirement benefits in the same manner as a surviving spouse; are not covered under most state intestacy laws that determine who receives a decedent's property if there is no Will; and are not permitted, by most state laws, to elect against a partner's Will and thereby receive a portion of the deceased partner's property.
Same-sex couples have made some strides under the law toward qualifying for the same benefits that married couples enjoy. In Massachusetts, Connecticut, Iowa, Vermont, Maine and New Hampshire, marriages for same-sex couples are legal and currently performed. In New York and Rhode Island, same-sex marriages from other states or foreign countries are recognized, but they are not performed. The states of California, Hawaii, Nevada, New Jersey, Oregon and Washington, by way of laws regarding domestic partnerships and civil unions grant persons in same-sex unions a similar legal status to married couples. Still, 36 states have statutes on the books prohibiting same-sex marriage, including some that also have constitutional bans. Only 3 states - New York, Rhode Island and New Mexico - have taken no action in either direction.
Although the U.S. Constitution requires each state to give "full faith and credit" to the laws of other states, the 1996 federal Defense of Marriage Act ("DOMA") expressly undercuts the full faith and credit requirement in the case of same-sex marriage. As noted above, 36 states have passed their own DOMA laws. Thus, because of the conflict between the U.S. Constitution and DOMA, it may ultimately be left to the Supreme Court of the United States to decide the issue of same-sex marriage.
Avoiding State Default Laws
Most unmarried couples will want to avoid their state's intestacy laws. These are the laws that determine who receives a decedent's "probate" estate if he or she dies without a Will. Except for a few states, intestacy laws do not recognize "unrelated persons." However, assets passing to a surviving joint tenant, or payable by beneficiary designation to a person or trust, are not part of the decedent's probate estate and therefore avoid the intestacy laws. Same-sex couples will also want to avoid most states' default laws on matters such as burial desires and priority among persons to act as guardians, conservators, personal representatives, and patient advocates.
Accordingly, unmarried couples should use Wills; Will substitutes (i.e., joint property, beneficiary designations, and payable-upon-death accounts); Revocable Living Trusts; general powers of attorney for financial matters; living wills and health care powers of attorney; and burial directives to avoid any adverse state law. Moreover, when unmarried couples designate partners as beneficiaries in Wills or Revocable Living Trusts, it is possible that disapproving family members may contest the Will or Trust. By including an "In Terrorem" clause in the Will or Trust Agreement, any person contesting the Will or Trust would receive nothing. Such a clause is intended to discourage persons from challenging a Will or Trust in court since nothing material may be gained by the action.
Qualified Retirement Plans
Although not technically a state default law issue, unmarried couples usually do not fare as well as their married counterparts when it comes to qualified retirement plans. Many 401(k) plans and pension plans provide that, upon a participant's death, his or her retirement account is to be distributed in a lump sum. As such, the distribution is fully taxable (as ordinary income) in the year of the participant's death. However, when the participant's spouse is the named beneficiary, the spouse can roll over the distribution into an IRA. Thus, the income tax on the distribution can be deferred until the surviving spouse attains age 70 1⁄2, at which time the spouse can "stretch" the distribution over 27.4 years.
Until recently, a non-spousal beneficiary would have been forced to take distributions of the entire qualified retirement plan within five years after the participant's death or, in some plans, immediately following the participant's death. Under the Pension Protection Act of 2006 (PPA), beginning in 2007, a non-spouse beneficiary of a qualified retirement plan can roll over, via a trustee-to -trustee transfer, the benefits into an "inherited" IRA. The inherited IRA must be titled in the participant's name for the benefit of the non-spousal beneficiary (e.g., "Mary Smith, Deceased IRA f/b/o Alice Jones"). The PPA also permits the post-mortem transfer of qualified retirement plans to inherited IRAs held by trusts for the benefit of non-spousal beneficiaries. Once the benefits are in the inherited IRA, the beneficiary may stretch the benefits over his or her life expectancy.
Domestic Partnership Agreements
As mentioned above, some states have enacted laws allowing domestic partners to register as such. By doing so, unmarried couples will have many of the rights and responsibilities afforded to married couples. However, in the vast majority of states, domestic partners are not recognized. Therefore, it may be beneficial for unmarried couples to define the terms of their relationship in a written Domestic Partnership Agreement (DPA). A DPA works much like a prenuptial agreement for couples planning to marry.
Basically, a DPA is a legally enforceable contract between two unmarried persons that clarifies the rights and obligations of each person in the relationship. Following are some of the provisions typically found in a DPA: A statement of the relative rights in property acquired before the date of the DPA (for example, such property could belong to the person who earned or acquired it); how income earned by the partners will be divided; how living expenses will be shared; how inherited property will be divided, if at all; whether jointly titled assets are to be created and, if so, how they are to be divided in case of separation; how assets will be divided in the event of separation, and whether post-separation support will be provided by one partner to the other; and how assets will be distributed in the event of death.
Beyond addressing financial concerns, a DPA can help set forth other parameters in the relationship thereby helping to clarify and strengthen the relationship. A DPA can also help to avoid potential disputes and misunderstandings by specifying a dispute resolution mechanism such as arbitration. Because some states do not recognize the validity of DPAs, it is important to consult a local attorney.
Basic Gifting Strategies
Like everyone else, unmarried couples having taxable estates will need more than a Will or Revocable Living Trust to reduce the federal estate tax. They will also need to implement a gifting program. While there is a present lapse in the estate and generation-skipping transfer taxes, it's likely that Congress will reinstate both taxes (perhaps even retroactively) some time during 2010. If not, on January 1, 2011, the estate tax exemption (which was $3.5 million in 2009) becomes $1 million, and the top estate tax rate (which was 45% in 2009) becomes 55%.
Federal estate tax law provides an unlimited marital deduction. Assets left to a surviving spouse through a Will, Trust or Will substitute are estate and gift tax free (if the surviving spouse is a U.S. citizen). In other words, a married couple can defer the estate tax until the death of the surviving spouse. Because of the Defense of Marriage Act (DOMA), unmarried couples are not afforded this opportunity - even in those states that recognize same-sex marriages, civil unions and domestic partners. Therefore, unmarried couples whose assets exceed the estate tax exemption will incur federal estate taxes upon the first partner's death, and possibly state death taxes depending on the state of domicile.
Following are some tax saving techniques available to unmarried couples:
Annual Gift Tax Exclusion. This exclusion allows the donor to make tax free gifts of up to $13,000 per donee per year, with no limit on the number of donees or the donees' relationships to the donor. This exclusion is scheduled to increase in amount, as it is now indexed to the rate of inflation. Lifetime annual gifts under this exclusion do not reduce the donor's $1 million lifetime gift tax exemption. (See below) Moreover, a gift tax return (Form 709) need not be filed for such gifts.
In addition, unlimited direct payments of the donee's tuition or medical bills are not subject to gift tax, nor do they count towards the donor's $1 million lifetime gift tax exemption or to the $13,000 annual gift tax exclusion. However, the funds must be paid directly to a qualified educational institution or medical provider. Education costs do not include room and board, books or supplies. Medical costs do not include amounts reimbursed by insurance companies.
Unmarried partners may earn substantially different incomes or have accumulated different amounts of wealth. The gift tax annual exclusion and the exclusion for tuition and medical costs allow the wealthier partner to transfer assets to the less wealthy partner during his or her lifetime. This strategy will be particularly beneficial when the wealthier partner's estate is over the estate tax exemption, the less wealthy partner's estate is below that amount, and they wish to benefit the same persons at the surviving partner's death.
Lifetime Gift Tax Exemption. In addition to the annual gift tax exclusion, a donor can gift a cumulative total of up to $1 million to anyone during his or her lifetime without any gift tax. This is the so-called "gift tax exemption." Gifts in excess of the $13,000 annual gift tax exclusion reduce the gift tax exemption dollar for dollar. Unlike the estate tax exemption, however, the gift tax exemption does not increase.
Any gift tax exemption used decreases, dollar for dollar, the estate tax exemption available at the donor's death. However, the income and appreciation on the gifted property is removed from the donor's estate, thereby reducing the estate tax. Thus, an unmarried couple can use the wealthier partner's gift tax exemption to make gifts to the less wealthy partner so that the overall estate tax of both partners is reduced.
Gifts to Irrevocable Trusts. Unmarried couples are often reluctant to make outright gifts to partners because the donor loses control over the gifted property. By making gifts to an irrevocable trust, the wealthier partner (grantor) can provide the less wealthy partner (beneficiary) with trust income and/or principal as needed, but can also determine where the remaining trust property will pass upon the beneficiary's death or dissolution of the relationship. Moreover, if it's properly drafted, the assets remaining in the trust can pass, estate tax free, to the "remaindermen" named in the trust agreement upon the beneficiary's death.
To be effective for estate reduction purposes, the trust must be irrevocable and the grantor should not be a trustee or beneficiary of the trust. However, the grantor can, within limits, retain the right to remove and replace trustees and, as noted above, the trust can be designed so that the beneficiary-partner is replaced by another beneficiary already named in the trust if the relationship is terminated.
To qualify for the $13,000 annual gift tax exclusion, irrevocable trusts usually contain a provision giving the trust's beneficiary a temporary right to withdraw gifts made to the trust, at least in part. This withdrawal right is often called a "Crummey" power, named after the Federal Court case that validated this technique.
Irrevocable Life Insurance Trusts. Unmarried couples often purchase life insurance for the benefit of the surviving partner to help supplement future income lost from the inability to do a spousal rollover, and the inability to receive pension survivor benefits. Life insurance can also be used to create an estate to provide financial security for the surviving partner, or to create the liquidity with which to pay estate taxes.
While life insurance proceeds are generally income tax free to the beneficiary, they are still part of the insured's gross estate and are subject to estate taxes. Accordingly, if the insured has a taxable estate (after including the face amount of life insurance), it may be advisable to transfer his or her life insurance policies to an Irrevocable Life Insurance Trust (ILIT).
If the life insurance policy is owned by and payable to an ILIT, the insurance proceeds will be both income and estate tax free. However, if an existing policy is transferred to an ILIT and the grantor-insured dies within three years of the transfer, the death proceeds are brought back into the grantor-insured's estate. This problem can be avoided if the ILIT is the initial owner and beneficiary of a new policy.
Gifts to an ILIT can be made with the grantor-insured's $13,000 annual gift tax exclusion using "Crummey" powers (See above) and/or with the grantor-insured's $1 million gift tax exemption. As mentioned above in connection with gifts to irrevocable trusts, the grantor-insured should not be a trustee or beneficiary of the ILIT. Besides keeping the insurance proceeds out of the grantor-insured's estate, the ILIT allows the grantor-insured to set the parameters upon which his or her partner (as the beneficiary of the ILIT) will receive trust income and principal. The ILIT should also be drafted so that, if the beneficiary is no longer in a relationship with the grantor-insured, another person (already named in the ILIT) automatically becomes the new beneficiary.
Before transferring a policy to an ILIT, applicable state law must be examined to determine if the ILIT has an "insurable interest" in the grantor-insured. If not, the insurance company might not be required to pay the death benefit. It may be possible to avoid this problem by having the insured purchase the policy and subsequently assign it to the ILIT. Under most state laws, the insurable interest requirement applies only to the initial owner and not to a subsequent assignee. As mentioned above, however, if a policy is assigned to an ILIT and the insured dies within three years of the assignment, the death proceeds are still includable in the insured's gross estate. One possible technique to avoid the three-year rule would be for the insured to sell the policy to an ILIT that is designed as a grantor trust.
Advanced Gifting Strategies
For unmarried couples with very large estates, fully utilizing the $13,000 annual gift tax exclusion and $1 million gift tax exemption may not be enough to significantly reduce the overall estate tax. Gifts in excess of the $1 million gift tax exemption are taxed at the same rates as estate transfers. In light of possible estate tax repeal or reform, many people are reluctant to make taxable gifts to reduce estate taxes. Therefore, effective estate planning for persons with large estates must involve strategies that help freeze or reduce the value of assets at minimal gift tax cost. Following are some strategies the wealthier partner can use to shift future appreciation to the less wealthy partner while minimizing taxable gifts to the maximum extent possible:
Low Interest Rate Loans. One simple way to shift potential appreciation from the wealthier partner to the less wealthy partner, without incurring a gift tax, is to make an interest-only loan. The loan must bear interest at the Applicable Federal Rate (AFR) published monthly by the IRS. The less wealthy partner reinvests the loan proceeds, and the appreciation in excess of the AFR will pass to the borrower free of gift tax and will also be excluded from the lender's estate. For the last several years, the AFR has been at all-time lows, making this strategy particularly beneficial. The loan should be documented with a promissory note.
Family Limited Partnerships or LLCs. A Family Limited Partnership (FLP) or Family Limited Liability Company (FLLC) allows the wealthier partner to make gifts to the less wealthy partner on a "discounted" basis while retaining some measure of control over the gifted partnership/membership interest. For example, the wealthier partner could transfer property to an FLLC in exchange for a 1% voting interest and a 99% non-voting interest. The nonvoting interests are then gifted to the less wealthy partner (either outright or in trust). The wealthier partner maintains control over the FLLC's assets through the voting interests by naming him- or herself as the manager of the FLLC. Moreover, the gift tax value of the non-voting interests may be discounted because they lack control and marketability.
Besides the tax reasons for creating an FLP or FLLC (i.e., discounting the value of the property for gift tax purposes and removing the income and appreciation on the gifted property from the donor's estate), there is also a variety of non-tax reasons for using an FLP or FLLC. As mentioned above, the donor can retain control over the management of the entity's property and the distribution of its profits. Assets in an FLP or FLLC are protected (to a degree) from creditors, and FLPs and FLLCs facilitate the making of gifts in much more efficient ways than direct gifts of property, particularly when real estate is involved.
The substantial benefits of using FLPS and FLLCs have subjected their use to increased scrutiny and challenge by the IRS. A recent line of case law has complicated the task of estate planners in advising clients on the use of FLPs and FLLCs. Thus, the proper structuring, administering and defending of the FLP or FLLC must be placed in the hands of a knowledgeable attorney.
Grantor Retained Income Trusts. A Grantor Retained Income Trust (GRIT) is an estate planning tool that has been around for many years. However, the Revenue Reconciliation Act of 1990 effectively eliminated the GRIT as a wealth transfer technique among "family" members. But GRITs are still a viable tool for unmarried couples - one of the few areas of the tax laws where an unmarried couple has an advantage over a married couple.
A GRIT is an irrevocable trust whereby the grantor (the wealthier partner) transfers assets to a trust while retaining the right to receive all of the net income from the trust assets for a fixed term of years. The net income must be paid at least as frequently as annually. At the expiration of the fixed term of years, the remaining trust principal is either distributed to the remainder beneficiary (the less wealthy partner) or held in further trust for the benefit of such beneficiary. However, if the grantor does not survive the fixed term, the assets in the GRIT are included in his or her estate, but any gift tax exemption used in establishing the GRIT is restored. Thus, the grantor is no worse off than if no GRIT had been created. In many cases, it might be advisable for the grantor to create an Irrevocable Life Insurance Trust to own a policy on his or her life to provide the liquidity - both income and estate tax free -to pay the increased estate tax that will be owed if the grantor fails to survive the GRIT's term.
The gift tax value with a GRIT will be only the value of the remainder interest (i.e., the difference between the full value of the property transferred to the GRIT and the present value of the grantor's income interest). The idea is to select a term that will give the present value of the grantor's income interest a substantial value (using the IRS's monthly published discount rate), but that the grantor is likely to outlive.
A big advantage of a GRIT is that if the assets transferred to the GRIT generate income at a rate lower than the IRS's discount rate for the month of the transaction, the net effect is to undervalue the gift to the remainder beneficiary. In contrast, where the remainder beneficiary is a family member, the Internal Revenue Code requires the payout to be a fixed annuity, a so-called Grantor Retained Annuity Trust, or GRAT.
The gift tax value can be further reduced if the assets transferred to the GRIT qualify for valuation discounts (such as an interest in a family limited partnership). It is possible, with a long enough term and a large enough valuation discount, that the gift tax value will be nominal. Appreciation of the asset's value during the fixed term thus escapes estate taxation. The GRIT should be drafted so that, if the grantor and the beneficiary are no longer in a relationship, then another person already named in the GRIT automatically becomes the new beneficiary.
The laws affecting unmarried couples are changing rapidly. Certainly more changes are likely, even challenges in the federal courts to the Defense of Marriage Act. The different rules concerning property rights from state to state add complexity to the situation, particularly for same -sex couples who move from a state recognizing civil unions or same-sex marriages to a state that does not. For unmarried couples it is important to have some form of estate planning to prevent state default laws from disinheriting their partners. Finally, because unmarried couples with large estates do not have the benefit of the unlimited marital deduction and other advantages that married persons enjoy, they need to aggressively seek out alternative solutions to maximize assets, reduce estate taxes and make use of powerful techniques not available to married couples.
TO THE EXTENT THIS ARTICLE CONTAINS TAX MATTERS, IT IS NOT INTENDED OR WRITTEN TO BE USED AND CANNOT BE USED BY A TAXPAYER FOR THE PURPOSE OF AVOIDING PENALTIES THAT MAY BE IMPOSED ON THE TAXPAYER, ACCORDING TO CIRCULAR 230.
Julius Giarmarco, J.D., LL.M, is the Chair of the Estate Planning Group of Giarmarco, Mullins & Horton, P.C., Troy, Michigan..