
Married Couples Have Options, but Must Avoid Traps in Planning Their Estates
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- Jan 30, 2025
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At the 59th Annual Heckerling Conference, panelists Charles Redd of Stinson LLP, Turney Berry of Wyatt, Tarrant & Combs LLP, and Laura Zwicker of Greenburg Glusker LLP discussed some of the complications that can arise during estate planning for married couples. The panelists discussed how couples should watch out for issues arising from community property treatment of assets, the limitations of spousal lifetime access trusts (SLATs), and how to qualify for the marital deduction while also removing those assets from your spouse’s estate.
Community Property Issues and Opportunities
Community property is a state-level treatment of property acquired during a marriage. “Community property” is defined as assets acquired by a married person during the marriage while living in the community property state, as acquired by either spouse during marriage. A notable advantage of community property is that you get a double step up of the basis – once upon the death of the first spouse, and again when the surviving spouse dies. It does not matter who dies first for the step up in basis of an asset. The nature of community property assets does not change when you move to another common law state.
Nine states have community property treatment: Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington, and Wisconsin. Due to community property laws, it is important to disclose the states that you have resided in with your estate planning attorney.
Community Property Trusts
Several states have passed “community property trust” legislation to take advantage of the favorable basis adjustment rules for community property assets or to allow spouses to elect a community property regime by agreement. These trusts provide that if a married couple holds property in a community property trust that has its situs in one of these states, it becomes community property. The legislation may require trust documents to contain warnings and may allow either spouse to unilaterally revoke the trust and receive back one-half or direct their part of the trust at death.
One panelist noted that people like a joint community property trust because they don't like to divide their assets anyway; they don't really need to understand the double step up, and one trust simplifies things for families. It should also be noted that you can move investment accounts to a joint trust but not retirement accounts.
Gifts of Community Property
Like other gifts, gifts of community property require the consent of both spouses, but these gifts differ in that they are deemed to be made equally by both spouses and are subject to automatic gift-splitting. In order to avoid this, a valid “transmutation” must take place prior to the gift being made.
If the effectiveness of a gift relies on the gifted property being the separate property of the transferor, e.g., a transfer to a trust in which one spouse will have an interest (a SLAT, trust holding life insurance), care should be taken that:
- the negotiation and documentation of the transmutation agreement would ensure its enforceability under state law, and
- there are no reimbursement rights or other property rights in the gifted asset that could have unexpected tax consequences as retained interests or otherwise.
Watch Out for SLAT Landmines
Utilizing a SLAT is one of the latest and greatest estate planning strategies, but there are significant considerations, both tax and non-tax. The purpose of a SLAT is to create a complete gift for federal gift tax purposes that is not included in the taxable estate of the settlor spouse or the beneficiary spouse. This is achieved by one spouse gifting assets to a trust with the other spouse as the beneficiary. The beneficiary spouse has the power to request distributions from the trust for purposes of health, education, maintenance, or support (HEMS).
There are two key things that should be avoided. First, the settlor should not be a trustee of the SLAT they established. Second, the settlor should avoid any understandings that could, as a practical matter, even if not legally enforceable, give the settlor a beneficial interest or powers of disposition of the SLAT property. These understandings could include:
- That the settlor’s spouse will turn over their distributions to the settlor,
- That the settlor will be reimbursed for income taxes generated by transactions in the SLAT for which they are personally liable, and
- That the spouse will use their power of appointment to bring in the settlor upon the spouse’s death.
Reciprocal Trust Doctrine
An easy trap to fall into with SLATs is the “reciprocal trust doctrine.” When married couples create trusts for each other’s benefits, there is the potential for the IRS to recharacterize the trust as having been created by the settlor for their own benefit. In this case, the value of the trust assets would be included in the settlor’s gross estate if the SLAT documents are substantially similar. To avoid this, you must differentiate the trusts and make them “materially” different. Some ways to accomplish this include:
- Creating a meaningful amount of time between the establishment of each SLAT,
- Contributing different types of assets to each SLAT (e.g., real estate to one and marketable securities to the other),
- Having different remainder beneficiaries, and
- Differentiating the choices of provisions made within each trust.
Over time, the trusts will become more different. If different asset types are contributed, one may become more valuable, which would further address the potential issues with reciprocal trusts.
Dissolution of Marriage
A SLAT can be a great estate planning tool for a couple whose marriage is solid. However, they can be problematic in the event of divorce.
The issue in divorce is that settlor spouse’s former spouse remains the beneficiary, and the settlor will be liable for income tax consequences generated by the SLAT. If the former spouse is the trustee, they could sell property within the trust and trigger capital gains that will be paid by the settlor spouse. And, if there is a power of appointment, the beneficiary spouse could exercise that power in a way that is inconsistent with the settlor’s wishes.
A “floating spouse provision” is one way to avert the above issues, although it could be a delicate proposition. The spouse is not specifically named in the instrument(s), which refers only to the “current” spouse. In the event of divorce, there will be no “current” spouse to benefit. In this case, informed consent must be obtained by both spouses when drafting the trust agreements. If the values of the trusts are roughly equivalent, this may be an acceptable approach to both parties.
Another alternative would be for the SLAT instrument to include a provision stating that, if the marriage is dissolved, neither the settlor’s spouse nor the settlor shall be a beneficiary. Finally, it may be possible to convince the spouse to relinquish certain interests and/or powers over the SLAT and/or to reimburse the settlor for income taxes generated in the SLAT in exchange for concessions in other matters.
Sale of Remainder Interest in Marital Trusts
A settlor can create a trust that, if executed properly, will qualify for the marital deduction and will not be included in their spouse’s estate. This is accomplished by the settlor creating and funding an irrevocable trust for benefit of the settlor’s spouse, with the spouse receiving a lifetime interest but having no power of appointment. The settlor would retain a remainder interest in the trust.
Contemporaneously, the settlor creates and funds another irrevocable, generation skipping transfer (GST) tax exempt trust for benefit of their descendants. The settlor can sell the remainder interest from the marital trust to the GST exempt trust for the fair market value of the remainder interest. The remainder interest is valued using the IRC Sec. 7520 rate to determine the remainder of the annuity payable to the spouse, with the lower generations then paying the difference.
The result of the transaction is that:
- the value of the trust property is removed from the settlor’s estate,
- the settlor’s spouse receives an income interest in the trust property for the shorter of their lifetime or the expiration of a term of years, and
- the value of the trust property isn’t included in the spouse’s gross estate.
Thus, the property isn’t subject to estate tax or gift tax before ultimate distribution to the children. Only the amount that the children pay to the settlor for the remainder interest and any investment return on that amount will be subject to estate tax in the settlor’s gross estate.
One big question is: How do kids get the assets to purchase the asset? If the children have sufficient wealth to purchase the remainder interest but not sufficient liquid assets, they could give the settlor a promissory note, although the children should have sufficient other assets, so they can pay the note. Another option is to make a gift so that the children can then buy the marital trust.
Since the marital trust pays only the trust income to the settlor’s spouse throughout the trust’s term, all post-transfer appreciation in the value of the underlying trust property should be transferred to the children free of gift and estate tax. The benefit of the strategy is enhanced to the extent the trustee invests, permissibly under applicable state law, with an emphasis on capital appreciation as opposed to income generation.
The result flowing from a marital trust remainder sale transaction may be superior to that generated by a grantor retained annuity trust (GRAT) or an installment sale to an irrevocable grantor trust. Both strategies transfer to remainder beneficiaries only the trust’s total investment return more than the IRC Sec. 7520 rate (on the GRAT) or the IRC Sec. 1274 interest rate (on the note). Those rates could be materially higher than the amount of trust accounting income required by state law in satisfaction of an income interest. An added benefit is that the mortality risk of the settlor is eliminated: if the spouse dies, the transaction still works, unlike a GRAT.
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