Community Property Planning Techniques For Professionals In Non-Community Property States

V. ESTATE PLANNING TECHNIQUES FOR IMPORTED COMMUNITY PROPERTY

A. Consultation with Community Property Attorneys

1. Many lawyers in common law jurisdictions may want to consult an attorney in the community property state from which their new clients have migrated.  Community property attorneys have a much better working knowledge of the regime than we have been able to convey to you in this presentation. However, the following basic guidelines may prove helpful in forming planning strategies.

B. Retaining Community Property Character of Assets

1. For reasons explained above, it is almost always very advantageous to retain the community property character of a migrant client's community property.

2. Techniques for Retaining Community Property

a. Recognizing Imported Community Property

(1) The first step in retaining community property is recognizing that it is a potential issue.  Professor Johanson recommends that the attorney's client information checklist cover the date of the clients' marriage and their states of domicile (1) before the marriage and (2) since the marriage.  If the answer to the second question includes one (or more) of the nine community and marital property states, the potential issue should be recognized immediately.

(2) A sample form for this purpose is attached as Exhibit 1 to Gerald B. Treacy, Jr., Planning to Preserve the Advantages of Community Property, 23 Est. Plan 24 (Jan. 1996).   

b. Segregating Community Property

(1) In community property states, all property of a married person is presumed to be community property absent evidence to the contrary.  In UDCPRDA states, this presumption applies to property acquired during marriage while domiciled in a community property state.  However, as the earlier cited Maryland Attorney General's opinion demonstrates, this presumption does not necessarily apply in the remaining 27 states, even if the 'time of acquisition rule' is followed.  Therefore, careful record keeping is essential to trace community property before it is commingled with separate property in the new state.  Note that this mirrors record keeping requirements in community property states to segregate separate property.

(2) Separate Accounts

(a) Planners may consider segregating community property assets such as cash into separate community property accounts.

(3) Joint Revocable Trusts

(a) Planners should consider the use of joint revocable trusts to hold community property assets.  These trusts are discussed in more detail below.

(b) See Appendix B for an example of a simple joint revocable trust that can be used to hold community property of a married couple residing in a non-community property state.

(4) (Not) Re-titling Assets

(a) Care should be taken not to title assets in any form of joint ownership after the move to the common law state, such as tenancy in common, or joint tenancy with a right of survivorship.  In UDCPRDA states, such a form of ownership creates a rebuttable presumption that the property is separate property, regardless of its source.  In all states, such changes in the form of ownership may convert community property into separate property.  See Rev. Rul. 68-80.

(5) Executing a New Community Property Agreement

(a) After the move to the common law state, spouses may want to execute a new community property agreement, designating which imported assets are to retain their community property character.  In addition, the agreement can recite and document which assets were acquired after the move with community property.

(b) The Community Property Agreement can be part of the Joint Revocable Trust, or it can be an entirely separate document.

C. The Joint Revocable Trust: An Estate Planning Technique Particularly Useful for Community Property

1. After recognizing imported community property, there are several estate planning techniques that are of particular use to estate planning with community property.  One that may be of particular interest is the joint revocable trust.  Please see Appendix A for a diagram of how the trust works.  Please see Appendix B for an example of a simple joint revocable trust, as discussed below.

a. The joint revocable trust is an instrument ideally suited to the concurrent ownership of property between spouses inherent in community or marital property.  We will focus on issues related to creating a joint revocable trust for clients who have migrated from community property to common law states.

(1) Funding the trust corpus

(a) The joint revocable trust normally may be funded or not during the settlors' lifetimes, depending on a number of factors.  For a migrant client from a community property state, particularly in a non-UDCPRDA state, the trust should be funded during the settlors' lives with community property to protect its character from mixing with separate property.

(2) The Settlors

(a) Both husband and wife should be settlors of the trust.

(3) Income During Settlors' Lifetime

(a) Income from property transferred to the trust should be designated as community property by the trust instrument.

(4) Terminating the original trust

(a) A simple joint revocable trust can be created to hold only the married couple's community property.  At the first spouse's death, the trust will simply be divided into two equal shares.  One share will pass the husband's separate revocable trust, and the other to the wife's separate revocable trust.  If the common law estate plan does not utilize revocable trusts, then one half will pass to the estate of the deceased spouse, and the other half to the surviving spouse.  See Appendix B.

(b) If you desire to build the dispositive provisions into the joint revocable trust, then the original trust should divide into a survivor's trust and a family trust upon the death of the first settlor to die.  A flow chart of such a plan is attached as Appendix A.

(i) For tax reporting purposes, it is important to establish when, following the deceased settlor's death, the original trust ceases to exist and the survivor's trust and family trust begin their existence.

(c) To avoid a premature distribution for alternate valuation purposes, the trust instrument should permit the trustee to postpone dividing the trust into separate trusts and defer the outright distribution of assets to the beneficiaries for six months.

(5) Defining the Survivor's Trust

(a) Upon the first settlor's death, it is important to segregate the surviving settlor's property held in trust and to define what portion of the deceased settlor's property will pass to the surviving settlor under the marital deduction.

(b) The trust instrument should provide that the survivor's trust will consist of the surviving spouse's interest in community or marital property held in the trust, any of the surviving spouse's individual property held in the trust, and a marital deduction provision.

(c) The trust instrument should provide that upon the surviving spouse's death the remainder of the surviving trust will pass to the family trust.  The surviving spouse has the power to revoke or amend the survivor's trust.

(d) An area of controversy in community property states is the potential income tax consequence, if any, of a non-pro rata allocation of community property assets between the estate or revocable trust of a deceased spouse and the surviving spouse.  As discussed above, the "item" theory of community property is generally applied at the death of a spouse.  Under this theory, the estate and the surviving spouse are deemed to own each and every community asset as a 50% tenant-in-common owner.  Accordingly, it would appear that, where community assets are involved, the estate and the surviving spouse would each have to take an undivided one-half interest in each and every community asset to avoid taxable exchange problems.  However, in PLR 8016050, the IRS ruled that where the surviving husband and estate of the deceased wife divided up the community assets based upon total value, there was no taxable exchange.  A similar result was reached in PLR 9422052, where the IRS held a non-pro rata division of community property between a survivor's trust, marital trust, and credit shelter trust was not a taxable exchange because the trustee had authority to make non-pro rata allocations.  Accordingly, it is of critical importance in drafting a joint revocable trust to include a provision specifically authorizing the trustee to make non-pro rata allocations.

 

(6) Revocation and Amendment

(a) During the settlors' lifetimes, the trust may be revoked with respect to the community or marital property by either settlor.  If separate property is in the trust, only the settlor who contributed it may revoke it.

(b) During their lifetimes, both settlors must agree to any amendments with respect to marital or community property.

(c) When the first settlor dies, the family trust must be irrevocable and unamendable, or the surviving spouse will have a general power of appointment over the trust, making the trust includable in the survivor's gross estate.

(d) Following the deceased spouse's death, the surviving spouse has the ability to amend, revoke, or terminate the survivor's trust.  This will qualify the assets distributed to the survivor's trust for the estate tax marital deduction.

D. Special Issues Relating to Irrevocable Trusts.

1. Practitioners must be very careful with respect to estate planning techniques involving irrevocable trusts and community property.  A potential trap exists with respect to an irrevocable trust in which one of the spouses has either a beneficial interest or has control over trust assets (e.g., one spouse is serving as trustee).

2. With respect to an irrevocable trust granting a beneficial interest in one spouse, the trap to avoid relates to the creation of a life income interest or similar right in one spouse where there is an irrevocable transfer of community property.  In such a case, the transfer of community property would result in an impermissible retained income interest in the spouse, causing inclusion under §2036.  This can be a particular problem in life insurance trusts where the premiums are paid with community funds.  Accordingly, practitioners must be very careful to counsel clients not to fund irrevocable trusts with community property where one spouse is also a beneficiary of the irrevocable trust.

3. Another problem exists where, for example, the husband creates an irrevocable trust for his children, naming his wife as the trustee.  If the trust is funded with community property, and if the trustee has control over the timing of trust distributions, one-half of the value will be included in the wife's taxable estate under §2038.

4. The remedy is, of course, to be sure that community assets are not used in funding trusts in the above-described situations.  If there are no assets other than community assets available for funding, then the practitioner might be able to avoid the problems through the creation of separate property through transmutation (i.e., through a written agreement which reclassifies the assets as the separate property of the grantor's spouse) or through partition.