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George F. Bearup, J.D. Senior Legal Trust Advisor

4-Sep-19

Michigan Community Property- In a Manner of Speaking

Take-Away: A Bill currently before the Michigan Legislature would permit married Michigan residents to declare that assets held by them in a community property trust would be classified as community property for all purposes, and in particular for an income tax basis adjustment on the death of one spouse. If the trust’s assets were classified as community property, the death of one spouse would cause a 100% adjustment to all of the trust assets’ income tax bases, thus enabling the surviving spouse to sell the trust’s assets and avoid paying capital gains taxes. Consequently, this law would provide an opportunity to married couples create a full ‘step-up’ in the income tax basis of their assets on the death of one spouse, which is the primary focus of most of estate planning these days, i.e. to avoid income taxes in light of the large estate tax exemptions and portability of an unused estate tax exemption. However, this Bill is apparently not gaining much traction in Lansing, at least not to date.

Background: Michigan is a common law jurisdiction. Eight states are community property jurisdictions: Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas and Washington. Wisconsin has adopted the Uniform Marital Property Act, which is based upon community property principles, and thus it is considered a community property jurisdiction for U.S. taxation purposes.

Three states have adopted what are called elective community property statutes. In Alaska, resident spouses can elect to have some of their property treated as community property if the property is transferred to an Alaskan community property trust where at least one trustee must be a resident of Alaska. Tennessee and South Dakota have also adopted similar elective community property trust statutes.

While only these 11 states either are, or permit via an election, community property principles to apply to marital property, it is important to remember that just between California and Texas alone, over 20% of the entire U.S. population lives in a community property jurisdiction.

Historical Note:  In the 1940’s Michigan for a brief period enacted community property legislation, but those laws were subsequently repealed.

Favorable Taxation: Community property vests in each spouse to the extent of one-half of such property. Consequently, when a spouse in a community property jurisdiction dies owning such property, the survivor is entitled to one-half of the community property plus the decedent’s separate property, both of which are included in the decedent’s gross estate. Upon the death of the first spouse to die, both the decedent’s separate property interest and the community property interests of both of the spouses receive a ‘stepped-up’ income tax basis. [IRC 1014(b) (6) and (10); Treasury Regulation 1.1041-2a (5).] Consequently, the Tax Code enables the surviving spouse to either sell the asset and avoid having to pay any capital gains taxes, or re-establish the depreciable basis for the community property asset. This tax treatment is unlike assets that are owned by spouses as tenants-by-the-entireties, where there is only a 50% income tax basis adjustment to the entireties owned asset. To be eligible to claim this special 100% basis ‘step-up’, at least one-half of the community property must be included in the estate of the spouse who dies first.

Disadvantages to Community Property: While obtaining a full income tax basis ‘step-up’ by claiming community property usually gets most of the attention these days, there are some obvious drawbacks to community property. For example, a lifetime gift of a community property asset will require the consent of the other spouse. If the spouses become divorced, community property principles [50%-50%] will generally govern the division of their marital estate. Upon the death of a community property spouse, estate tax administration expenses, deductions and losses allocable to the surviving spouse’s interest in the community property are not deductible. Finally, if a community property spouse dies, the qualification for favorable estate tax elections that are based upon the size of the decedent’s adjusted gross estate [e.g. IRC 2032; 6166] may be harder to achieve because only one-half of the closely held community property business interests will be includible in the decedent’s estate.

Federal Preemption:  Some federal statutes preempt what would otherwise be a state’s treatment of certain assets as community property. For example, ERISA preempts community property principles, as do federal copyright and bankruptcy laws. Accordingly, in some situations state-created community property rights of a spouse will be ignored when federal laws (and rights) come into play.

Taxation of Community Property Retirement Assets: With regard to the taxation of IRA distributions, federal law expressly provides that it will disregard community property principles and will fully tax the IRA owner in a community property jurisdiction on all IRA distributions. [IRC 408(g). See, also, Private Letter Ruling 201623001, which confirms that a spouse’s community property rights in the other spouse’s retirement account will be ignored when taxable distributions are taken from a retirement account.]

Community Property Brought to Michigan: If a married couple move to Michigan from a community property jurisdiction, that property is generally presumed to continue to be their community property unless: (i) there is an enforceable agreement to the contrary; (ii) the property was brought into the marriage by one of the spouses; (iii) the property was given to one of the spouses; (iv) the property was inherited by one of the spouses; or (v) the property had been separate property prior to the couple’s becoming domiciled in the prior community property jurisdiction. [See, also, Restatement (Second) Conflict of Laws, Section 259 (1971) which echoes this presumption of community property brought into a common law state.]

Uniform Disposition of Community Property Rights at Death Act: Michigan is one of 16 states that have adopted this Uniform Act. [MCL 557.261 to .271.] This statute creates a rebuttable presumption as to death-time transfers of assets. The statute is limited to defining the marital rights of a surviving spouse with regard to real property located in Michigan and personal property (wherever it is situated) of a spouse who is domiciled in Michigan. The Act’s rebuttable presumption is that property that was acquired while the parties were married and domiciled in a community property jurisdiction will be considered community property in Michigan, and reciprocally for their common law property. The Act takes a liberal approach to tracing assets and, as a broad generalization, it considers that property received in exchange for community property in Michigan, will retain its character as community property even though acquired in a common law jurisdiction. However, the Act does not address any of the following: (i) rights of ownership; (ii) rights and duties of management and control between spouses; (iii) rights to make gifts; (iv) rights to income during marriage;(v) rights to appreciation of community property assets during the marriage; and (vi) rights upon divorce.

Uniform Probate Code: Under the Uniform Probate Code, as adopted in Michigan, an individual may choose the law of a state other than their domicile to control the disposition of property at death. [MCL 700.2705 ‘The meaning and legal effect of a governing instrument other than a trust are determined by local law of the state selected in the governing instrument, unless the application of that law is contrary to the provisions relating to the elective share…’] This section only pertains to the interpretation, construction and legal effect of the governing instrument (other than a trust); it cannot be used to establish jurisdiction or venue for probate proceedings.

Preserving Community Property for Basis Increase: If a married couple bring their community property with them when they move to Michigan, some steps should be taken in order to continue the assets’ community property classification in order to claim a 100% income tax basis ‘step-up’ on the death of one spouse under Michigan’s adoption of the Uniform Act.

  • Community Property Agreement: The spouses should enter into a Community Property Agreement that identifies the assets that they import to Michigan, to clearly identify their intent that such assets are intended by them to retain their community property character, even if the assets are later exchanged for other assets, or current (common law) income is used to preserve or enhance the community property This Agreement will also demonstrate the spouses’ intent to refute the creditor claims of one spouse that the community property asset was in some way ‘transmogrified’ by their marital actions, treatment, or source of assets used to preserve the community property asset into a common law tenant-in-common asset.
  • Tracing: The assets imported to Michigan must be traced to their community property This means as soon as possible that those community property assets need to be identified and any records that substantiate their origin (title, time, basis) in the community property jurisdiction preserved.
  • Segregation: The community property assets should be segregated from other marital assets that are acquired while the spouses reside in Michigan to simplify future accounting and tax basis determinations. Often a joint trust with both spouses named as settlors, co-trustees, and beneficiaries, and its material purpose to preserve their community property will be used to achieve this segregation purpose.
  • Tax Reporting: Income generated by community property assets during the marriage should be reported as the spouses’ joint income, and not be claimed by just one spouse if they decide to file ‘married but separate.’

Unwinding Community Property: A married couple may enter into an agreement that converts their community property into their separate property. However, they have to be careful because if the property is divided unequally, that transaction could result in a taxable gift to the transferee spouse of one-half of the community property. This implied gift could be problematic if the transferee-spouse is not a U.S. citizen, where gifts between spouses can result in a gift tax liability due to the limited marital deduction that is available for gift tax reporting purposes. [IRC 2523(i).]

Michigan’s Proposed Community Property Trust Legislation: This Michigan Community Property Trust Bill has been floating around Lansing for a few years now, but it is not getting much attention. [At one time, back in 2016, it was assigned the proposed compiled law number MCL 700.7616.] Much of the proposed legislation was initially modeled on Tennessee’s Community Property Trust Act. The proposed Michigan Community Property Trust legislation looks much like a conventional joint trust that many spouses already adopt to avoid probate on the death of one spouse. In order to achieve the income tax basis ‘step-up’ contemplated through the trust’s community property classification, ‘magic language’ would have to be included in the joint trust instrument that expresses the spouses’ intent for the community property classification, for both income tax and also property law purposes. Inasmuch as the proposed Bill to establish a Michigan Community Property Trust has been languishing in Lansing for several years now, without it is questionable if Michigan will ever become the fourth state to adopt this type of elective community property treatment.