Take-Away: If individuals reside with one another, but they have no intention of marrying, then planning opportunities should be considered. Most of the problems posed by Chapter 14 of the Tax Code valuation rules can pretty much be ignored when the individuals are not family members.

Background: There is an increasing phenomena in our society where more and more individuals are living together but not choosing to marry. One possible explanation is the size of the divorce-prone Baby Boomer population, with many of them re-partnering later in life. “The number of people over 50 who cohabit with an unmarried partner jumped 75% from 2007 to 2016, the Pew Research Center reported last month- the highest increase in any age group.” Paula Span, More Older Couples are ‘Shacking Up’, New York Times (May 8, 2017.)

There could be several explanations for this trend. Many of these individuals endured a divorce early in life and they never want to go through that painful process again. Others, whose earnings may be close to the same, may choose not to marry simply to avoid the so-called marriage penalty that is imposed on married couples when they file a joint income tax return. Or, if one partner still has young children, that partner may want to be able to file federal tax returns using the more favorable head of household tax rates, which would be lost if they were married. Other tax reasons may also exist why marriage between cohabitants is expressly rejected, e.g. avoiding joint and several income tax liability on jointly filed income tax returns.

Estate Planning for Unmarried Couples: For estate planning purposes, if a couple is unmarried many of the limitations and restrictions imposed under Chapter 14 of the Tax Code do not apply. As a gross generalization, the purpose of Chapter 14 is to ensure that the value assigned to a retained interest or restrictions for gift tax purposes comports with the economic realities of the transaction. But because unmarried partners are not considered family members within the definition of Chapter 14, certain estate planning techniques that are limited or simply not available to married individuals under Chapter 14 remain available to unmarried partners. [Chapter 14 in a nutshell: IRC 2701 deals with transfers of interests in corporations or partnerships among family members; IRC 2702 deals with transfers of interests in trusts where family members are remainder beneficiaries; IRC 2703 deals with valuation of business interests among family members when there are restrictions or limitations imposed on the transfer of an interest in the family owned entity; and IRC 2704, which treats the lapse of certain rights as a taxable transfer between family members.] If you work with unmarried partners, a few of planning techniques that you may want to mention follow:

  • IRC 2702 Limitations:  Suppose an husband creates a trust for the benefit of his spouse (income) with a remainder to his children. Unless the interest in trust is a qualified interest [like a fixed annuity] under IRC 2702 the spouse’s income interest will be valued at $0.00. This means that the entire value of the property transferred to the trust will be treated as a taxable gift to the children (the remainder beneficiaries,) even though the value of the gift of the trust’s beneficiary remainder interest may actually be far less using traditional valuation rules. But unrelated parties are not subject to these special valuation provisions of IRC 2702. In order to work around these rules, a conventional married couple would have create a qualified interest and use a grantor retained annuity trust (GRAT) or a qualified personal residence trust (QPRT) to avoid the 100% gifted value rule. But neither a GRAT nor a QPRT will be required if the couple is unrelated.
  • Applicable Family Member: For purposes of applying IRC 2702 the Tax Code defines an applicable family member as: (i) an individual’s spouse; (ii) any ancestor or lineal descendant of the individual or the individual’s spouse; (iii) any sibling of the individual; or (iv) any spouse of any individual described in the prior categories. [IRC 2702(e) referencing IRC 2704(c)(2).] Thus, a non-applicable family member would be the grantor’s nephew (lineal descendants of siblings are not mentioned.)
  •  Caution: Sometimes it is easy to get mixed up when applying the Chapter 14 rules. One of the common mix-ups is applying the definition of family member provided for one section to another section under Chapter 14. For example, compare the definition of applicable family member used for IRC 2702 just described to the definition of member of the family that is used for IRC 2704 (prohibiting valuation restrictive agreements with closely held family businesses.) IRC 2704 uses a considerably broader definition: A member of the family includes family members as defined in Treas. Reg. 25-2701-1(d): The transferor’s spouse; lineal descendants of the transferor or the transferor’s spouse; and the spouse of any such lineal descendant. Consequently,  nieces, nephews, stepchildren and siblings-in-law are included in IRC 2704’s definition but not in IRC 2702’s use of applicable family member.
  • Grantor Retained Interest Trust: One technique available to unmarried couples is to use a GRIT. A grantor retained interest trust is an irrevocable trust in which the grantor retains an income interest for a term of years, and at the end of the term the trust estate is then distributed to a named individual or individuals,  provided that the grantor is then living. Chapter 14 eliminated the use of GRITs in conventional estate planning if the remainder beneficiary of the trust was a ‘family member.’ Because an unmarried partner does not fall within the definition of family member [IRC 2702(e)] a GRIT can be an excellent way to allow a wealthier partner to retain an income stream during the retained income- term of 10 years; this allows the trust principal to pass at a reduced transfer tax value at the expiration of the partner’s 10 year income-term. Example:  The grantor places rental income producing property in an irrevocable trust and retains the right to all of the income from the trust for a specified term. Usually highly appreciating property will be used to fund the GRIT. Therefore, the amount that passes to the remainder beneficiary will exceed the projected value for gift tax purposes. At the end of the income-term, the property can remain in trust or be distributed outright for the designated remainder beneficiary, usually the grantor’s partner and his/her children. If the grantor survives the income-term, then the property is excluded from the grantor’s taxable estate. If the grantor dies before the end of the income-term, the corpus of the trust is included in the grantor’s taxable estate. [IRC 2036(a)(1).]
  •  GRIT Benefits: The benefit that arises from using a GRIT is that the fair market value of the property that the grantor transfers to the GRIT is reduced by the value of the grantor’s retained income-term interest used to determine the gift tax value of the transfer of the remainder interest.[Treas. Reg. 25.2512-5(d)(2).] The value of the grantor’s retained income-term interest, just like the value of a GRAT’s annuity interest retained by the grantor, is based on the actuarial value of the remainder interest (the value of the property transferred, the length of the retained income-term, the grantor’s age (if the grantor retains a contingent reversionary interest- i.e. dying before the income term ends) and the IRC 7520 interest rate that is effective in the month of the transfer of the assets to the GRIT. Thus, any appreciation in GRIT’s property is transferred to remainder beneficiaries, provided the grantor survives the income-term. A GRIT might be used, for example, for an unmarried couple where the wealthier partner wishes to retain the income from his/her assets through 2025, but then have the GRIT income-term interest expire prior to 2026 when the grantor’s federal estate tax exemption drops back to $5.0+ million.
  • Qualified Personal Residence Trust: Under normal qualified personal residence trust (QPRT) terms, the grantor cannot ‘hard-wire’ into the trust instrument the right to repurchase the residence, which might be desirable if the goal is to obtain an income tax  basis step-up in the residence if owned by the grantor at the time of his/her death. With unmarried partners, this ‘buy-back’ prohibition does not apply. Thus, an irrevocable trust  that holds title to the grantor’s residence could contain a right of repurchase, which would permit the grantor to repurchase the residence just before the grantor’s exclusive use term defined in the trust expires. Since the QPRT is a grantor trust for income tax reporting purposes, the grantor can repurchase the residence from the trust with no gain or loss recognized to the grantor.

Split Interest Purchase: One of the perceived abuses that ultimately prompted the adoption of the Chapter 14 rules were split interest purchases. Example: Assume Dad wants to purchase a Naples condo. He approaches his adult children and says to them that he, Dad, wishes to purchase a life estate in the Naples condo, and the children can purchase the remainder interest in the Naples condo, resulting in his children owning the Naples condo on Dad’s death, while avoiding probate of that asset. Since Dad never ‘transferred’ anything, and he only owned a life estate, the full value of the Naples condo would avoid any estate taxation. [You can easily guess where the children came up with the cash to purchase their remainder interest in the Naples condo, forcing the IRS to use form over substance, or step-transaction legal theories to collapse the transaction into Dad retaining in interest in a transferred asset.] Because the outcome of the split-interest purchase arrangement was one of those ‘too good to be true’ scenarios when it comes to avoiding estate taxes, Congress responded by passing IRC 2702. Under IRC 2702, if the joint purchasers are applicable family members, the person purchasing the term interest (life estate or term of years, i.e. Dad) is treated as acquiring the entire property and then transferring the remainder interest to the other purchaser (the children), and the retained interest (Dad’s life estate) is valued as $0.00. The result is an immediate taxable gift to the children of the full value of the Naples condo. But if the joint purchasers are not applicable family members, IRC 2702 does not apply to the transaction. Thus, all of the appreciation in the purchased Naples condo is shifted to the remainder beneficiary at the end of the term of years (or life estate.) In short, if an unmarried couple decided to purchase a Naples condo, they could split the purchase price, which could not be done if they were  husband and wife.

Sale of Remainder Interest: This is another alternative to a QPRT. Unlike the QPRT, where the grantor reserves the right to live in the residence for a set period of time, and if the grantor does not survive that time period, the full value of the residence is included in the grantor’s taxable estate, with the sale of a remainder interest, the grantor can retain the use of the residence for life, rent-free. This avoids the risk that the grantor might not survive the QPRT exclusive use term. A grantor could not sell a remainder interest in the residence to qualified family member without triggering IRC 2702’s valuation rules. Thus, for an unmarried couple, one partner could sell the remainder interest in that partner’s home to the other partner, or to the other partner’s children.

Drafting Tip: Many of these estate planning strategies, like a marriage, work so long as the partners  get along. When there is a concern about locking in the rights of a current spouse is it sometimes suggested that rather than naming that person as the trust beneficiary, it might be better to say ‘the person to whom I am currently married and not legally separated from at that time’ to address the potential for a future divorce or legal separation. The same approach can be used when the individuals are not married but are committed partners in a relationship. For example a partner could be named as the remainder beneficiary of a GRIT ‘if, but only so long as such individual has permanently resided with me for at least 300 days of the prior 365 days before the termination of my income interest in this trust, and if such individual fails meet this condition precedent, then such individual shall be treated for purposes of this trust and any distributions under this trust as having predeceased me.” Thus the rights conferred under the trust instrument are dependent upon the duration of the relationship and not upon the marital status of the individual.

Conclusion: If there is a dramatic increase in the number of individuals who choose to live with one another without a marriage certificate, then some planning opportunities open up to them that are not available if they had married. When they talk about ‘providing for my partner should I die’ then consider these planning techniques that Chapter 14 would otherwise prohibit.