Structuring an estate to obtain an income tax basis ‘step-up’ upon the death of a client continues to be a significant goal of many estate plans. New planning strategies try to exploit old estate tax rules to intentionally cause an asset to be included in a decedent’s taxable estate. This approach attempts to create rights to control assets, usually held in trust, in order to claim a ‘step-up’ in the income tax basis of those assets upon the right-holder’s death. [IRC 1014]. Not to be overlooked, however, in the quest for a higher income basis in assets is the significant advantage that community property continues to enjoy when one spouse dies. Legislation is on the horizon in Michigan which would allow many more assets to receive a full basis ‘step-up’ on the death of each spouse.
Basis ‘Step-up’ Rule For Community Property
Relying upon the unlimited marital deduction, a married couple in a community property jurisdiction possesses the ability to incur no transfer tax on the death of one spouse, and a full (100%) ‘step-up’ in the income tax basis of all community property assets, which clearly benefits the surviving spouse. Both the deceased spouse and the surviving spouse’s one-half interests in the community property will be included in the deceased spouse’s taxable estate [IRC 2033] and each one-half community interest will receive a basis adjustment to the community property asset’s fair market value. [IRC 1014(b)(6); Regulation 1.1041-2a (5)] This rule which leads to a 100% income tax basis increase applies even though the surviving spouse permits his or her share of the community property to be transferred according to the will or trust of the deceased spouse. In contrast, in a common law jurisdiction like Michigan, there is currently only a 50% increase in a jointly owned asset’s income tax basis on the death of one spouse; only one-half of the value of the jointly owned asset is included in the deceased spouse’s taxable estate. [IRC 2040(b)] IRC 1014(b)(6) provides:
In the case of decedents dying after December 31, 1947, property which represents the surviving spouse’s one-half share of community property held by the decedent and the surviving spouse under the community property laws of any state or possession of the United States or any foreign country, if at least on-half of the whole of the community property interest in such property was includible in determining the value of the decedent’s gross estate under Chapter 11 of subtitle B.. of the Internal Revenue Code of 1939.
History of IRC 1014(b)(6)
The reasoning behind the full basis ‘step-up’ in community property under IRC 1014(b)(6) can be traced back to the time that this tax rule was enacted. Back in the 1940s’ most marital property was earned by the husband. Thus, in a common law jurisdiction like Michigan, most of a married couple’s assets might have legally been classified as the husband’s separate property. If the husband died first, presumably all of the husband’s separate property assets would receive a basis ‘step-up.’ In contrast, in a community property jurisdiction where the husband’s earnings are treated as community property, only one-half of the married couple’s assets would receive a ‘step-up’ in income tax basis on the husband’s death, leading to unequal tax treatment of married citizens in common law and community property jurisdictions. IRC 1014(b)(6) was enacted to address that perceived inequality: “Section 1014(b)(6) was designed to equalize the incidence of taxation between community-property and common-law states.” [Willging v United States, 474 F.2d 12, 14 (9th Cir 1973)] Nine states follow community property principles: Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington, and Wisconsin.
Other states in more recent years have attempted to provide the benefits of community property ownership to their citizens. Tennessee [Tenn. Code Ann. SS 35-17-1-1 et. al.] has enacted a statute which permits resident and nonresident spouses to classify their assets as community property by transferring title to the assets to a qualifying trust which declares that the assets held in the trust are community property. Michigan is currently looking at proposed legislation that is modeled, to a degree, on Tennessee’s elective community property trust statute, called The Michigan Community Property Trust Act. [proposed MCL 700.7616.]
Uniform Disposition of Community Property Rights at Death Act
Despite the disparate treatment between community property and common law jurisdictions, often overlooked is the fact that Michigan is one of fourteen states that has adopted the Uniform Disposition of Community Property Rights at Death Act (for ease of reference called the Uniform Act.) MCL 557.261 to 557.271. That Uniform Act provides that real property and personal property of a person who is domiciled in the state where the Uniform Act is adopted, that was originally community property, will retain its community property character for testamentary purposes when a spouse dies. Consequently, if community property assets are brought by a married couple into Michigan from a community property jurisdiction, those community property assets will retain their community property character. As a result, those community property assets may then be subject to a full (100%) income tax basis ‘step-up’ on the death of one spouse.
However, the Uniform Act is not intended as an income tax basis statute. The Uniform Act only preserves community property rights held by the surviving spouse. For example, the surviving community spouse’s one-half interest in such property cannot be used to pay the decedent’s creditors. Moreover, the Uniform Act does not specifically provide that it preserves the community character of the property; rather, the Uniform Act only causes the property to be disposed of in a similar manner on one spouse’s death as to what would have occurred with regard to the property had the couple remained domiciled in the initial community property jurisdiction.
The Internal Revenue Service (the Service) has not directly commented upon whether property that is covered by the Uniform Act is entitled to a 100% basis ‘step-up,’ and no reported court decisions specifically address that question. However, arguments can be made to support the conclusion that property that is covered by the Uniform Act under a written agreement is still entitled to a full (100%) income tax basis ‘step-up’ on the death of one spouse. There may also be some indirect precedent to support a full (100%) income tax basis ‘step-up’ for property that is covered by the Uniform Act.
- Law Commission Comments: The Uniform Act treats separate property transmuted by agreement to be community property. The Comments to the Uniform Law Commission’s Uniform Act (1971) note: “Subsection (1) is designed to cover… any property which was not originally community property but became such by agreement…”. While the Comments to any Uniform Act are not binding precedent, many courts will equate Uniform Law Commission Comments to a statute’s legislative history, albeit while not formally a part of the Uniform law.
- Treasury’s Field Service Advisory: In Service Treasury Field Service Advisory (FSA) [1993 WL 1609164 (IRS FSA)] the Service treated property held in Oregon, which had adopted the Uniform Act, as community property. The facts were pretty straightforward. A married couple sold their community residence in California and used the sales proceeds to purchase a new home in their joint names in Oregon, a non-community property state. The FSA concluded that “under Oregon law, property to which the Uniform Act applies, retains its character as community property although the property is situated in Oregon, a non-community property state…[In] all cases, the controlling factor is the characterization of the property under state law.” The result was that the Oregon residence was allowed a full ‘step-up’ in basis on the death of one spouse. Michigan’s adoption of the Uniform Act could be viewed as its recognition of the characterization of the community property by formal agreement of the spouses. But like a private letter ruling issued by the Service, a FSA cannot be cited as binding precedent. [IRC 6110(k)(3)]
- Internal Revenue Manual: In the Internal Revenue Manual Section 22.214.171.124.2 entitled “Community Property Law” the Service notes, in part: “Alaska has also adopted a community property system, but it is optional. Spouses may create community property by entering into a community property agreement or by creating a community property trust.” From an admittedly limited perspective, it can be argued that with Michigan’s adoption of the Uniform Act it has adopted a community property ‘system.’ See also MCL 700.7602(a)(2) which recognizes that a trust in Michigan can consist of community property, i.e. it can be amended only by the joint action of both spouses.
- Private Letter Rulings: Private Letter Rulings, usually arising from community property jurisdictions, tend to treat common law property that is commingled with community property by written agreement between the spouses as community property, and thus subject to IRC 1014(b)(6) on the death of one spouse. The Service’s acceptance of the written spousal agreements to transmute common law property to community property appears to be based upon a plain language of IRC 1014(b)(6), “held by the decedent and the surviving spouse under the community property laws of any State” which contemplates transmutation of the character of the property by a spousal agreement.
In Revenue Ruling 87-98, 1987-2 C.B.206, the Service found the effect of a community property agreement, admittedly for federal income tax reporting purposes by the spouses, to be binding on the Service. In finding that Washington’s law permitted a married couple to transmute their separate property to community property, the Service noted: “[W]here a husband and wife residing in the State of Washington agree in writing that all presently owned property and all property to be acquired thereafter, both real and personal, will be community property, such agreement changes the status of presently owned separate property and subsequently acquired property to community property…If property held in a common law estate is community property under state law, it is community property for purposes of Section 1014(b)(6) regardless of the form in which title was taken.” This private letter ruling addressed the effort by spouses to ‘split’ income generated by community property assets, which they then reported on their separate income tax returns.
However, in Revenue Ruling, Rev. Rul. 68-80 the Service held that if a married couple moves to a state which by law forces a change in ownership from community to common law character, it will not allow a full ‘step-up’ in income tax basis of a deceased spouse’s assets. The facts in that Revenue Ruling were that a couple moved from New Mexico (a community property jurisdiction) to Virginia (a common law jurisdiction). The spouses exchanged their community property for Virginia real estate, taking title to the Virginia real estate as tenants in common. The Service denied a full ‘step-up’ in tax basis on the death of one spouse. It held ”there is nothing in the Internal Revenue Code or regulations that would indicate that IRC 1014(b)(6) relating to ‘community property held’ was intended to include separate property that had previously been converted from community property to separate property.” A narrow reading of this Revenue Ruling is that the Service will not apply IRC 1014(b)(6) to property that has been intentionally converted by spouses from community property to separate property if the couple move to a common law jurisdiction.
In sum, it may be possible for a married couple who move from a community property jurisdiction to Michigan to preserve the community character of those migrating assets if they avail themselves of Michigan’s adoption of the Uniform Act and express that intent in writing.
Community Property Agreements—An Existing Tool Revisited
If the object of the spouses is to maintain the community character of the assets brought by them to Michigan to assure that the surviving spouse can assert the benefit of an IRC 1014(b)(6) 100% income tax basis ‘step-up’ on the death of their spouse, that intention should be expressly stated in a written agreement and not left to implication. For example, if community real property is sold while the couple reside in Michigan, and Michigan real estate is purchased using the sales proceeds, it is possible that a court might find the purchase of the Michigan real estate to have been taken by the couple as tenants-in- common, despite the fact that the origin of the purchase proceeds is community property. To avoid that presumption, a contrary intent needs to be clearly expressed by the spouses in a written agreement. Similarly, if a community property asset is transferred from one spouse to the other’s name alone, it may no longer be viewed under Michigan law as community property unless an agreement manifests a different intent that the asset is to retain its community property character despite being held in the name of only one spouse.
While the income generated by a community property asset will normally retain its community property character, if that income is commingled with other income earned while the couple reside in the common law jurisdiction, then it is possible for the community property income to either lose its character as community property, or the survivor will then carry the burden of proof to trace and identify the community property origins of the commingled income.
Because of these challenges, it is important for estate planners to take affirmative steps on behalf of their clients to clearly express their intention that such property will continue to be held, reinvested, and treated by them as their community property. Keep in mind that the Uniform Act provides that if the married couple takes title to real estate in Michigan in a survivorship form, doing so will create a rebuttable presumption that their jointly owned property is no longer subject to the Uniform Act as community property. [MCL 557.263]
There are many repercussions to intentionally classifying property as ‘community’ that could more than negate the benefit to claim a full income tax basis ‘step-up’ on the death of one spouse, divorce being the most obvious. Assume that a husband, while residing in California, uses his California earnings to purchase stock in his name alone. The married couple then moves to Michigan. The husband now wants to gift the stock to a child from a prior marriage. The stock cannot be gifted by the husband without his wife’s consent, since 50% of the stock is hers, its origin being traceable to the husband’s California earnings. Or, suppose the wife faces a judgment creditor which intends to execute on the stock that is held in the husband’s name alone. The judgment creditor can take 50% of the stock because 50% of the stock is owned by the wife as her community property interest if the judgment creditor can successfully prove the stock’s community property origins, which may be established simply by referring to the community property agreement between the spouses where the stock is listed as a community asset.
There also exists the danger that a married couple who hold their community property as tenants by the entireties might be viewed by a Michigan court as intentionally taking title in that manner to transmute the asset to common law property, as entireties property is a common law form of ownership between spouses. If the intent is to preserve the community property character of assets, then conventional estate planning techniques for spouses will need to be reconsidered in a new light to preserve the community property character of assets.
The opportunity to obtain a full basis ‘step-up’ in community property assets may lead to a different advice given to clients who possess community property. For example, during the lifetime of the spouses, they might want to avoid inter-vivos transfers which can cause the loss of the asset’s community property character. Moreover, the spouses might try to increase the value of community property assets, or accelerate depreciation of community property assets in order to benefit from the full (100%) income tax basis adjustment permitted by IRC 1014(b)(6) on one spouse’s death.
A community property agreement will need to identify and segregate the community property assets from other assets acquired in Michigan, and document the intent of the spouses to retain the community property character of the identified assets, albeit while they reside in a common law jurisdiction, regardless of how title is taken for those assets. If these identified assets are held in a trust, it is a good idea to expressly refer to the community property agreement in the trust instrument. If no trust exists, the spouses should refer to the community property agreement in each spouse’s will. If the community property assets can retain their physical presence in the community property state, so much the better. The use of a separate trust or limited liability company to hold title to the community property assets will help to prevent a commingling of those assets with common law marital assets. However, if a trust or LLC is used as a title-holding entity, then it might be wise to select as its governing law the community property jurisdiction where the assets were acquired to reinforce the parties’ intent to have the assets classified as community property.
Community Property Trust—A New Planning Tool
As noted earlier, some states have adopted statutes that permit spouses to classify assets as community property. While these states are common law jurisdictions, each state permits spouses the option to designate assets as community property. Alaska permits married couples to merely designate assets as community property by a written agreement. Tennessee’s statute requires that the couple use a trust to hold title to their designated community property assets. The proposed Michigan legislation tries to follow the Tennessee statue as a model, and mandates the use of a trust to hold title to the intended community property assets. The proposed Michigan Community Property Trust bill contains the following features:
- Title must expressly declare it to be a community property trust, e.g. “The John and Mary Doe Trust, a Michigan Community Property Trust”.
- The spouses will be required to make a public declaration that the assets held in the name of the trust are intended by them to be community property, to avoid any confusion since Michigan continues to be a common law/ separate property jurisdiction.
- The bill uses the terminology ‘Community Estate’ so as to track the language that is used in the Internal Revenue Manual Section 126.96.36.199.4 (March 4, 2011).
- The bill uses the term “Period of the Michigan Community Property Estate, which contemplates that the spouses may choose, for a period, to not have the assets held in the trust treated as community and then later restore the community property character of the assets, without the need to terminate the trust, i.e. the community property character of the assets can be ‘toggled’ on and off by choice.
- Domicile will be a requirement imposed on the spouses who elect to establish such a trust. In contrast, under the Alaska and Tennessee statutory regimes, non-domiciled spouses are permitted to establish such trusts, so long as there is a resident trustee.
- The rights and obligations which the spouses possess, or which they can deviate from with regard to the control or the management of the community property that is held in the trust must be clearly expressed in the trust, and not left to implication; and
- The trust instrument must contain the following warning:
THE CONSEQUENCES OF THIS TRUST MAY BE VERY EXTENSIVE, INCLUDING BUT NOT LIMITED TO, YOUR RIGHTS WITH RESPECT TO CREDITORS AND OTHER THIRD PARTIES, AND YOUR RIGHTS WITH YOUR SPOUSE BOTH DURING THE COURSE OF YOUR MARRIAGE AND AT THE TIME OF A DIVORCE. ACCORDINGLY, THIS AGREEMENT SHOULD ONLY BE SIGNED AFTER CAREFUL CONSIDERATION. IF YOU HAVE ANY QUESTIONS ABOUT THIS AGREEMENT, YOU SHOULD SEEK COMPETENT ADVICE.
It remains to be seen if Michigan’s legislature will adopt this proposed trust legislation to expand upon what is permitted under the Uniform Act, which generally applies only to those spouses who migrated to Michigan bringing their community property assets with them.
When planning an estate an initial inquiry needs to be made as to the origin of all assets held by a married couple. They may be good candidates to adopt a Community Property Agreement. If Michigan ever adopts an elective community property trust statute, such as the proposed Bill that is slowly working its way through Lansing, then the opportunity will exist to increase the income tax basis of all marital assets which will take on an even more prominent role in the estate planning process.