As long as federal laws discriminate against all couples, loopholes exist for estate planners to discriminate back
Unmarried partners don't enjoy the protections and benefits that are unique to marriage. For example, unmarried partners aren't entitled to an intestate share and don't have the statutory right to demand an elective share, as spouses do. Unmarried partners can hold property as joint tenants with rights of survivorship, but they can't hold property as tenants-by-the-entirety. State laws don't recognize oral agreements and understandings between unmarried partners. Moreover, the Employee Retirement Income Security Act (ERISA) requires a spouse to be the beneficiary of at least 50 percent of the other spouse's retirement benefits (unless the spouse consents to a different arrangement), but provides no such protection to unmarried partners.
In some instances, however, unmarried partners may benefit from legal loopholes that have been closed to married partners. For example, they can buy back a residence in a qualified personal residence trust (QPRT) to get a stepped-up basis and can take advantage of the old common law grantor retained income trusts (GRITs) that Internal Revenue Code Chapter 14 outlawed for family members.
When planning the estates for unmarried partners, estate planners need to understand the disadvantages unmarried couples face so they can overcome them and also learn about the opportunities and strategies available to unmarried couples. Here are some key issues estate planners should consider when advising unmarried partners.
Unless an individual provides otherwise, upon his death, his assets will be distributed according to the state's law of intestacy. Most state laws provide that if an individual dies intestate and is survived by a spouse and children, his property will pass first to his spouse, then his children, and then, if the individual has no spouse or children, his property will pass to various blood or adopted relatives generally depending on some measure of the closeness of the degree of kinship. State law determines what constitutes a “spouse.” Several states (Connecticut, Iowa, Maine, Massachusetts, New Hampshire and Vermont) allow same-sex marriages. For purposes of interpreting federal statutes and administrative regulations, rulings or interpretations, however, the 1996 federal Defense of Marriage Act (DOMA) defines “marriage” exclusively as a “legal union between one man and one woman” and “spouse” as “a person of the opposite sex who is a husband or a wife.”
So, if an unmarried individual doesn't make specific provisions for his partner, by will or otherwise, then upon his death, his surviving partner will likely receive nothing. The surviving partner could be left without any assets and could even become homeless, yet be responsible for bills and loans that were accumulated together with his late partner. Therefore, if unmarried partners intend to benefit each other, they must plan ahead.
If the unmarried partners aren't of the same sex, they may obtain the benefits available to a married couple by entering into a marriage before the death of one of the partners. This will work even in the case of a deathbed marriage, although such a marriage may be subject to challenge by family members if the ailing partner's capacity is diminished. And, note that although certain states recognize common law marriage, they only recognize it for opposite sex unions.
Wills Subject to Challenge
Even if unmarried partners have a will, it may be subject to challenge. If the families of the unmarried partners don't approve of their lifestyle or relationship, the families may seek to challenge their wills on the grounds of lack of testamentary capacity, improper execution, undue influence, fraud or mistake. Estate planners advising unmarried partners should take the following precautions to minimize the risk of challenges to their wills:
Make sure the will is properly executed
Take pains to observe the formalities of execution, and where possible, have an attorney supervise the execution.
Include specific statements designed to refute lack of capacity
Specific statements regarding omissions of certain family members may help prevent contests. Stating negatively why a certain family member hasn't been provided for can be problematic because such statements may incite the family member to challenge the will or be grounds for a testamentary libel claim. On the other hand, making positive statements about why an unmarried partner has chosen to benefit his partner over his blood relatives can protect the will from contest.
Advise partners to retain separate attorneys
This can help protect the will from later challenges based on undue influence. Even if the same attorney represents both partners, the attorney should advise the unmarried partners to consider executing their wills separately or even interviewing separately with the attorney. Although unmarried partners may desire to be treated as much like married couples as possible, the possibility of will contests on grounds of undue influence, collusion, etc., cautions towards taking extra measures that will shield their will from challenge.
Use testamentary substitutes
The unmarried partners can support the disposition of assets contained in their wills by naming each other as the beneficiary of life insurance, by owning property jointly and by using other testamentary substitutes that pass to the surviving partner by operation of law.
Include an in terrorem or “no contest” clause
This clause would disinherit an unsuccessful will contestant. Of course, you must leave a potential contestant something to lose before such a provision would have any deterrent effect.
Advise partners regularly to execute new wills
Unmarried partners should consider executing more than one will with substantially similar terms six months to one year apart. This approach will create a further disincentive for others to challenge the will in the first place, in addition to providing another level of protection in case of a lawsuit.
Keep in mind that the separation of unmarried couples or domestic partners doesn't automatically revoke a will disposition to the partner. So if unmarried couples separate, they must change their will if they want to revoke the will disposition to the former partner. In contrast, in most states, where a will appoints a spouse as a fiduciary and/or names him as a beneficiary, the subsequent divorce of the spouses will revoke such appointment or disposition of property, unless the testator expressly provides otherwise.
Unmarried partners should consider entering into agreements that create contract rights that override wills. Here are some examples of those types of agreements:
- Pre- and post-nuptial agreements. These regulate the obligations between spouses who marry.
- Separation agreements. These regulate the obligations between spouses who divorce or separate.
- Domestic partnership agreements. These regulate the obligations between couples who don't marry.
- Contracts to make wills. These require one person to make a disposition in favor of another.
- Shareholder and partnership agreements. These regulate the obligations between business partners.
- Buy/sell agreements. These permit one partner to succeed to the business interests of another partner.
Unmarried couples should also consider employing testamentary substitutes such as trusts, life insurance, jointly held property and property that passes by beneficiary designation or operation of law.
An unmarried partner can set up a trust for the other partner to help avoid his assets from becoming subject to his surviving relatives. Various trust vehicles exist and, as seen below, some may provide unique benefits to unmarried partners.
Life insurance is important for an unmarried partner. Paying estate taxes with the proceeds of life insurance held in a trust may be a useful option to one who isn't willing to undertake aggressive gifting strategies that might otherwise be required to reduce estate tax. Also, if the individual's family doesn't approve of an individual's lifestyle or partner, the family can contest a gift of property in a will. If the partner is named as the beneficiary of a life insurance policy, it's more difficult to bring a contest and may be more difficult to find out that the assets have been transferred.
Jointly held property
Property held jointly with right of survivorship passes automatically upon death to the surviving tenant. There's no presumption of survivorship for unmarried partners, so survivorship must be specifically stated in the governing deed or account registration form.
Property that passes by beneficiary designation or operation of law
Similar to jointly held property, property with beneficiary designations, such as retirement accounts, transfer-on-death accounts, Totten trusts, etc. pass by operation of law upon death to the surviving named beneficiaries and don't await probate of a will or administration of a trust.
Marital Estate and Gift Tax Deductions
A married individual can leave assets to a spouse who is a U.S. citizen and receive the benefit of the unlimited estate tax marital deduction provided by IRC Section 2056(a), effectively deferring estate tax on those assets until the surviving spouse gives them away or dies. Although domestic partners may be treated as spouses for certain purposes, they aren't recognized as such for federal tax purposes. The estate tax marital deduction isn't available to unmarried persons. On each partner's death an estate tax will be assessed on assets in excess of the deceased partner's estate tax exemption.
Transfers of assets between married partners are tax-free. The gift tax doesn't apply. Transfers between unmarried partners, however, can be taxable gifts subject to the annual exclusion limits and the lifetime exclusion of the donor. Gifts of luxury items like jewelry or cars can be subject to gift tax if the value of such items exceeds the annual exclusion amount and the donor has already used his lifetime exemption. Unmarried partners must be aware of the possibility that the payment of living expenses by one of them may be seen as a potentially taxable indirect gift to the other. If such a gift is in excess of the annual exclusion amount, the donor will be required to file a gift tax return.
Because the marital deduction to defer the payment of estate taxes isn't available to unmarried partners, lifetime gift planning is more important for them in reducing estate taxes. If the gift tax exemption stays at $1 million, it will be particularly important to consider gift planning that doesn't result in the payment of a gift tax.
If a married couple separates, IRC Section 2516 says that transfers made pursuant to a divorce agreement are deemed transfers for full and adequate consideration and so aren't subject to the gift tax. This section isn't available to unmarried couples who separate.
The generation-skipping transfer (GST) tax is a flat tax assessed at the highest federal estate tax rate (currently it's unclear what that rate is). It's payable on transfers to individuals two generations or more below the transferor's generation (for example, grandchildren and great-grandchildren), whether outright, in trust or by distributions from trusts. Gifts of $13,000 to a skip person are subject to an annual exclusion similar to the annual gift tax exclusion, although somewhat different rules apply to gifts in trust. Each individual had a lifetime GST exemption of $3.5 million through 2009 that was applicable to outright gifts as well as to other transfers, including transfers in trust or by will and distributions from trusts. Beginning in 2004, the GST exemption for gifts during lifetime or transfers at death began to increase with the estate tax exemption, and the GST tax rate decreased with the highest estate tax rate. Like the estate tax, the GST tax was temporarily repealed in 2010 but may continue through 2011 at its 2009 level of 45 percent, again either prospectively, retroactively or not at all, and may be reinstated in 2011 at 2001 levels (55 percent) in the absence of Congressional action.
The generation assignment of unmarried partners isn't based on family relationships, as with married partners. Rather, it's based on the relative ages of the unmarried partners. Any individual between 12½ and 37½ years younger than the transferor is in the first generation below the transferor. A new generation occurs every 25 years thereafter.
If an individual marries another who is a generation or more younger than he is, his spouse will nevertheless be treated as being in the same generation for GST purposes and transfers made to the spouse will be free of GST tax (and gift and estate tax). Unmarried partners can't transfer assets to much younger partners and avoid the GST tax in this way.
Unmarried partners aren't able to use the second partner's GST exemption by splitting gifts and aren't able to use the deceased partner's GST exemption on the death of the second partner through a reverse QTIP election (IRC Section 2652(c)(3)).
Unmarried partners have an advantage over married partners when it comes to the QPRT. In a QPRT, the grantor places his residence in trust for himself for a period of years (for example, 10 years). At the end of that period, the trust terminates and the residence passes to his beneficiaries. Because the grantor retains the use of the house for, in this example, 10 years, the amount of the gift to his beneficiaries isn't the current fair market value of the residence (assume $1.5 million) but rather the present value of their right to receive the residence in 10 years, which will be somewhat less than half. (The exact discount will depend upon the prevailing interest rates and the grantor's age at the time of the transfer to the QPRT.) If the grantor still has his gift tax exemption available, there may be no federal gift tax. If the residence doubles in value over the 10-year period, when the trust terminates, the trust beneficiaries will receive a $3 million residence with no further estate or gift tax consequences. The longer the term of the QPRT, the smaller the value of the gift, but the lower the likelihood that the grantor will survive the trust term. Because the beneficiaries receive the residence as a gift rather than as a bequest, they don't get a step up in basis. Therefore, if the grantor's basis in the residence is $200,000 and the residence is worth $3 million, at the end of the trust term, the trust beneficiaries would recognize a $2.8 million capital gain if they sold the house. They would avoid, however, the estate tax on $3 million. At the QPRT termination, title to the residence will pass to the trust beneficiaries or to a trust for their benefit. The grantor then pays the beneficiaries fair market rental each month, also free of gift-tax implications. In the past, some grantors would buy back the residence right before the trust term expired to get a stepped-up basis. But Treasury Regulations Section 25.2702-5(b)(1) now bars the grantor from doing this if family members are the beneficiaries of the QPRT. But, these regulations don't apply if unmarried partners and/or other unrelated parties are the beneficiaries of the QPRT. So, the grantor may buy back the residence from the trust at no gain or loss right before the trust term expires so that cash or other assets may pass to the remaindermen in place of the residence and the residence can then be passed to the grantor's beneficiaries at a stepped-up basis.
For a QPRT to work efficiently, the grantor must survive the trust term. If the grantor dies during the trust term, the residence's value is included in his estate when he dies. This result, however, is no worse than had he done nothing.
Unmarried partners can also take advantage of certain type of GRITs that are no longer available to married partners. In a GRIT, the grantor places an asset that he expects to appreciate in a trust to “freeze” it at its gift tax value but retains a right to income for a specified term. That retained income interest in the property minimizes the value of the gift. Although the income that the grantor receives during the term of the trust would be includible in his estate, post-transfer appreciation would not be, if the grantor survives the trust term. The Internal Revenue Service enacted IRC Chapter 14 to address the perceived abuse of this type of transaction among “applicable” family members. It ensures that any gift tax value assigned to a remainder interest comports with the reality of the transaction and the economic value of the retained interest. Under Chapter 14, any interest in the trust retained by the grantor or applicable family member is assigned a value of zero if the interest isn't a qualified interest. Without a qualified interest, there's no reduction of the taxable gift to reflect the value of the retained interest. GRITs are still a powerful tool available to unmarried partners because Chapter 14 deals with intra-family transactions and doesn't apply to unmarried couples. The downside, as with the QPRT, is that assets receive no step up in basis at the grantor's death if the assets contributed to the GRIT have appreciated in value. Also, if the grantor doesn't survive the trust term, the trust assets are includible in the grantor's estate at their fair market value as of the date of the grantor's death. As with the QPRT, such a result is no worse than if the grantor had done nothing.
Family Limited Partnerships
Family limited partnerships (FLPs) are mechanisms which, if properly implemented and administered, can create entity-level discounts for assets which themselves aren't inherently discountable or at least wouldn't be so heavily discounted. Recent case law has restricted the size of discounts when an understanding can be implied between partners of the FLP who are husband and wife. The 2010 Budget Proposal, if enacted, would implement further restrictions on the discounting available in valuing assets through the application of IRC Section 2704. Arguably, no such implications would exist between unmarried partners.
Private foundations and charitable split interest trusts, which must include certain private foundation rules, must prohibit transactions with a disqualified person. The spouse of a disqualified person is also a disqualified person; the unmarried partner of a disqualified person, however, is not. Thus, unmarried partners may engage in certain transactions with private foundations that married partners may not.
“Defective” Grantor Trusts
Most irrevocable lifetime trusts (ILTs) are structured to avoid both future income tax to the grantor and inclusion of the assets in the grantor's estate for federal estate tax purposes. However, under the grantor trust rules of IRC Sections 671 through 678, the grantor is treated as the owner of all items of income, deduction and credit of a trust if the grantor, the grantor's spouse or, in some cases, a “nonadverse” or “related or subordinate party” subservient to the wishes of the grantor holds certain powers over or interest in the trust. Unmarried partners don't fall within the spousal attribution rules or the definition of a “related” or “subordinate” party (unless, perhaps, the partners enter into an employment relationship). Accordingly, they'll be much less likely to obtain inadvertent grantor trust status.
If the grantor's beneficiaries are in relatively high income tax brackets and the grantor wishes to transfer assets to an ILT for their benefit, the grantor may wish to consider establishing an intentionally “defective” grantor trust for the benefit of his beneficiaries. Such a trust will permit the grantor to shift wealth but keep the burden of its income tax even though all of the trust's income will be paid to or held for the beneficiaries. Under current law, the grantor will not pay gift tax for this shift in tax burden. Note that the “defect” is an income tax effect only, and the trust will not be subject to estate tax in the grantor's estate.
Retirement plans accumulate geometrically during one's life because of income tax-free compounding, but the assets are subject to two levels of tax simultaneously upon one's death. As a result, one's beneficiaries can receive, if both taxes are applicable, less than 20 cents on the dollar after taxes.
Various estate-planning strategies apply to retirement assets, although unmarried partners need to be careful about implementing them. First, if the donor otherwise planned to make charitable gifts, the gifts should be made first out of retirement assets. This will avoid both income tax and the estate tax.
Both married and unmarried partners can also designate that retirement benefits be paid over the life expectancies of the donor, the donor's children or other beneficiaries. While the retirement assets will be subject to a full estate tax, the income tax recognition can be spread out over the balance of the lives of the donor's beneficiaries, with continued tax-free growth generally unchanged by accumulating for 10 to 15 years after the donor's death.
Although a surviving spouse may roll over a deceased spouse's qualified plan or individual retirement account into his own plan, such rollovers aren't available to unmarried partners. That means that the surviving partner must start receiving distributions and paying tax on those distributions soon after the death of the participant partner. This can be particularly problematic if the plan requires a lump-sum distribution or the death of the participant partner.
Another strategy with retirement assets is to withdraw so much of the assets as will avoid any applicable surcharge, recognize the current income tax and use the balance to purchase life insurance that will replace the amount of the plan's assets that will be consumed by taxes at the donor's death.
Unmarried partners have no minimum entitlement to each other's retirement plans under ERISA as married partners do. This is disadvantageous to the surviving partner but potentially advantageous to the plan participant.
Joshua S. Rubenstein is a co-managing partner at Katten Muchin Rosenman LLP in New York City