Lack of Parity Between Separate Property and Community Property
States
After
the death of the first spouse, residents of community property
states have a distinct income tax advantage over residents
of separate property states. Assume that a couple's property
is owned approximately equally between them. In a separate
property state, this ownership could consist of entirely separate
ownership of various assets, or joint ownership in the form
of tenancy in common, joint tenancy with right of survivorship,
or tenancy by the entirety. At the death of the first spouse
to die, the basis of the decedent's assets (but not the decedent's
spouse's assets) is adjusted to the fair market value of such
assets at death (IRC section 1014(b)(1)). In a general growing
economy, this adjustment is usually upward--thus the term
"stepped-up basis" -- at death.
Contrast
the above basis result to the adjustment provided in community
property states. The decedent's one-half share of the community
property is adjusted pursuant to IRC section 1014(b)(1), as
described above, and then section 1014(b)(6) provides a similar
adjustment for "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 one-half of the whole of the community
interest in such property was includable in determining the
value of the decedent's gross estate." Therefore, at the death
of the first spouse, the basis of all community property,
regardless of whether held by the decedent or the surviving
spouse, is stepped up.
This lack
of parity can produce significant income tax differences if
the surviving spouse sells the assets during the period between
the first spouse's death and the surviving spouse's death.
In separate property states, one-half of the assets sold will
produce capital gain that would have been completely avoided
if the couple had instead lived in a community property state.
Furthermore, the sale of assets during this period of the
surviving spouse's lifetime is likely. The family business
may need to be sold due to the decedent's lack of participation,
or pursuant to an existing buy-sell agreement. Real property
may be considered burdensome to manage. Market conditions
may dictate the sale of assets before an expected downturn.
A
Remedy For This Unfairness:
An
"Elect-In" Community Property System
The
goal of the Alaska Legislature is to allow taxpayers to obtain
the above-described community property full step-up in basis,
to the extent they so desire. A married couple may elect to
treat all their property as community property. Alternatively,
they can elect that only certain assets be treated as community
property, leaving the balance of their assets as "individual
property" (separate property). This election is accomplished
by execution of a community property agreement or community
property trust.
The Alaska Legislature Provided That Non-Residents of Alaska
May Use Alaska's Elect-In Community Property System
Through An Alaska Trust
The
Sponsor Statement for HB 199, which has become the Alaska
Community Property Act, provides in part:
The
bill not only allows Alaska couples to enter into an agreement
to have some or all of their assets treated as community
property, but it also permits married persons who do not
reside in Alaska to have their assets treated as community
property under Alaska law by executing an Alaskan Community
Property Trust. Such a trust must have an Alaskan trustee.
It is anticipated that many married persons who reside outside
Alaska will wish to label a portion, or all, of their assets
as community property because they believe that it is a
more appropriate method of owning their assets and they
wish to obtain the income tax advantages which are available
to community property upon the death of the first spouse.
Some believe
that community property represents a more fair and rational
system of sharing the ownership of property during marriage
because it essentially treats the marriage like a partnership:
as assets are earned during the marriage, they are treated
as owned 50/50 by the two partners (the husband and wife).
Others believe community property is not a fair or rational
system. Regardless of one's beliefs, it seems appropriate
to allow Alaskans, and residents of other states, the freedom
to choose the arrangement that is most appropriate for them.
The
Alaska Community Property Act
New Chapter
75 of Title 34 of the Alaska Statutes enacts the Alaska Community
Property Act, effective May 23, 1998. This statute is based
on the Uniform Marital Property Act (the Uniform Act), which
has been adopted only by Wisconsin. However, unlike the Uniform
Act, the Alaska act provides for an "elective" community property
system. As a general rule, Alaska's established separate property
system would apply to marital property. However, spouses may
elect to have some or all of their property treated as community
property. If both spouses are domiciled in Alaska, the election
occurs through the execution of a community property agreement
or community property trust. If one or both spouses are not
domiciled in Alaska, then this election can be made by the
spouses by transferring property to a community property trust.
The community
property agreement and community property trust have many
similar characteristics. They are written instruments, signed
by both spouses, and enforceable without consideration. A
bold-lettered notice must be placed at the beginning of the
document advising the spouses that the agreement may have
extensive legal consequences. Within an agreement or trust,
the spouses may agree on (1) the rights and obligations in
the property, notwithstanding when and where the property
is acquired and located; (2) the management and control of
the property; (3) the disposition of the property on dissolution,
death, or another event; (4) the choice of law governing the
interpretation of the trust instrument; and (5) any other
matter that affects the property and does not violate public
policy. In addition, in a community property agreement, the
spouses may agree (1) on making a will, trust, or other arrangement;
and (2) that upon the death of either of them, the property
passes without probate to a designated person, trust, or other
entity by nontestamentary disposition.
A community
property agreement may be entered into before marriage, but
only becomes effective upon marriage. Both a community property
agreement and a community property trust may be amended or
revoked by a later agreement or trust, without consideration.
The agreement or trust cannot adversely affect child support.
Extensive provisions are included to protect the rights of
creditors of a spouse, and bona fide purchasers dealing with
the spouses. An agreement or trust may not be enforced against
a spouse who proves that the instrument was unconscionable
when made or was not executed voluntarily, or that the spouse
against whom enforcement is sought was not given a fair and
reasonable disclosure of the property and financial obligations
of the other spouse.
A community
property trust is designed to be used by couples when one
or both spouses are not domiciled in the state of Alaska.
In order to provide a nexus with Alaska, a number of additional
requirements are added. At least one trustee must be an individual
domiciled in Alaska, or an Alaska trust company or bank. Other
co-trustees may be nonresidents, and may include the spouses.
The Alaska trustee's powers must include maintaining records
for the trust on an exclusive or a nonexclusive basis and
preparing or arranging for the preparation of, on an exclusive
or a nonexclusive basis, any income tax returns that must
be filed by the trust. The trustee must maintain records that
identify which property held by the trust is community property.
Appreciation and income of property transferred to a community
property trust is community property if the terms of the trust
so provide. With a few exceptions, a community property agreement
or community property trust can vary any of the provisions
of the Alaska Community Property Act.
A spouse has a present undivided one-half interest in Alaska
community property. If a community property agreement provides
that all property acquired by either or both spouses during
marriage is community property, then the property of the spouses
acquired during marriage and after the determination date
(the later of the date of the marriage or the agreement or
trust) is presumed to be community property. Further, when
all property is agreed to be community property, the income
earned or accrued by a spouse or attributable to property
of a spouse during marriage and after the determination date
is community property. Also, application by one spouse of
substantial labor, managerial activity, or similar efforts
on individual property of the other spouse creates community
property of the other spouse attributable to such efforts
if reasonable compensation is not paid.
Regardless
of whether the community property agreement provides that
all property acquired by either spouses during marriage is
community property, property that is owned by a spouse at
the time of marriage but before the determination date is
not community property except as otherwise provided in the
agreement. Similarly, property acquired by a spouse during
marriage and after the determination date remains individual
property if acquired by gift or inheritance; in exchange for
other individual property of the spouse; from appreciation
or income of the spouse's individual property; by a decree,
community property agreement, or reclassification designating
it as individual property; as a recovery for damages to property
resulting from breach of the good faith requirement in matters
regarding community property; or for personal injury.
On divorce,
community property will be equitably divided between the spouses.
If the words "survivorship community property" are used, then
on the death of a spouse the ownership rights of that spouse
vest solely in the surviving spouse by nontestamentary disposition.
Mixing community property with property having another classification
reclassifies the other property as community property unless
the property that is not community property can be traced.
The general
management and control of Alaska community property depends
on title and agreement. A spouse acting alone may manage and
control: community property held in that spouse's name alone;
a policy of insurance owned by that spouse; deferred compensation
benefits that accrue as a result of that spouse's employment;
and community property held in the name of both spouses in
the alternative. Community property held in the names of both
spouses other than in the alternative is managed and controlled
by both spouses acting together. Management and control of
community property held in a trust us determined by the terms
of the trust. An individual's right to manage and control
does not include the right to make gifts to third parties,
except for relatively nominal amounts. However, if both spouses
report such a gift on their federal gift tax returns, or if
the nondonor spouse consents to "split gifts" on the donor
spouse's gift tax return, then this is treated as the spouses
acting together in making the gift.
Issues
To Consider
Alaska's
new elect-in community property system is the only such elect-in
system now in effect in the United States. However, Oklahoma
briefly experimented with a similar system during the period
from 1939 through 1945. This was prior to the allowance of
joint income tax returns in 1948. Under this prior elect-in
system, a couple elected to have Oklahoma's new community
property law apply to them. They each reported one-half of
their income on their separate returns. The Internal Revenue
Service challenged this splitting of income, arguing that
one spouse was taxable on all of the income derived from his
earnings. The U.S. Supreme Court, in Commissioner v. Harman,
323 U.S. 44 (1994), upheld the commissioner's position. The
Supreme Court decision seems to focus on the distinction between
a "consensual" and a "legal" (mandatory) community property
system. The Court also stated: "The important fact is that
the community property system of Oklahoma is not a system,
dictated by State, as an incident of matrimony." (323 U.S.
at 48.)
The Harman case, as discussed above, did not involve an adjustment of
basis at death but rather the reporting of the income earned
by both spouses. In 1948, Congress allowed the filing of joint
income tax returns, which in effect provided the income tax
reduction remedy that Oklahoma's elect-in system was attempting
to achieve. Also in 1948, Congress approved IRC section 1014(b)(6),
allowing full basis adjustment at the death of the first spouse
to die. The proponents of the new Alaska act state that the
legislative history underlying Congress's 1948 legislation
does not reflect a distinction between consensual and mandatory
community property systems. Therefore, they conclude that
Congress intended the full-basis step-up to apply whether
the community property system was elective or mandatory.
Perhaps
the most significant weakness in the Harmon decision
was pinpointed by Justice William O. Douglas, in his dissent.
He stated that "in some of the so-called 'legal' [mandatory]
community property states separate property of one spouse
may be converted by contract or deed into community property
or vice versa." (323 U.S. at 54.) Therefore, residents of
these states (e.g., Washington and California) may elect in
or out of the community property system. However, the IRS
has not attempted to deny separate reporting of taxable income,
nor the full basis adjustment of IRC section 1014(b)(6), to
residents of such states. Interestingly, McCollum v. United
States, 58-2 U.S.T.C. section 9957 (USDC Okla. 1958),
allowed a full step-up in basis under the Oklahoma elect-in
statute. However, the district court's opinion clouds its
holding by apparently relying on Oklahoma's change in law
after 1945 to a mandatory community property system.
The use
of an Alaska community property trust by nonresidents adds
an additional issue. Proponents of this legislation emphasize
the Restatement's reliance on the law of the state designated
in the instrument. (Restatement, Second, Conflict of Law sections
268 and 270.) The extent of the taxpayers' and their trust's
Alaska contacts is also stressed.
Alaska
residents and nonresidents alike will need to carefully evaluate
whether "electing" to Alaska's community property system is
advantageous. An analysis concerning the potential income
tax benefits in regard to the couple's specific situation
may well be the first step. However, of equal importance will
be the nontax consequences of partially or fully adopting
a community property system. Some couples may be attracted
to the equality and other characteristics of the Alaska community
property. Other couples may conclude that the nontax consequences
of a community property system are not to their liking.
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