Today, with portability and a historically high applicable exclusion amount, inclusion of the value of trust assets in a beneficiary’s gross estate will often be desirable. Internal Revenue Code Section 1014(a) provides that the basis of property in the hands of a person acquiring the property from a decedent or to whom the property passed from a decedent, shall, if not sold, exchanged or otherwise disposed of before the decedent’s death by such person, be the fair market value (FMV) of the property at the decedent’s date of death.1 Accordingly, assuming the FMV of each asset exceeds its basis, inclusion will facilitate a step-up in the basis of the assets to their FMV as of the decedent’s death. For low basis, highly appreciated assets, a step-up in basis will minimize what would have been a sizable gain realized by the beneficiary on the sale or exchange of such assets.2 At the same time, so long as the value of the beneficiary’s gross estate is equal to or less than his applicable exclusion amount,3 no federal estate tax will result. What a deal!4
Avoiding IRC Section 1014(e)
Section 1014(e) sets out an exception to the general rule of Section 1014(a) with respect to transfers of appreciated property acquired by the decedent within one year of his death. Section 1014(e)(1) states that, if the decedent acquired appreciated property by gift during the 1-year period ending on the date of the decedent’s death and such property is acquired from the decedent by (or passes from a decedent to) the donor of such property (or the spouse of such donor), the basis of such property in the hands of such donor (or spouse) shall be the adjusted basis of such property in the hands of the decedent immediately before the death of the decedent. A close reading of this statutory language suggests that the provisions of Section 1014(e) could be avoided in cases of certain transfers of assets involving spouses and trusts created by them that take place within one year of the death of either spouse.
Assume an individual transfers her assets to her spouse, who likely will die within one year of such transfer. Assume, further, that the donee spouse’s estate plan, instead of directing a bequest of his estate to the donor spouse outright, directs that bequest to a trust providing that his spouse and descendants living from time to time may receive distributions of income and, perhaps, principal in accordance with a very broad or no standard. All assets in the discretionary trust should be eligible to receive a step-up in basis pursuant to Section 1014(a), regardless of how soon the donee spouse dies after the gift from the donor spouse. In this scenario, the donor spouse doesn’t acquire her assets back from the donee spouse. The discretionary trust acquires the assets. Thus, Section 1014(e) shouldn’t apply.5 It’s possible, but by no means assured, that this strategy may work equally well when a qualified terminable interest property trust is used instead of a discretionary trust.6
Allocating Wealth Between Spouses
Portability notwithstanding, when spouses have unequal net worth, they may benefit from dividing their estates and allocating their wealth more evenly between them. Unequal allocation of wealth between spouses can result in forfeiture of valuable basis step-up and payment of unnecessary capital gains taxes.
Assume one spouse (the wealthy spouse) owns substantially all the couple’s assets and that the aggregate value of such assets exceeds the basic exclusion amount.7 Such assets are highly appreciated. The other spouse (the poor spouse) is the first to die. If assets had been transferred to the poor spouse more than a year before the poor spouse died,8 such assets would have been included in the poor spouse’s gross estate, would have received a full step-up in basis to FMV as of the poor spouse’s date of death and could have passed to the wealthy spouse free of estate tax. While it’s true that the executor of the poor spouse could elect portability9 and transmit the deceased spousal unused exclusion amount10 to the wealthy spouse, in this scenario, the wealthy spouse won’t own any assets during his remaining life that have a stepped-up basis. Accordingly, if any of the couple’s assets need to be sold during the surviving spouse’s remaining life to generate cash to pay for the surviving spouse’s health, maintenance, support, care or comfort, all that’s available to be sold are highly appreciated, low basis assets. Had the spouses reallocated their assets between them while both were alive, then, at the death of the first spouse to die, there could have been a meaningful amount of assets with a stepped-up basis that could have been sold at minimum capital gains tax cost to generate cash to pay for the surviving spouse’s needs.
Community Property Trust
Section 1014(b)(6) provides, in general, that a surviving spouse’s one-half share of community property is considered to constitute property “acquired from or to have passed from the decedent.” Thus, the basis of the surviving spouse’s one-half share of community property is its FMV at the date of the predeceased spouse’s death.11 Since, by reason of Section 1014(b)(1), the basis of the predeceased spouse’s one-half share of community property would, quite naturally, be established under the general rule of Section 1014(a), the overall result of Section 1014 is that both halves of community property receive a basis equal to FMV at the date of the predeceased spouse’s death.
Married couples residing in community property states can very easily avail themselves of this remarkable benefit. Obtaining this benefit is more of a challenge for spouses living in common law property states.12 It may be possible, however, if they’re willing to transfer assets to an Alaska or Tennessee community property trust.13 A community property trust is, essentially, a trust whose dispositive and administrative provisions mimic the beneficial interests and rights of spouses in community property not held in trust. Specifically, each spouse ultimately has control, during life and at death, unless or until intentionally relinquished, over half of the assets in trust. In addition, the governing instrument contains a declaration that the assets transferred to the trust are community property (Alaska) or that the trust is a community property trust (Tennessee).
Unfortunately, there’s no statute, regulation, ruling or case specifically and unambiguously saying that assets conveyed to a community property trust by a spouse or spouses domiciled in a common law property state are “community property” within the meaning of Section 1014(b)(6).
Three fundamental questions must be addressed in discerning whether assets placed in a community property trust by nonresidents of Alaska or Tennessee are “community property” within the meaning of Section 1014(b)(6):
1. Will property be recognized as “community property” for purposes of Section 1014(b)(6) if community property status was implemented by a voluntary act as opposed to automatically flowing from the owners’ status of living in a community property state and being married?
2. Is it possible for property to be recognized as “community property” for purposes of Section 1014(b)(6) if legal title to the property is held in trust? Section 1014(b)(6) became law in 1948, long before the proliferation of inter vivos trusts, and so it’s reasonable to believe that Congress, in enacting Section 1014(b)(6), didn’t contemplate that community property could be owned, in a legal sense, by any person or persons other than spouses outright.
3. In answering the first two questions, is it relevant that the spouses are nonresidents of Alaska or Tennessee and are in fact residents of a common law property state?
The answer to the first question appears to be “probably.” In McCollum,14 spouses made a choice (a voluntary act), as then permitted by applicable state law, to own certain real estate as community property. Following the death of the first to die, the survivor asserted that Section 1014(b)(6) applied in determining the basis of the survivor’s half of the property. The district court agreed and distinguished Harmon,15 a U.S. Supreme Court case that was somewhat analogous but didn’t concern Section 1014(b)(6).16 Furthermore, in Revenue Ruling 77-359, the Internal Revenue Service ruled that a legally enforceable agreement between a husband and wife (again, a voluntary act) that certain property that had been separate property should henceforth be considered community property would be recognized for income tax purposes.
The second question seems to be answered definitively by Rev. Rul. 66-283. In that ruling, a husband and wife had transferred their community property to a revocable trust. Under applicable state law, community property could be held in trust without losing its character as such. The IRS ruled that, at the death of the predeceased spouse, the basis of the surviving spouse’s one-half share of the community property held in trust would be established under Sec-
tion 1014(a) because of Section 1014(b)(6).
The answer to the third question seems the most elusive. If nonresidents of Alaska or Tennessee, residing in a common law property state, were to create in Alaska or Tennessee what was ostensibly a community property trust but whose validity was later determined not to be governed by the law of Alaska or Tennessee, Section 1014(b)(6) would be rendered inapplicable because there would be no community property. To minimize the possibility of this result, it would be important that: (1) the trust have a “substantial relation” to Alaska or Tennessee (a requirement seemingly satisfied because, under the applicable community property trust statute, the trust would be required to have an Alaska or Tennessee resident trustee), (2) application of Alaska or Tennessee law not violate a strong public policy of the state with which the trust has its most significant relationship (a requirement less easily satisfied depending on the state with which the trust is considered to have its most significant relationship, the public policies of that state and the strength of those public policies), and
(3) the trust instrument operate as a valid post-nuptial agreement.17
If clients and their advisors approach the community property trust technique with sound judgment and careful attention to detail, it may in some circumstances be an excellent basis boosting strategy.18
1. In certain circumstances enumerated in Internal Revenue Code Section 1014(a), fair market value at date of death isn’t the standard. Those circumstances are ignored in this article.
2. In this connection, see new IRC Section 1014(f), which became law on July 31, 2015 and requires, among other things, that the basis of property acquired from a decedent can’t exceed the value of such property as finally determined for estate tax purposes if inclusion of such property in the decedent’s estate increased estate tax liability.
3. See IRC Section 2010(c)(2).
4. Of course, state estate and inheritance tax consequences must be considered.
5. See Mark R. Siegel, “I.R.C. Section 1014(e) and Gifted Property Reconveyed in Trust,” 27 Akron Tax J. 33, 50-52.
6. See Estate of Kite v. Commissioner, T.C. Memo. 2013-43, 8 n.9.
7. See IRC Section 2010(c)(3).
8. See Section 1014(e).
9. See Section 2010(c).
10. Section 2010(c)(4).
11. Section 1014(a).
12. For ease of reference, in this article, Alaska and Tennessee aren’t included within the term “common law property state” even though common law property is the default property ownership regime for spouses in both states.
13. See AS 34.77.100; Tenn. Code Ann. 35-17-101, et seq.
14. McCollum v. United States, 58-2 U.S.T.C. par. 9957 (D. Okl. 1958).
15. Comm’r v. Harmon, 323 U.S. 44 (1944).
16. Section 1014(b)(6) wasn’t enacted until four years after Harmon was decided.
17. See Restatement (Second) Conflict of Laws Section 270 (1971). See also M. Read Moore and Nicole M. Pearl, “Coming Soon to Your State: Community Property,” 48 U. Miami Heckerling Institute on Estate Planning (2013).
18. There are further caveats and complications involved in using community property trusts that are beyond the scope of this article. Additional issues include unanticipated gift tax consequences, whether one or both of the spouses desire all the consequences of a community property arrangement and possible loss or reduction of protection against creditors’ claims.