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An Introduction to Community Property Trusts
An Introduction to Community Property Trusts
On June 29, 2021, Governor Ron DeSantis approved Senate Bill No. 1070, Chapter 2021-183. Contained within this bill was the Community Property Trust Act, Florida Statutes Sections 736.1501–151. Florida is now the latest state to allow community property trusts. Other states allowing community property trusts include Alaska, Kentucky, South Dakota, and Tennessee.
What is community property, and why is community property important? Instead of being purely community property law states, some states address community property through the allowance of trusts or the enactment of the Uniform Disposition of Community Property Rights at Death Act (UDCPRDA). What is a community property trust, and why is a community property trust important? What is UDCPRDA? Why would Florida (or any other nontraditional community property state) enact community property trust legislation? This article addresses basic questions related to community property and the use of community property trusts.
What Is Community Property, and Why Is It Important?
Wisconsin, Washington, Texas, New Mexico, Nevada, Louisiana, Idaho, California, and Arizona are traditional community property states. In these “traditional” community property states, assets acquired by a married couple during a marriage, other than through gift or inheritance, belong to both spouses as equal undivided interests.
[Community property] rights are vested in each spouse at the time the asset is acquired. The vesting occurs even if title is held in the name of just one spouse. In other words, taking title in the name of one spouse does not override the community property nature of an asset.
Compare that immediate vesting with the situation in a traditional common law marital property state. . . . In common law marital property states, the rights to property acquired in the name of one spouse during a marriage may ultimately be divided between the spouses, but such property right for the spouse who is not the owner of record does not become vested until the right is determined by a court in a dissolution action; or at death, through inheritance or by application of an elective share action. The spouse who is not the owner of record does not have a vested property right at the time of the acquisition of the asset.
See Willliam D. Brewer & Nicholas M. Frost, Community Property in Oregon: Advising Couples Transitioning from a Community Property State to Oregon at 3, Presented to the Eugene-Springfield Tax Association (Apr. 30, 2013).
Under section 1014(b)(6) of the Internal Revenue Code of 1986, as amended (Code), property shall be considered to have been acquired from or to have passed from the decedent, which represents a 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, if at least one-half of the whole of the community interest in such property was includible in determining the value of the decedent’s gross estate. See I.R.C. § 1014(b). This means that “[u]nder federal income tax law, all community property (including both the decedent’s one-half interest in the community property and the surviving spouse’s one-half interest in the community property) receives a new basis at the death of the first spouse to die equal to its fair market value.” Philip J. Hayes & Nicole M. Pearl, Community Property Issues in Estate Planning, Telephone Seminar/Audio Webcast, TSVB30 ALI-ABA 1 (Feb. 27, 2014). For tax purposes, section 1014(b)(6) of the Code is important because the surviving spouse of a marriage will receive a fair market value basis in all community property upon the death of the first spouse. “In contrast, the surviving spouse of a marriage in a common law state will receive a FMV basis only in the property owned by the first spouse to die; the tax basis of property owned by the surviving spouse is unaffected by the death of the other spouse.” See Paul L. Caron & Jay A. Soled, New Prominence of Tax Basis in Estate Planning, 150 Tax Notes 1569 (Mar. 28, 2016).
and the real estate is sold at year’s end for its $1 million fair market value. In a common law state, section 1014(a) (1) of the Code results in a $550,000 income tax basis to Lori. Roque’s basis in his half of the land increases from the original $50,000 to $500,000 (the date-of-death value). Lori’s basis in her half of the land remains $50,000. The subsequent sale of the land produces a $450,000 gain ($1 million amount realized less $550,000 basis) and a tax liability of $90,000 ($450,000 × 20 percent (20 percent long-term capital gains tax rate)). In a community property state, section 1014(b)(6) of the Code results in a $1 million income tax basis to Lori. In light of that adjustment, the subsequent sale of the land produces zero gain ($1 million amount realized less $1 million basis) and zero tax liability.
What Is a Community Property Trust, and Why Is It Important?
Community Property Trusts, Generally
Each of Alaska, Florida, Kentucky, South Dakota, and Tennessee has adopted its own version of community property trust law allowing married couples to choose between community property and the traditional common law approach to marital property. But unlike Florida, Kentucky, South Dakota, and Tennessee, Alaska allows a nonresident married couple to choose community property both by setting up a trust with an Alaska resident trustee to make the trust assets community property and by agreement (a community property agreement). Alaska Stat. § 34.77.10 et seq. The Alaska legislature based its statute on the Uniform Marital Property Act. Jonathan G. Blattmachr, Howard M. Zaritsky & Mark L. Ascher, Tax Planning with Consensual Community Property: Alaska’s New Community Property Law, 33 Real Prop. Prob. & Tr. J. 615, 618 (Winter 1999). Under the Alaska, Florida, Kentucky, South Dakota, and Tennessee community property trust laws, an individual needs only to transfer property to a community property trust satisfying the state statute in order to opt into a community property regime with respect to the transferred property.
Especially for residents of non–community property states, the reasoning for choosing among Alaska, Florida, Kentucky, South Dakota, and Tennessee as the situs of a community property trust boils down to specific provisions aimed at achieving maximum creditor protection for self-settled community property trusts; arguably, South Dakota has legislation on point and has a greater asset protection trust ranking according to some attorneys than Alaska and Tennessee (Florida and Kentucky do not have self-settled trust legislation). See discussion in William D. Lipkind & Terry Prendergast, New South Dakota Special Spousal Trust, Steve Leimberg’s Estate Planning Newsl., No. 2433, July 7, 2016, www.leimbergservices.com; Steve Oshins, 11th Annual Domestic Asset Protection Trust State Rankings Chart (Apr. 2020), https://bit. ly/3n3S4ji. But it should be noted that Alaska is an opt-in community property state; a married couple domiciled in Alaska may establish community property by entering into a community property agreement, as opposed to requiring a creation of a trust. Alaska Stat. § 34.77.060. Spouses may pick and choose among their holdings, holding some assets as community property and others as separate property. Id. It should also be noted that community property trusts are typically not marketed for creditor protection purposes; instead, the benefits are mainly income tax based (other benefits are discussed below).
Community Property Trusts and Tax Treatment by IRS
There are a few uncertainties to consider before preparing a community property trust. A few follow:
Harmon and Revenue Ruling 77-359. During the 1940s, Hawaii, Michigan, Nebraska, Oklahoma, Oregon, and Pennsylvania enacted laws allowing residents to opt in to community property treatment. In Commissioner v. Harmon, 323 U.S. 44 (1944), the Supreme Court ruled that an Oklahoma statute allowing spouses to elect community property under that state’s law would not be recognized for federal income tax purposes. Accordingly, some commentators argue that the IRS may rely on Harmon to disallow the full stepup in basis for community property acquired through an opt-in community property state.
But other commentators believe that Harmon does not affect the community property classification under an optin system. In Revenue Ruling 77-359, 1977-1 C.B. 357, the IRS addressed the tax treatment of community property agreements entered into by a husband and wife residing in the State of Washington (a community property state). It concluded that the conversion of separate property to community property by residents of a community property state would be effective for federal gift tax purposes but ineffective for the transmutation of income from such property. The Ruling, citing Harmon, noted, “[t]o the extent that the agreement affects the income from separate property and not the separate property itself, the Service will not permit the spouses to split that income for Federal income tax purposes where they file separate income tax returns.” Based on this 1977 Revenue Ruling, the IRS may treat the underlying property as community property and not distinguish between elective and default community property regimes.
Due Process. Section 1 of the Fourteenth Amendment of the US Constitution provides, in part, “nor shall any State deprive any person of life, liberty, or property, without due process of law.” A move across state lines arguably cannot deprive a spouse of the vested property rights the spouse has under the laws of community property because there would be no due process to cause the change. Under basic conflict of laws principles, a right belonging to either or both spouses in property is not affected by a change in domicile by the couple to a different state. See Restatement (Second) Conflict of Laws § 259.
Basis Rules. IRS Publication 555 addresses community property and how individuals can figure out their income if they are married, are living in a community property state or country, and file separate returns. Revised in 2020, it does not consider “the federal tax treatment of income or property subject to the ‘community property’ election under Alaska, Tennessee, and South Dakota state laws.” IRS Publication 555: Community Property at 2 (rev. Mar. 2020). It should be noted that the next time this publication is amended, it will probably state the same thing for Florida and Kentucky. IRS Publication
555 would affect only Alaska’s opt-in community property regime and would not address the efficacy of Alaska community property trusts. The IRS may view these types of community property systems as providing too much flexibility to the taxpayers to opt in and out of community property status and thus that the Alaska-type system is more akin to tax avoidance rather than a state property law system. But no reported cases or IRS rulings have addressed the federal income tax capital gains basis step-up for property held in a community property trust established in Alaska, Kentucky, Tennessee, South Dakota, or Florida.
Opt In vs. Opt Out. Why is it so important that Alaska has an opt-in statute coupled with community property trust legislation? Some attorneys have noted, “[n]o reported cases or IRS rulings have addressed the federal income tax capital gains step-up of basis in property held in an Alaska community property trust or a Special Spousal Trust similar to that permitted in South Dakota.” Terry Prendergast, South Dakota Special Spousal Property Trusts: South Dakota “Steps-Up” to the Plate and Hits a Home Run for Surviving Spouses, 61 S.D. L. Rev. 431, 433 (2016). An attorney in at least one of the non-opt-in states takes the position that because its legislation makes specific reference to community property for purposes of section 1014(b)(6) of the Code, the surviving spouse’s receipt of a 100 percent stepup in basis on the property held in the community property trust by the decedent and the surviving spouse should by respected by the IRS. Id. But just because state legislation highlights a section of the Code does not mean that the IRS will respect such a conclusion.
Further, the author of this article had been a member of a subcommittee within the Florida Bar’s Real Property Probate & Trust Law Section that studied the community property trust legislation issues before the statutory enactment of such trust legislation in Florida. An opt-in statute coupled with community property trust legislation was important to some subcommittee members initially; however, solely community property trust legislation passed. The author observed that without an opt-in approach (or Florida enacting community property legislation like Wisconsin did in 1984), some initial subcommittee members shied away from fully committing to approving community property trust legislation. Their general reasoning: Do you really have community property under Florida state law if the only way to get it is with a trust arrangement? See also Jeremy T. Ware, Section 1014(b)(6) and the Boundaries of Community Property, 5 Nev. L.J. 704, 730–32 (Spring 2005).
Accordingly, attorneys in Florida, Kentucky, South Dakota, and Tennessee (meaning, non–community property states) who recommend community property trusts to their clients need to properly address the income tax issues of taking non–community property and using a community property trust to create community property.
What Is UDCPRDA?
Alaska, Arkansas, Colorado, Connecticut, Florida, Hawaii, Kentucky, Michigan, Minnesota, Montana, New York, North Carolina, Oregon, Utah, Virginia, and Wyoming have all adopted the UDCPRDA. See Disposition of Community Property Rights at Death Act (Unif. L. Comm’n 1971), https://bit.ly/3DPfTSb. Not all states that have introduced this Uniform Act have enacted it. For example, North Dakota failed to enact it in 2017. See N.D. Legis. Branch, Bill Actions for HB 1213, https://bit.ly/3yQHLBK. In non–community property states, the UDCPRDA preserves “the rights of each spouse in property that was community property before the spouses moved to the non–community property state, unless they have severed or altered their ‘community property’ rights.” Unif. L. Comm’n, Summary, Uniform Disposition of Community Property Rights at Death Act, https://bit.ly/3jHqeHK. Its drafters were specific in limiting its scope:
If enacted by a common law state, it will only define the dispositive rights, at death, of a married person as to his interests at death in property “subject to the Act” and is limited to real property, located in the enacting state, and personal property of a person domiciled in the enacting state. . . . By way of illustration, in at least one community property jurisdiction, the wife has no right to dispose of any part of the community property if she predeceases her husband. If the law of that jurisdiction is construed so as to treat this as a rule of property, then the move to the common law state should not alter the “property interest” of the spouses by conferring a right on the wife which she did not previously possess. On the other hand, if the provision is treated as simply establishing a pattern of dispositive rights on death of a wife who predeceases her husband, rather than a property right, the common law state of new domicile could prescribe an alternative pattern of dispositive rights. The Act does not resolve this question; rather it simply makes clear that it does not affect existing “property rights,” leaving to the courts the interpretation of the effect of the community property state’s law.
See Nat’l Conf. of Comm’rs on Unif. State Laws, Uniform Disposition of Community Property Rights at Death Act at 3, 4 (Feb. 7, 1972), https://bit.ly/3yK81gX.
Thus, the UDCPRDA preserves rights coming from the former community property state at death but does not create community property rights in the new state. Currently, the Uniform Law Commission (ULC) is revising and updating the UDCPRDA with the Uniform Community Property Disposition at Death Act (UCPDDA). Unlike UDCPRDA, UCPDDA
(1) broadens the UDCPRDA to recognize the non-probate revolution that has occurred over the past 50 years; the 1971 UDCPRDA applied only to probate assets; (2) broadens the UDCPRDA to expressly preserve some rights that spouses would have had in the community property jurisdiction for certain bad faith acts or acts of mismanagement of community property by a spouse, whereas the UDCPRDA “only define[d] the dispositive rights, at death, of a married person as to his interests at death in property” subject to the act; and (3) resolves numerous uncertainties and ambiguities that have arisen over time concerning the specific language of the 1971 UDCPRDA.
See Letter from David English to Unif. Law Comm’n, Issues Memorandum for Second Reading (June 28, 2021), https://bit.ly/2WSyxrq.
Although the UCPDDA updates UDCPRDA, it too does not create community property rights in the new state. At present time, the UCPDDA must be reviewed and edited by the ULC, and the official comments finalized. The final act is expected to be published on the ULC website in early October 2021, and state legislatures can expect to begin considering the act for adoption in 2022.
How Might a Non–Community Property State Approach Community Property Trust Legislation?
As previously mentioned, neither UDCPRDA nor UCPDDA creates community property rights in a state that has not enacted community property law. Most states would appear to be too entrenched in non–community property rights to adopt community property. So, if a state is wary about UCPDDA and is not going to adopt community property, how might it address community property rights?
The state could consider enactment of community property trust legislation! What are the benefits? If enactment of community property trust legislation is via a statute, what might that statute look like? Here are some considerations:
Benefits for States to Consider
Here are six benefits to consider.
1. Another Tool in the Practitioner’s Toolbox. So long as the potential issues described above are explained to clients and the clients (and spouses) are counseled on the ethical issues involved in an attorney representing both spouses, allowing clients to transfer property to a community property trust gives them another planning tool. Adoption of community property trust legislation enables surviving spouses who have property passing through a community property trust to receive a 100 percent step-up in basis on that property for federal income tax purposes, thus creating a benefit similar to that of surviving spouses in community property states. Most states’ public policies would support this type of legislation.
Married couples moving from a community property jurisdiction to a state without community property legislation would be the most obvious beneficiaries if a state passed this type of legislation. Community property trusts would also be advantageous for married couples whose assets are not currently deemed to be community property but have one or more of the following characteristics: (1) a longterm stable marriage (so that the trust will truly get the step-up at death); (2) highly appreciated property, stocks, or real estate (owned by one or both spouses); (3) an over-weighted financial portfolio that they have delayed selling because of exposure to capital gains tax; (4) rental real estate or other real property that the surviving spouse would not want to manage and instead would sell; (5) property that could benefit from the 100 percent step-up in basis, such as self-created intellectual property, negative-basis but highly depreciated property, gold, artwork, or other collectibles; or (6) no present or foreseeable creditor concerns.
Even if a married couple does meet some of the criteria, it is important to keep in mind that not all of the couple’s property has to be transferred to the community property trust.
2. More Clarity Regarding Full Step- Up in Basis. The community property trust platform would provide more clarity and certainty than relying on many states’ versions of the UDCPRDA and the limited case law available.
3. Evening the Planning Opportunities Available with Those in Community Property States. With respect to the benefits of federal income tax laws’ step-up in basis, allowing the creation of community property trusts in many states would equalize the benefits of married couples in those states to those in community property states, regardless of the property regimes the states have adopted.
4. Streamlining the Estate Planning Process. Allowing married couples to transfer assets to a community property trust would simplify the estate planning process. There would be no need to equalize a couple’s assets between spouses (as often practitioners suggest). It would give practitioners a simpler method to divide assets between spouses if necessary to fund a trust for estate planning purposes, while also obtaining the tax benefits afforded community property. Income tax basis planning would also be much easier to accomplish.
5. No Need for Tracing. If a married couple used a community property trust, there would be a clear bifurcation between community and separate property. Currently, establishing community property rights for residents of non– community property states requires tracing in order to identify community property and to quantify the amount of community property versus separate property. This labor-intensive exercise often resembles a forensic accounting project. In making the required community versus separate property determination, the practitioner needs to ascertain how the property is treated under the law of the couple’s prior community property jurisdiction as part of the tracing process. Allowing a couple’s community property to be segregated in a community property trust would alleviate the need for the tracing process.
6. Evidence of Couple’s Intent. If a married couple transfers assets to a community property trust, the transfer evidences the married couple’s intention for those assets to be treated as the couple’s community property and to acquire the rights (and to relinquish others) associated with this type of property classification. This evidence of the couple’s intent would arguably diminish post-death litigation regarding whether property is community or separate.
Statutory Language for Community Property Trust Legislation
Minimum Requirements. A proposed statute would, at a minimum, provide that (1) a community property trust requires one or both spouses to transfer property to the trust; (2) the trust expressly declares that some or all of the property transferred is community property under the state’s law; (3) at least one trustee has a nexus with the state, fitting the definition of a “qualified trustee”; (4) the trust agreement sets forth the powers of the qualified trustee, which, at a minimum, include the duty to segregate trust property, maintain records, and prepare any income tax returns that must be filed by the trust; (5) the trust must be signed by both spouses; and (6) the trust contains at its beginning a declaration in capital letters similar to the following declaration required by Alaska:
THE CONSEQUENCES OF THIS TRUST MAY BE VERY EXTEN- SIVE, 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 MAR- RIAGE 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.
Alaska Stat. § 34.77.10(b). See Fla. Stat. § 736.1503.
Optional Features of a Community Property Trust. Each state’s community property trust statute has optional provisions that may (or may not) be included in the community property trust agreement, including each spouse’s rights and obligations in the property transferred to the trust, regardless of when and where the property was acquired or located; management and control of the property transferred to the trust; disposition of the property transferred to the trust on dissolution, death, or the occurrence or nonoccurrence of another event; choice of law governing the interpretation of the trust; any other matter affecting the property transferred to the trust, so long as it does not violate public policy or a statute imposing a criminal penalty; and provisions regarding the right to amend or revoke.
Following are some clauses in each state’s legislation:
Alaska. Like the other states’ statutes, an Alaska community property trust may not be amended or revoked unless the agreement itself provides for it, or unless amended or revoked by a subsequent community property trust. Alaska Stat. § 34.77.10(e). Further, unless a community property trust expressly provides otherwise, at any time after the death of the first spouse to die, the surviving spouse may amend the community property trust with respect to the surviving spouse’s property (the surviving spouse’s one-half of the community property and any separate property of the surviving spouse) to be disposed of at his or her death. Id.
Florida. Because of Florida’s homestead law, Fla. Stat. § 736.1510 provides that Florida homestead property transferred to a Florida community property trust shall continue to qualify as homestead under Florida law.
Kentucky. Despite passing its state statute in 2020, Kentucky’s legislation notably does not have an unenforceable trust clause, which is a clause providing that a trust executed during marriage is not enforceable if the spouse against whom enforcement is sought proves that the trust was unconscionable, the trust was executed involuntarily by one of the spouses, or financial disclosure was not adequate. See Alaska Stat. § 34.77.10(f ); Fla. Stat. § 736.1512; S.D. Codified Laws § 55-17-14.
South Dakota. South Dakota’s statute specifically provides that a Special Spousal Trust (South Dakota’s terminology for a community property trust) is considered a trust established under the community property laws of South Dakota, and property transferred to the trust as special spousal property means that it is community property for the purposes of I.R.C. § 1014(b)(6). S.D. Codified Laws § 55-17-5. Until Florida passed its legislation, South Dakota was the only community property trust legislation state that referred to the Code. See Fla. Stat. § 736.1511. Special rules exist regarding transfers of nonprobate assets to Special Spousal Trusts. S.D. Codified Laws § 55-17-7.
Tennessee. Tennessee’s community property trust legislation was second in time. (Alaska was first.) See J. Paul Singleton, Yes, Virginia, Tax Loopholes Still Exist: An Examination of the Tennessee Community Property Trust Act of 2010, 42 U. Mem. L. Rev. 369, 378 (2011). Otherwise, Tennessee’s statute resembles other states’ community property trust legislation.
Conclusion
States are constantly trying to get an edge over one another in terms of business. To stay current, states will need to consider whether enacting community property trust legislation is viable. n
Michael A. Sneeringer is a partner in the Naples, Florida, office of Porter Wright. He is Probate & Property’s Articles Editor for Trust and Estate and the group chair of the ABA RPTE Section’s Non-Tax Estate Planning Considerations Group.
