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THE TAX MOTIVE: FULL STEPPED-UP BASIS - LACK OF PARITY BETWEEN SEPARATE PROPERTY AND COMMUNITY PROPERTY STATES.
THE ALASKA COMMUNITY PROPERTY ACT.
A. The Act and Its "Election."
B. Community Property Agreement and Trust.
C. What is Alaska Community Property?
WILL ALASKA COMMUNITY PROPERTY QUALIFY FOR A FULL BASIS ADJUSTMENT UNDER I.R.C. §1014(b)(6)?
A. A Present Vested Interest.
B. The United States Supreme Court Decision in Commissioner v. Harmon.
MUST "EARNINGS" BE INCLUDED TO QUALIFY AS COMMUNITY PROPERTY?
WILL PROPERTY CONTRIBUTED BY NONRESIDENTS TO AN ALASKA COMMUNITY PROPERTY TRUST QUALIFY?
GIFT TAX CONSEQUENCES REQUIRE CAREFUL IMPLEMENTATION.
A. Potential Gifts Upon Execution of Agreement or Trust.
B. Gifts to Other Parties Upon the Death of the First Spouse.
NON-TAX PROPERTY CONSEQUENCES OF ELECTING ALASKA COMMUNITY PROPERTY.
A. What Will the IRS Response Be?
CONCLUSION: THE ABILITY TO CHOOSE.
David G. Shaftel & Stephen E. Greer, 1999 © All Rights Reserved.
William P. Cantwell served as Reporter to the Drafting Committee on the Uniform Marital Property Act of the National Conference Commissions on Uniform State Laws.
In July 1983, the National Conference of Commissioners on Uniform State Laws promulgated the Uniform Marital Property Act (UMPA). Under the procedures of the Conference, promulgation constitutes approval of a proposed uniform law and a recommendation that it be adopted by all of the stated. The vote for promulgation was close.
The Uniform Marital Property Act was the work product of a committee constituted in 1981. The committee's Prefatory Note to the Act described it as paralleling community property laws but following a sui generis approach utilizing useful common law as well as community property concepts. The note emphasized that the Act was rooted in the sharing ideal which is at the center of the historical community property approach to the ownership of property by married couples.
A group in Wisconsin had been working on a marital property legislation based on the sharing idiom prior to the formation of the UMPA committee. It continued that work throughout the drafting period of UMPA.
Those efforts continued after promulgation and Wisconsin adopted an act with many of the UMPA provisions effective in 1985. It is the only state to have adopted the basic substance of UMPA prior to 1998. Developments subsequent to the Wisconsin adoption led to Internal Revenue Service acceptance of that legislation as community property for Internal Revenue Code purposes and Wisconsin is now considered a community property state for income, estate, and gift tax purposes as well as for intraspousal property rights and obligations during marriage. Wisconsin thus joined the other eight American community property states of Arizona, California, Idaho, Louisiana, New Mexico, Nevada, Texas, and Washington. According to 1997 population estimates, some 76,011,000 people live in these states. This is slightly more than 28 percent of the estimated U.S. population of 276,636,000.
After the 1983 promulgation, there was interest in UMPA in a number of states other than Wisconsin. This occurred at the level of legislative committees, legislative study groups, or variously composed citizen groups. Included among these were Colorado, Utah, Nebraska, Kansas, Illinois, Michigan, Indiana, New York, and Connecticut. The National Organization of Women gave the legislation serious consideration, and there was a predictable flurry of activity among law reviews and in other professional literature. The American Bar Association gave the Act very limited approval and its Real Property, Probate, and Trust Law Section withheld approval of its provisions. In most quarters there were strong debates, mirroring those which had occurred before the commissioners. However one characterizes the advent and reception of the suggested Act, no legislation encompassing UMPA's scope developed in states other than Wisconsin, and after the late 1980s, interest in it waned and it became dormant until passage of the Alaska Community Property Act on May 28, 1998.
Encompassing much of the language of UMPA, but utilizing the semantics of community property, rather than marital property, the Alaska Act manifests a possible renewed interest in using sharing as the organizing principle of economics. However, it creates a new approach not a part of UMPA or the laws of any other community property state. That approach makes the application of the sharing principle wholly voluntary. It encourages the adoption of the Alaska regime by nonresidents as well as Alaska residents. It can be seen as a somewhat felicitous method for nonresidents to regulate their marital property rights, possible preferable to the use of highly detailed and often highly expensive pre- or post-marital agreements, with the potential of making some tax advantages available as well.
Historically, community property is divisible into two types. One of these is known as a legal community and the other is a conventional community. A legal community constitutes a form of marital regime for all marriages in a discrete jurisdiction, decreed by governing statutory or constitutional provisions. A conventional community (probably better described as a contractual community) is one sanctioned by a particular jurisdiction but made voluntary for married persons in the jurisdiction. The UMPA provisions were those of a legal community. In North America, a modified form of conventional community property exists in Quebec, and such a system was used but quickly abandoned by Oklahoma in mid-century.
With its provisions, Alaska has now adopted its particular form of conventional or contractual community property. Direct legislation establishing the permissive provisions of conventional community as the exclusive route to a sharing regime currently exists in no other jurisdiction in the United States.1 The highly ingenious Alaska approach is well covered in the accompanying article by David G. Shaftel and Stephen E. Greer. A unique and challenging aspect of the Alaska legislation is its permissive application to property owned by spouses domiciled in other jurisdictions. This novel approach actually makes a good deal of the substance of the UMPA drafting available on a widespread but wholly voluntary basis. If in fact favorable tax interpretations should attach to the Alaska legislation, as described in the article, it is possible that the dual advantages of a sharing approach and favorable tax treatment could actually become available and useful in many estate planning situations not only in Alaska but in other separate property jurisdictions. Of significance is that domiciliaries of any separate property states who feel that a sharing approach is desirable will now have a statutory framework for adoption of such an approach that offers stability and structure.
Prior to 1998, nine states had community property systems in effect.3 All of these existing community property states have mandatory community property systems where the default property system is community property. However, a married couple in such a state may opt-out of the community property system, with respect to some or all of their property, by executing a community property agreement.
Residents and nonresidents of Alaska may desire to elect the Alaska community property system for some or all of their property. This article first discusses the various issues involved in whether election of Alaska's community property system, by residents or nonresidents, will qualify the couple for the income tax benefit of full adjustment of basis at the death of the first spouse. A suggested upside/downside analysis is provided for the planner. Also, the non-tax property rights differences between community property and separate property systems are compared. Finally, the Administration's proposed legislative changes are analyzed.
2This new 1998 legislation is discussed in Shaftel, New Developments in Alaska Trust Law, Estate Planning, February 1999.
3Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington, and Wisconsin.
41939 Okla. Sess. Laws Ch. 62, art. 2, §2 (repealed 1945); 1943 Or. Laws ch. 440, §2 (repealed 1945).
5Que. Civ. Code art. 1964 (Y. Reynaud & J. Baudonin eds. 1974). Quebec's default system is the "legal regime of partnership of aquests," which is closer to its community property system than to its separate property system.
6As recalled by William Cantwell, Reporter, Uniform Marital Property Act Committee of the National Conference of Commissioners on Uniform State Laws. A thorough analysis of the history of the optional community property system, and the policy arguments in favor of states adopting this system, are presented by Professor Richard W. Bartke in Marital Sharing--Why Not Do It By Contract?, 67 Geo. L.J. 1131 (1979).
II. THE TAX MOTIVE: FULL STEPPED-UP BASIS -- LACK OF PARITY BETWEEN SEPARATE PROPERTY AND COMMUNITY PROPERTY STATES.
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. 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.
8I.R.C. §1014(b)(6) was enacted in 1948 as part of Congress's effort to achieve geographical equalization of income, gift and estate tax treatment between the residents of separate property and community property states. Congress was responding to the argument presented by residents of community property states that generally the husband held title to all of the family assets. Therefore, if a husband died in a separate property state, all of these assets would receive a basis adjustment. However, if the husband died in a community property state, only one-half of the assets would receive such adjustment. Consequently, I.R.C. §1014(b)(6) was enacted to "equalize" the basis adjustment treatment for married couple's regardless of whether they lived in separate property or community property states. S. Rep. 1013, 80th Cong., 2d Sess. (1948), 1948-1 C.B. 285, 301-306; General Explanation of the Administration's Revenue Proposals, Dept. of the Treas., Feb. 1999.
9Sponsor Statement for H.B. 199, 1998 Alaska Legislature.
Prior to analyzing the issues which this new Act presents, it is important to review the basics of Alaska community property.
10New Chapter 75 of Title 34 of the Alaska Statutes.
22Some reviewers of the Act have asked whether the community property character of the trust's property would change if the Alaska trustee subsequently resigns or is replaced, with the result that no Alaska trustee is in office.
27A.S. 34.77.030(d). However, "income" does not include wages and earnings unless specifically so defined in a community property agreement.
29A.S. 34.77.120. Careful funding of life insurance trusts holding policies on one spouse's life will be necessary under the new Act. I.R.C. §2036(a) could apply if the surviving spouse has a beneficial interest and if community property was contributed to the trust. To avoid this consequence, the settlor-insured should contribute separate property to the trust. If such property is not available, the couple should convert community property to the separate property of the settlor-insured. (Marital Property Law in Wisconsin, §10.35, State Bar of Wisconsin CLE Books (April 1995)).
IV. WILL ALASKA COMMUNITY PROPERTY QUALIFY FOR A FULL BASIS ADJUSTMENT UNDER I.R.C. §1014(b)(6)?
B. The United States Supreme Court Decision In Commissioner v. Harmon. The Internal Revenue Service agrees that the Wisconsin version of the Uniform Marital Property Act creates a community property system for federal income tax purposes.38 However, Alaska has modified that Act by making it elective. Alaska's new opt-in community property system is the only such elective system presently in effect in the United States. Prior to the allowance of joint income tax returns, Oklahoma briefly experimented with a similar optional system during the period from 1939 through 1945. Oklahoma's legislature was motivated by the much larger income tax burden upon a wage earner spouse in a common law state than upon a couple in a community property state who could each report one-half of the income. Under Oklahoma's opt-in system, the Harmons elected to have that state's new community property law apply to them. They each reported one-half of their income on their separate returns. The I.R.S. challenged this splitting of income, arguing that the husband was taxable on all of the income derived from his earnings. The United States Supreme Court, in Commissioner v. Harmon,39 upheld the Commissioner's position. The Supreme Court's main concern was that the consensual nature of Oklahoma's opt-in community property system in effect allowed the couple to assign one-half of the husband's income to his wife in violation of the principles established in Lucas v. Earl.40 The majority found that the Harmons' agreed election of community property status under Oklahoma's opt-in system was so similar to the Earls' contractual agreement (that the husband's earnings would be joint property), that the assignment of income doctrine should be similarly applied. In its opinion, the majority emphasized the distinction between a consensual (opt-in) and a legal (opt-out) community property system.
The key issue here is whether Harmon's consensual versus legal distinction should be limited to assignment of income situations. Certainly, a taxpayer's ability to shift the burden of income taxes by agreement must be controlled. The consensual versus legal distinction has served this purpose. However, the control of assignment of income is no longer necessary in the marital situation, since joint returns were allowed in 1948.
"in some of the so-called "legal" community property states separate property of one spouse may be converted by contract or deed into community property or vice versa."41 This conversion ability allows residents of community property states to opt-out of or opt-into the state's community property system by execution of a community property agreement.42 The courts and the Internal Revenue Service have given tax effect to such community property agreement optional changes.43 Even though residents of the nine community property states may opt-out of or opt-in to the system at will, the Service has not attempted to deny them the separate reporting of taxable income, nor the full basis adjustment of I.R.C. §1014(b)(6). It seems unfair for the Internal Revenue Service to acquiesce in this "consensual" characteristic of existing community property states, yet deny it to elective community property systems.
The conservative planner may wish to "draft around" Harmon's assignment of income issue. A provision could be included in the community property agreement or trust requiring the couple to file joint income tax returns during the existence of such instruments.
37See, Poe v. Seaborn, 282 U.S. 101 (1930), where the court held the community property laws of Washington gave each spouse a present vested interest in the other's earnings and thus income splitting was permitted; Hopkins v. Bacon, 282 U.S. 122 (1930); Bender v. Pfaff, 282 U.S. 127 (1930); Westerdahl v. Comm'r, 82 T.C. 83 (1984); Rosenkranz v. Comm'r, 65 T.C. 993 (1976); Zaffaroni v. Comm'r, 65 T.C. 982 (1976); Angerhofer v. Comm'r, 87 T.C. 51 (1986); see and compare U.S. v. Robbins, 269 U.S. 315 (1926), where the court held the community property laws of California at the time gave the wife a mere expectancy in the community property and this was insufficient to permit a splitting of income for federal income tax purposes.
38Rev. Rul. 87-13, 1987-1 C.B. 20.
42Justice Douglas was referring to Washington and California. (323 U.S. at 54.) However, it appears that all states with a community property system allow conversion between community property and separate property (except for Texas which only allows an opt-out)(802 Tax Mgmt. (BNA) at A-3 to A-4, and A-13 (1995)).
43Massaglia v. Comm'r, 286 F.2d 258 (10th Cir. 1961) involved a New Mexico couple who entered into an agreement converting community property to separate property. The 10th Circuit upheld the I.R.S.'s denial of a full step-up in basis to the surviving spouse. Crosby v. Comm'r, 20 T.C.M. (CCH) 1422 (1961) held similarly in regard to a Washington agreement. Fleming v. Comm'r, 47 T.C.M. (CCH) 1281 (1984), held that a New Mexico agreement validly reclassified the husband's community property income into his separate income for tax purposes. Revenue Ruling 73-390, 1973-2 C.B. 12, and Revenue Ruling 73-391, 1973-2 C.B. 13, held that California couple's may by agreement reclassify earned income and investment income, respectively, from community property to separate property.
45Proponents of the Alaska Community Property Act have asserted other arguments for not applying Harmon to the basis adjustment area. (See Jonathan G. Blattmachr, in "The New Alaska Community Property Act and Other Important Changes That Affect Our Clients," Alaska CLE entitled "Tax Planning With Consensual Community, Alaska's New Community Property Law," Anchorage, AK (Aug. 4, 1998), page 29).
46There is one case in which a U.S. district court in Oklahoma allowed a full adjustment in basis for a period which overlapped both Oklahoma's opt-in and opt-out community property systems. In 1943, the couple acquired property as joint tenants and elected into Oklahoma's consensual system. In 1948, after Oklahoma had changed to a mandatory community property system, the husband died. The court evidently relied upon the 1943 election to characterize the couple's joint tenancy property as community property under the mandatory system. (McCollum v. United states, 58-2 U.S.T.C. §9957).
V. MUST "EARNINGS" BE INCLUDED TO QUALIFY AS COMMUNITY PROPERTY?
Comparison of the Uniform Marital Property Act and the Alaska statute indicates a significant difference in the definition of "income." UMPA includes a spouse's wages and earnings; the Alaska Act does not.51 Alaska residents may execute a community property agreement in which they agree that their earnings will be community property. Nonresidents may only elect community property status through formation of a trust and contribution of assets to the trust. Thus, they cannot commit to future earnings being classified as community property. At most, they can voluntarily contribute their net earnings to the trust after such earnings accrue.
The 10th Circuit in Hammonds v. Commissioner stated "It is a fundamental postulate of the community property system that whatever is gained during coverture, by the toil, talent or other productive faculty of either spouse, is community property. Indeed, the sole source from which the community estate must arise is the toil, talent or other productive faculty of the spouses and the earnings and income from community property itself."53 Also the Service apparently thinks earnings are of some importance. In ruling favorably on the community property status of the Wisconsin Act, the Service noted that under the Act marital property (community property) included income derived during marriage.54 Finally, a leading commentator concludes that a system of acquests and gains making the earnings and gains of the husband community property but not those of the wife is nothing more than a pretense of being a community property system.55 Therefore, an argument can be made that a system which by its default rules does not give each spouse an immediate vested ownership interest in the other's wages and earnings is not a community property system.
In response, and in defense of the Alaska system, the argument is that the scope of inquiry should be limited to an examination of the spouses' rights in the subject property. In other words, if the spouses' rights in the Alaska community property are similar to the rights enjoyed by spouses in the nine other community property states, then there is no meaningful reason for denying the classification of the property as community property. Furthermore, as discussed above, all nine other states allow a couple to agree that certain property, such as their earnings, will not be characterized as community property. Such flexibility does not prevent them from being recognized as valid community property systems for federal income tax purposes.
47William Q. de Funiak and Michael J. Vaughn, Principles of Community Property, §1 (2d ed. 1971).
49McClanahan, Community Property Law In the United States, §6.1 (1982).
50de Funiak et al., supra note 43, at §66.
51Compare A.S. 34.75.900 (12) with UMPA §1 (10). By purpose or coincidence, by excluding earnings from the definition of income, the Alaska legislature effectively removed the Alaska Act from the principal holding of Harmon; i.e., the elective nature of the Oklahoma system equates to a transfer of rights constituting an "assignment of income" governed by Lucas v. Earl.
52Comm'r v. Harmon, 323 U.S. 44, 56 (1944).
53106 F.2d 420, 422 (10th Cir., 1939).
54Rev. Rul. 87-13, 1987-1 C.B. 20.
55de Funiak et al., supra note 46.
VI. WILL PROPERTY CONTRIBUTED BY NONRESIDENTS TO AN ALASKA COMMUNITY PROPERTY TRUST QUALIFY?
If nonresidents of Alaska who reside in a state with a common law property system contribute property to an Alaska community property trust, which state's property law system should apply to the trust and its assets? Analysis of this issue is based upon the principles provided by the Restatement (Second) of Conflict of Laws, in its general principles, and sections discussing marital property, contracts and trusts.
Section 187, the Restatement provision regarding contracts, provides that the parties' choice of law will be refused only to protect a fundamental policy of the domiciliary state, provided the domiciliary state has a materially greater interest than the state of the chosen law in the determination of the particular issue. Interestingly, the Restatement provides "The more closely the state of the chosen law is related to the contract and the parties, the more fundamental must be the policy of the state of the otherwise applicable law to justify denying effect of the choice of law provision."60 It is difficult to imagine a closer relationship of a state's law to a contract than the case of Alaska law as it relates to the Alaska community property trust.
Section 270, the Restatement provision regarding trusts of movables, is very similar to the choice of law provision found in contracts. This section provides that the parties' choice of law will be upheld unless found violating a strong public policy of the state with which, as to the matter at issue, the trust has its most significant relationship.
Section 258, the Restatement provision concerning marital property, applies a test similar to contracts and trusts of movables. However, comment (d) of this section states it is not applicable if a valid contract between the spouses provides otherwise. In other words Section 187, involving contracts, has priority.
In summary, pursuant to the principles of the Restatement, the couple's choice of Alaska law should control unless it is found to have violated a fundamental or strong public policy of laws of their domicile. It is difficult to imagine this circumstance. It would seem that the domiciliary state would be most interested in protecting the non-propertied spouse. Analysis of the non-tax consequences of electing Alaska community property61 demonstrates that the non-propertied spouse is generally better off under a community property system than a common law system.
56It might be wise to transfer real estate to an LLC or limited partnership, in order to have the trust property characterized as a movable. Otherwise, the law of the situs usually determines the classification of real estate. (Restatement (Second) Conflict of Laws §278 (1971)).
57Restatement (Second) Conflict of Laws, §258 (2) (1971); Zaffaroni v. Comm'r, 65 T.C. 982, 987 (1976); Seizer v. Sessions, 915 P.2d 553 (Wash. App. Div. 2, 1996).
58Restatement (Second) Conflict of Laws, 6 (1971).
59Id. Because the trust is in the nature of a postnuptial agreement, an initial inquiry must be whether the domiciliary state recognizes postnuptial agreements. Most states do, but provide that a duty of disclosure is owed the other party, the agreement must be signed voluntarily, and each party must have the opportunity to consult with counsel. (Alexander Lindey and Louis I. Parley, Lindey on Separation Agreements and Antenuptial Contracts, §91.02.) The protections afforded each spouse under the Alaska Act most likely satisfy these standards. (A.S. 34.77.100(b) and (f)).
60Restatement (Second) Conflict of Laws, §187, comment g.
61See the discussion of non-tax consequences, below.
63For other decisions in which courts have engaged in a conflict of laws analysis for tax issues, see: Hammonds v. Comm'r, 106 F.2d 420 (10th Cir. 1939), real estate acquired in Texas in exchange for personal services rendered by nonresident is community property; Comm'r v. Porter, 148 F.2d 566 (5th Cir. 1945), income received by Texas resident from New York trust held to be community property unless trust language clearly indicates intent that New York law apply to issue; Estate of Lepoutre, Deceased v. Comm'r, 62 T.C. 84 (1974), character of property acquired in France and transferred to Connecticut determined by French law, thus community property characteristics retained and only half included in decedent's estate under I.R.C. §2033; Zaffaroni v. Comm'r, 65 T.C. 982 (1976), U.S. source income earned by Uruguayan citizens residing in Mexico was community property. A thorough discussion of this subject is provided in the materials for "A Short Course on the Transitory Community," presented by M. Read Moore and Malcolm A. Moore at the 1998 Annual Fall Estate Planning Practice Update, ALI-ABA Video Law Review.
The Pyle result should not occur of the agreement or trust gives the surviving spouse the unrestricted ability to withdraw or consume the property in question. In addition, to avoid the Pyle issue, the drafter of an Alaska community property agreement or trust may provide express authority allowing the surviving spouse to amend the agreement with respect to property to be disposed of at the death of the surviving spouse. An argument can be made that the surviving spouse's act of amendment is the "occurrence of a particular event," and therefore allowed by the existing Alaska statutory language.75 The 1999 Alaska legislature is considering a technical amendment which would enact a default rule similar to that enacted by Wisconsin.
64This gift results from the fact that the community property will be owned equally between the two spouses. (A.S. 34.77.030(c)). See Rev. Rule 77-359, 1977-2 C.B. 24.
65I.R.C. §2523(b) and (i). See also, I.R.C. §2056(b) and (d)(1).
66Reg. §25.2523(b)-1(a)(3). See Estate of Boydstun v. Comm'r, 48 T.C.M. (CCH) 311 (1984), which held that a marital trust was a non-deductible terminable interest in the estate tax context (involving a pre-1981 fact situation). A similar estate tax holding was reached by the Tax Court in the 1998 decision in Estate of Walsh v. Comm'r, 110 T.C. 393. In Estate of Hedrick v. Comm'r, 1994 U.S. App. LEXIS 20641 (9th Cir. 1994), the Ninth Circuit strained to find a right to revoke, so as to qualify the trust assets for the estate tax marital deduction.
68Wisconsin Statutes, Section 766.58(3)(f), based on UMPA §10(c)(6).
71766 F.2d 1141. (7th Cir., 1985).
72This issue is discussed in Marital Property Law In Wisconsin, §10.48, State Bar of Wisconsin CLE Books (April 1995).
73See A.S. 34.77.090(e) and .100(e).
VIII. NON-TAX PROPERTY CONSEQUENCES OF ELECTING ALASKA COMMUNITY PROPERTY.
Conversion of a spouse's separate property into Alaska community property has significant non-tax consequences, which are summarized as follows.
A. Management And Control. This right is broadly defined under the Act.76 In most common law states, the separate property owner, alone, would have all of these management and control rights. Under the Alaska Community Property Act, often the spouses will share this right.
B. Gifting. In many common law states, the owner would be allowed to unilaterally make gifts. Under the Alaska Community Property Act, the fact that a spouse has the right to manage and control does not permit gifts of community property, except in very limited circumstances.77 Both spouses together may make gifts.
D. Disposition at Death. In common law states, the separate property owner may dispose of property in such owner's individual name. In many such states, the surviving spouse has the right to an elective share.79 Under the Alaska Community Property Act, the deceased spouse may dispose of his or her one-half of the community property.80 The surviving spouse does not have the right to elect against such community property.81 Because the elective share may be less than one-half, the separate property owner may have the right to dispose of more property than his or her community property counterpart.
E. Liabilities. In many common law states, the property would only be subject to the contracts or liabilities of the owner.82 Generally, neither spouse is liable for the separate debts of the other.83 Under the Alaska Community Property Act, an obligation incurred by a spouse during marriage, including an obligation attributable to an act or omission during marriage, is presumed to be incurred in the interest of the marriage or the family.84 After the determination date, an obligation incurred by a spouse in the interest of the marriage or the family may be satisfied from community property and the separate property of that spouse.85 Therefore, the converted property may become subject to the obligations incurred by the other spouse during marriage.
79For example, A.S. 13.12.201 et seq., which provides for an elective share of one-third of the augmented estate.
When enacted in 1948, the stepped-up basis for community property was premised on the fact that "the usual case was that practically all the wealth of the married couple was the property of the husband." S. Rep. 1013, 80th Cong., 2d Sess. (1948), 1948-1 C.B. 285, 304. Societal changes and changes to the estate tax treatment of jointly held property in 1981 have undermined the premises on which section 1014(b)(6) was based. Consequently, surviving spouses in community property states now enjoy an unwarranted tax advantage over those in common law states.
The Treasury Department's concern is the unequal treatment of residents of community property and separate property states. Treasury does not explain the "societal changes" upon which it is basing its proposal. One may speculate that these changes are the more equal ownership of family assets between spouses, often resulting from increased parity in earnings, and from sound estate planning advice. However, even if such ownership changes are occurring, elimination of the full basis adjustment is only one remedy for the disparity of treatment between community property and separate property states. That remedy may not be the wisest.
As discussed above, after one spouse dies, it is often necessary for the surviving spouse to sell certain assets. 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. Assets may need to be sold in order to raise funds to replace the decedent's earnings. The full basis adjustment of I.R.C. §1014(b)(6) alleviates the post-death tax burden resulting from these necessary sales.
At present, there is a significant push for tax relief. The nation has a budget surplus. In these circumstances, there is an alternative remedy which would both achieve equality between community property and separate property states and provide needed tax relief. This remedy would be to extend the full basis adjustment to any form of jointly owned property which is equally owned by only husband and wife. Such property would include community property, joint tenancy, tenancy by the entireties, and tenancies in common.
There is direct legislative precedent for this alternative approach on very similar facts. In the mid 1940s, one-earner families in separate property states were required to report all of their income on a single return. In contrast, couple's in community property states could each report one-half of the family income. As a result, Oklahoma, Oregon, Michigan, Nebraska, and Pennsylvania all switched to community property systems. Congress became concerned about the lack of geographical equalization in the treatment of the income of married couple's. The remedy was not to deny the ability to split income to couple's in community property states, but rather was to allow all couple's to split income by filing joint return. S. Rep. 1013, 80th Cong., 2d Sess. (1948), 1948-1 C.B. 285, 301.
The above-described alternative remedy to the Treasury's perceived tax inequality seems wiser tax policy than elimination of a benefit which the residents of community property states have received for over 50 years. In short, if a legislative change is to be provided, then the full basis adjustment of I.R.C. §1014(b)(6) should be extended, not eliminated.
Absent a legislative change, the Service may decide not to challenge couple's who have executed Alaska community property agreements or trusts.89 The significance of the non-tax aspects of opt-in community property, and the rational weaknesses of applying Harmon to situations other than those involving assignment of income, may direct such a decision. Alternatively, the Service may argue that Harmon applies equally to a basis adjustment as it did to splitting income. If so, the Service may cling to Harmon until it is overruled or found inapplicable by the Supreme Court.
B. Fractional Interest Discount. I.R.C. §1014 adjusts the basis property to "the fair market value of the property at the date of the decedent's death...." Therefore, from an income tax standpoint, it is in the recipient's interest to have the fair market value as high as reasonably possible. However, it is important to recognize that a spouse's one-half interest is a fractional interest. A series of cases have held that such community property interests are subject to minority interest discount and lack of marketability discount.90 This fair market value reduction will limit the basis adjustment of both spouse's halves of the community property.
C. Upside/Downside Analysis. Estate planning for an income tax basis adjustment at the death of the first spouse to die will generally focus upon property which the spouses will hold in their individual names or revocable trusts. Such property will usually not be the subject of other transfer tax reduction approaches. Consequently, there does not seem to be a "lost opportunity" downside effect on transfer taxes when planning this area.
In separate property states, most planners use the "guess who" approach. That is, the planners and their clients try to decide which spouse is going to die first, and they transfer appreciated property to that spouse's ownership. I.R.C. §1014(e) must be considered.91 The obvious disadvantage of this "guess who" approach is that the guess may be incorrect.
If there is no significant information indicating which spouse will die first, many planners may revert to a "hedge" approach. Appreciated property is split approximately equally between the spouses so that one half of such property will receive a basis adjustment at the death of the first spouse to die.
Instead of using the "guess who" or "hedge" approaches, the planner may encourage the execution of an Alaska community property agreement or formation of an Alaska community property trust. Guessing and compromise are eliminated. It does not matter which spouse dies first.92 If the full basis step-up tax consequences withstand scrutiny, then the full basis adjustment is obtained no matter which spouse dies first. If the Service challenges the basis adjustment and is successful, then the result would probably be treatment of the property as equivalent to a tenancy by the entireties or tenancy in common for basis adjustment purposes.93 Consequently, the worst result appears to be a fall-back to the one-half basis adjustment of the "hedge" result.
Therefore, the planning choice appears to be between the "guess who" approach and the Alaska community property agreement or trust. If the planner and clients conclude there is a high probability that one spouse will die first, the "guess who" approach is preferable. The full step-up in basis is relatively assured. However, if such predictability is not present, then the Alaska community property agreement or trust becomes quite attractive.
89The court in Angerhofer v. Comm'r, 87 T.C. 51 (1986), footnote 4, stated that the government in its brief conceded that the optional elect-in German marital regime, known as gutergemeinschaft, was a community property regime. It is uncertain whether the Harmon issue was discussed or the extent of recognition given for tax purposes.
90Propstra v. United States, 680 F.2d 1248 (9th 1982) (15% discount for one-half community property interest in real estate); Estate of Lee, 69 T.C. 860 (1978) (minority discount allowed for one-half community property interests in common stock and all outstanding preferred stock); Estate of Illa Jean Anderson, 56 T.C.M. 78 (1988) (20% discount for one-half community property interest in real estate); Estate of Thomas A. Fleming v. Comm'r, T.C.M 1997-484 (minority discount and lack of marketability discounts allowed for one-half community property interests in outstanding stock of closely-held corporation); see Estate of Bright v. United States, 658 F.2d 999 (5th Cir. 1981) (court refused to attribute surviving spouse's community property interest to the deceased spouse in regard to the IRS's control premium agreement); and see Estate of Wayne-Chi Young v. Comm'r, 110 T.C. No. 24 (1998) (no discount for jointly owned property that was not community property; case includes recent discussion of community property discount cases and rationale).
91This section provides that if appreciated property is acquired by the decedent by gift during the one-year period ending on the decedent's death, and such property is acquired from the decedent by (or passes from the decedent to) the donor, then the basis of the property will not be adjusted. Since no regulations have been issued under this provision, it is unclear whether a basis adjustment would be denied if the property was distributed to a bypass trust or marital trust rather than directly back to the donor-spouse.
92However, I.R.C. 1014(e) may apply if one spouse converts separate property to community property, and the donee-spouse dies within one year.
93See generally, 7 Powell & Rohan, Powell on Real Property, ¶¶601-609 (tenancy in common), and ¶¶620-624 (tenancy by the entirety); I.R.C. §2033 and §2040(b) (for joint interests created after December 31, 1976).
X. CONCLUSION: THE ABILITY TO CHOOSE.
The drafters of the Uniform Marital Property Act were convinced that the sharing and equality characteristics of community property provided a superior property ownership system. This conclusion is directly supported by the worldwide popularity of community property. However, four-fifths of the states in the United States, with their English heritage, have not made this system available to their residents. They should have that choice.
Copyright � Shaftel Law Offices, PC. All rights reserved.

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