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Timestamp: 2019-04-19 16:44:51+00:00

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This article analyzes whether the election of Alaska's new optional community property system--by residents or nonresidents of the state--will qualify a couple's assets for a full step-up in basis at the death of the first spouse.
Prior to 1998, nine states had community property systems in effect.2 All of these existing community property states have mandatory community property systems in which the default property system is community property. A married couple in such a state, however, may opt out of the community property system--with respect to some or all of their property--by executing a community property agreement.
In 1998, Alaska became the tenth community property state and, in contrast, adopted an optional community property system. That is, the default property system is separate property, but a couple may opt into a community property system. Previously, both Oklahoma and Oregon adopted optional community property systems, and then repealed them.3 Quebec's community property system has been optional since 1970.4 The initial discussions of the approach for the Uniform Marital Property Act (UMPA) considered an opt-in system, but the drafters ultimately changed their approach to a mandatory community property system.5 Residents and nonresidents of Alaska may wish to elect the Alaska community property system for some or all of their property.
After the death of the first spouse to die, 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, at the death of the first spouse, the basis of the decedent's assets is adjusted to the fair market value (FMV) of such assets at death.6 In a community property state, the decedent's one-half share of the community property is adjusted pursuant to Code 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. . .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 decedent's spouse, is adjusted.
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 time of the surviving spouse's life 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.
Before analyzing the issues presented by this new Act, it is useful to review the basics of Alaska community property.
Will Alaska community property qualify for a full basis step-up?
U.S. Supreme Court decision in Harmon. The IRS agrees that the Wisconsin version of the Uniform Marital Property Act creates a community property system for federal income tax purposes.36 But 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 U.S.
Prior to the allowance of joint income tax returns, Oklahoma briefly experimented with a similar optional community property system from 1939 through 1945. Oklahoma's legislature was motivated by the much larger income tax burden on a wage earner spouse in a common law state than on 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 IRS challenged this splitting of income, arguing that the husband was taxable on all the income derived from his earnings.
The U.S. Supreme Court, in :Harmon,37 upheld the IRS. 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 of Lucas v. Earl.38 The majority of the Court 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. The control of assignment of income, however, is no longer necessary in the marital situation, since joint returns were allowed in 1948.
Even though residents of the nine community property states may opt out of or opt into the system at will, the Service has not attempted to deny these individuals the separate reporting of taxable income, nor the full basis adjustment of Section 1014(b)(6). It seems unfair for the IRS 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.
Must 'earnings' be included to qualify as community property?
Another issue confronting the Alaska Act is whether the absence of a vested property interest in the other spouse's earnings precludes community property recognition for tax purposes. Our community property roots lie in the "ganancial" Spanish system, which defines community property as the community of acquests and gains during marriage.45 Fundamental to any understanding of the ganancial system of community property is the need to differentiate between lucrative title and onerous title.
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.49 Alaska residents may execute a community property agreement in which they agree that their earnings will be community property. Nonresidents may elect community property status only through formation of a trust and contribution of assets to the trust. Thus, nonresidents cannot commit to future earnings being classified as community property. At most, they can voluntarily contribute their net earnings to a trust after such earnings accrue.
The distinctive feature of the community property system is that the products of the industry of either spouse are attributed to both; the husband is never the sole "owner" of his earnings; his wife acquires a half interest in them from their very inception. 1 de Funiak, Principles of Community Property (1943) § 239.
The Tenth Circuit in Hammonds51 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."
Moreover, 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 that Act marital property (community property) included income derived during marriage.52Finally, a leading commentator has concluded 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. 53 Consequently, 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.
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 on the Restatement (Second) of Conflict of Laws--both its general principles and sections discussing marital property, contracts, and trusts.
The property in an Alaska community property trust will normally be intangible personal property, broadly characterized in Restatement terminology as "movables."54 In the absence of a choice of law provision, the classification of movables is usually determined by the law of the domicile at the time of acquisition.55 However, couples using an Alaska community property trust will invariably include a choice of law provision indicating their intent that the property be classified as community property under Alaska law.
Section 187, the Restatement provision regarding contracts, states that the parties' choice of law will be refused only to protect a fundamental policy of the domiciliary state, provided that 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."58 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 it is found to violate 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 that applicable to contracts and trusts of movables. Comment (d) of this section makes clear, however, that this section 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 nontax consequences of electing Alaska community property (discussed later) demonstrates that the non-propertied spouse is generally better off under a community property system than under a common law system.
The above analysis and conclusion are supported by the Tax Court decision in Estate of Richman.59 This case involved a factually similar situation to that confronting a nonresident using an Alaska community property trust. The court upheld the settlors' choice of law although it differed from the law of the state where the settlors were domiciled.
In Richman, a Texas couple used community property to purchase beneficial interests in a Massachusetts business trust. The trust had a standard account application, and the couple chose to hold their beneficial interests as a joint tenancy with rights of survivorship (JTROS). The trust had a choice of law provision stating that Massachusetts law, which recognized JTROS accounts, would govern the validity and construction of the trust. The husband died, and his estate claimed a marital deduction for his interest in the account, which passed by operation of Massachusetts law to his wife.
In 1985, the Seventh Circuit decided Pyle,68 which involved an Illinois joint will. The court held that, upon the death of the first spouse, the surviving spouse made a taxable gift to the residuary beneficiaries who would inherit after the surviving spouse's death. The court's decision rested on the fact that after the death of the first spouse, the surviving spouse could no longer amend the joint will. As a result, the gift was complete.
To avoid the Pyle issue, the drafter of an Alaska community property agreement or trust should 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. It is probable that the Alaska legislature will consider a technical amendment similar to that enacted by Wisconsin.
Conversion of a spouse's separate property into Alaska community property has significant nontax consequences, which are analyzed as follows.
Management and control. This right is broadly defined under the Alaska Act.72 In most common law states, the separate property owner, alone, would have all of these management and control rights. Under the Alaska Commmunity Property Act, often the spouses will share this right.
Gift giving. 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.73 Both spouses together may make gifts.
Disposition at death. In common law states, the separate property owner may dispose of property in that owner's individual name. In many such states, the surviving spouse has the right to an elective share.75 Under the Alaska Community Property Act, the deceased spouse may dispose of his or her one-half of the community property.76 The surviving spouse does not have the right to elect against such community property.77 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.
Liabilities. In many common law states, the property would be subject to the contracts or liabilities of only the owner.78 Generally, neither spouse is liable for the separate debts of the other.79 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.80 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.81 Thus, the converted property may become subject to the obligations incurred by the other spouse during marriage.
What will the IRS response be? The Service may decide not to challenge couples who have executed Alaska community property agreements or trusts.85 The significance of the nontax 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 an estate tax value 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. The Service could limit its challenge to nonresidents of Alaska, relying on choice of law arguments. Finally, the Service may seek a legislative change.
Upside/downside analysis. Estate planning for a basis adjustment at the death of the first spouse to die generally focuses on property that the spouses hold in their individual names or revocable trusts. Such property is usually not 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. Section 1014(e) must be considered.
This 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 (i.e., the basis will not be stepped up). Because 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. The obvious disadvantage of this "guess who" approach is that the guess may be incorrect.
If there is no significant information indicating which spouse is likely to 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 step-up 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 the formation of an Alaska community property trust. Guessing and compromise concerning order of death are eliminated. It does not matter which spouse dies first.86 If the Service challenges the basis adjustment and is successful, 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.87 Accordingly, the worst result appears to be a fall-back to the "hedge" outcome.
Thus, 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 that there is a high probability that a particular spouse will die first, the "guess who" approach is preferable. The full step-up in basis is highly likely.
If such predictability is not present, the Alaska community property agreement or trust becomes attractive. If the full basis step-up tax consequences withstand scrutiny, this benefit is obtained no matter which spouse dies first. If this tax result is successfully challenged, the clients at least receive a basis step-up for one-half the property. This is as good as an averaging result for a 50-50 guess, and the same as the hedge approach.
1This new 1998 legislation is analyzed in Shaftel, "Newest Developments in Alaska Law Encourage Use of Alaska Trusts," 26 ETPL 51 (Feb 1998).
2Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington, and Wisconsin.
31939 Okla. Sess. Laws Ch. 62, art.2, §2 (repealed 1945); 1943 Or. Laws ch. 440, §2 (repealed 1945).
4Que. Cov. Code art. 1964 (Reynaud and Baudonin eds., 1974). Quebec's default system is the "legal regime of partnership of acquests," which is closer to its community property system than to its separate property system.
7Sponsor Statement for H.B. 199, 1998 Alaska Legislature.
8New Chapter 75 of Title 34 of the Alaska Statutes.
12A.S. 34.75.060, 34.75.090, and 34.75.100.
18A.S. 34.75.090(g), 34.75.090(h), and 34.75.100(f).
20Some 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.
23The "determination date" is the later of the date of marriage, or the effective date of a community property agreement or trust. A.S. 34.75.900(7).
25A.S. 34.75.030(d). "Income," however, does not include wages and earnings unless specifically so defined in a community property agreement.
35See Poe v. Seaborn, 282 U.S. 101, 9 AFTR 576 (S.Ct., 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, 9 AFTR 580 (S.Ct., 1930); Bender v. Pfaff, 282 U.S. 127, 9 AFTR 582 (S.Ct., 1930); Westerdahl, 82 TC 83 (1984) Rosenkranz, 65 TC 993 (1976) Zaffaroni, 65 TC 982 (1976); Angerhofer, 87 TC 51 (1986); see and compare Robbins, 269 U.S. 315, 5 AFTR 5679 (S.Ct., 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.
36Rev. Rul. 87-13, 1987-1 CB 20.
37323 U.S. 44, 32 AFTR 1411 (S.Ct., 1944).
38281 U.S. 111, 8 AFTR 10287 (S.Ct., 1930).
39Harmon, 323 U.S. at 54.
40Justice Douglas was referring to Washington and California. It appears, though, that all state's with a community property system allow conversion between community property and separate property (except for Texas, which allows only an opt-out) (802 Tax Mgmt. (BNA) at A-3 to A-4, and A-13 (1995)).
41Massaglia, 286 F.2d 258, 7 AFTR2d 517 (CA-10, 1961), involved a New Mexico couple who entered into an agreement converting community property to separate property. The Tenth Circuit upheld the IRS's denial of a full step-up in basis to the surviving spouse. Crosby, TCM 1961-272, held similarly in regard to a Washington agreement. Fleming, TCM 1984-130, held that a New Mexico agreement validly reclassified the husband's community property income into his separate income for tax purposes. Rev. Rul. 73-390, 1973-2 CB 12, and Rev. Rul. 73-391, 1973-2 CB 13, held that California couple's may by agreement reclassify earned income and investment income, respectively, from community property to separate property.
45de Funiak and Vaughn, Principles of Community Property, §1 (2d ed., 1971) (hereinafter "de Funiak").
47McClanahan, Community Property Law in the United state's, §6.1 (1982).
48de Funiak, supra note 45, at §66.
49Compare 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.
50Harmon, 323 U.S. at 56.
51106 F.2d 420, 23 AFTR 379 (CA-10, 1939).
52Rev. Rul. 87-13, 1987-1 CB 20.
53de Funiak, supra note 45.
55Restatement (Second) Conflict of Laws, §258 (2); Zaffaroni, 65 TC 982, 987 (1976); Seizer v. Sessions, 915 P.2d 553 (Wash. App. Div. 2, 1996).
56Restatement (Second) Conflict of Laws, §6.
58Restatement (Second) Conflict of Laws, §187, comment g.
60For other decisions in which courts have engaged in a conflict of laws analysis for tax issues, see: Hammonds, 106 F.2d 420, 23 AFTR 379 (CA-10, 1939), real estate acquired in Texas in exchange for personal services rendered by nonresident is community property; Porter, 148 F.2d 566, 33 AFTR 1118 (CA-5, 1945), income received by Texas resident from New York trust was held to be community property unless trust language clearly indicates intent that New York law apply to issue; Estate of Lepoutre, 62 TC 84 (1974), character of property acquired in France and transferred to Connecticut was determined by French law; thus, community property characteristics were retained and only half was included in decedent's estate under Code Section 2033; Zaffaroni, 65 TC 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.
61This gift results from the fact that the community property will be owned equally between the two spouse's. (A.S. 34.75.030(c).) See Rev. Rul. 77-359, 1977-2 CB 24.
62Code Sections 2523(b) and 2523(i). See also Code Sections 2056(b) and 2056(d)(1).
63Reg. 25.2523(b)-1(a)(3). See Estate of Boydstun, TCM 1984-312, which held that a marital trust was a nondeductible terminable interest in the estate tax context (involving a pre-1981 fact situation). In Estate of Hedrick, 74 AFTR2d 94-7468 (CA-9, 1994), the Ninth Circuit strained to find a right to revoke, so as to qualify the trust assets for the estate tax marital deduction.
65Wis. Stat. §766.58(3)(f), based on UMPA §10(c)(6).
68766 F.2d 1141, 56 AFTR2d 85-6521 (CA-7, 1985).
69This issue is discussed in Marital Property Law in Wisconsin, §10.48, State Bar of Wisconsin CLE Books (Apr 1995).
70See A.S. 34.75.090(e) and 34.75.100(e).
75For example, A.S. 13.12.201 et seq., which provides for an elective share of one-third of the augmented estate.
85The court in Angerhofer, 87 TC 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 propety regime. It is uncertain whether the Harmon issue was discussed or the extent of recognition given for tax purposes.
86Section 1014(e) may apply, however, if one spouse converts separate property to community property, and the donee-spouse dies within one year.
87See generally 7 Powell and Rohan, Powell on Real Property ¶¶601-609 (tenancy in common), and ¶¶620-624 (tenancy by the entirety); Code Sections 2033 and 2040(b) (for joint interests created after 12/31/76).

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