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Planning to Preserve the Advantages of Community Property

Estate Planning

Originally Published in Estate Planning.


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When clients move from a community property state to a common law jurisdiction, it is crucial to plan for the community assets in order to preserve the “double” step-up in basis at the first spouse’s death.

The community property character of assets of spouses moving from a community property state is not shed at the border. Yet many experienced estate planners in common law states behave as if it were, or more correctly, fail to address the issue at all with their new clients. For planners with little background in community property principles, trying to analyze the community character of assets of transplanted clients can be as daunting as trying to think in a foreign language half-learned in high school. Frequently, no attempt is made to identify and plan for community property. This oversight can have far-reaching negative consequences, including the possibility of a malpractice claim against the attorney.

The lack of familiarity with community property principles among planners in common law states certainly contributes to the problem, as does the diversity of community property principles among the community property jurisdictions–Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington, and, since 1986, Wisconsin.1 The complexity and variety of community property rules resist summary, but several common themes appear. Property acquired during the marriage other than by lifetime or testamentary gift or descent, and the rents, issues, and profits thereof, constitute community property.2 Property acquired through the personal efforts of either spouse is community property,3 as are proceeds from the sale of community property and income generated by community property.4 Each spouse owns a present, equal, undivided interest in the community property.5 Property acquired during the marriage is presumptively community property,6 and the fact that record title reflects only one spouse’s name does not generally overcome this presumption.7 Consequently, a planner in a common law jurisdiction cannot rely on the fact that record title is in the name of one spouse alone. Property retains its community character notwithstanding a couple’s move to a common law jurisdiction,8 although courts outside the community property jurisdictions have not always adhered strictly to this principle, to say the least.

Beyond these rules, community property principles can vary considerably from state to state. Two examples of the sort of diversity that exists among the community property jurisdictions on even fundamental matters make this point. On the issue of the character of income, or “fruits,” attributable to separate (non-community) assets of either spouse, while most jurisdictions treat the “fruits” as separate property as well,9 several treat them as community property.10 The issue of apportionment between community and separate property when one spouse invests personal efforts in his or her separate property business is more complex. Two competing apportionment formulas have emerged, with differing results achieved even among courts within the same state.11 Presenting a host of other instances of diversity among the community property jurisdictions would not be difficult.

Effects of undetected community property

Unless new clients happen to volunteer the information that they have resided in a community property state, an attorney in a common law state can easily fail to detect community property among the clients’ assets. Consider the implications of undetected community property for even a modest estate plan in a common law state. Assume that insurance on the husband-insured’s life is transferred to the trustee of an irrevocable life insurance trust (ILIT), providing for a lifetime trust for wife at husband’s death, with remainder to children. Husband’s will provides for a credit shelter trust for the benefit of children, and a QTIP trust for wife; in case of simultaneous deaths, the will provides that wife is presumed to have survived husband. Husband designates a third party as attorney-in-fact under a durable power of attorney, with authority to make gifts of real and personal property up to the amount of the gift tax annual exclusion. Undetected community property can derail this straightforward plan at several critical points.

If the life insurance premiums were paid from community property funds (such as the earnings of either spouse), the wife may own an undivided one-half interest in the policy. She will potentially co-own the policy with the ILIT trustee, whether or not she or the attorney in the common law state realize this. Ordinarily, a life insurance policy purchased with community property funds is itself community property. If the insured spouse has designated a third party as beneficiary of a cash-value policy, the designation is effective only as to the insured-spouse’s community one-half interest (in addition to any separate interest). The surviving spouse is entitled to the remaining portion of the policy proceeds notwithstanding a contrary beneficiary designation.12 In the example, at wife’s death, her proportionate interest in the policy proceeds will be includable in her estate under Section 2036, triggering unexpected estate tax, and nullifying up to half the anticipated tax effectiveness of the ILIT, depending on the community property-sourced portion of the policy.

As to the will, the survivorship presumption may well be unnecessary, given the “natural” estate-splitting qualities of community property, unless the spouses’ respective separate property interests are sufficiently diverse to warrant an inclusion of such a presumption. Of greater concern, if the assets that the attorney contemplated would fund the credit shelter trust are in fact community property assets, only the decedent’s one-half interest in them will pass under the will (absent some sort of election). The credit shelter trust will instead soak up assets that were expected by the practitioner and the testator to pass into the QTIP trust. The wife may revise her will following the husband’s death to benefit individuals other than those named as remaindermen upon termination of the QTIP trust, such as her own children by a prior marriage or a new spouse. Had the advisor identified the issue in the planning process, the decedent may well have made different provisions for the spouse and children.

If, on the other hand, the failure to identify the community property persists until the death of the surviving spouse, other problems might arise. The apparent acquiescence of the surviving spouse in the use of her community one-half interest in assets to fund a trust for children, for example, may be deemed to have constituted an unreported taxable gift to the children, potentially with attendant interest and penalties. Alternatively, beneficiaries under the surviving spouse’s will may conceivably have a cause of action against the trustee and the attorney who mishandled the trust funding, with remedies including, depending on the jurisdiction, restoration of the funds involved with interest.

As to the durable power of attorney, gifts inadvertently made by the attorney-in-fact of undetected community property assets titled in the principal’s name alone may be ineffective, depending on applicable spousal consent requirements. For example, a transfer of community real estate by one spouse without the other’s consent may be voidable at the instance of the non-consenting spouse.13 A similar problem may occur if a guardian or conservator is appointed for an incapacitated spouse, triggering unforeseen difficulties in managing and disposing of community property assets in the guardianship.

If the spouses have executed a “community property agreement,” providing for automatic vesting of all community property in the surviving spouse at the death of the first spouse, further unanticipated results will occur. For instance, any credit shelter provisions in the will of the first decedent will be bypassed. Such agreements are authorized in several community property jurisdictions.14 A community property agreement executed by both spouses may accomplish one or more of the following goals:

  1. It may characterize all existing property of the spouses as community property, sometimes with the exception of certain scheduled assets that are to remain in the separate property of one or the other spouse.
  2. It may prospectively transmute into community property all property acquired by either spouse following the date of execution of the agreement.
  3. It may provide that, at the death of the first spouse, all community property will automatically vest in the surviving spouse, without the necessity of any probate proceeding.

Community property agreements bearing one or more of these characteristics are sometimes called “one-,” “two-,” or “three-pronged” community property agreements, respectively. The community property agreement may be recorded if realty is involved in order to give the third parties notice rather than to effectuate the transmutation to community property, which is deemed to be accomplished by the execution of the agreement.

The three-pronged community property agreement establishes, in effect, ownership interests akin to joint tenancy with right of survivorship and so it is often used as an all-inclusive probate avoidance device. As a consequence, even in community property jurisdictions, its existence can nullify a well-considered credit shelter will or trust plan unless the agreement is discovered and revoked. Attorneys in common law jurisdictions should try to determine whether transplanted clients have signed such an agreement. Often, spouses forget ever having signed one. Standard practice in some community property jurisdictions for tax-sensitive estates is to have the spouses execute a written revocation of any three-pronged community property agreement that they may have executed in the past, and to replace it with a one- or two-pronged “status” agreement.

Attempts to plan for retirement benefits in the new common law domicile can also be undermined by undetected community property interests. An issue yielding widely divergent results among the community property jurisdictions is whether the non-employee spouse who dies first may dispose of his or her community property interest in the employee spouse’s retirement plan at death. At one extreme is the “terminable interest rule” adopted in Wisconsin,15 under which the non-employee spouse is afforded no such right. In contrast, California, which originally had followed the terminable interest rule, has abrogated the rule by statute16 and permits the predeceasing non-employee spouse to dispose of such an interest. Adding to the confusion, the Ninth Circuit has ruled that ERISA preempts state community property law and that the predeceasing non-employee spouse has no dispositive rights in plans governed by ERISA.17

Problems raised by undetected community property are not limited to spouses moving from a community property jurisdiction. Even if the clients were not married, but lived together in the community property jurisdiction, ownership rights akin to community property interests may have accrued. Some courts analyze property acquired during long-term “meretricious” relationships in terms of community property principles, at least upon break-up of the relationship.18

In addition, parties who may never have resided in a community property state may have acquired community property under one of the temporary community property regimes adopted in Hawaii, Michigan, Nebraska, Oklahoma, Oregon, and Pennsylvania, to achieve income-splitting between the spouses prior to the revenue act of 1948. In most of these states, community property acquired during the effective period of these temporary statutes was permitted to retain its community character, subject in some states to a formal assertion of a community claim within a designated time.19

Planning for community assets

Practitioners should strive to identify any community property issues as early as possible in the planning process. Unfortunately, the community property of the transplanted clients may be difficult to detect. Clients rarely know dependably whether a particular asset is community or separate in character, and usually no reliance should be placed on their guesses as reflected in client-completed data forms. Therefore, raising the question, “Do you own any community property?” may be a waste of time. There will probably be no alternative to determining the character of each asset on an individual basis under the community property laws of the spouses’ original domicile. Perhaps the most effective way to identify community property is to include questions relating to community property, as shown in Exhibit 1. Clients will understandably be unwilling to finance development of their attorney’s expertise on community property law, and frequently the most prudent option is to involve experienced outside counsel.

After identifying the clients’ potential community property assets, a planner in a common law state should determine how such assets will be treated under the law of the new state. Thirteen states have adopted the Uniform Disposition of Community Property Rights at Death Act (the “Uniform Act”).20 The Uniform Act basically provides that, upon the death of the first spouse, only the decedent’s half of any community property is subject to testamentary disposition or distribution under the state’s succession laws. Such property passes free of election, dower, or curtesy rights of the surviving spouse.21 Disposition by trust apparently falls outside the purview of the Uniform Act. Real property located in the adopting state is treated as community property if acquired with the rents, issues, or income of, proceeds from, or in exchange for, community property under the laws of another jurisdiction.22

The drafters’ commentary notes that the Uniform Act applies to property not originally community property, but which became community property by agreement.23 As to personalty or realty only partly sourced in community property, only the proportionate part so sourced is subject to the Uniform Act.24 In earlier drafts, the provisions addressing the area of partial community character covered “many pages,”25 and the shortening of the language concerning this issue reflects some of the drafters’ frustration with local differences among the community property jurisdictions. The Uniform Act leaves to the practitioner the task of determining what portion of an asset is community in character.

The Uniform Act adopts the community property presumption as to property acquired during the marriage.26 The surviving spouse may “perfect” title in his or her half of the community property, by court order or by an instrument signed by the personal representative, heir, or devisee with court approval.27 The personal representative has no duty to discover or attempt to discover community property absent a written demand by or on behalf of the surviving spouse. Similarly, if community property is in the hands of the surviving spouse, the personal representative, heir, or devisee of the decedent spouse may initiate an action to perfect title.28 The personal representative is relieved of any fiduciary duty to discover or attempt to discover whether any property held by the surviving spouse is community property, absent a written demand by an heir, devisee, or creditor of the decedent. Nothing is said of the attorney’s duty to discover community property in these various circumstances.

Third-party purchasers or lenders as to a surviving spouse with “apparent title” (i.e., record title) take their interests free of any rights of the decedent’s personal representative or heirs and devisees.29 If the personal representative, or an heir or devisee, holds “apparent title” to community property as a result of the decedent’s death, purchasers or lenders take their interests free of any rights of the surviving spouse.30 Again, nothing is said about the potential liability of an attorney for failure to identify community property interests, and the reader can probably draw his or her own conclusions from this silence.

In short, the Uniform Act serves the salutary goal of clarifying what becomes of community property once it is detected, but leaves the process of detection (and the risks of failure to detect) to the attorney. In common law states that have not adopted the Uniform Act (the majority of them), the record of the courts in recognizing and giving effect to community property interests is spotty but improving. Several notorious older decisions raised the wrath of community property commentators.31 More recently, the courts have protected community interests of migrating clients by a variety of means, including the application of a resulting trust theory.32

Disadvantages of recharacterizing community property

What should a planner in a common law jurisdiction recommend to transplanted clients once their community property interests have been detected? A course that may hold superficial appeal is to convert the community property by spousal agreement into co-tenancy, probably a form more familiar to the attorney. The change would approximate, at least in some ways, the co-ownership interests inherent in community property. In addition, the “natural” estate-splitting quality of the underlying community property can presumably be preserved in this fashion. Any such rearrangement of the parties’ respective ownership interests raises questions as to the need for independent counsel.

The chief disadvantage of the co-tenancy approach is that it will likely sacrifice the “double” step-up in basis afforded to both halves of the community property at the death of the first spouse under Section 1014(b)(6). The common law practitioner may wish to recommend that the spouses revoke any three-pronged community property agreement they may have executed, and replace it with a one- or two-pronged version, in order to retain the community character and so preserve the full step-up in basis at the first spouse’s death. Concerns arise as to the validity of a one- or two-pronged community property agreement signed by spouses when they are no longer domiciled in a community property jurisdiction that recognizes such agreements. In all likelihood, the laws of the new common law domicile will offer no guidance on the question.

Consideration may be given instead to leaving the three-pronged community property agreement in place and relying on the surviving spouse to disclaim his or her interest under the agreement at the death of the first spouse. Disclaimer laws in the new state of domicile will almost certainly provide no specific authority for such a disclaimer. A revocation of the three-pronged community property agreement should leave the community property character of the spouses’ assets intact, however. To help refute any suggestion that the revocation of the three-pronged agreement while the parties are domiciled outside a community property jurisdiction evidences an intention to negate the community property character altogether, a provision may be inserted in the revoking document confirming the contrary intention of the spouses.

Any attempts to recharacterize the community property assets as held in tenancy in common or some other form of ownership more readily recognizable in a common law jurisdiction may well run afoul of Rev. Rul. 68-80.33 That Ruling involved spouses who had held community property realty in New Mexico. After a move to Virginia, they “traded” their New Mexico real estate for realty in the new state, taking title as tenants in common. The Service ruled that the Virginia realty did not qualify for the “double” basis step-up at the husband’s death because the Service determined (probably incorrectly) that the property had been converted from community property to separate property. Hence, taking title in co-tenancy or a similar form of ownership runs the risk of being construed as effectuating a severance of the community property interests, precluding the “double” basis step-up at the death of the first spouse.

Preserving community character of assets

The challenge for a common law practitioner typically is to attempt to preserve the community character of assets in such a way as will have the greatest chance of recognition and effectiveness in the new state of domicile.34 For example, the attorney may suggest that the parties execute a marital agreement confirming that assets will retain their community property character, notwithstanding the move to the new common law jurisdiction.

If the spouses take title to realty in the new jurisdiction, consideration should be given to reflecting the community character of the asset in the deed, but in such a way as will not confound title examiners. This may be achieved, for example, by reciting that the couple takes title as “husband and wife,” with an additional recital that they hold their property as community property to be governed under the laws of the former state of domicile. Some support for such a solution is suggested in Rev. Rul. 87-98,35 which did not involve a move from a community property to a common law jurisdiction. After taking title to realty as joint tenants with right of survivorship in their domicile, a community property state, the spouses in that Ruling executed joint wills in which they declared the property to be a community asset. The Service relied on this recital to rule that the property qualified for the “double” basis step-up at the first spouse’s death. It is far from clear, however, that the Service would have reached the same result had the facts involved a move out of a community property jurisdiction.

Other useful strategies that have been suggested for preserving the community character of assets following a relocation to a common law jurisdiction include: (1) funding a revocable letter inter vivos trust with community property and selecting the law of the community property state as governing law36; (2) using a custody or agency account designated as community property37; and (3) adopting an “identifier-vehicle,” such as a memorandum, agreement, or brokerage account, to memorialize and give effect to the community interest.38 The selection of the best format, or combination of formats, among these or others the attorney fashions will depend on the particular circumstances of the transplanted clients as well as the likelihood the new state of domicile will give effect to one or another of these strategies.

Conclusion

As early as possible in the representation, estate planners in common law states should attempt to detect any community property interests of clients who have moved from community property jurisdictions. Specific questions in a client-completed confidential estate planning data form can provide a foundation for further investigation, which may present significant challenges, given the wide diversity of laws among the community property jurisdictions. A practitioner should ordinarily strive to maintain the double basis step-up, the “natural” estate-splitting quality, and other advantages afforded community property, and should prepare the estate plan in light of the community property interests.

1 Wis. Stat. §§766.001 et seq.

2 See, e.g., Ariz. Rev. Stat. Ann. §25-211.

3 See, e.g., Wood v. Wood, 124 Idaho 12, 855 P.2d 473 (1993).

4 See, e.g., In re Miles’ Estate, 72 Cal. App. 2d 336, 164 P.2d 546 (1945).

5 See, e.g., McNabney v. McNabney, 105 Nev. 652, 782 P.2d 1291 (1989).

6 See, e.g., Graham v. Radford, 71 Wash. 752, 431 P.2d 193 (1967).

7 See, e.g., Kitchens v. Kitchens, 407 S.W.2d 300 (Tex. Civ. App., 1966).

8 See, e.g., Restatement (Second) of Conflict of Laws, section 260 (1971).

9 See, e.g., Ariz. Rev. Stat. Ann. §25.213; Wash. Rev. Code §26.16.010-020.

10 Idaho Code §32-906(1); La. Civ. Code Ann. art. 2339; Tex. Fam. Code Ann. §5.01(b).

11 Compare Pereira v. Pereira, 156 Cal., 102 P. 488 (1909), with Van Camp v. Van Camp, 53 Cal. App. 17, 199 P. 885 (1921).

12 E.g., Aetna Life Ins. Co. v. Wadsworth, 689 P.2d 46 (Wash., 1984).

13 Geronimo Hotel & Lodge v. Putzi 151 Ariz. 477, 726 P.2d 1227 (1986); Droeger v. Friedman, Sloan & Ross. 54 Cal. 3d 26, 283 Cal. Rptr. 584 (1991).

14 See, e.g., Wash. Rev. Code §26.16.120; Haynes v. Stripling, 812 5.W.2d 397 (Tex. App. 1991).

15 Wis. Stat. Ann. §766.31.

16 Cal. Fam. Code §2610.

17 Ablamis v. Roper, 937 P.2d 1450 (CA-9, 1991). But see Boggs v. Boggs, 840 F. Supp. 462 (DC La., 1994).

18 See, e.g., in re Marriage of Lindsey. 101 Wash.2d.299, 678 P.2d 328 (1984).

19 See, e.g., Neb. Rev. Stat. §42-619.

20 AK, AR, CO, CT, FL, HI, KY, MI, MT, NY, OR, VA, and WY.

21 Uniform Disposition of Community Property Rights at Death Act, section 3.

22 Id., section 1(2).

23 Id., comment to section 1.

24 Id., sections 1(1)(ii) and (2).

25 Id., comment to section 1.

26 Id., section 2(1).

27 Id., section 4.

28 Id., section 5.

29 Id., section 6(a).

30 Id., section 6(b).

31 Commonwealth v Terjan, 197 Va. 596. 90 S.E.2d 801 (1956); In re Hunter’s Estate. 125 Mont. 315, 236 P.2d 94 (1951); de Funiak, “Commonwealth v. Terjan: Common Law Mutilates Community Property.” 43 Va. L. Rev. 49 (1957).

32 E.g., Quintana v. Ordono, 195 So.2d 577 (Fla. Ct. App. 1967).

33 1968-1 CB 348.

34 See Moore, “Migration and Property in the 1990’s: The Increasing Importance of Community Property-Separate Property Recognition and Resolution,” 25 U. Miami Inst. On Ext. Plan. ¶1100 (1991) (hereinafter, “Moore”); Johanson, “The Migrating Client: Estate Planning for the Couple From a Community Property State,” D U. Miami Inst. On Est. Plan. ¶800 (1975) (hereinafter “Johanson”).

35 1987-2 CD 206.

36 See Moore, supra note 34, at ¶1110.2; Johanson, supra note 34 at ¶830.2.

37 See Moore, supra note 34, at ¶1110.3.

38 Cantwell and Cox, “Community Property for Every Lawyer,” Colo. Law. (Aug 1974) 321, at 330.

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