Estate Planning for Same-Sex Couples involves complex legal and tax considerations that must be taken into account before making a choice.
By Nancy G. Fax
Estate Planning for Same-Sex Couples: The Legal Landscape
Six jurisdictions in the United States recognize same-sex marriages: the District of Columbia, Connecticut, Iowa, Massachusetts, New Hampshire and Vermont. California recognized same-sex marriages for a few months in 2008 (and approximately 18,000 same-sex couples were married in that period). The Maryland legislature voted against same-sex marriages in 2011. It is likely that a same-sex marriage bill will be introduced in the General Assembly in 2012. Several states do not permit same-sex marriage but do recognize valid same-sex marriages entered into elsewhere. Other states have created a legal relationship that provides financial and other rights comparable to marriage, such as civil union or registered domestic partnership. The vast majority of the states, however, ban same-sex marriage, and some of those states prohibit civil unions and registered domestic partnerships as well.
Aside from the myriad approaches taken by the states, the federal Defense of Marriage Act defines marriage as a legal union between one man and one woman for all purposes under federal law, including the tax code. It also provides that any state may refuse to recognize a marriage, or comparable legal relationship, between persons of the same sex even if valid in the state where the parties married or entered into the relationship.
Basic Estate Planning
The basic elements of an estate plan – will, power of attorney, advance health care directive, beneficiary designations – are important for everyone, but they are even more important for same-sex couples. This is because the state and federal law rights and protections available to spouses and other family members often are not available to same-sex couples. Even if the same-sex couple was married in one of the states that recognizes same-sex marriage, the couple is not recognized as married under federal law and may not be recognized as married in another state.
Let’s look at an example: Ozzie and Harriet, a married heterosexual couple, neglect to put together a basic estate plan. They have no wills, no powers of attorney, no advance health care directives and no beneficiary designations. Ozzie becomes incapacitated and can no longer conduct his own financial affairs or make his own health care decisions. Under state law, Harriet will have priority to be appointed as Ozzie’s guardian and she will have the authority to make health care decisions for him. Upon Ozzie’s death, under state law, Harriet will automatically inherit some portion or all of Ozzie’s estate and, under federal law, she will automatically be entitled to 100% of any qualified retirement plan survivor benefits Ozzie had. With regard to Ozzie’s funeral and burial/cremation arrangements, Harriet will be in charge of all decisions. All of these results will occur even without any planning because of applicable state and federal laws.
Now let’s look at another example: Olive and Hannah are an unmarried lesbian couple and they have not entered into a civil union or registered as domestic partners. Like Ozzie and Harriet, they have lived together in a stable relationship for many years and, like Ozzie and Harriet, Olive and Hannah have no estate plan in place. When Olive becomes incapacitated, Hannah has no priority to become Olive’s guardian and has no authority to make health care decisions for Olive. Under most state laws, assuming Olive has no adult children, Olive’s parents or siblings would have the right to oversee Olive’s care. Upon Olive’s death, Hannah would receive nothing from Olive’s estate and she would have no claim to any portion of Olive’s qualified retirement plan survivor benefits. Finally, Hannah would have no authority to make any funeral or burial/cremation arrangements for Olive; Olive’s next of kin would have the authority to do so.
These contrasting examples demonstrate how important it is for married same-sex couples and unmarried partners (samesex or otherwise) to create a basic estate plan, including a will, a power of attorney, an advance health care directive and beneficiary designations for life insurance and retirement accounts. In addition, if desired, each member of an unmarried couple should consider executing a written statement designating his or her partner as the person authorized to make funeral arrangements and decisions about burial or cremation.
Gift and Estate Tax Planning
Under federal law, a married couple enjoys the benefits of the unlimited gift and estate tax marital deductions. Because of these deductions, a married person can transfer unlimited assets to his or her spouse by gift during lifetime or by bequest at death with no federal gift or estate tax. The gift and estate tax deductions are not available to samesex couples, whether or not validly married under state law, because of the federal Defense of Marriage Act, which defines marriage as a heterosexual relationship. In those states that impose a state level estate tax or an inheritance tax, the status of the same-sex couple (whether or not married, in a civil union or registered domestic partnership) will determine the applicability of the state tax.
Same-sex couples, therefore, are more likely to face gift and estate taxes on transfers between them than similarly situated married heterosexual couples. Accordingly, it is important to plan for potential imposition of estate or inheritance tax at the death of the first to die. In these situations, the acquisition of life insurance and the ownership of the life insurance in an irrevocable life insurance trust may be a good option to provide liquidity and reduce estate shrinkage. In considering the acquisition of life insurance, unmarried same-sex couples should be aware of the possibility that an insurance company may question whether they have an insurable interest in each other and may require additional documentation to establish the existence of an insurable interest.
At least for 2011 and 2012, the federal gift and estate tax exemptions are set at $5 million, so many people will not be affected by federal transfer taxes. We do not know what the exemptions will be after 2012. In addition to the federal transfer taxes, 21 states and the District of Columbia impose estate and/or inheritance taxes, and these taxes need to be taken into consideration. In the District of Columbia and Maryland, the threshold for estate tax is $1 million and the rates range from 5.6% to 16%. Virginia has no state estate tax.
One Estate Planning Advantage
There is one type of estate planning strategy that same-sex couples can take advantage of in a way that married or related parties cannot. Chapter 14 of the Internal Revenue Code deals with transfers among traditional family members and prohibits “freeze” transactions which are used to pass property from one generation to the next at a reduced transfer tax cost. A freeze transaction can be defined as a gift by one member of a family to another member of the family to freeze the gift at its gift tax value. Any post-gift appreciation is removed from the donor’s gross estate and shifted to the donee.
Among other things, Chapter 14 prohibits the use of common-law grantor retained income trusts (GRITs) for the transfer of assets to members of a family. A GRIT is an irrevocable trust to which the grantor transfers assets such as a residence, business or other assets for a period of years. The grantor retains the right to occupy the residence or the right to the income produced by the trust for the term of the trust. Upon expiration of the term of the trust, the assets are distributed to the beneficiary of the trust (the grantor’s partner or spouse). The benefit of the GRIT is that the fair market value of the property transferred to the trust is reduced by the value of the grantor’s retained interest in determining the gift tax value of the transfer. In addition, any appreciation in the trust property is transferred to the beneficiary.
Neither a same-sex spouse nor a samesex partner constitutes a family member for purposes of Chapter 14. Accordingly, this tax-efficient planning technique, which cannot be used by a traditional family, is available to same-sex couples.
Estate Planning for Same-Sex Couples: Asset Ownership
It is critically important to make deliberate decisions about how to title assets. This is true for all couples, but it has particularly important ramifications for same-sex couples. Joint ownership of assets by same-sex couples may create the potential for unintended gifts or inadvertently inflate the estate of the first owner to die, possibly resulting in an increase in taxation on assets left to the survivor.
With jointly owned accounts, gifts occur not when money is deposited into an account, but rather when assets are withdrawn from the joint account. If contributions to the account are not equal, the excess of contributions that are beyond the annual gift tax exclusion (currently $13,000 for the year in which withdrawals occur) would be a taxable gift. If either party’s withdrawal exceeds this amount, a gift tax return may be required, although no gift tax is likely to be due because of the lifetime gift tax exemption ($5 million in 2011 and 2012).
When same-sex spouses or partners title real property jointly, a gift can occur at the time of purchase if the parties contribute disproportionate amounts for a down payment and the contribution difference between the parties exceeds the annual gift tax exclusion amount ($13,000 in 2011). A gift can also be triggered upon paying the mortgage on the property if one party contributes an amount above his or her pro rata obligation that exceeds the annual gift exclusion.
Another complication is that the Internal Revenue Code provides that when an asset (including real property) is jointly titled, the entire value of the asset is included in the gross estate of the first to die, unless the surviving party can prove his or her contributions. For this reason, when a same-sex couple establishes jointly owned accounts or has jointly owned real estate, it is critically important to keep records of each party’s contributions.
In some cases, acquiring assets individually or as tenants in common may be advisable in order to avoid the adverse transfer tax consequences described above. If assets are already jointly titled, then it might make sense to consider moving joint accounts to individual or tenancy in common accounts (pro rata based on ownership). If a couple has made disproportionate contributions to the acquisition of jointly titled real property, the parties may wish to execute a new deed titling the property in their names as tenants in common in percentages that reflect their respective contributions.
Same-sex couples, like other couples, need to consider how best to protect assets from future creditors of either member of the couple. A married couple can own property as tenants by the entirety, which is a form of ownership available only to married people. If property is owned as tenants by the entirety, it cannot be attached by a creditor of one of the spouses (except the IRS). From an asset protection standpoint, this is one of the benefits of marriage. On the other hand, property owned as joint tenants with right of survivorship, a form of ownership available to married and unmarried people alike, is vulnerable to attachment by a creditor of one owner. For those married couples who wish to own property jointly, tenancy by the entirety is preferable to joint tenancy for protection against creditor claims. In the District of Columbia and any state that recognizes same-sex marriage, same-sex married couples can own real estate in tenancy by the entirety.
Cohabitation or Domestic Partnership Agreements
Same-sex couples planning to marry should consider whether to have a premarital agreement. For those same-sex couples who cannot or do not wish to marry, a cohabitation or domestic partnership agreement may be an important part of their overall plan. Such an agreement will provide a degree of certainty with respect to how expenses will be handled, how income will be shared or separated, how assets will be titled, what will happen to assets in the event the relationship terminates (by death or dissolution), and how disputes will be resolved.
As is true for any couple, the right estate plan for a same-sex couple depends on the particular wishes and objectives of the parties. Planning for the same-sex couple is especially important and challenging, however, because of the complex legal and tax considerations that must be taken into account. Unless and until same-sex marriage is universally recognized, we will continue to have to deal with these complexities in planning for same-sex couples.
Managing partner Nancy Fax serves on the board of the Community Foundation for Montgomery County. The foundation houses a large variety of funds through which individuals, families and businesses in Montgomery County do their charitable giving, and it maintains the Sharing Montgomery Fund which provides grants to dozens of local non-profit organizations each year. Nancy previously served as chair of the foundation’s board from 2004 to 2006. Nancy also serves on the Board of Directors of the Bethesda-Chevy Chase High School Educational Foundation. The foundation funds programs that provide support for B-CC High School students to reach their academic potential and help them build a pathway to college.