By: Roy A. Sjoberg, Esq.
I. INTRODUCTION - WHAT THIS PRESENTATION/OUTLINE IS INTENDED TO TEACH
The allure of the double step-up in basis under Internal Revenue Code § 1014(b)(6) is likely the key income tax advantage available through the community property system. Not only must the Minnesota lawyer be aware that community property attributes are not forfeited automatically when a former community property client moves to Minnesota, but must also consider the availability of the elective Alaska community property trust. If no attempt is made by the Minnesota lawyer 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.
This presentation/outline will first familiarize the reader with the basics of community property (also referred to as marital property) in the states of Wisconsin and Alaska. "Watch out for this" examples will be presented throughout to give the reader practical advice in recognizing problem areas. Practice tips will be presented as solutions for the problem areas recognized. This presentation/outline will also assist in providing ways to preserve the community property nature of assets brought into a common law state. Then, following a brief review and analysis of the Alaska community property trust, a listing of select community property law resources will be presented.
"Watch out for this" Example 1: "The Tainted Irrevocable Life Insurance Trust ('ILIT')." Two years ago, your successful business owner client moved from the Twin Cities, along with his wife, to the Wisconsin side of the St. Croix River Valley. Four years ago, you had this business owner establish an ILIT which had his wife serve as the trustee and which provided his wife with a lifetime income interest in the trust. Each year your office made sure that the contributions to the trust were made by the business owner rather than by his wife in order to avoid the retained life interest problems under IRC § 2036. The life insurance policy is four years old and two of the annual premiums have been paid from your client's earnings after having moved to Wisconsin. Now if your client dies first and his spouse dies second, at least one-half of the death benefit will be included in the spouse's taxable estate under IRC § 2036.
Practice Tip: Through a marital property agreement or other Wisconsin planning documents, such as a unilateral statement, the client could have caused all contributions to this ILIT to be treated as being made from the client's separate property. However, if the community property earnings have already been used to pay one or more premiums, consider having the client abandon or otherwise terminate the tainted trust and begin anew.
II. THE BASICS OF COMMUNITY OR MARITAL PROPERTY
A. In General.
(1) Community Property States.
(a) Traditional. Community property law states are Arizona, California, Idaho, Louisiana, New Mexico, Nevada, Texas, and Washington.
(b) Wisconsin. Wisconsin adopted a marital property system which went into effect on January 1, 1986. Wisconsin and Alaska are the only two states to either adopt or pattern their laws after the Uniform Marital Property Act (herein the "UMPA"). The IRS has ruled that Wisconsin marital property is the equivalent of community property for income tax purposes. (Rev. Rul. 87-13, 1987-1 C.B. 20.)
(c) Alaska. Alaska has adopted an "elective" community property system for Alaska residents and for non-residents who transfer assets to an Alaska trust. The Alaska Community Property Act, effective in 1998, allows a married couple, who are both residents of Alaska, to elect to classify property as community property. In addition, non-resident spouses may transfer property to an Alaska community property trust, and it will be characterized as community property under Alaska law. The Alaska trust provisions will be covered in more detail under Article IV of this presentation/outline. While the Wisconsin statute is mandatory unless a couple elects out, the Alaska statute provides the opposite; Alaska residents must elect the community property treatment of assets if they want it to govern. Because the statute is relatively new, the government has not ruled on whether elective community property under Alaska's new law is community property for income tax purposes.
There are significant differences in the community property laws of these ten states. Therefore, when addressing community property issues for a particular client couple who migrated to Minnesota, the lawyer needs to examine the laws of the particular community property state, or states, in which the couple resided before changing their residence to Minnesota.
Minnesota made unsuccessful attempts to adopt the UMPA in 1985, 1986, 1987 and 1989.
While most states have adopted community property by statute, Texas's community property system is contained in its constitution, which means that any change (such as permitting marital property agreements to alter the nature of property) must be made by constitutional amendment. This, at least in part, explains why Texas is the only community property state that does not permit the spouses to reclassify, by means of a marital property agreement, separate property into community property.
(2) Underlying Principles.
(a) The basic thrust of community property law is that the acquisition of property by either spouse during marriage is treated as a contribution to the community. The result is community property. The relative values of the contributions made by each spouse is not an issue as both are presumed equal.
(b) The spouses own community property in equal and undivided interests.
(c) Each spouse may dispose of his or her community property interest in an asset during life and at death.
(d) Each spouse owes the other spouse certain fiduciary duties in the management of community property.
(e) Generally, the law of a community property state presumes that property a married couple acquires while residing in a community property state, except property acquired by gift or inheritance, is community property.
(f) In Idaho, Louisiana, Texas, and Wisconsin, income from most separate properties is treated as community income. In the other five states, income from separate property is treated as separate property.
"Watch out for this" Example 2: "Presumption of Community Property." Your clients just moved to Minnesota from Seattle, Washington. When they filled out the personal financial statement you requested they bring to their first appointment, the wife indicated that through her job, she was able to acquire $1,000,000.00 worth of Microsoft stock at a tax basis of $80,000.00. The clients retained no specific records on the source of the acquisition of any of their assets. However, you have learned that when they first moved to Washington neither of them had any assets of significant value and that neither of them had any significant gifts or inheritances during their marriage. Furthermore, they stated they never entered into a prenuptial agreement or a marital property agreement before or during their marriage. A stockbroker referred this client to you and has already indicated that the Minnesota account is now listed solely in the wife's name. You then create a new Minnesota revocable trust for each of them. Three years later, the husband dies first, and your notes do not reflect that he may own a community property interest in the Microsoft shares of stock and thus, the wife may miss out on the double step-up in basis.
Practice Tip: When you discover that a couple moving to Minnesota has highly appreciated property:
(1) Always ask your clients whether they have ever lived in a community property state and if so, have them identify when and how the property was acquired. (2) Then determine if it is advantageous to protect the community property aspect and take steps, as discussed later in this presentation/outline, to preserve the community property nature.
(1) Community Property is Generally Defined in the Negative. A married couple domiciled in a community property state is presumed to own all of their property as community or marital property, regardless of titling, absent:
(a) An agreement to the contrary; or
(b) Proof that the property was brought into the marriage by either spouse, a gift received by either spouse, inherited by either spouse, or a spouse's separate property before the couple became domiciled in the community property state.
Furthermore, in Wisconsin, due to the fact that the marital property regime was recently enacted, classification depends heavily on whether the assets were acquired before or after "the determination date." The determination date in Wisconsin is the last to occur of: (1) marriage, (2) date of establishment of domicile by both spouses in Wisconsin; or (3) January 1, 1986.
(2) Quasi-Community Property or Deferred Marital Property. Some states (specifically, California, Idaho and Wisconsin), create a category for a spouse's property acquired in another state that would have been classified as community property, if acquired under similar circumstances, while the couple was domiciled in that state. This classification is designed to protect spouses against disinheritance by providing a special elective share to the surviving spouse.
In California, Idaho and Wisconsin, if the holding spouse dies first, he or she may only be able to freely dispose of one-half of the quasi-community or deferred marital property. On the other hand, if the non-holding spouse dies first, the non-holding spouse has no power of disposition over the quasi-community property or deferred marital property.
"Watch out for this" Example 3: "Vanishing Elective Share Rights." Your Minnesota client moves away to a community property state. Because your clients each had children of a prior marriage and no prenuptial agreement, your clients understood that if their Wills leave their entire estates to their children of their prior marriage, the spouse would have the right to utilize their elective share rights, which they both agreed was fair. Now they call you from Arizona asking you if anything needs to be done with their estate plan as Arizona residents. Luckily, you recall this outline, which reminds you that Arizona law does not provide for elective share rights, as the only quasi-community property laws that apply are the states of California, Idaho and Wisconsin. You advise them that the elective share provisions, relied upon under Minnesota law, no longer apply.
Practice Tip: When your client moves to a community property state, if you are not intimately familiar with that community property state's laws, insist that the client have the estate plan documents reviewed by a community property lawyer.
(3) Life Insurance. The effect of community property laws on life insurance ownership varies depending on both the state and the type of insurance. In most states, ownership of term insurance depends on the source of payment for the premium in the year of the decedent's death. Cash value life insurance ownership varies from state to state.
(a) Some states follow the "apportionment rule." Under this rule, policy ownership is apportioned based on what type of funds were used to pay premiums. For example, under California law, the death benefits will be allocated between separate and community property in proportion to the separate or community nature of the funds used to pay the premiums.
(b) If the state follows the "inception of title rule," the classification of the policy and its proceeds depends on whether community property or separate property funds were used to pay the initial premium, no matter what funds were used in later years to pay premiums.
(c) Wisconsin has special classification rules for life insurance. The marital component of life insurance in Wisconsin begins with the first premium paid with marital property, regardless if separate property is used for payments thereafter. Wis. Stat. § 766.31 (2003).
(4) Deferred Employee Benefits.
(a) ERISA Preemption. In all community property states, retirement benefits are part separate property and part community property, in proportion to the contributions to the plan before marriage and the contributions to the plan during marriage. However, state community property laws that grant the non-employee spouse rights of lifetime or testamentary disposition over one-half of the community property employee benefits are in direct conflict with federal employee benefit law that prohibits alienation of those benefits by someone other than the employee participant. Because a conflict as to rights of a non-employee spouse developed between the various Federal Circuit Courts of Appeals, the U.S. Supreme Court finally resolved the issue, at least in part, in Boggs v. Boggs, 520 U.S. 833, 841, 117 S.Ct. 1754, 1761, 138 L.Ed.2d 45 (1997). Boggs held that ERISA does preempt state law so a spouse may not transfer a community property interest in an undistributed pension plan by testamentary instrument.
On the other hand, IRAs do remain subject to state community property laws. For example, if qualified plan benefits are rolled into an IRA during the lifetime of the participant spouse, then the state community property laws will apply to those IRAs. However, if qualified plan benefits are paid to an IRA after death, then ERISA continues to preempt the state community property laws.
Not all plans covered by ERISA are preempted. For example, group life insurance is a welfare plan, not a pension plan, and thus conflicting ERISA provisions do not apply. See Emard v. Hughes Aircraft Co., 153 F.3d 949 (9th Cir. 1998), cert. denied sub nom., Stencel v. Emard, 119 S.Ct. 903 (1999).
(b) IRA Management and Control. Even if an IRA has community property aspects, because of the fact that IRAs are required to be trusts or custodial accounts, the governing instrument of an IRA need only allow the owner spouse to designate the beneficiary of the IRA. Furthermore, once a spouse creates and funds an IRA, the owner spouse and the non-owner spouse no longer "own the property contributed to the trust or custodial account. Rather, they own a beneficial interest in the trust or custodial account." Pharies, S. Andrew, Community Property Aspects of IRAs and Qualified Plans, 13-Oct Prob. & Prop. 33, at 36. The rights conferred by that beneficial interest are set forth in the governing instrument. To the extent that the owner spouse reserves management rights to himself or herself, the non-owner spouse will not be able to exercise those rights.
(c) Migration to Common Law Jurisdictions. In the case of a couple that has moved from a community property state to a common law state, common law jurisdiction courts must consider the question of how to characterize employee benefits. Courts generally have taken either the "date of acquisition approach" or the "apportionment approach" in dealing with facts and other issues involving employee benefits. Under the "date of acquisition approach," the court looks to the character of the asset when acquired and determines that the move from the community property state to the common law state does not affect the characterization of such assets. With the "apportionment approach," the court determines what portion of the benefits is community property and what portion is separate property, basing the apportionment on where the couple resided when benefits were accrued.
(d) The Terminable Interest Rule. The terminable interest doctrine generally relates to interests of non-participant spouses in retirement plans and death benefits earned by the participant spouse. In states recognizing the terminable interest rule, the rule will generally be that whatever interest the predeceasing, non-participant spouse had in such benefits, will "terminate" on his or her death. In some states, it also terminates on divorce. The states of Wisconsin and New Mexico follow this rule in the case of death, but do not follow it upon divorce. Texas only applies the doctrine with respect to public retirement plans. Neither California nor Washington follow the terminable interest rule.
If the terminable interest rule does not apply, then serious complications may emerge if the non-participant spouse is the first-to-die and only the participant spouse has the power to make a beneficiary designation. The non-participant spouse could intentionally or inadvertently dispose of his or her community property interest in, for example, an IRA by his or her Will.
"Watch out for this" Example 4: "The Inadvertent IRA Disposition." You prepare a Pourover Will and Revocable Trust for a non-IRA owner wife and her IRA owner husband who have just moved here from California. The Pourover Wills "pour" all property to the decedent's Revocable Trust, which then funds the Bypass Trust as provided in the Revocable Trust Agreement. Such a disposition could cause current income taxation of the distributed amount and could cause imposition of the 10% excise tax for premature distribution if the owner spouse has not attained the age of 59-1/2 and the non-owner spouse is the first spouse to die. IRC § 72(t)(1). If it was the owner spouse that was the first-to-die, then only the owner spouse's portion should be governed by the beneficiary designation established in the IRA account. If, mistakenly, the entire IRA account (including the non-owner's one-half interest) passed to the Bypass Trust, then the assets of the Bypass Trust remaining at the non-owner's death may be includable in her gross estate under IRC § 2036.
Practice Tip: If you realize that there is a community property interest in an IRA, then state in the beneficiary designation that only the owner spouse's community property interest is to be distributed to the Bypass Trust and that the non-owner's spouse's community property interest will be transferred outright to the non-owner spouse.
(e) Wisconsin. In Wisconsin, employee benefits are part separate property and part community property, in proportion to contributions to the plan before and after the determination date.
(5) Special Rules for Classification.
(a) Tracing. Assets acquired during marriage with separate funds, and assets acquired with the proceeds of sale of separate assets, are separate property. However, to maintain their separate character in a community property state the assets must be clearly traceable as separate property. This is very difficult as a practical matter.
(b) Commingling. Separate property may lose its identity by commingling if adequate records are not kept. This is due to the presumption that all property is community property.
"Watch out for this" Example 5: "Surprise Shareholders." Your married, business owner client decided to move from Minnesota to Wisconsin with her husband. She owns an S corporation. Because it was formed before her marriage, you had advised her that the shares of stock were separate property. Since her move to Wisconsin, the corporation needed additional capital. Some of the income from the corporation was not distributed, but, instead, reinvested in the corporation. After that point, all of the stock held by your client has become community property. Accordingly, if her spouse passes away first and leaves his interest to his children of a prior marriage, your client may discover that she now has her spouse's children as co-shareholders.
Practice Tip: If one of your clients desires to move to Wisconsin and owns a company, consider having the client execute a marital property agreement. If that is not available, then Wisconsin, and only Wisconsin, permits the titled stockholder to enter into a buy/sell agreement (assuming there to be other shareholders) which places restrictions on the non-titled spouse's right to dispose of the shares, if the non-titled spouse dies first. Wis. Stat. § 766.51(9) (2003). For example, the Wisconsin buy/sell agreement can require that the non-titled spouse's "ownership" interest be subject to a first right of refusal. Note that even with this provision in place, the shares would still be community property and eligible for the double step-up in basis.
(c) Pre and Postnuptial Agreements. Pre and postnuptial agreements always need to be reviewed to determine whether classification of property has been established by agreement. For example, property acquired in a community property state can be reclassified as separate property by means of a valid prenuptial agreement. In some states, including Wisconsin, even postnuptial agreements can reclassify property from community property to separate property.
"Watch out for this" Example 6: "Full Impact of Marital Property Agreement." H and W, formerly domiciled in Wisconsin, become domiciled in Minnesota. Prior to their marriage, W inherited marketable securities having a cost basis of $50,000.00. Just before leaving for Minnesota, W's security portfolio had a fair market value of $5,000,000.00. While living in Wisconsin H and W entered into a valid marital property agreement that provided all of W's marketable securities would be marital property. After living in Minnesota for several years, W's marketable securities portfolio had a value of $10,000,000.00. H died. W received a new cost basis in the entire portfolio of $10,000,000.00. W liquidates the entire portfolio in order to better diversity her holdings. W receives $10,000,000.00 with no capital gains tax.
(d) Property Held as Tenants by the Entirety or as Joint Tenants With Right of Survivorship. In theory, property held as tenants by the entirety or as joint tenants with right of survivorship cannot exist at the same time as community property because of the survivorship right. However, Washington, Nevada, and Texas have enacted legislation to allow married couples to hold community property as joint tenants.
Wisconsin allows a special type of survivorship interest for marital property titled survivorship marital property. Like joint tenancy, the surviving spouse owns the entire property at the death of the first spouse-to-die, but unlike joint tenancy property, a double step-up in basis is allowed.
"Watch out for this" Example 7: "Title Problems." Your clients have moved from Minnesota to Wisconsin and continued to use their same stockbroker located in St. Paul. Your clients think that title to property does not make a difference so they leave the property titled in the old account as joint tenancy with right of survivorship. Will the property be considered as community property once domicile is set up in Wisconsin?
Practice Tip: To assure there are no issues on whether the property is community property or if it continues its separate property nature, title should be changed to a community property account or better yet, to a joint revocable trust. In Wisconsin, a marital property agreement is highly effective.
C. Tax Considerations.
(1) Estate Tax Issues. If community property law of the given jurisdiction provides that each spouse, no matter how property is titled, owns an undivided one-half interest in community property and that interest is subject to disposition at death by that spouse, one-half of the value of the community property would be includable in the deceased spouse's estate at the death of the first spouse. For example, if a non-owner spouse of an insured dies first, the non-owner spouse's community property interest in the life insurance policy is subject to estate tax. Rev. Rul. 75-100, 1975-1 C. B. 303.
Because community property laws provide protection for the surviving spouse, there is no need for elective share laws in community property states. Moore, 2000 Institute on Estate Planning,16-6. For this reason, the surviving spouse's interest in community property is not includable in the estate of the deceased spouse as a statutory right in lieu of dower or courtesy under IRC § 2034. Commissioner v. Chase Manhattan Bank, 259 F.2d 231 (5th Cir. 1958).
As indicated previously in this presentation/outline, if a community property life insurance policy on the life of one spouse is used to fund an irrevocable life insurance trust, or if premiums are paid from community funds, then if the surviving spouse is granted a life income interest in the trust after the insured's spouse death, IRC § 2036(a) requires inclusion of one-half the value of the trust in the surviving spouse's estate at the surviving spouse's subsequent death because the surviving spouse will be considered a co-grantor of the trust. U.S. v. Gordon, 406 F.2d 332 (5th Cir. 1969). To avoid this problem, all contributions to the trust, whether the policy or cash to support premium payments, should be made from the insured spouse's separate property.
Finally, many estate planning authorities recommend equal division of all assets owned by the spouses for optimum estate tax planning objectives. If all the couple's property is community property, no matter how titled, each owns an undivided one-half interest in all property. Thus, equalizing has already occurred, and there is no need to transfer property between the spouses. This has the advantage of permitting joint control of the community property assets to be maintained, rather than one spouse having to give up control of assets as would happen if asset transfers were required to achieve equalization.
(2) Income Tax Issues.
(a) Double Step-Up In Basis. If at the death of the first spouse-to-die one-half of the value of community property owned by the couple is includable in the deceased spouse's gross estate for federal estate tax purposes, then both the decedent's one-half interest and the surviving spouse's one-half interest in the community property receive a new basis equal to the fair market value of the property at the date of the decedent's death (or at the alternate valuation date), as finally determined for federal estate tax purposes. IRC § 1014(b)(6). If, on the other hand, the couple owned property not as community property, but as joint tenants with a right of survivorship or as tenants by the entireties under common law regimes, there is a step-up in only one-half basis of the property passing by survivorship. IRC § 1014(b)(9). The one exception to this rule is that if separate property is converted to community property less than one year before the death of the spouse who did not originally own the property there is no step-up in the basis of the donee spouse's one-half interest if it passes back to the donor spouse. Still, the donor spouse receives a step-up in basis of the donor spouse's one-half interest since the donor spouse's interest was not received by gift from the deceased spouse. Moore, 1991 Institute on Estate Planning, at ¶ 1111.
Note, that the double step-up in basis adjustment does not apply to quasi-community property or deferred marital property.
Planning Tip: If your client has a spouse with a terminal illness in a common law state, your client will not be able to receive a step-up in basis by transferring the property to his terminally ill spouse if that terminally ill spouse dies within one year of the transfer and the interest comes back to your client.
On the other hand, in a community property state, even if the spouse passes away within one year and the interest comes back to your client, your client will still receive a step-up for one-half. Under the right set of circumstances, consideration should be given to establishing domicile in a community property state or utilizing the Alaska community trust laws.
(b) Charitable Deduction Carry Forward. If a spouse makes a charitable gift of separate property that results in a carry forward charitable deduction, but dies before fully using the charitable carry forward, the carry forward will be wasted. The deceased spouse's successors in interest cannot use the carry forward. However, with community property it is less likely to have the carry forward wasted because each spouse owns one-half of the property.
D. Non-Tax Considerations.
(1) Lifetime Management and Control. The separate property of each spouse is completely within the owner/spouse's control under all community property systems.
Rights regarding the management and control of community property vary from state to state. Subject to a fiduciary obligation to deal fairly, each spouse has the authority, acting alone, to make decisions and exercise control over all community property.
(2) Power to Make Lifetime Gifts. In some community property states, a gratuitous transfer of community property without the other spouse's consent, can be set aside by the spouse during the spouse's lifetime or (to the extent of one-half of the property) on the donor spouse's death.
"Watch out for this" Example 8: "Deemed Gift of One-Half of Death Benefit." If a life insurance policy is community property, the consent by the spouse of the insured to the designation of a beneficiary (to someone other than the spouse) will have unexpected gift tax consequences for the spouse. At the death of the insured, the spouse is deemed to make a gift of one-half of the proceeds.
Practice Tip: It is usually advisable to classify a life insurance policy as the separate property of the insured spouse.
(3) Testamentary Disposition Rights. In all community and marital property states, each spouse has an unrestricted right to dispose of their separate property. Also, unless the terminable interest rules apply, each spouse has the unrestricted power of testamentary disposition of his or her one-half interest in community or marital property, regardless of the order of deaths of the spouses.
"Watch out for this" Example 9: "Life Insurance Revisited." If the non-insured spouse dies first, and if there is a community property component in the life insurance policy, and assuming that the terminable interest rule does not apply, then if the deceased non-insured spouse's testamentary documents leave that interest to a Bypass Trust, and if the policy is not yet partitioned when the insured spouse dies, the proceeds themselves can pass to the non-insured spouse's Bypass Trust still without inclusion in the gross estate of the insured spouse, even if the insured spouse had paid premiums for three years after the non-insured spouse's death. Estate of Cavenaugh v. Comm'r, 51 F.3d 597 (5th Cir. 1995).
Practice Tip: Generally, it is easier to have a life insurance policy held as separate property, but with careful planning, the community property component can be used to reduce estate tax exposure.
(4) Creditor Rights. As you might suspect, community property states vary with respect to creditor's rights in community and separate property, but in general, creditors can reach community assets to satisfy debts incurred by either spouse during marriage. Although in some states, the debt must have been incurred for the benefit of the community in order for the creditor to reach community property.
III. COMMUNITY PROPERTY HELD IN A COMMON LAW STATE
A. Effect of Migration.
(1) In General. When a husband and wife move from a community property state to a common law state, the property they acquired with community funds, and property traceable to those community funds, continues to be community property in most states, despite the fact that the couple now lives in a common law state. For conflict of law analysis, see Moore, Coming Soon to Your State: Community Property,§ 7(b),(c) and (d). Change of Domicile as Affecting Character of Property Previously Acquired as Separate or Community Property,14 A.L.R.3d 404; Moore, Migration and Property in the 1990s: The Increasing Importance of Community Property-Separate Property Recognition and Resolution,1991 Institute on Estate Planning, ¶ 1108.3; 15 Am. Jur.2d, Community Property § 15-18.
For personal property, the Restatement (Second) of Conflicts of Laws Rule states that the law of a married couple's domicile at the time of acquisition usually determines the nature of each spouse's rights in tangible and intangible personal property. Restatement (Second) of Conflicts of Laws, Introduction and §§ 258, 259.
(2) Minnesota and Neighboring States. In Minnesota, there are no cases or statutes that have addressed this issue.
Iowa addressed this issue in 1991. An Iowa court applied Texas community property law to determine the spouse's interest in a brokerage account created and funded when the spouses lived in Texas. The Court emphasized that in the absence of an effective choice of law by the spouses, greater weight will be given to the state where the spouses were domiciled at the time the moveable property was acquired in determining the applicable state law. Guided by these principles, the Court ruled that the Texas community property law should control the disposition of the account, despite removal to Iowa, a non-community property state. In re: Marriage of Welchel, 476 N.W.2d 104 (Iowa App. 1991).
(3) Uniform Probate Code. The Uniform Probate Code permits couples to choose the law of a state other than their domicile to control disposition of property at death. Both, Minnesota and Wisconsin, have adopted the Uniform Probate Code in this regard.
(4) Uniform Disposition of Community Property Rights at Death Act. The Uniform Disposition of Community Property Rights at Death Act ("UDCPRDA") has been adopted in fourteen states - Alaska, Arkansas, Connecticut, Florida, Hawaii, Kentucky, Michigan, Montana, New York, North Carolina, Oregon, Virginia and Wyoming. Notably, Minnesota is absent from this list. States that have adopted the UDCPRDA recognize and preserve community property brought from a community property state to a common law state for purposes of rights of disposition at death. Under the Act, the personal property that was acquired as, or became, community property under the laws of another jurisdiction, or that was acquired with income or proceeds from community property, or is traceable to community property remain community property in the common law property state. With respect to real property, any real property purchased in the UDCPRDA state with community property brought into the UDCPRDA state remains community property.
B. Real Property in a Community Property State.
(1) In General. The general rule as provided by the Restatement (Second) Conflicts of Law § 234 sets forth the multi-party test.
(a) Section 1 of § 234 provides that, "The effect of marriage upon an interest in land acquired by either of the spouses during coverture is determined by the law that would be applied by the courts of the situs."
(b) Section 2 goes on to note that the court of the situs "would usually apply their own local law in determining such questions."
(c) Thus, real property acquired in a community property state during marriage would be presumed to be community property under the law of the situs, unless the situs state applied the law of the state of residence of the couple to determine the character of the property (an unlikely result).
In Black v. Commissioner, 114 F.2d 355 (9th Cir. 1940), the 9th Circuit held that domiciliaries of a common law state would acquire a community property interest in land located in Washington and Idaho because those states were community property states.
(2) Wisconsin. A different rule applies to Wisconsin, however. Wisconsin marital property law does not apply until both spouses are domiciled in the State of Wisconsin. For example, Minnesota residents' 1990 purchase of a lake cabin for $75,000.00 which is now worth $350,000.00, is not eligible for the double step-up in basis. For real estate held by Minnesota residents in community property states other than Wisconsin, there are two important steps that the Minnesota resident can take to preserve the community property character of the asset.
(a) Memorialize the character of the property through a "property status agreement" entered into under and governed by the laws of the community property state.
(b) Transfer the property to a special joint revocable trust to preserve its character as community property. The joint trust would hold only the property of the community property state, identify its character as community, and specify the law that governs the trust.
(3) The Converse. Interestingly, California courts have held that real estate acquired in a common law state with community funds is community property. Tischauser, 142 Cal. App.2d 252, 298 P.2d 551 (1956). Therefore, it is possible that real estate located in a common law state, notwithstanding the law of the situs, which usually controls, may be found to be community property, at least if California law applies.
C. Methods for Preserving or Changing Status of Property.
For reasons explained previously in this presentation/outline, it is almost always advantageous to retain the community property character of property when a client moves from a community property state to a common law state. There are certain techniques utilized to preserve the community property character.
(1) Identify the Issue. In the attorney's client information checklist, make sure the date of marriage and the states of domicile since the date of marriage are obtained. If the client has resided in a community property state, determine the date that the clients became domiciled in the community property state and the dates the clients ceased being domiciled in each of the community property states, if more than one.
(2) Segregate the Community Property. The next step is to segregate the community property for the 27 states that are not community property and have not adopted the UDCPRDA. Then it is critically important to trace community property before it is commingled with separate property in the new state.
(a) Community Property Accounts. The estate planner could suggest that the clients segregate the community property assets into a special community property account. The special account should continue to be held in the community property state with a community property state governing law clause. This would allow the spouses to use the services of a corporate fiduciary or brokerage firm, for record-keeping, without establishing a trust. Many brokerage houses allow spouses to open accounts as "community property" rather than the less satisfactory joint tenants with right of survivorship designation.
(b) Joint Trust. Alternatively, a joint revocable trust to hold only the community property assets could be considered.
Real estate owned by a community law couple in a community property state and real estate purchased with community property in a common law state should both be titled in the joint trust to clarify and confirm the intent to continue to hold the property as community property.
(3) Avoid Retitling Assets. Be certain that community property assets are not deposited into an account listed as joint tenancy with right of survivorship or tenancy in common. Note that in UDCPRDA states, such a designation creates a rebuttable presumption that the property is separate property, regardless of its source. In all states, such changes in the form of ownership may convert community property into separate property. See, Rev. Rul. 68-80.
(4) Enter Into Community Property Agreement. Depending on the laws of the new domiciliary state, a married couple may enter into a community property agreement. The spouses may agree on (1) the rights and obligations in the property, notwithstanding when and where the property is acquired and located; (2) the management and control of the property; (3) the disposition of the property on dissolution, death or another event; (4) the choice of law governing the interpretation of the instrument; and (5) any other matter that affects the property and does not violate public policy. In addition, in Wisconsin the spouses may agree that upon the death of either of them, the property may pass without probate to a designated person, trust, or other entity by non-testamentary disposition. While the community property agreement will help clarify the parties' intentions, which would be beneficial, if the agreement materially alters the present or future rights of either party in property or income, as it is almost certain to do, each spouse should be advised to consider being represented by independent counsel to insure that the agreement cannot be challenged by claims of over-reaching or lack of understanding.
D. Estate Administration.
Assets of a Minnesota decedent who previously resided in a community property state may be subject to claims by the surviving spouse that the property was community property, even though the asset is titled in the decedent's individual name at death. Even if the original community property has been sold and title was then taken in the decedent's name, if the original character of the property can be traced back to community property, the surviving spouse's interest could be asserted. There is presently no statutory or case law on this subject.
It is unfortunate that Minnesota has not adopted the Uniform Disposition of Community Property Rights at Death Act. Where the Uniform Disposition of Community Property Rights at Death Act is in effect, on the death of a married person, one-half the property to which the Act applies is considered property of the surviving spouse and is not subject to testamentary disposition by the decedent or distribution under the laws of intestate succession. The other one-half of the decedent's property is subject to testamentary distribution or decent under the laws of intestate succession. The decedent's one-half of the subject property would not be subject to the surviving spouse's elective share.
IV. ALASKA COMMUNITY PROPERTY TRUST
In 1997, the Alaska legislature, in an attempt to reduce the state's economic dependence on natural resources, passed the Alaska Trust Act, which authorized the formation of self-settled spendthrift discretionary trusts and abolished the rule against perpetuities. The next year, the legislature continued this effort by enacting a variety of trust administration provisions and the Alaska Community Property Act. Shaftel and Greer, Obtaining a Full Stepped-Up Basis Under Alaska's New Community Property System, Estate Planning Magazine, March 1999, at 109. The Act essentially adopts the Uniform Marital Property Act in Alaska. To that extent, Alaska community property law now closely resembles the marital property regime in Wisconsin. The Act, however, is unique in that it does not require couples to opt out of the community property regime to avoid its application. Rather, the Act requires couples to affirmatively elect the Alaska community property system. AlaskaStat. § 34.77.030(a).
A married couple domiciled in any state can establish an Alaska "Community Property Trust" and, by transferring property to such a trust, make that property community property under the Act. AlaskaStat. § 34.77.060(b). The economic motive behind this legislation is to encourage Alaska non-residents to utilize trust services of Alaska trust companies so as to obtain the significant tax advantage offered by community property with the double step-up in basis. Has the IRS ruled on the double basis adjustment under Code § 1014(b)(6) as it regards the Alaska community property trust? Not yet. In publication #555, "Community Property" (released January 26, 1999), the IRS notes that the publication does not address the taxation of "income or property subject to the 'community property' election under the Alaska state laws."
The essential element of the community property trust under Alaska law is that at least one trustee must be a "qualified person." AlaskaStat. § 34.77.100(a). The Act defines a "qualified person" as follows: "(1) an individual (a) who, except for brief intervals, military service, attendance in an educational or training institution, or absences for good cause shown, resides in this state; (b) whose true and permanent home is in this state; (c) who does not have a present intention of moving from this state; and (d) who intends to return to this state when away; (2) a trust company that is organized under AS 06.25 and that has its principal place of business in this state; or (3) a bank that is organized under AS 06.25 or a national banking association that is organized under 12 U.S.C. 21-216d if the bank or national banking association possesses and exercises trust powers and has its principal place of business in this state." AlaskaStat. § 34.77.100(b).
B. Validity In General.
The establishment of an Alaska community property trust by non-residents of Alaska raises two important conflicts of law issues that may affect the validity of the trust.
(1) The Alaska Community Property Trust is a Form of Marital Property Agreement. Can a married couple effectively choose the law of a state other than their state of domicile to govern their rights to their property? Comment (b) to § 258 of the Restatement (Second) of Conflicts of Laws states that spouses can choose the law of a state other than their domicile to determine their respective interests in their property. Thus, a valid Alaska community property trust should function as a valid marital property agreement unless the domiciliary state's interest in having its own laws apply outweighs the couple's freedom to choose the law that governs their property relationship.
(2) The Alaska Community Property Trust is Also a Trust. Accordingly, to determine whether an Alaska choice of law provision in an inter vivos trust of intangibles established by non-residents is valid, the lawyer must also consider conflicts rules applicable to trusts. Moore, Coming Soon To Your State: Community Property,2000 Institute On Estate Planning, pp. 16-15 through 16-32. The only public policy that is given as an example to the comments to § 270 of the Restatement (Second) of Conflicts of Laws is that, if spouses elect another state in order to avoid the elective share law of the state of the domicile, that would be an ineffective choice of law because it would violate a strong public policy of the domiciliary state. If, however, the spouses elect the Alaska community property trust, the domiciliary common law state should not object because community property law will almost always provide a surviving spouse more protection than the elective share statute would have in the domiciliary state.
In states that have adopted the Uniform Probate Code, flexibility is given to the persons in selecting the law that governs the disposition of their property. Section 2-703 of the 1990 revision to the UPC provides that the meaning and legal effect of a governing instrument is determined by the local law of the state selected in the governing instrument, unless the application of that law is contrary to elective share laws, the provisions relating to "exempt property and allowances or any other public policy of the state otherwise applicable to the disposition." In Minnesota, see, Minn. Stat. § 524.2-703 (2003).
Thus, where a non-community property state has not adopted the UPC 1990 revision, the adoption of the Alaska community property trust will likely be valid unless it is found to violate a strong public policy of the spouse's domiciliary state, but in a UPC state that has adopted the 1990 revision, the validity of an Alaska community property trust will depend only on whether it violates a public policy of the domiciliary state, rather than a strong public policy.
C. Validity for Minnesota Residents.
Since Minnesota is a UPC state and has adopted Section 2-703 of the 1990 revisions to the UPC, the validity of an Alaska community property trust for Minnesota residents would depend on whether it violates "a public policy" of Minnesota.
Could Minnesota courts hold that because Minnesota has rejected community property there is a public policy against community property? That argument is weak because under general conflicts principles, when people move into this state from a community property state, their community property does not lose its status. Thus, the complaining common law state would be faced with the situation that some of its domiciliaries could have community property and some could not. In addition, married couples residing in the common law property state could still purchase real property in the community property state and hold it as community property, and presumably the domiciliary common law property state could do nothing about it. Accordingly, couples considering an Alaska community property trust could probably safely assume that the trust will be valid even though they reside in a common law property state.
Another argument against the validity of an Alaska community property trust for Minnesota residents is that the trust might violate the public policy of Minnesota for not allowing postnuptial agreements. This is perhaps the most difficult argument to overcome for Minnesotans because unless the requirements of a postnuptial agreement under Minnesota law are followed, there could be a question as to whether or not the Alaska community property trust is an invalid postnuptial agreement. It would be necessary for the proponents of the trust to argue that the instrument is first and foremost a trust and that an Alaska community property trust would not violate Minnesota's postnuptial agreement rules anymore than a Minnesota joint trust would.
In conclusion, until the above issues are clarified, the Minnesota practitioner should use an Alaska community property trust with caution and be certain to give adequate written disclosures about the uncertainties to clients who wish to proceed with this new estate planning opportunity.
V. REPRESENTING MIGRANT CLIENTS AND ETHICAL RULES OF PROFESSIONAL CONDUCT
It is literally unavoidable that actions taken or not taken that either preserve community property or reclassify community property as separate property will benefit the material interest of one spouse to the detriment of the other. As was mentioned above concerning the Alaska community property trust, if such a trust is akin to a postnuptial agreement, then all the attendant requirements of separate representation may come to bear. See, Minn. Stat. § 519.11 (2003).
A. Model Rules of Professional Conduct.
Rule 1.7, Conflicts of Interest is already familiar to most estate planning lawyers who confront this every time they represent a married couple jointly in estate planning. The ACTEC commentary on the rule provides estate planning practitioners some comfort as it states, "advising related clients who have somewhat differing goals may be consistent with their interests and the lawyer's traditional role as the lawyer for the family." However, reclassification or failure to reclassify, either by act or omission, may produce results far greater than contemplated by the "somewhat differing goals" language contained in the comment. In spite of this, it still may be appropriate for a common law practitioner to represent a migrant couple from a community property state jointly, but the practitioner would want to be certain to: (1) make a complete disclosure of the potential conflicts of interest; (2) obtain the couple's fully informed consent to such representation; and (3) be prepared to withdraw if a conflict develops. The common law practitioner must weigh how limited the spouse's inconsistent interests are in comparison with their consistent interests in cooperation, coordinated planning, and cost effective representation.
B. Engagement Letter.
In conclusion, a well-written engagement letter is strongly recommended when representing clients with significant assets who migrate to Minnesota from one of the ten community property states.
A Select Listing of Valuable Community Property Law Resources.
I. Bradley, Erkhardt's Workbook for Wisconsin Estate Planners, published by State Bar of Wisconsin CLE Books.
II. Campfield, Regis W. & Berall, Frank S., 803 T.M., The Migrant Client: Tax, Community Property, and Other Considerations.
III. Kasner, Jerry A. and Golden, Alvin J., An Overview of Community Property Law, ACTEC Annual Meeting (March, 1999).
IV. Moore, M. Reid, Coming Soon to Your State: Community Property, Univ. of Miami Inst. on Est. Plan, ¶ 16-1 to 16-32 (2000).
V. Moore, M. Reid, Migration and Property in the 1990s: The Increasing Importance of Community Property-Separate Property Recognition and Resolution, 25 Univ. of Miami Inst. on Est. Plan. ¶ 1113.2 (1991).
VI. Pharies, S. Andrew, Community Property Aspects of IRAs and Qualified Plans, 13-Oct Pub. 33 (1999).
VII. Reinecke, David W., Community Property Issues for Noncommunity Property Practitioners, American Law Institute-American Bar Association CLE (2002).
VIII. Shaftel, David G. and Greer, Stephen E., Obtaining a Full Stepped-Up Basis Under Alaska's New Community Property System, 26 Est. Plan 3 (March 1999).
IX. Treacy, Jr., Gerald B., Planning to Preserve Advantages of Community Property,23 Est. Plan 24 (Jan. 1996).
By: Roy A. Sjoberg, Esq.