Estate planning for unmarried couples, Pt. 2
By Julius Giarmarco
Giarmarco, Mullins & Horton, P.C.
Part one of this article deals with non-tax estate planning issues facing unmarried couples. Part three will examine several advanced gifting strategies for high-net-worth unmarried couples.
Like everyone else, unmarried couples having taxable estates will need more than a Will or revocable living trust to reduce the federal estate tax. They will also need to implement a gifting program. While there is a present lapse in the estate and generation-skipping transfer taxes, it's likely that Congress will reinstate both taxes (perhaps even retroactively) some time during 2010. If not, on January 1, 2011, the estate tax exemption (which was $3.5 million in 2009) becomes $1 million, and the top estate tax rate (which was 45 percent in 2009) becomes 55 percent.
Federal estate tax law provides an unlimited marital deduction. Assets left to a surviving spouse through a will, trust or will substitute are estate and gift tax free (if the surviving spouse is a U.S. citizen). In other words, a married couple can defer the estate tax until the death of the surviving spouse. Because of the Defense of Marriage Act (DOMA), unmarried couples are not afforded this opportunity -- even in those states that recognize same-sex marriages, civil unions and domestic partners. Therefore, unmarried couples whose assets exceed the estate tax exemption will incur federal estate taxes upon the first partner's death, and possibly state death taxes, depending on the state of domicile.
Following are some tax saving techniques available to unmarried couples:
Annual gift tax exclusion. This exclusion allows the donor to make tax free gifts of up to $13,000 per done, per year, with no limit on the number of donees or the donees' relationships to the donor. This exclusion is scheduled to increase in amount, as it is now indexed to the rate of inflation. Lifetime annual gifts under this exclusion do not reduce the donor's $1 million lifetime gift tax exemption. (See below) Moreover, a gift tax return (Form 709) need not be filed for such gifts.
In addition, unlimited direct payments of the donee's tuition or medical bills are not subject to gift tax, nor do they count towards the donor's $1 million lifetime gift tax exemption, or to the $13,000 annual gift tax exclusion. However, the funds must be paid directly to a qualified educational institution or medical provider. Education costs do not include room and board, books, or supplies. Medical costs do not include amounts reimbursed by insurance companies.
Unmarried partners may earn substantially different incomes or have accumulated different amounts of wealth. The gift tax annual exclusion and the exclusion for tuition and medical costs allow the wealthier partner to transfer assets to the less wealthy partner during his or her lifetime. This strategy will be particularly beneficial when the wealthier partner's estate is over the estate tax exemption, the less wealthy partner's estate is below that amount, and they wish to benefit the same persons at the surviving partner's death.
Lifetime gift tax exemption. In addition to the annual gift tax exclusion, a donor can gift a cumulative total of up to $1 million to anyone during his or her lifetime, without any gift tax. This is the so-called "gift tax exemption." Gifts in excess of the $13,000 annual gift tax exclusion reduce the gift tax exemption dollar for dollar. Unlike the estate tax exemption, however, the gift tax exemption does not increase.
Any gift tax exemption used decreases, dollar for dollar, the estate tax exemption available at the donor's death. However, the income and appreciation on the gifted property is removed from the donor's estate, thereby reducing the estate tax. Thus, an unmarried couple can use the wealthier partner's gift tax exemption to make gifts to the less wealthy partner so that the overall estate tax of both partners is reduced.
Gifts to irrevocable trusts. Unmarried couples are often reluctant to make outright gifts to partners because the donor loses control over the gifted property. By making gifts to an irrevocable trust, the wealthier partner (grantor) can provide the less wealthy partner (beneficiary) with trust income and/or principal as needed, but can also determine where the remaining trust property will pass upon the beneficiary's death or dissolution of the relationship. Moreover, if it's properly drafted, the assets remaining in the trust can pass, estate tax free, to the "remaindermen" named in the trust agreement upon the beneficiary's death.
To be effective for estate reduction purposes, the trust must be irrevocable and the grantor should not be a trustee or beneficiary of the trust. However, the grantor can, within limits, retain the right to remove and replace trustees and, as noted above, the trust can be designed so that the beneficiary-partner is replaced by another beneficiary already named in the trust, if the relationship is terminated.
To qualify for the $13,000 annual gift tax exclusion, irrevocable trusts usually contain a provision giving the trust's beneficiary a temporary right to withdraw gifts made to the trust, at least in part. This withdrawal right is often called a "Crummey" power, named after the Federal Court case that validated this technique.
Irrevocable life insurance trusts. Unmarried couples often purchase life insurance for the benefit of the surviving partner to help supplement future income lost from the inability to do a spousal rollover, and the inability to receive pension survivor benefits. Life insurance can also be used to create an estate to provide financial security for the surviving partner, or to create the liquidity with which to pay estate taxes.
While life insurance proceeds are generally income tax free to the beneficiary, they are still part of the insured's gross estate and are subject to estate taxes. Accordingly, if the insured has a taxable estate (after including the face amount of life insurance), it may be advisable to transfer his or her life insurance policies to an Irrevocable Life Insurance Trust (ILIT).
If the life insurance policy is owned by and payable to an ILIT, the insurance proceeds will be both income and estate tax free. However, if an existing policy is transferred to an ILIT and the grantor-insured dies within three years of the transfer, the death proceeds are brought back into the grantor-insured's estate. This problem can be avoided if the ILIT is the initial owner and beneficiary of a new policy.
Gifts to an ILIT can be made with the grantor-insured's $13,000 annual gift tax exclusion using "Crummey" powers (See above) and/or with the grantor-insured's $1 million gift tax exemption. As mentioned above in connection with gifts to irrevocable trusts, the grantor-insured should not be a trustee or beneficiary of the ILIT. Besides keeping the insurance proceeds out of the grantor-insured's estate, the ILIT allows the grantor-insured to set the parameters upon which his or her partner (as the beneficiary of the ILIT) will receive trust income and principal. The ILIT should also be drafted so that, if the beneficiary is no longer in a relationship with the grantor-insured, another person (already named in the ILIT) automatically becomes the new beneficiary.
Before transferring a policy to an ILIT, applicable state law must be examined to determine if the ILIT has an "insurable interest" in the grantor-insured. If not, the insurance company might not be required to pay the death benefit. It may be possible to avoid this problem by having the insured purchase the policy and subsequently assign it to the ILIT. Under most state laws, the insurable interest requirement applies only to the initial owner and not to a subsequent assignee. As mentioned above, however, if a policy is assigned to an ILIT and the insured dies within three years of the assignment, the death proceeds are still includable in the insured's gross estate. One possible technique to avoid the three-year rule would be for the insured to sell the policy to an ILIT that is designed as a grantor trust.
Part Three of this article discusses several advanced estate planning strategies for high net worth unmarried couples.
THIS ARTICLE MAY NOT BE USED FOR PENALTY PROTECTION. THE MATERIAL IS BASED UPON GENERAL TAX RULES AND FOR INFORMATION PURPOSES ONLY. IT IS NOT INTENDED AS LEGAL OR TAX ADVICE AND TAXPAYERS SHOULD CONSULT THEIR OWN LEGAL AND TAX ADVISORS AS TO THEIR SPECIFIC SITUATION.
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