The Unmarried Penalty: Gift, Estate Tax, And Other Planning Considerations For Unmarrieds

The Unmarried Penalty: Gift, Estate Tax, And Other Planning Considerations For Unmarrieds

Article posted in Transfer Taxes on 26 September 2000| comments
audience: National Publication | last updated: 16 September 2012
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Summary

The impact of the biases in favor of married couples found in state laws and in the federal tax code on planned giving for unmarried couples is explored in this article by Chris Yates. The usefulness of various planned giving vehicles for these non- traditional couples is examined and observes that, depending on the circumstances, these couples may be among the best or the worst prospects for planned giving.

by Chris Yates

Chris Yates is currently director of gift and estate planning at the California Institute of Technology in Pasadena, CA. From 1992 until 1998, he was associate director of planned giving at Stanford University. He served as associate director of undergraduate admissions at Stanford from 1989 to 1992, and was an associate with the law firm of Morrison & Foerster from 1986 until 1989. Yates has a bachelor's degree in history and economics from Stanford University, and earned his JD at the University of Chicago Law School in 1986. He has served on the board of the Northern California Planned Giving council and is a past president. Yates is a current member of the National Committee on Planned Giving's Board of Directors and serves on the editorial advisory committee for The Journal of Gift Planning.

The author would like to express his appreciation to Fred Hartwick, Deputy Director of Planned Giving at Stanford University in Stanford, CA. This article is an expanded and updated version of an article by the author and Hartwick published in The Journal of Gift Planning, vol. 2, no. 4, 4th quarter 1998.


As more and more "baby boomers" become prospects for planned and major gifts to charitable organizations, it seems likely that planned giving fundraisers will be increasingly confronted with situations in which prospects are not part of a traditional married couple. These non-traditional prospects include heterosexual couples who have chosen not to marry, as well as lesbian and gay couples who, regardless of whether or not they wish to marry, are not accorded full marital status under any current state laws (including Vermont) nor for purposes of the federal tax codes. As a result, it is incumbent upon gift planners to be sensitive to, and familiar with, the special challenges such couples face in planning their estates and in making gift transfers to each other or heirs. This article will examine some ways in which the bias in favor of married couples under the federal transfer tax codes as well as state laws impacts unmarried couples. In light of the impact of these laws, it will consider ways in which various planned gift vehicles may be useful to these non-traditional couples, and how such couples may in some situations be among the best prospects, and in other situations may be among the worst prospects for a planned gift to charity.

Transfer Tax Law Bias. Although we have heard much of late about the "marriage penalty" under the income tax laws, very little mention is made of the much more significant extent to which the federal transfer tax laws are slanted in favor of legally married couples. Unmarried couples face several tax and estate planning issues that differ significantly from married couples, and many of these issues arise from differing treatment under the current gift and estate tax laws. The current transfer tax system only narrowly escaped obliteration when Congress, by a close margin, failed to override President Clinton's veto of legislation to repeal the gift and estate taxes on September 7, 2000. Although the federal gift and estate tax code remains in place for now, future changes or even another attempt at repeal seem likely, with its fate likely hinging on the outcome of the upcoming Congressional and Presidential elections.

State Laws. In addition to the bias in the federal gift and estate tax code, most state laws accord significant legal rights in property owned or acquired by a spouse. These spousal protection laws do not apply to unmarried couples. The accompanying chart provides a handy summary of the most common gift and estate tax planning tools and their applicability to married versus unmarried couples.

Estate Planning Tools
Married Versus Unmarried Partners


Wealth Transfer Strategy          Married         Unmarried
Annual Exclusion of
$10,000 per recipient                X                X
Gift Splitting
$20,000 per recipient                X
Lifetime Exemption
of $675,000                          X                X
Unlimited
Charitable Deduction                 X                X
Unlimited Transfer During
Life or at Death between
Partners/Spouses
(a.k.a. "the Marital Deduction")     X
Tax Free Gift of Income
Interest to Partner/Spouse
via QTIP and/or
Charitable Remainder Trusts          X
Community Property (including
"double step up" in basis at
death of first partner/spouse)       X
Intestacy Rules Favoring
Partner/Spouse                       X


The important fundraising implication of the bias in these laws is that unmarried prospects who wish to make transfers that will support their life partners must carefully consider the tax implications and invest time and resources in developing an estate plan that minimizes the transfer tax effects and help ensure that their intentions to benefit their partners are carried out. As a result of the heavier tax burden they bear in connection with the gift and estate tax, some non-traditional/unmarried couples may feel that they cannot afford to allocate as much of their estates for charitable gifts as their legally married counterparts might consider.

Unlimited Marital Deduction. The chief advantage enjoyed by legally married couples is the unlimited marital deduction, which exempts from gift and estate tax all transfers (either while living or at death) between married couples.1 Note: One should be careful to remember that this powerful planning tool is generally unavailable to a donee spouse who is not a citizen of the United States. 2 Thus, a married individual may support a surviving wife or husband with his or her entire estate, and no taxes will be due until the death of the survivor.

Asset Splitting. The transfer tax system provides for a "unified credit" as a one-time individual credit in life and at death against taxes payable on transfers to other individuals. 3 The current level of the unified credit produces an exclusion amount of $675,000. The unified credit is due to increase in increments over the next several years, until the exclusion amount reaches $1,000,000 in 2006. One of the most important tools in estate planning involves splitting assets between a couple in order to take full advantage of each spouse's unified credit, thus allowing both spouses to shelter as much as possible from estate taxes and maximize their transfers to heirs. This way, no matter which spouse dies first, the couple can utilize their combined maximum unified credits, which would currently allow them to shelter a full $1,350,000 (increasing to $2,000,000 by 2006) from estate taxes.

For example, a husband who is the sole owner of all of a couple's property, can use the unlimited gift tax marital deduction to transfer half of his assets to his wife (or at least the current exclusion amount under the unified credit) and will owe no tax on this transfer. In a community property state, because of their legal marital status, each spouse already owns an undivided interest in all of the couple's property acquired during their marriage, other than by gift or inheritance. But even in a community property state, asset splitting may prove to be a valuable tool for minimizing a married couple's exposure to transfer taxes, especially where one spouse enters into the marriage with significantly more assets than the other does.

On the other hand, unmarried couples do not have the same opportunity to split their assets. Since the unlimited gift tax marital deduction is not available to them, such transfers would be subject to gift tax. One partner can make annual gifts to the other using her or his annual exclusion amount, which allows for the transfer of $10,000 per year without tax consequences. But this is often too small an amount to make much of a difference.

Annual Exclusion/Gift Splitting. Less significant, but still important as a tax savings tool, is the annual exclusion, which allows individuals to give $10,000 (now indexed for inflation in $1,000 increments) to as many people as the individual wants each year, free of gift tax. 4 To minimize transfer taxes, most people with wealth are advised to pass as much as they can to their heirs while they are alive by using the full amount of their annual exclusion every year. A married person with separate property may give $20,000 tax free to several people each year if his or her spouse agrees to gift splitting. This law does not apply to unmarried couples, meaning that an unmarried partner in this type of situation may give only half as much to each individual donee free of tax using the annual exclusion.

Qualified Terminal Interest Property Trusts. Generally, transfers of terminable interests (e.g., a life estate, an interest measured by a term of years, joint and survivor annuities) do not qualify for the marital deduction, with one important exception. Qualified terminable interest property (QTIP) is property passing from a decedent to his or her surviving spouse, who is entitled to all income from the property (or a portion thereof) for life, payable at least annually. This so-called QTIP property qualifies for the marital deduction. One of the most popular estate planning tools for married couples is the QTIP trust, which allows a spouse to leave a qualifying income interest in property to the surviving spouse, with the remainder to designated beneficiaries (including charities). The value of the property in the trust is shielded from the estate tax by means of the marital deduction, meaning that for his or her remaining life, the surviving spouse will have enjoyment of the income interest based on the full amount left to the trust, without reduction for payment of estate taxes. Upon the death of the surviving spouse, the value of the remaining trust property will finally be included in the survivor's gross estate and subject to tax with the balance going to his or her beneficiaries. Unmarried partners may not delay taxation using a QTIP trust. Assets that would normally have gone into a QTIP trust at the death of the first partner to die will instead be subject to estate tax at that point, decreasing the value of the property remaining for the benefit of the surviving partner.

Charitable Remainder Trusts (CRT). A special rule under the estate tax code allows a spouse or married couple to create a charitable remainder annuity trust or unitrust and, so long as the two spouses are the only non-charitable beneficiaries of the trust, the prohibition on deduction of transfers of terminable interests does not apply and the marital deduction is available for the value of the annuity or unitrust interest passing to the surviving spouse. 5 As a result, there is no taxable transfer and no transfer tax implication. This special rule does not apply to unmarried partners. If an unmarried partner establishes a charitable remainder trust and names his or her partner as a beneficiary, the annuity or unitrust interest conveyed is treated as a taxable transfer.

Furthermore, if the donor partner dies within three years of the date of transfer of assets to a charitable remainder trust for the benefit of the donee partner, the value of his or her estate must be increased by the amount of the gift tax paid on the lifetime noncharitable transfer. 6 This three-year rule applies in other analogous planned gift situations as well, e.g., where the decedent has established a charitable gift annuity or retained life estate that benefits a donee partner.

Stepped-Up Basis. In community property states, the entire basis in all community property assets receives a "double step-up" in basis when the first spouse dies, i.e., it is not just the basis in the one-half interest actually transferred that is stepped up. Thus, when a married person resident in a community property jurisdiction dies, the surviving spouse will have to pay capital gain tax only on appreciation that occurs after the deceased spouse's date of death.

Unmarried couples cannot hold assets as community property since they are not legally married. If they own any property as joint tenants, only one-half the property will receive the stepped-up basis when the first partner dies. The surviving partner will be faced with full capital gains tax liability on his or her half of the property if it is sold. This offers a silver lining from the fundraisers point of view: Given the potential capital gains tax liability that would result on the sale of jointly held property inherited from a partner, the surviving partner may be more willing to give these assets to charity since the capital gains tax would be avoided.

Joint Tenancy. In order to avoid probate, many couples opt to hold title to property in joint tenancy. Unless both tenants contribute equally to the purchase of the asset, however, there are gift tax implications.

For example if a spouse uses his or her own assets (such as an inheritance) to buy a vacation home and then puts it in joint tenancy with the spouse, the unlimited gift tax marital deduction will avoid all taxes in respect of the one-half interest transferred as a gift. If an unmarried partner does the same thing by purchasing property and putting it in joint tenancy, the value of the one-half interest conveyed to his or her partner will be treated as a taxable gift.

Retirement Assets And Statutory Share. A married person cannot name someone else (including charity) as the beneficiary of a retirement plan without spousal consent. In community property states, a spouse would probably already own a one-half interest in those assets. On the other hand, an unmarried individual has no rights to any retirement assets owned by his or her partner.

A statutory or forced share against an estate is available to a spouse in separate property states. For example, if a wife writes a will that disinherits her husband, he can still claim a share of the estate for himself, usually one-third or one-half. An unmarried partner has no such right under these laws.

Intestacy Laws. Under the general laws of intestacy, if a married man or woman dies without a will, then his or her surviving spouse will automatically receive a substantial share of the estate according to state law. Under the Uniform Probate Code, the surviving spouse would receive $50,000 plus one-half of the residue of the deceased spouse's estate. In community property states, the surviving spouse would already own one-half of the community property, and she or he would inherit the deceased spouse's entire share. She or he would also get a portion of the decedent's separate property, usually one-half or one-third, depending on the number of surviving children. The rules of intestacy apply very differently to a surviving unmarried partner-he or she would get nothing. The decedent's assets would go to his or her family members-children, parents, siblings, or other more distant relatives-but the laws of intestacy do nothing to protect unmarried partners: The surviving partner has no rights to any of the decedent's property. It is therefore imperative that unmarried partners have an estate plan that allows them to fulfill their intentions with respect to each other.

Fundraising Considerations And Strategy

The question of whether or not non-traditional unmarried couples should suffer the inequities that currently exist under the federal transfer tax and state probate laws are subjects for other articles in other publications. My goal here is to demonstrate some differences under the law between married and unmarried partners in relation to estate and gift planning, and to highlight the challenges that non-traditional couples who are charitable gift prospects face in this regard. In my view and based on experience, significant numbers of these prospects will include generous charitable gifts through their estate planning despite the challenges outlined above. Indeed, because unmarried couples are generally less likely to have children than their married counterparts, they may, in many cases, prove to be the better prospect for a planned gift to charity.

Despite the difference in treatment under the tax and probate laws, planned gift fundraisers should keep in mind that many of the same considerations that influence married planned gift prospects apply to unmarried couples who are prospects as well.

Charitable remainder trusts provide a good vehicle for benefiting oneself and/or a life partner, while leaving a significant legacy to charity. Many of the same incentives apply equally to married and unmarried couples: avoiding capital gains tax on appreciated property; obtaining a significant tax deduction (for income tax and/or gift and estate tax purposes); investment management for a partner/beneficiary who is not interested in, or capable of managing money; and spendthrift considerations. At the same time, be cognizant of the transfer tax factors described above, since unmarried couples are not able to claim a marital deduction for any life or term interest that is transferred from one partner to the other. In most cases where an unmarried couple establishes any type of charitable remainder trust, either jointly or individually, that benefits both partners or the non-donor partner, gift and/or estate tax consequences will result. One way a charitable gift planner might turn this issue to his or her advantage is to point out that the gift and/or estate tax charitable deduction resulting from the remainder gift to charity will help to minimize the amount of the taxable transfer to the donee partner and reduce the tax due in comparison to the gift or estate tax that would result from an outright transfer directly to the donee partner.

Example: Tom establishes a 5% charitable remainder unitrust for the ultimate benefit of his alma mater with a gift of highly appreciated stock in a computer software company that he purchased five years ago for $250,000. The stock is now worth $1 million, but it has a volatile trading history and pays no dividends. Tom names his life partner, Martha, a recently retired school teacher who is age 65, as the sole lifetime beneficiary of the unitrust interest. There will be no capital gain tax when the stock is sold by the trustee and reinvested in a more diversified portfolio. Tom will be entitled to an income tax deduction of $471,520. 7 Martha will benefit from professional money management for these assets and the security of knowing she will receive a significant annual distribution (paid quarterly) for the rest of her life just as she enters into retirement. Because the payout rate is set at the statutory minimum of 5%, the possibility that the distributions to Martha will grow over time if the trust assets appreciate is further enhanced. By establishing the unitrust, Tom is entitled to a gift tax deduction of $471,520, so that his taxable gift to Martha is only $528,480 (i.e., $1,000,000 - $471,520). Furthermore, assuming Tom did not make any other gifts to Martha during the year the trust was created, he could utilize his annual $10,000 exclusion to reduce the taxable gift to $518,480. In this particular example, using the unitrust allows the donor to nearly halve the amount of the taxable gift to his partner while providing a substantial deferred gift to his favorite charity, in addition to the other important benefits described above. In a situation like this, the gift planner can make some powerful and persuasive points in favor of the charitable remainder trust option. Consider that if Tom had given the stock outright to Martha, it would have constituted a taxable transfer of $1 million, and he would have owed gift tax on some or all of this amount, depending on his prior taxable gifts and whether or not he had already used up his annual exclusion of $10,000 with respect to Martha. In addition, Tom's low basis in the stock would have carried over to Martha, who would then owe significant capital gains taxes if she ever sold it.

It is probably worth noting that, due to a 1995 IRS Private Letter Ruling, there is some question as to whether or not the Service might disqualify a charitable remainder trust where there are joint or multiple donors, other than in the case of legally married spouses. That particular ruling involved several family members of different generations who joined together in funding what was to be a charitable remainder trust. The IRS disqualified the trust on the grounds it was an "association" taxable as a corporation. 8 As a result, unmarried partners who wish to jointly fund a charitable remainder trust may want to consider funding two separate trusts individually, naming each other as a joint and/or survivor beneficiary. Of course, this might require the couple to first sever their joint interests in the property to be given.

Charitable gift annuities offer many of the same benefits between life partners as charitable remainder trusts. Like the charitable remainder trust, there is no marital deduction available to unmarried partners, and as a result there are very likely to be gift tax consequences, even if the annuity is funded with joint property. Furthermore, if appreciated property is used to fund the annuity, the taxable gain, calculated under the bargain sale rules, 9 must be fully recognized by the donor in the year the annuity is created unless the donor is the only annuitant, or the donor and a designated survivor annuitant are the only annuitants. 10 This can be a big problem for unmarried partners where a donor partner would like to establish a charitable gift annuity for the sole benefit of the donee partner. In the example described above, if Tom were to create a gift annuity for the sole benefit of Martha, Tom would owe substantial capital gains tax in addition to gift tax as a result of making this gift to Martha and to charity. If a married couple wished to accomplish the same result, the donor spouse could simply transfer the appreciated property outright to the donee spouse utilizing the full marital deduction, and the donee spouse could then fund the gift annuity naming himself or herself as the sole annuitant, thus avoiding the problem of having to recognize all the taxable capital gain in the current year.

A gift to charity of a remainder interest in a personal residence or farm may also be attractive to unmarried couples. The donor is entitled to an income tax deduction for the value of the remainder interest in the year that the gift is made. 11 The donor and/or the donor's partner retain a life estate in the property and are entitled to occupy or otherwise make use of it for the rest of her or his lives, and the charity will eventually receive the benefit of this significant asset. Of course, if the donor's partner is included as a life tenant, there will be gift and/or estate tax implications, which would be true even if the property were owned jointly by the couple, due to the survivor's interest. However, the charitable gift and estate tax deductions will help reduce the transfer tax liability. The income and transfer tax benefits afforded by this type of gift may make a great deal of sense for many unmarried partners, particularly if there are no children or other heirs to whom the couple might wish to leave their home.

Nongrantor charitable lead trusts can be an especially effective method for an unmarried partner to transfer significant assets to her or his partner and minimize or even eliminate transfer taxes, 12 while providing substantial current and future support for charity. Because the donee partner will not receive the trust assets until the term of the lead trust has expired, this type of charitable trust works best when the donor and the donor's partner are both relatively young, or where the donee partner is significantly younger than the donor. And of course, lead trusts are always worth considering in situations where children or grandchildren are involved.

Example. Luke, age 75, is interested in making significant gifts to support ongoing improvements to a local bird sanctuary owned by the Audubon Society, and wants to be able to enjoy seeing the benefits of his support while he is still living. In addition, he would like to be able to provide his life partner James, age 60, with a significant sum of money on which he can rely during his later years when he may require home care and other expensive services and/or medical treatment. Working with his estate planning attorney, Luke establishes a non-grantor 10% charitable lead annuity trust for a term of 15 years, funding it with $1 million in cash. The trustee invests the cash in a diversified portfolio with a reasonable expectation for growth over time. The Audubon Society will receive $100,000 per year for 15 years, and thereafter the remaining assets will be distributed to James free of gift and estate tax. Although Luke will not receive an income tax deduction, he receives a very large gift tax deduction of $877,260, 13 meaning that the amount of the taxable gift to James is only $122,740 (i.e., $1,000,000 - $877,260). Since this is not a gift of a present interest to James, Luke cannot utilize his annual $10,000 exclusion to offset the taxable gift. 14

Avoiding Probate. One benefit common to all of these planned gift vehicles is that beneficial and lifetime interests passing from the decedent to her or his surviving partner will bypass probate proceedings. This not only avoids the costs and delays associated with the probate process, but also helps to reduce the likelihood of challenges from family members or other heirs hostile to the surviving partner.

Conclusion

Here are 10 practical pointers, in no particular order, for gift planners and donor advisors to remember when working with an unmarried couple as prospects for a planned charitable gift.

  1. Charities should make sure donor database systems are able to keep track of and solicit unmarried couples either jointly or individually, according to each couple's preference. Keep in mind that it may be important to such prospects that an organization recognize the validity of their relationship, especially if they are jointly making charitable gift decisions.
     
  2. When planning invitations to events, if other participants' spouses are to be invited, it makes sense to include an unmarried prospect's partner, or if you aren't sure of the prospect's status, extend an invitation to bring a "spouse, partner, or guest."
     
  3. Gift planners and donor advisors need to be sensitive to their prospect's sense of privacy and should avoid prying into personal relationships when the prospect has not initiated such a discussion. Be alert for clues the prospect may drop along the way in this regard.
     
  4. Although a charitable gift planner should be careful not to plan prospects' estates, he or she ought to be especially alert to raise red flags with respect to the particular tax and legal issues that will arise in situations where a couple is not married.
     
  5. Many of the benefits of a planned gift to charity DO apply equally to both married and unmarried prospects.
     
  6. By including a testamentary charitable remainder trust for the lifetime benefit of a surviving partner in her or his estate plans, a donor can be assured that the surviving partner will have a reliable source of support for life after the donor is gone and, in addition, leave a significant legacy to charity, all at a substantial estate tax savings relative to an outright bequest to the partner.
     
  7. A charitable lead trust can provide a terrific means for supporting a favored charity or charities and achieve quite substantial gift and estate tax savings on transfer of assets to a life partner. However, these vehicles work best where the couple is either relatively young, or where the donee partner is significantly younger than the donor partner.
     
  8. Most inter vivos life income gift vehicles avoid the probate process, which can be an especially attractive benefit to unmarried couples.
     
  9. Given the complexity of the issues that arise under the federal tax codes and state laws with respect to unmarried partners, it is all the more important that such prospects be advised by competent legal and tax counsel in all aspects of planning their estates. If an unmarried and committed couple do not already have plans for their estates in place, they are probably well advised to do so promptly.
     
  10. The bias in favor of married couples that is inherent in the transfer tax laws means that unmarried partners will often bear a heavier burden in terms of gift and/or estate tax consequences as a result of making a life income gift or other deferred charitable gift. This may discourage such prospects from making planned gifts to charity, but on the other hand, the charitable tax deduction (both income and gift/estate) can provide powerful leverage for maximizing the total cumulative benefit to the couple and to charity.


Our organizations will thrive only if our donors, clients, and prospects feel welcomed, respected, and appreciated. It is incumbent upon us, as members of the gift planning profession, to educate ourselves about the tax and legal issues that affect both traditional, as well as non-traditional couples, and to be sensitive to ways in which we can make all donors, clients, and prospects feel that they are an important and integrated part of our organization's constituency.


Footnotes


  1. IRC § 2056(a); IRC § 2523(a).back

  2. IRC § 2056(d)(1).back

  3. IRC § 2010; IRC § 2505.back

  4. IRC § 2503(b).back

  5. IRC § 2056(b)(8).back

  6. IRC § 2035(b).back

  7. Calculation assumes beneficiary payments are made at the end of each calendar quarter and an IRS discount rate of 7.6%.back

  8. Private Letter Ruling 9547004.back

  9. Treas. Reg. § 1.1011-2(a)(4).back

  10. Treas. Reg. §§ 1.1011-2(a)(4)(ii) and 1.1011-2(c), Example (8).back

  11. IRC § 170(f)(4); Treas. Reg. § 1.170A-12.back

  12. IRC § 2055(e)(2)(B); IRC § 2522(c)(2)(B).back

  13. Calculation assumes payments to the charity are made at the end of each calendar year and an IRS discount rate of 7.6%.back

  14. IRC §2503(b)(1).back

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