Navigating the New Domestic Partner Rules

Transcription

1 Navigating the New Domestic Partner Rules According to the 2000 U.S. census, 5.5 million couples live together in the United States but are not married. The census identified 594,000 same-sex couple-led households, and one out of eight such households lives in California. More and more of these couples seek to solidify their relationships legally, and they will look for estate planners who are familiar with the issues that concern them. Most planners are already familiar with the estate planning techniques most helpful to domestic partners; they are the same tools used by married couples. Planners simply must learn to apply these tools aggressively, creatively and thoughtfully to overcome the personal issues and tax obstacles that unmarried partners face. I. CALIFORNIA LAW EVOLVES A. The Old Days Prior to the availability of domestic partnership registration (discussed below), domestic partners used a variety of approaches to create legally recognized and enforceable relationships. The most common examples include powers of attorney and cohabitation agreements. Some couples registered their families as unincorporated nonprofit associations (which provided proof of immediate family status for hospital visitation rights), some contracted with each other to make wills and some went even further by asking courts to approve adoptions by older partners of younger ones. To a large extent, domestic partnership registration has made these measures unnecessary. However, unmarried couples must still be ready to take additional steps to protect and enforce their relationships. B. The Advent of the Domestic Partnership Registry Among the greatest fears of unmarried couples is the denial of visitation privileges when one partner is hospitalized. The California legislature addressed this issue by amending the Family Code (effective January l, 2000) so that registered domestic partners gained hospital visitation rights. Partners are able to secure these rights by registering their domestic partnership with the California Secretary of State. The 2000 legislation set forth live requirements for establishing a domestic partnership: 1. The persons must have a common residence; 2. The persons assume joint responsibility for each other s basic living expenses; 3. Neither person can be legally married or part of an existing domestic partnership; 4. Both persons must be over eighteen years old; and 5. Both persons must be capable of consenting to the partnership. 1 The legislation also created a simple mechanism for registering a domestic partnership. The partners sign a Declaration of Domestic Partnership with the Secretary of State, which can be downloaded from the Secretary of State s website ( Then they file the declaration with the Secretary of State. There s a $10 filing fee. (The mechanism for terminating a domestic partnership is also relatively simple. The partners sign a Notice of Termination of Domestic Partnership with the Secretary of State. This form can also be downloaded at the Secretary of State s website. There is currently no filing fee for this document.) C. Additional Rights Attach to Registered Domestic Partners Although the advent of domestic partnership registration provided a few other benefits (for example, the filed Declaration of Domestic Partnership gave domestic partners an easy way to establish eligibility for domestic partner coverage under private insurance), the registry clearly left many issues unresolved. The legislature addressed some of these issues in AB 25, which was enacted to be effective January 1, This legislation gave ten new and substantial rights to registered domestic partners: 1. Health Care Decisions The patient s domestic partner now has the same authority us a spouse to make a health care decision for the incapacitated patient Use of Form Wills; Right to Appointment as Administrator The statutory will form has been revised so that the testator has the option of leaving his or her estate to a domestic partner. 4 Termination of a domestic partnership revokes a bequest to a former domestic partner. 5 In selecting the administrator of a decedent s estate, preference will be given to a surviving domestic partner Appointment as Conservator In selecting a court-appointed conservator of the estate, preference is now given to the proposed conservatee s domestic partner. In this proceeding, the domestic partner is specifically entitled to appear at the hearing and to address the appointment of a conservator Adoption A registered domestic partner is now able to adopt the child of his or her partner using the stepparent adoption procedures Continuing Health Care Insurance The registered domestic partner of a state employee/retiree and the children of that domestic partner are now eligible for continued health insurance after the employee s death or retirement if the partner was enrolled in the state health insurance plan prior to the death/retirement Limited Death Benefits and Survivor s Allowances Surviving domestic partners of deceased employees of selected California counties are now entitled to the same benefits given to surviving spouses. 10 (Currently, this is limited to San Francisco county and will be available in San Mateo county if approved by its Board of Supervisors.) 7. Right to Claim State Disability Benefits A domestic partner is now entitled to file claims for state disability benefits on behalf of an eligible but incapacitated partner Right to Use Sick Leave A domestic partner whose employer allows an employee to use his or her sick leave to care for his or her spouse and/or the children of such

2 spouse is now entitled to use his or her sick leave to care for his or her domestic partner and/or the children of such partner Right to Unemplovrnent A person who voluntarily leaves a job to accompany his or her domestic partner to a new job in a place from which it is impractical to commute and to which the person s employer cannot transfer employment is eligible for unemployment benefits Certain Medical Expenses of Domestic Partner and Certain Employer-provided Insurance Benefit for Partners Excluded from Gross Income California will no longer tax certain medical expenses paid for domestic partners, and certain employer-paid premiums will no longer be included in the partner/employee s income. 14 D. The List Continues to Grow AB 25 gave the domestic partnership registration process some teeth, but it left many important issues unresolved, perhaps the most important being some automatic right to inheritance. In 2001, Assembly Member Koretz introduced a bill that would have resolved this issue by establishing a civil union regime much like Vermont s, but the bill died in committee. Less than a month after Koretz s bill died, Assembly Member Keeley introduced AB 2216, a bill aimed more specifically at this issue. This bill, which was signed into law on September 10, 2002, effective July I, 2003, modified intestate succession rules by giving a surviving registered domestic partner the same entitlement to his or her deceased registered domestic partner s separate property that a surviving spouse is currently entitled to. 16 E. Other Legislative Efforts Are Likely Given the multiple attempts to legislate in this area, it seems certain that the California legislature will continue to attach rights to the domestic partnership registration. For now, however, attorneys who represent domestic partners must continue to apply the standard issue estate planning tools creatively and thoughtfully and overcome the remaining obstacles. II. THE REMAINING OBSTACLES A. No Marital Deduction/Unlimited Interspousal Transfers Transfers between domestic partners are subject to the gift tax to the extent they exceed the annual gift exclusion and/or the lifetime applicable exclusion amount. Without the unlimited marital deduction, a partner whose entire estate is left to his domestic partner must plan for an estate tax at his death if his estate exceeds his applicable exclusion amount. And whereas a wealthy husband might plan for this estate tax by gifting large amounts to his wife in order to equalize their estates, a wealthy domestic partner cannot do so. Further, a partner who pays more of the couple s living expenses is making taxable gifts to the extent the disparity in payment exceeds $11,000. Another result is that a surviving partner cannot roll over his deceased partner s retirement plans, which means two things: (1) the retirement plan assets cannot be deducted from the deceased partner s taxable estate; and (2) the surviving partner will be required to begin taking (taxable) distributions relatively soon after the decease partner s death based on the minimum distribution rules. Without the marital deduction, the effectiveness of another valuable income tax planning tool is diminished. Suppose wife creates a charitable remainder trust that lasts for her lifetime with the benefits continuing for her husband s lifetime. The marital deduction protects the income stream husband receives after wife s death. 17 On the other hand, the present value of the income stream to a surviving domestic partner will be a taxable gift. B. No Gift Splitting A wife who has substantial separate property assets can make gifts of twice the annual gift exclusion if her husband will elect to split the gifts and use his annual exclusion. Domestic partners cannot do so, which means that a domestic partner cannot gift the same amount of assets without incurring a gift tax. C. Increased Possibility of Real Property Reassessments The Franchise Tax Board interprets interspousal transfers narrowly. A transfer between spouses does not count as a change in ownership, which is the triggering event for a property tax reassessment. Transfers between domestic partners, on the other hand, do count as changes in ownership, which means that Partner 1 cannot give an interest in her real estate to Partner 2 without reassessment of the interest transferred to Partner 2 for real property tax purposes. There are special rules that allow Partner 1 to transfer a joint tenancy interest to Partner 2. These rules allow Partner 1 to add Partner 2 to title as a joint tenant while postponing the reassessment until one of the partners dies. If Partner 1 dies first, then 100% of the property would be reassessed upon the transfer to Partner 2. If Partner 2 dies first, then only the 50% of the property reverting to Partner 1 would be reassessed. 18 Of course, the transfer of a joint tenancy interest is a gift, and, as noted above, this gift would be subject to the gift tax since the gift tax interspousal transfer rules don t apply to domestic partners. D. No Community Property So No Double Step-Up in Basis Married couples frequently chose to hold their assets as community property because that type of property benefits from a double step-up in basis when the first spouse dies. Community property cannot exist between unmarried partners. As a result, a surviving domestic partner will face greater income or capital gain taxes when she sells a jointly owned asset because only the deceased partner s interest in the property is entitled to a step-up in basis. Of course, this entire structure will change if the current estate tax law remains in place and carryover basis rules are reinstated. 19 E. Increased Taxation of Joint Tenancy Property Without very thorough contribution records for joint tenancy property, the value of the entire property will be included in the deceased partner/ joint tenant s taxable estate. 20 In contrast, a wife is presumed to own only half of joint tenancy property she holds with her husband. 21 What s worse is that, absent very thorough contribution records, the entire value of the entire property will be included again in the surviving joint tenant s taxable estate.

3 F. Certain Employer Benefits Are Taxable Generally, benefits paid by an employer for an employee s domestic partner are deemed taxable income to the employee/partner. Although AB 25 modified California law to exclude these benefits from taxable income, federal law has not changed. G. No Social Security Benefits Although a surviving spouse is entitled to continue collecting his deceased spouse s social security benefits, a surviving domestic partner is not entitled to do so. H. Corporate Agreements Many partnership and shareholder agreements as well as stock option plans prohibit the transfer of interests to anyone outside the participant s family members. These agreements very rarely include domestic partner in the definition of family members. I. Disclaimer Restrictions Estate planners frequently draft trusts that give the surviving spouse the option to disclaim an interest in her deceased spouse s property (in order to give the survivor some flexibility to plan for changes in tax laws) with the property going into an irrevocable trust for the benefit of the survivor. Given last year s federal tax legislation, this approach is increasingly useful; however, it cannot be used by domestic partners because only a legal spouse can disclaim property but still benefit from it (whether through a trust or otherwise). A disclaimer trust for a domestic partner that is designed this way will not qualify for disclaimer treatment under Internal Revenue Code III. PLANNING STRATEGIES A. Living Trusts 1. The Basics All the reasons a married couple is well advised to use revocable trusts instead of wills apply to domestic partners, but there are several factors that make living trusts even more appropriate for domestic partners: a. No Probate Homestead Probate Code 6500 gives a surviving spouse the right to remain in the couple s residence during the probate process. A surviving domestic partner does not have the same rights. b. No Family Allowance Under Probate Code 6450, a surviving spouse is entitled to a family allowance during the probate process, and this is meant to prevent financial hardship for the survivor. A surviving domestic partner is not entitled to a similar allowance. As a result, a surviving partner who was financially dependent on her deceased partner could suffer serious hardship during the probate proceeding. c. No Spousal Property Petition Where a deceased spouse s will leaves everything to the surviving spouse, the survivor can avoid the lengthy and expensive probate process by using a spousal property petition. This option is not currently available to a surviving domestic partner. 2. Joint Revocable Trust Many domestic partners would prefer to create a joint revocable trust (instead of two separate trusts), but this is generally not a good idea. For one thing, joint trusts allow greater potential for indirect gifts between partners. Likewise, contribution of assets to a joint trust opens the door for the potential total inclusion of all assets in a deceased partner s estate (discussed above). Perhaps most decisively, Treas. Reg imposes significantly more onerous reporting requirements for trusts that have more than one owner for income tax purposes. (Of course, the regulations specifically exempt married couples who file jointly from these reporting requirements.) 3. Bypass Trust Why include a bypass trust instead of leaving the entire trust estate to the survivor? For the same reasons a married couple would choose to use an A/B trust plan. First, the assets inside the bypass trust are protected from the surviving partner s creditors. Second, the assets inside the bypass trust will be obviously excluded from the survivor s taxable estate, which is handy in light of the inclusion issues associated with joint assets. Third, access to the assets inside the bypass trust can be limited to prevent the unscrupulous next of kin from making off with them. Fourth, the assets outside the bypass trust can be governed by very different distribution instructions. 4. Limited Power of Appointment Should the survivor have a limited power of appointment? In the past, attorneys have tended to rely on no contest clauses to protect the surviving partner from uncooperative family members of the deceased partner. Including language that specifically identifies certain behavior that would lead to disinheritance was thought to make the deceased partner s wishes clear and to prevent the surviving partner from needing to take affirmative steps with regard to a particularly uncooperative relative. But, given a potential contestant s right to seek preliminary judicial determination of whether an intended action will violate a no contest clause 22, thereby vitiating automatic enforcement of the clause, many practitioners have started giving the surviving partner the right to appoint the remainder of the estate away from contingent beneficiaries. 5. Unitrust Payout Consider using a unitrust payout to the surviving partner. While there is always the potential for conflict between the current beneficiary (the surviving partner) and the remainder beneficiaries (e.g., other members of the deceased partner s family), this potential may be even greater for domestic partners, whose families may not accept the relationship. As a result, it may be a good idea to design the trust for the benefit of the surviving partner so that he or she receives an annuity or unitrust payout instead of distributions of income with access to principal based on ascertainable standards. This approach allows the surviving partner to receive any amount presumably sufficient to cover maintenance and support needs while encouraging a long-term view on investments, which benefits the remainder beneficiaries.

4 6. Generation-Skipping Transfer Tax In many circumstances the trust should address the generation-skipping transfer tax ( GSTT ). Because domestic partners are unrelated for tax law purposes, it s important to consider the ages of beneficiaries in relation to the settlor. For example, if Partner 2 is more than 37½ years younger than Partner 1, then transfers from Partner 1 to Partner 2 will trigger GSTT. Furthermore, if Partner 1 has a son who has not been legally adopted by Partner 2, then transfers from Partner 2 to the child may trigger GSTT if the child is more than 37 1/2 years younger than Partner Successor Trustee Who should be the successor trustee? This is a particularly difficult issue. On one hand, the surviving partner would almost certainly expect to be named as the successor trustee. But on the other hand, remainder beneficiaries who never accepted the partnership may be more inclined to harass a surviving partner who is acting as the sole successor trustee. For this reason, some practitioners recommend naming an independent third party either as a successor co-trustee with the surviving partner or, perhaps, as the sole successor trustee. 8. Start Planning When should domestic partners start their estate plans? As soon as possible. A potential contestant will have a much harder time proving incapacity or undue influence if the plan is instigated while the partner is young. And since courts are less likely to upset a distribution that has been affirmed in several versions of an estate plan, domestic partners may be well advised to restate their estate plans fairly regularly. B. Charitable Trusts 1. Charitable Remainder Trust The charitable remainder trust ( CRT ) remains an important tax planning tool - especially for retirement assets. Although a surviving partner s interest in a CRT is not protected by the marital deduction, these trusts continue to offer a means of reducing capital gains tax and being able to reinvest 100% of the appreciation for greater future returns. One way of preventing a taxable gift upon creation of an inter vivos CRT is by giving the donor partner the first income interest and subjecting the other partner s successive income interest to revocation by the donor. This strategy is no different from the one used regularly to avoid gifts when children are the successor income beneficiaries of a CRT. 2. Charitable Lead Trust For a domestic partner whose estate exceeds her applicable exclusion amount, the charitable lead trust should be of particular interest. A common strategy involves full use of a bypass trust with the remainder of the estate funneling into a testamentary charitable lead annuity trust. The value of the gift to the surviving partner will be reduced by the charity s interest. (Of course, there may still be a tax at the first death, which must be planned for; see Life Insurance Trusts, at III.C., infra.) At the end of the trust s term, the balance of the estate passes to the surviving partner. Under this arrangement, the surviving partner has use of the assets in the bypass trust with the assurance of a second inheritance at some point in the future. In the meanwhile, the surviving partner can rely on the bypass trust. C. Life Insurance Trusts For a surviving partner, life insurance is the primary source of liquidity for paying estate taxes due when the first partner dies; it also often replaces the benefits a surviving spouse would receive through a marital trust. Although cross-ownership is the most straightforward ownership approach, irrevocable life insurance trusts remain very common because they offer both creditor and remarriage protections. GSTT issues arise frequently in designing these trusts. The planner must also be careful about how the trust is funded. To avoid an Internal Revenue Code 2036 problem, the insured partner should establish the trust and make cash gifts to the trust, which should be subject to withdrawal. The beneficiary partner s money should not be used to pay the premiums. D. Grantor Retained Income Trusts At least for now, domestic partners are not related parties, which means that Chapter 14 of the Internal Revenue Code doesn t apply to transactions between them. As a result, a domestic partner can transfer an asset to a grantor retained income trust ( GRIT ) and receive any income earned by the asset until the trust s term expires, at which time ownership of the asset vests in the other partner or, if creditors are a worry, then in an irrevocable trust for the other partner s benefit. This technique removes post-transfer appreciation from the donor partner s estate and uses less of his lifetime exemption because the actuarial value of the retained interest reduces the total value of the gift. When drafting a GRIT like this, the planner should make certain that the donee partner s interest terminates if the partnership terminates while being careful that the donor partner does not have a right to alter enjoyment, which would run afoul of Internal Revenue Code E. Qualified Personal Residence Trusts Like a GRIT, a qualified personal residence trust ( QPRT ) allows one partner to remove his interest in the couple s residence from his taxable estate while using less of his lifetime exemption because the actuarial value of the retained use (the right to occupy the residence) reduces the total value of the gift. Transfers of fractional interests to the QPRT are routine so long as the partners do not retain continued joint use of the property. Consider transfer of the donor partner s entire interest, which means that, after termination of the trust, the donor partner will have a legal obligation to pay rent to the donee partner. Although this would be taxable as rental income to the donee partner, it will give the donee partner a stream of income that may be important in making sure the donee partner can afford to keep the residence. It will also lead to transfers of additional wealth to the donee partner that would not be considered gifts. F. Installment Notes As noted above, Chapter 14 of the Internal Revenue Code does not currently apply to domestic partners, which means that these unrelated parties can continue to use installment sales. In this strategy, Partner 1 sells an appreciating asset to Partner 2 and receives an installment note that is not due until Partner 2 s death. The transfer (1) removes the asset and its subsequent appreciation from Partner 1 s estate and (2) defers capital gains taxes on the appreciation until Partner 2 s death. G. Advance Health Care Directives In the past, powers of attorney authorizing one domestic partner to make health care decisions for the other partner were crucially important. Since January 2000, a domestic partner has had the statutory right to visit

5 his or her partner in the hospital? 23 Probate Code 4716, enacted in 2002 as part of AB 25, provides that if a patient lacks the capacity to make a health care decision, the patient s domestic partner shall have the same authority as a spouse has to make a health care decision for his or her incapacitated spouse. This statutory directive has eased many troubled minds, but the question remains about how a partner convinces a hospital of his domestic partner status without carrying around a copy of the partners Declaration of Domestic Partnership. Since doctors and hospitals are more accustomed to seeing Advance Health Care Directives, planners should continue to recommend that domestic partners execute these documents. Planners also should encourage them to add language expressly authorizing the agent to visit the patient and making it clear what kind of visitation rights the agent should have, especially in relation to that group of people health care facilities may consider family members. The recent legislation did not address another great fear-the right to direct funeral arrangements. Absent specific directions concerning this right, the authority falls to the decedent s spouse, then to adult children, then parents, then next of kin. 24 To avoid this, each partner should expressly grant to his or her partner authority to dispose of his or her body in an Advance Health Care Directive. H. Powers of Attorney for Asset Management In legally recognized marriages, each spouse has a general right to control the couple s community property during the incapacity of one of them. 25 Domestic partners do not have this right. As a result, the partners may desire to expressly authorize each other to manage assets. Some planners carefully limit gift-making authority in a power of attorney to avoid an IRS argument that property subject to the gifting authority should be included in the agent s estate because the agent s power amounts to a general power of appointment. Although other attorneys opine that such an argument would fail, there is a more settled reason to draft grants of giftmaking authority carefully. If the agent can and does make to gifts to himself when there is no evidence of previous gifts from the principal to the agent, those who stand to benefit if the principal dies may well claim that the agent has breached his fiduciary duty. I. Nominations of Conservators In the past, nominations of conservator were essential. Without this nomination, an uncooperative family could have a conservator appointed, who could then terminate any power of attorney appointing a domestic partner as agent. After AB 25, this tactic is less likely to work because domestic partners are given equal preference when appointing a conservator. 26 Still, out of an abundance of caution, planners should continue to have their clients nominate their domestic partners specifically because the appointment process is in the court s discretion. A writing that specifically nominates an individual and gives an explanation as to why appointment of this particular person is in the best interest of the proposed conservator will go a long way toward convincing a judge to comply with the nomination. ENDNOTES 1. Family Code See Family Code Probate Code Probate Code Probate Code Probate Code 8461, 8462, and Probate Code 1460, 1811, 1812, 1820, 1821, 1822, 1829, 1861, 1863, 1871, 1873, 1874, 1891, 1895, , 2212, 2213, 2357, 2359, 2403, 2423, 2430, 2504, 2572, 2580, , 2622, 2651, 2653, 2681, 2682, 2687, 2700, 2803, and 2805; see also Probate Code Family Code 9000, 9002, 9004, & Government Code Government Code Unemployment Insurance Code Labor Code Unemployment Insurance Code 1030, 1032, and Revenue and Taxation Code AB 1338 was introduced by Assembly Member Koretz on February 23, 2001, and died on February 7, Probate Code 6401 and See Internal Revenue Code 2056(b)(8). 18. Revenue & Taxation Code 65(c). 19. Carryover basis is a major concern for tax planners because it caused such havoc when it was tried in the 1980s, and it is very likely that any future estate tax legislation will clarify whether carryover basis will be used if the estate tax is repealed. 20. Internal Revenue Code 2040(b) says that only the value Partner 2 acquires for full and adequate consideration from Partner 1 will be excluded from Partner 1 s estate. Treas. Reg places the burden of proving contribution on the deceased joint tenant s executor. 21. Internal Revenue Code 2040(a). 22. Probate Code Family Code (referring to Health and Safety Code 1261). 24. Health and Safety Code 7100(a). 25. See, e.g., Family Code Probate Code 1812(b)(1). * Snell & Wilmer L.L.P., Orange County, California Reprinted from California Trusts And Estates Quarterly Volume 9, Issue 1, Spring 2003