Dear Friend and Colleague,
This one-two punch creates estate tax and non-tax opportunities and pitfalls for same-sex couples who now will be able to marry in California.
On the last day of its 2013 term, the U.S. Supreme Court issued two monumental rulings dealing with same-sex marriage. InHollingsworth v. Perry, 570 US ____ (2013), the Court dismissed the appeal of a lower court’s finding that Proposition 8 is unconstitutional. As a result, same-sex couples in California are once again free to marry. More significantly, in United States v. Windsor, 570 US ____ (2013), the Court ruled that §3 of the Defense of Marriage Act (DOMA) which limited the definition of marriage to the union of a man and a woman, is unconstitutional. The result is that federal benefits conferred to married couples in over 1000 federal statutes now benefit same-sex couples as well.
The most significant estate tax benefit resulting from the demise of DOMA is the ability of a same-sex married person to qualify for the “unlimited marital deduction.” Under §2056 of the Internal Revenue Code, if a married person leaves his or her estate to a spouse, there is no estate tax on the transferred property, regardless of the size of the estate. The unlimited marital deduction is Congress’ expression that, for purpose of the estate tax, married persons are treated as a unit, with Congress willing to wait until the second of two spouses dies before exacting an estate tax.
Another benefit suddenly conferred upon same-sex couples as a result of the demise of DOMA is qualification for the unlimited gift tax marital deduction. Married couples are free to make unlimited interspousal gifts without incurring gift taxes, which often facilitates estate tax planning and asset protection planning. Same-sex couples now have the same ability.
An important by-product of the ability of California same-sex couples to marry is that their assets will now be presumed to be community property. Section 760 of the Family Code creates a presumption of community property (“All property…acquired by a married person during the marriage in this state is community property.”) The result is that same-sex couples will qualify for the full “step-up-in-basis” that heterosexual couples in community property states have enjoyed for decades.
Here is how the step-up works. If a person inherits an appreciated asset from a decedent, the capital gain inherent in the appreciated asset is forgiven. If Mr. Brown bought one share of Ford Motor Co. stock for $1, and leaves it to his son Jimmy at a time when it is worth $10, the $9 capital gain that Mr. Brown would have incurred had he sold the stock disappears. Jimmy obtains a date-of-death tax basis in the stock equal its date-of-death value, viz., $10. If Jimmy later sells the stock for $11, his capital gain is $1, not $10. But there’s a catch. In order to qualify for the step-up, the decedent must have owned the property, and the recipient must inherit the property. But if the inherited property is community property, it would appear that the recipient owned half of the property all along, and could inherit only the other half.
That problem is solved by §1014(b)(6) of the Internal Revenue Code, which provides that both halves of community property qualify for the step-up. As result, married couples in community property states are freed of a conundrum that married couples face in separate property states. If John Smith and Jane Smith, a married couple in New York, title their assets as tenants in common or as joint tenants, and one of them dies, the survivor will obtain a step-up in only half of the value of the assets. If all of the assets are titled in John Smith’s name, and Jane Smith dies, John Smith will receive no step-in any of the assets, having inherited none of the assets.
Community property is not an unalloyed benefit, and it is here that same-sex couples will need to think twice before they acquire assets. If, in the previous example, John Smith, a New York resident, were sued and a judgment obtained against him, the judgment creditor could satisfy his judgment only against John Smith’s assets. The creditor would have no ability to attach Jane Smith’s separate property. But California law runs in the opposite direction. Section 910 of the Family Code provides that the “community estate” is liable for the debts of either spouse, even if the debt was incurred prior to the marriage. Section 913(b)(1) of the Family Code provides that the separate property of each spouse is exempt from claims against the other spouse, to the same extent as in separate property states.
If asset protection is the paramount objective, a same-sex couple should consider entering into a prenuptial agreement that removes them from community property. The agreement should make it clear that regardless of when an asset is acquired or how it is titled, neither spouse can obtain a community property interest in the asset. If the same-sex couple is already married, §850 of theFamily Code permits married couples to enter into interspousaltransmutation agreements, removing both their current assets and any after-acquired assets from community property. Transmutation agreements are subject to the laws of fraudulent conveyances. If one spouse is subject to the clutches of creditors, and the spouses enter into a transmutation agreement transmuting all or most of their assets into the separate property of the non-debtor spouse, the transfer will likely will deemed a fraudulent conveyance. As in most contexts, planning works better if it is done earlier rather than later.
Very Truly Yours,