presented to the ABA Tax Section Fiduciary Income Tax Committee

1. ABA Tax Section Mid-Year Meeting
Fiduciary Income Tax Committee
January 25, 2014
Phoenix, Arizona
Brian P. Tsu Melinda Merk
Henderson, Caverly, Pum & Charney LLP SunTrust Bank Private Wealth Management
San Diego, California Vienna, Virginia

2. Agenda
 Community Property Overview
 Key non-tax characteristics
 Federal income and wealth transfer tax aspects
 Potential pitfalls using joint trusts
 Transmutation agreements/planning
 Increased use of Joint Revocable Trusts (JRTs) in Common Law
Property States
 Common law property basics
 Typical design of JRTs for non-community property
 Federal income and transfer tax issues and pitfalls
 Other post-mortem administrative issues
 Using “Community Property” JRTs to convert common law to
community property
2

3. Overview of Community Property -
Community Property Jurisdictions
 Community property principles apply to property acquired by spouses while domiciled in
certain jurisdictions
 Community property also applies to same-sex couples if the state recognizes the same-sex
marriage for state law purposes
 States differ as to whether community property applies to registered domestic partners
 Currently, community property jurisdictions include Arizona, California, Idaho,
Louisiana, New Mexico, Nevada, Texas and Washington as well as many foreign countries
 In addition to the above jurisdictions, Wisconsin has adopted the Uniform Marital
Property Act, in effect adopting a community property system unless spouses elect out
 The IRS has ruled that Wisconsin marital property is the equivalent of community
property for income tax purposes [Rev. Rul. 87-13]
 Alaska has also adopted the Uniform Marital Property Act, except that spouses must elect
to treat property as community property
 The IRS has not ruled on whether Alaska’s system constitutes community property for
federal tax purposes
3

4. Overview of Community Property –
Categories of Property
 In general, there are two categories of property in a community
property jurisdiction:
 Community property
 Separate property
 In some community property jurisdictions, such as California, a third
category of property, known as quasi-community property exists
 Quasi-community property seeks to treat as community property, for
purposes of disposition at death or at divorce, property acquired during
marriage in a common law jurisdiction prior to the spouses domicile in
a community property jurisdiction
 Quasi-community property does not constitute community property
for federal tax purposes
4

5. Overview of Community Property –
Working Definition
 What is separate property?
 Property (1) owned by a spouse before marriage, (2) any
property acquired by gift, inheritance or bequest after
marriage, and (3) property converted from community
property by valid agreement
 What is community property?
 All other property acquired by spouses during their marriage
while domiciled in a community property jurisdiction
 Note: Community property jurisdictions presume that
property acquired by spouses is community property unless
shown otherwise. The IRS acknowledges this presumption as
well [IRS Publication 555]
5

6. Overview of Community Property –
Key Characteristics
 Ownership: Each spouse owns one-half of community property
 Management: Each spouse has equal management rights over
community property
 Each spouse can dispose of only one-half of the community
property at death
 Also, in general, unless a transferring spouse has the consent of the
other spouse, a spouse may only give away one-half of the
community property during life
 Title: Title to community property is generally irrelevant to the
interests of each spouse
 However, where the character of property is unclear, title may give
rise to presumptions regarding the character of the property
6

7. Tax Aspects of Community Property –
Federal Income Tax
 Inclusion: One-half of community income is included in the gross
income of each spouse [Lucas v. Earl, 281 U.S. 111 (1930); Rev. Rul. 55-
726]
 Basis: At the death of either spouse, each spouse’s one-half interest in
community property receives a basis adjustment equal to fair market
value. [IRC Section 1014(b)(6)]
 Note that quasi-community property does not receive basis adjustment
 Grantor trusts: For grantor trust purposes, a “grantor” includes “any
person…who directly or indirectly makes a gratuitous transfer of
property to a trust” [Treas. Reg. § 1.671-2(e)(1)]
 Accordingly, upon transferring community property to a trust, each
spouse is treated as a grantor of that trust
7

8. Tax Aspects of Community Property –
Federal Wealth Transfer Tax
 Community property equalizes estates between spouses as
each owns one-half of such property
 Inclusion: Upon the death of a spouse only one-half of the
value of community property is included in the gross estate
under section 2033
 Gifting: Accordingly, each spouse is also considered a donor of
community property for gift tax purposes
 Split gifts: Because each spouse is considered a donor for
gift tax purposes, gifts of community property are
automatically split for gift tax purposes [Instructions to
Form 709]
8

9. Tax Aspects of Community Property –
Federal Wealth Transfer Tax
 Fractional discounts: A discount may be available for
transfers of non-marketable community property. [See
Propstra v. U.S., 680 F.2d 1248 (9th Cir. 1982)]
 The IRS has argued unsuccessfully that such property should
be valued at 100% of fair market value less costs of partition.
[See Estate of Cervin v. Comm’r, 68 T.C. Memo 1994-550]
 GST tax: The foregoing aspects of community property also
apply to the generation-skipping transfer tax. They apply
for purposes of determining:
 the “transferor” under section 2652(a); and
 the value of property transferred as such value is determined
for gift or estate taxes
9

10. Community Property Pitfalls –
Preservation of Community Property in JRTs
 As a general rule, transferring property to a revocable trust
does not change the character of the transferred property
 That said, the revocable trust should provide, as to any
community property:
 Property transferred to the trust shall retain its character as
community property
 As long as both spouses are alive, they may at any time alter,
amend or revoke the trust in whole or in part, provided that
any part of the trust estate so withdrawn shall be transferred
to them as community property
 Net income from the trust is community property, and is to be
paid to or applied for the benefit of the grantors [Rev. Rul. 66-
283]
10

11. Community Property Pitfalls –
Joint Irrevocable Trusts
 While many of the planning considerations present in
planning for a gift of common law or separate property
to an irrevocable trust overlap, the creation of an
irrevocable trust that holds community property raises
additional traps for the unwary
 Many pitfalls arise from the fact that each spouse is
considered a donor/grantor as to gifts of community
property for wealth transfer and income tax purposes
11

12. Community Property Pitfalls –
Incomplete Gifts
 In many community property jurisdictions, the non-
transferring spouse must consent a transfer of community
property
 If that consent is not provided, the gift may be incomplete
under Treas. Reg. §25.2511-2(b) as the donor has not ceded
“dominion and control”
 Because it is sometimes possible for a spouse to have
acquired a community property interest in separate
property, it may be prudent to obtain the written consent
of the spouse even when making a gift of separate property
12

13. Community Property Pitfalls –
Retained Interests under IRC §§2036 and 2038
 Because each spouse is treated as a donor of community property, take care to
ensure that the terms of the irrevocable trust holding such property do not
create retained interests
 Spousal beneficial interests: Beware of gifts of community property to an
irrevocable trust in which a spouse is a beneficiary if the intention is to exclude
the trust assets from the gross estate of that spouse (for example ILITs and
SLATs)
 Beware of community property funds used to fund premiums especially if the
state is an “inception from title” state
 Fund such trusts with separate property
 Even if trust is funded with separate property, beware of states (for example
Texas) where income from separate property is community property [But See
Rev. Rul. 81-221 based on Federal Fifth Circuit’s conclusion re: Texas law]
 Spouse as trustee: Beware of gifts of community property to an irrevocable
trust in which a spouse has control over a beneficial interest (for example as a
trustee)
 Limit trustee discretion to ascertainable standard
 Fund trust with separate property
13

14. Community Property Pitfalls –
Qualified Personal Residence Trusts
 The success of a QPRT as a wealth transfer vehicle success
depends on the grantor surviving the term of the trust
 If a residence owned as community property is transferred to a
QPRT, both spouses must outlive the term for the trust to succeed
 Alternatives to joint QPRTs
 The residence is commonly transmuted to create one-half separate
property interests with the spouses creating separate QPRTs so that
should one spouse predecease the term, the other trust may still
succeed if the other spouse survives the term
 Separate QPRTs also allows for other benefits, not unfamiliar to
practitioners in common law jurisdictions, including different
terms tailored to the ages of each spouse and the availability of a
fractional discount
14

15. Community Property Pitfalls –
Sales to Intentionally Defective Grantor Trusts
 Typically, a sale is structured so that an individual is selling property to
a wholly-owned trust under the grantor trust rules to avoid gain or loss
on the sale [Rev. Rul. 85-13]
 If the grantor trust is “seeded” with community property, each of the
spouses is a grantor of the trust
 However, as both of the grantors are spouses, gain on the sale to the
trust is probably avoided under section 1041
 Upon the death of the first spouse, a portion of the trust ceases to be a
grantor trust [Rev. Rul. 75-267]
 As a result, complexities related to a partial grantor and partial non-
grantor trust may arise as to the:
 income tax treatment of the payments on the note
 questions regarding gain recognition
 income tax reporting for the purchasing trust (part IDGT and part taxable trust)
 Similar issues may also arise upon the death of the first spouse as to
joint ILITs
15

16. Community Property Pitfalls –
Grantor Trusts Issues under IRC §§ 674(c) and 675(3)
 Related or subordinate party status is relevant to
powers possessed by independent trustees to
distribute income or principal to certain classes of
beneficiaries under IRC Section 674(c), and with
respect to a grantor's borrowing of trust funds from
the trust under IRC Section 675(3)
 In-laws may often be selected as “independent”
trustees. If a trust is funded with community property,
an in-law may be a related or subordinate party with
respect to the other spouse
16

17. Overview of Transmutation Agreements -
Planning Opportunities
 Consider transmuting appreciating separate property into community
property to obtain a basis step-up equal to 100% of the fair market
value of the property
 Conversely, consider transmuting depreciating community property
into separate property to limit the basis step-down to 50% of the value
of the property
 Transmuting community property into separate property to create
separate trusts for the purpose of:
 avoiding retained interests where a spouse has a beneficial interest or a
problematic power
 Increasing the likelihood of success and customizing the terms of each
QPRT to each spouse
 avoiding the problems associated with a partial grantor trust in the
context of a sale to IDGT
17

18. Overview of Transmutation Agreements -
Pitfalls
 Transmutation have consequences far beyond income
or wealth transfer taxation
 Inherent conflict between spouses
 Some states have a presumption of undue influence
 Potential for claim against attorney upon spouses’
divorce
18

19. Overview of Transmutation Agreements -
Best Practices
 Inform spouses of potential conflict
 Consider separate representation
 Put agreement in writing, specifically interests being
transmuted
 But see Einim, T.C. Memo 1984-130
 Transmutation must be permitted under state law [See Rev.
Rul. 77-359]
 Both spouses are informed of the assets and liabilities of
the other spouse
 Both spouses are given sufficient time to consider the
agreement
 Consult family law counsel
19

20. Common Law Property – Basics
 In non-community property states, only 50% of any joint spousal property
(JSP) is included in deceased spouse’s estate [IRC Section 2040(b)]
 Results in 50% (vs. 100%) stepped-up basis for JSP at the first spouse’s death
 Tracing rules apply if surviving spouse is a non-US citizen
 100% stepped-up basis may be available for JSP created prior to 1977 under the
so-called Gallenstein rule
 Traditionally, separate revocable trusts are created by each spouse and funded
with the couple’s separate and/or JSP
 Often requires the severance of joint ownership/tenancy by entirety (TBE)
protection to sufficiently fund bypass trust at first spouse’s death
 Some states (VA, MD, Missouri, Indiana, Illinois Hawaii and DE) preserve TBE
character
 Deceased spouse’s 50% interest in any JSP can also be disclaimed by surviving
spouse into bypass trust via qualified disclaimer
20

21. Increased Use of JRTs in Common Law
Property States
 Tax law changes made permanent under the American Taxpayer Relief Act of
2012 (“ATRA”) have eliminated or lessened the need to plan for the Federal
estate and gift tax for many married couples
 Increased Federal estate/gift tax exemption ($5.34MM for 2014)
 Portability election allows for transfer of deceased spouse’s Federal estate/gift
tax exemption amount to surviving spouse
 Not available for GST tax or state estate tax purposes
 In order to make the election, Federal estate tax return must be filed at the first
spouse’s death
 JRTs are viewed as simpler estate planning solution
 One trust document vs. two separate trusts for each spouse
 Alleviates need to divide couple’s joint and/or separate property between two
separate trusts
 “Community property” JRT (formed in AL and TN) may allow couple domiciled
in common law property state to obtain 100% stepped-up basis at first spouse’s
death
21

22. JRTs – Typical Design
(Non-Community Property)
 Scenario #1 – Estate Equalization JRT
 Each spouse owns or is deemed to own (via deemed gifts upon
contribution of any separate property to the trust) an undivided 50% of
the trust assets
 No separate shares are maintained
 Both spouses are co-trustees
 During their joint lifetime, spouses retain joint right to income and
principal, and joint right to amend and revoke
 Upon revocation, trust assets are distributed 50/50 to each spouse
 May also provide for automatic revocation and 50/50 distribution upon divorce,
unless decree of divorce directs or the spouses mutually agree otherwise
 Upon first spouse’s death, deceased spouse’s 50% share is directed to
bypass trust (or to the surviving spouse’s share, with ability to disclaim
into bypass trust)
 Surviving spouse retains right to income and principal, and right to
amend/revoke, over surviving spouse’s share
22

23. JRTs – Typical Design
(Non-Community Property)
 Scenario #2 – Separate Share JRT
 Separate shares are created and maintained for joint property contributed to the
trust, and for any separate property contributed by each respective spouse
 Both spouses are co-trustees
 Spouses retain joint right to income and principal with regard to the joint
property share, and unilateral right to income and principal with regard to their
respective share of separate property
 Spouses retain joint right to amend and revoke with regard to the joint property
share, and unilateral right to amend and revoke with regard to their respective
share of separate property
 Can be cumbersome to revoke/unwind upon divorce if separate shares are not
maintained
 Upon first spouse’s death, deceased spouse’s 50% share of joint property, and of
all of his or her separate property, is directed to bypass trust (or to the surviving
spouse’s share, with ability to disclaim into bypass trust)
 Surviving spouse retains right to income and principal, and right to
amend/revoke, over surviving spouse’s share
23

24. JRTs – Typical Design
(Non-Community Property)
 Scenario #3 – General Power of Appointment JRT
 Equalization or Separate Share plan designs are utilized
during the spouse’s joint lifetime
 Upon the first spouse’s death, the deceased spouse has a
testamentary general power of appointment over part or all of
the trust assets
 In default of such exercise, the deceased spouse’s remaining
estate tax exemption amount is directed to bypass trust, any
excess is directed to surviving spouse’s share
 Surviving spouse retains right to income and principal, and
right to amend/revoke, over surviving spouse’s share
 Goal is to obtain maximum funding of bypass trust and 100%
stepped-up basis at first spouse’s death
 Can also be utilized using separate revocable trusts
24

25. JRTs - Federal Gift Tax Issues
(Non-Community Property)
 Potential gift to non-donor spouse upon contribution of unequal amounts of any
separate property to JRT
 Donor spouse’s right to revoke does not make gift incomplete if only exercisable jointly
with, or only with the consent of, a person who has a substantial adverse interest (i.e., non-
donor spouse)
 Even if unilateral right to revoke over separate property is retained (Scenario #2), may be difficult to
exercise if separate shares are not maintained
 Gift would a “terminable interest” (i.e., life estate) that may not qualify for the unlimited
gift tax marital deduction under IRC Section 2523(e) or 2523(f)
 Should qualify as life estate with power of appointment under IRC Section 2523(e), if non-donor
spouse has unilateral right to revoke (or power to appoint in favor of his or her estate) over gifted
portion
 Would not be considered “qualifying income interest” eligible for QTIP treatment under IRC Section
2523(f), if trust principal from gifted portion can be distributed to the donor spouse (i.e., any person
other than the donee spouse)
 Potential gift by surviving spouse to remainder beneficiaries when bypass trust portion of
JRT becomes irrevocable at first spouse’s death
 Any such gift can be rendered incomplete if surviving spouse retains a testamentary
special power of appointment over the bypass trust
25

26. JRTs – Federal Estate Tax Issues
(Non-Community Property)
 May be unclear what portion of JRT is includible in deceased spouse’s estate
 Affects what portion of the trust assets would be eligible for stepped-up basis at first
spouse’s death
 “Qualified joint interest” treatment under IRC Section 2040(b) only applies to property
held by spouses as TBE or JTWRS
 To the extent spouse contributed property to the trust and retained a right to alter, amend,
revoke, or terminate such interest (either alone or in conjunction with any other person),
property would be includible in his or her estate under IRC Section 2038
 To the extent spouse has general power of appointment over part or all of the trust assets,
trust assets would be includible in his or her estate under IRC Section 2041
 IRS says no stepped-up basis for portion of trust assets contributed by the surviving spouse, under
IRC Section 1014(e) [PLRs 200101021 and 200210051]
 Tracing may be required to determine character/ownership of trust assets, if separate
shares are not maintained
 Potential inclusion of bypass trust assets in surviving spouse’s estate under IRC Section
2036(a)(1) if he or she is treated as a contributor/transferor of these assets, particularly
under Scenario #2 where separate shares for separate property are not maintained
 IRS ruled favorably on this (no inclusion) for JRT where general power of appointment was
given to first spouse to die [PLRs 200101021 and 200210051]
26

27. JRTs - Federal Income Tax Issues
(Non-Community Property)
 Amount includible in deceased spouse’s estate/amount
generally eligible for stepped-up basis, unless IRC Section
1014(e) applies
 Can trustee pick and choose assets upon division at the first
spouse’s death, or does fractional interest of each asset have to
be used?
 Other reporting issues common to joint spousal accounts
 Only one spouse’s SSN can be used during joint lifetime
 Separate EIN must be obtained for deceased spouse’s portion
of trust at first spouse’s death (“administrative trust”) and for
bypass trust
 Surviving spouse’s SSN should be used for remaining portion of trust
assets
27

28. Limited IRS Rulings on JRTs
(Non-Community Property)
 PLR 200101021
 Facts
 JRT funded solely with TBE property
 Either spouse had unilateral right to revoke; if exercised, an undivided 50%
interest in the trust property was returned to each spouse as tenants in common
 First spouse to die had testamentary general power of appointment over all of the
trust assets; upon failure to exercise, amount equal to remaining exemption
amount passed to Credit Shelter Trust, any excess amount passed outright to the
surviving spouse
 IRS ruled as follows:
 No completed gift upon funding due to unilateral right to revoke
 Deceased spouse’s one-half of the trust assets included in his/her estate under
IRC Section 2038, surviving spouse’s one-half of trust assets included deceased
spouse’s estate under IRC Section 2041
 Completed gift of surviving spouse’s one-half of trust assets to deceased spouse at
first spouse’s death – qualifies for the gift tax marital deduction and prevents
stepped-up basis in this portion under IRC Section 1014(e)
 Credit Shelter Trust not includible in surviving spouse’s estate because the
property is treated as passing from the deceased spouse and not from the
surviving spouse
28

29. Limited IRS Rulings on JRTs
(Non-Community Property)
 PLR 200210051
 Facts
 JRT funded with JTWRS and/or separate property
 Either spouse had unilateral right to revoke; if exercised, trust property was to be
distributed in accordance with the direction of both spouses
 Each spouse also had a unilateral power to withdraw principal (lifetime general
power of appointment)
 Upon first spouse’s death, trust was divided into Credit Shelter Trust (up to
deceased spouse’s remaining exemption amount) and Marital Trust
 IRS ruled as follows:
 Portion of trust property transferred to the trust by the deceased spouse was
included in his/her estate under IRC Section 2038, portion contributed by the
surviving spouse included in deceased spouse’s estate under IRC Section 2041
 Completed gift of surviving spouse’s entire interest in the trust to deceased
spouse at first spouse’s death – qualifies for the gift tax marital deduction and
prevents stepped-up basis in this portion under IRC Section 1014(e)
 Credit Shelter Trust not includible in surviving spouse’s estate because the
property is treated as passing from the deceased spouse and not from the
surviving spouse
29

30. Other Post-Mortem Administrative Issues
(Non-Community Property)
 Can be cumbersome/confusing having one trust
document for deceased share’s irrevocable portion and
surviving spouse’s revocable portion after first spouse’s
death
 Consider transferring surviving spouse’s portion into
newly-created separate revocable trust
30

31. “Community Property” JRTs
 Statutes in AL and TN allow nonresidents to establish a community property trust, and to potentially
convert property transferred to the trust to community property
 At least one trustee must be a resident of the state
 See Alaska Stat. §§ 34.77.020 - 34.77.995; 4.Tenn. Code Ann. §35-17-101, et seq.
 IRC Section 1014(b)(6) says the surviving spouse’s one-half share of community property held “under
the community property laws of any state” shall be eligible for a stepped-up basis
 US Supreme Court ruled that a statute allowing spouses to elect a community property system under
Oklahoma law would not be recognized for federal income tax reporting purposes. [Commissioner v.
Harmon, 323 U.S. 44 (1944)]
 “The Harmon decision should also apply to the Alaska system for income reporting purposes.” [Internal Revenue
Manual, Section 25.18.1.1.2]
 Case was decided prior to the allowance of joint returns – IRS argued income should be included on husband’s
separate return under the assignment of income doctrine
 Rev. Rul. 77-359 - Washington couple agreed to convert their separate property to community
property. IRS ruled that conversion was effective for federal tax purposes, but added “ To the extent that the
agreement affects the income from separate property and not the separate property itself, the Service will not permit
the spouses to split that income for Federal income tax purposes where they file separate income tax returns.”
 See Blattmachr, Zaritsky and Ascher, “Tax Planning with Consensual Community Property: Alaska’s
New Community Property Law,” 33 Real Property, Probate and Trust Journal (Winter 1999).
31

32. Contact Information
Brian P. Tsu
Partner
Henderson Caverly Pum &
Charney LLP
12750 High Bluff Drive,
Suite 300
San Diego, CA 92130
Tel: (858) 755-3000, Ex. 130
Fax: (858) 755-9900
E-mail: btsu@hcesq.com
Melinda Merk, JD, LLM,
CFP ®
Senior Vice President,
Regional Trust Advisor
Private Wealth Management
SunTrust Bank
8330 Boone Blvd, Suite 700
Vienna, VA 22182
Tel: 703/442-1534
Fax: 703/859-7653
melinda.merk@suntrust.com
32

33. Bios
 Brian Tsu is a partner in the Estate Planning,
International Private Client and Taxation Groups at
Henderson, Caverly, Pum & Charney LLP. Mr. Tsu
advises clients in the areas of domestic and
international estate planning, business succession
planning, estate and trust administration and
charitable planning. Mr. Tsu also advises clients on a
variety of domestic and international tax matters,
including federal wealth transfer, fiduciary income
and business entity taxation.
 Mr. Tsu received his LL.M. in Taxation in 2009, from
Northwestern University School of Law, received his
law degree in 2004, from the University of Dayton
School of Law, received his Master of Science in
Professional Accounting in 2002, from Seton Hall
University and his bachelor’s degree in Accounting in
2000, from Boston College. Mr. Tsu is admitted to
practice law in California and Illinois and is also a
registered certified public accountant (Illinois).
 Mr. Tsu is a regular speaker and contributing member
of the American Bar Association, Tax and Real
Property, Trust & Estate Sections; the Society of Trust
and Estate Practitioners (STEP); the California State
Bar Association, Taxation and Trusts & Estate
Sections; the San Diego County Bar Association,
Estate Planning, Trust & Probate Section.
33

34. Bios
 Melinda Merk is a Senior Vice President and
Regional Trust Advisor and part of the Greater
Washington Private Wealth Management team at
SunTrust Bank. She focuses on providing multi-
generational wealth transfer planning advice and
estate and trust services to high net worth individuals,
families , and business owners.
 Melinda has over 18 years experience in the estates and
trusts area. Her prior experience includes serving
clients as a Tax Director in the Personal Financial
Services group at PricewaterhouseCoopers LLP, and as
a Tax Manager in the National Tax Department at
Ernst & Young LLP. She was also engaged in the
private practice of law as a Senior Counsel in the
Private Wealth Services group at Holland & Knight
LLP. She has significant experience advising clients
with regard to domestic and foreign trusts, family
limited partnerships, grantor retained annuity trusts,
dynasty trusts and other wealth transfer strategies,
charitable trusts, estate and trust administration, and
asset protection planning.
 Melinda received a B.S. (cum laude) from Shepherd
College, a J.D. from the Duquesne University School of
Law, and an LL.M. in Taxation (with distinction) from
the Georgetown University Law Center. She is also a
Certified Financial Planner.™
34