Estate Planning for Registered Domestic Partners: Navigating the State and Federal Conflict

• Publication year: 2009

ESTATE PLANNING FOR REGISTERED DOMESTIC PARTNERS: NAVIGATING THE STATE AND FEDERAL CONFLICT

By Steven M. Goldberg^* and Naomi E. Metz^**

I. INTRODUCTION

Estate planning for same-gender couples generally aims to achieve the same goals as estate planning for heterosexual couples. Conflicts between California and federal law, however, make achieving these goals more challenging for same-gender couples. California law gives same-gender couples the right to be registered domestic partners (RDPs), with essentially the same rights and responsibilities as married couples. This status is not, however, recognized as a marriage for federal income tax or estate tax purposes. As a result, estate planning for same-gender couples will often be more complex and difficult than for heterosexual couples. Estate planners need to provide options to their RDP clients to cope with the conflicting laws, while pursuing the traditional goals of legacy planning, asset protection, and tax minimization.

II. THE CONFLICT BETWEEN CALIFORNIA AND FEDERAL LAW

A. California Law

The California Domestic Partners Rights and Responsibilities Act of 2003 (AB 205), which became effective January 1, 2005, granted RDPs almost all "the same rights, protections, and benefits," and subjected RDPs to the "same responsibilities, obligations, and duties . . . as are granted to and imposed upon spouses."¹ Of particular importance for estate planning purposes are the community property ownership system, the obligation of mutual support, liability for "community" debts and, in the event of a dissolution, the obligation to divide property in the same manner as it is divided between spouses in the event of a divorce.

As a result of subsequent legislation, as of January 1, 2007, RDPs had to begin filing their state income tax returns as "Married/RDP filing jointly" or "Married/RDP filing separately."² Absent a written agreement to the contrary, they were also obligated to characterize their earned income as community property for state income tax purposes, as they had been required to do for all other community property income since January 1, 2005.³

B. Federal Law

Federal law does not follow these rules. As the result of the Defense of Marriage Act (DOMA),⁴ the Internal Revenue Service ("IRS" or "Service") has determined that RDPs are to be treated as single individuals for federal income tax purposes. Accordingly, the IRS has taken the position in Chief Counsel Advisory (CCA) 2006008038 that RDPs must file their federal income tax returns as individuals or, where appropriate, as head of household.⁵ Because this conflicts with the obligations of RDPs for income tax filing under California law, RDPs who file jointly must also have a pro forma federal joint return prepared in order to properly file their California return.⁶

In addition to the fact that RDPs are precluded from splitting their community property income and using the married persons' joint-filing status for federal income tax purposes, there are many other substantive federal tax rules that apply to married couples that likely do not apply to RDPs. These include, but are certainly not limited to, the following:

1. The federal gift tax marital deduction provided in Internal Revenue Code (IRC) section 2523(a);⁷
2. The federal estate tax marital deduction provided in Section 2056(a);
3. The special rule allowing a surviving spouse to disclaim into a bypass trust without violating Section 2518(a);⁸
4. The double step-up in basis for community property allowed under Section 1014;
5. The ability to split gifts as spouses on Form 709;
6. Nonrecognition treatment for transfers for income tax purposes upon dissolution under Section 1041, and gift tax exemption for transfers made pursuant to dissolution under Section 2516; and
7. Deduction of alimony for income tax purposes, as provided in Section 215.

C. Transfers in Satisfaction of the RDPs' Obligations Under California Law Should Not be Treated as Gifts

Despite DOMA and CCA 2006008038, there is a strong argument that federal estate and gift tax laws should respect the liabilities and legal obligations that RDPs have under California law. This argument is based primarily on a central tenet of the transfer tax system—that legal interests and rights in property are determined by state law, and once established, federal law designates which interests and rights, so established, are to be taxed.⁹ This cornerstone of the transfer tax system (indeed, of taxation in general) has been affirmed repeatedly over the years in both federal and state courts, and has been deemed applicable to an array of property interests.¹⁰

Federal tax law also provides that transfers for full and adequate consideration, or in satisfaction of a legal obligation, are not transfers subject to estate or gift tax.¹¹ This principle has been held to apply in a variety of situations. For example, transfers that satisfy the transferor's obligation to support a minor child are deemed

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to be transfers for adequate consideration and, therefore, are not characterized as gifts.¹² Other well-known examples of this principle are that a grantor's payment of income taxes due from an irrevocable "defective" grantor trust is not a gift,¹³ payment of claims against an estate are deductible from a decedent's gross taxable estate,¹⁴ and the value of a "retained interest" is not includible in a decedent's gross estate if the original transfer was a bona fide sale for full and adequate consideration.¹⁵

In California, the community is liable by statute for a debt "incurred by either spouse [or RDP] before or during the marriage, regardless of which spouse [or RDP] has the management and control of the property, and regardless of whether one or both spouses [or RDPs] are parties to the debt."¹⁶ Also, although one RDP's separate property is generally not liable to cover separate property debts of the other partner, or community debts, each RDP is personally liable for debts for "necessaries of life" incurred by either party while the RDPs are living together.¹⁷ "Necessaries of life" have been defined in California courts to include those things that are necessary to sustain a spouse or RDP at the station in life to which the RDP is accustomed.¹⁸ An RDP is also personally liable for debts for "common necessaries," even when the RDPs are living apart.¹⁹ Because a partner can be responsible for the cost of "common necessaries" even when the RDPs are living separately, "common necessaries" are restricted to those items that can "be regarded universally, or substantially so, as necessary to sustain life."²⁰ Accordingly, it appears that under California law, a number of different types of expenses should be properly characterized as nontaxable payments for legal obligations, although there is a possibility that qualifying legal support obligations may be limited to basic necessities—food, clothing, and shelter and, perhaps, the ambiguous "something more" that the Eighth Circuit recognized in Hill v. Commissioner.²¹

In light of the two foundational rules of the federal tax system discussed above, it is clear that a decision by the IRS to disregard the statutory obligations of RDPs would produce results that would be both inequitable and illogical. Since both spouses and RDPs are under the identical obligation under California law to satisfy certain debts of the other spouse/RDP, to pay alimony in appropriate circumstances, and to divide community property upon dissolution of the relationship, it would be illogical and inequitable for the IRS to treat the spouse's satisfaction of these support obligations as a nontaxable transfer and at the same time treat the RDP's as a taxable gift. This is all the more true because federal tax laws treat transfers made in satisfaction of support obligations between other unmarried parties, such as parents and children or other qualified dependents, as nontaxable events for gift tax purposes.²² This should make it difficult for the IRS to justify ignoring RDPs' statutory support obligations under California law.

However, despite the strong logic of the foregoing arguments,

and despite the deference normally accorded to state property law, the IRS may well ultimately decide to disregard RDPs' property rights and support obligations. As it did in CCA 2006008038, the IRS may argue that DOMA requires it to ignore the legal support obligations imposed on RDPs under California law because they arise "outside the context of a husband and wife," although the sparse language of DOMA does not appear to mandate this result.²³ The IRS may also claim that they are justified in ignoring RDPs' support obligations and community property rights because they are a fundamental departure from the laws of all other states, a position the IRS has taken in its regulations concerning the definition of income and principal under state trust law.²⁴ However, the IRS would have to justify this position in the face of the long line of cases, some of which are cited in this article, holding that state law establishes the property rights and legal relationships of individuals, and federal tax law simply applies to those situations. Moreover, despite the significant (and, the authors believe, unfortunate) opposition to the legalization of relationships between same-gender couples in some states, there can be no denying that the trend is shifting dramatically towards the approval of the legal recognition of same-gender relationships.²⁵ It might be less of a stretch for the IRS to take the position that it can ignore the community property rights of RDPs, particularly in light of the fact that the Service currently does so for purposes of federal income taxation.

As this discussion highlights, the existing framework within which RDPs operate for estate planning purposes is unsettled, and the application of the transfer tax laws to transfers between RDPs are...