With the increased emphasis on income tax planning caused by the higher estate and gift tax exemptions and portability, many practitioners are revisiting the issue of "stepped-up " basis, which has always favored joint owners who live in community property states. South Dakota's legislature, reacting to this phenomenon, added Special Spousal Trust legislation in 2016 that enabled surviving spouses whose property passes through the trust to receive a 100% stepup in basis on the property for federal income tax purposes, thus creating a benefit similar to that of surviving spouses in community' property states.
Lucy and Ricky were longtime ranchers in western South Dakota. They sacrificed and purchased their 2000 acre ranch through the years, receiving a portion as a gift from Lucy's father and mother. The land, which Lucy and Ricky held as joint tenants, had a federal tax basis of $100 per acre. Their friends Fred and Ethel were longtime ranchers in Idaho, a community property jurisdiction. Fred and Ethel also sacrificed and bought their 2000 acre ranch through the years, and received a portion as a gift from Fred's father and mother. The land was held as community property with a federal tax basis of $100 per acre.
Last year, both Fred and Ricky died suddenly, and each of their ranches' value had risen to $2,100 per acre. Both Lucy and Ethe (l) prepared to sell the ranches at fair market value for $2,100 per acre. Lucy's sale occurred first, and her federal tax basis in the 2000 acres was $2,200,000.' The sale brought the fair market value of $2,100 per acre for the 2,000 acres or $4,200,000; so Lucy had a federal capital gain of $2 million, and owed at least $400,000 in federal income taxes. (2) Ethel's sale was a week later, and her federal tax basis in the 2,000 acres was $4,200,000. (3) Ethel's sale also brought the fair market value of $4,200,000, but because she lived in Idaho, she had no capital gain and owed nothing in federal income taxes.
This $400,000 federal tax burden on South Dakota widows and widowers--and all citizens of Separate Property States--is caused by a unique provision of the federal tax code which recognizes a 50% step-up in basis at death of one joint tenant in non-community property states. (4) In South Dakota, a non-community property state, the surviving spouse is only considered to receive 50% of the property from the decedent. In the Idaho example, however, the property is considered "community property held by the decedent and the surviving spouse under the community property laws of any State," and thus the federal tax law considers the surviving spouse's share to have come from the decedent, resulting in a 100% step-up in the basis of the property for computing capital gains. (5)
Nine states, which base their property law on Spanish and French law, have had community property as their marital property law since statehood. (6) South Dakota and the other forty states whose laws are based on English law, have had a non-community property regime for marital property and thus are separate property states. (7) While each of the nine community property states' laws are slightly different, a community property regime is generally similar to a fifty-fifty partnership where each spouse is considered to hold an undivided interest in the whole of the property. This is in contrast to separate property states where spouses can generally hold separate property. In a separate property state, the legal title of an asset is likely to be determinative of its ownership, and property titled in one spouse's name is presumptively that spouse's property. Conversely, in a community property state, an asset titled in one spouse's name may be either a spouse's separate property or the couple's community property, and the title is not determinative of ownership. In community property states, there generally exists a presumption that any property owned by either or both spouses during or after the marriage is community property. This presumption commonly places the burden of proof on the party asserting that a particular asset is separate property to show why it is separate property.
In 1998, Alaska passed a law allowing for formation of a community property trust: a statutorily defined trust providing that property transferred to the trust becomes community property held by the decedent and surviving spouse under the law of Alaska if the trust satisfies the requirements of the Alaska legislation. (8) More recently, Tennessee passed legislation recognizing such a trust. (9) In 2016, South Dakota passed legislation to allow spouses in the state to create a South Dakota special spousal trust. (10) The Internal Revenue Service ("IRS") has not formally addressed the taxation of income or property subject to the community property election under Alaska state laws. IRS Publication 555 Community Property, released in March 2012, does not consider "the federal tax treatment of income or property subject to the 'community property' election under Alaska state laws." (11) No reported cases or IRS rulings have addressed the federal income tax capital gains step-up of basis in property held in an Alaska community property trust or a Special Spousal Trust similar to that permitted in South Dakota. (12) The recent South Dakota legislation provides that the South Dakota Special Spousal Trust is considered a trust established under the community property laws of South Dakota, and property transferred to the trust as special spousal property means that it is community property for the purposes of I.R.C. [section] 1014(b)(6). (13) Thus, the South Dakota legislation clearly intends that the surviving spouse would receive a 100% step-up in basis on the property held in the Special Spousal Trust by the decedent and surviving spouse. (14) Some have suggested that a state cannot allow an opt-in to community property in this specific circumstance, but in each of the nine states where community property is the default, spouses may opt-out by agreement. (15) To allow spouses to opt-in, where separate property is the default, should be considered another side of the same coin.
Property transferred to the South Dakota Special Spousal Trust is considered community property, even if one spouse or the other contributed more than 50 /o of the property that is transferred; (16) so the South Dakota statute provides for significant disclosures between the spouses and consent of the spouses (both of whom must execute the trust). (17)
Some commentators conclude that the policy of facilitating marriage as an equal economic partnership for the purpose of transfers to the trust is a strong advantage to this type of trust, in addition to the federal income tax benefit. The statute provides a mechanism for...