Strategic Estate Planning for Cohabiting Partners – Part Two

Understanding Gifting Strategies for Cohabiting Couples

Cohabiting couples with taxable estates require more than just a Will or Revocable Living Trust to lessen the impact of federal estate tax. A well-structured gifting program is also crucial. Despite a temporary lapse in estate and generation-skipping transfer taxes, it is anticipated that Congress will reinstate these taxes, potentially retroactively, within 2020. If not reinstated, starting January 1, 2011, the estate tax exemption will revert to $1 million from the $3.5 million in 2009, and the top estate tax rate will jump from 45% to 55%.

The federal estate tax law offers an unlimited marital deduction, allowing assets transferred to a surviving spouse to be exempt from estate and gift taxes, provided the spouse is a U.S. citizen. This deferral of estate tax is not available to unmarried couples due to the Defense of Marriage Act (DOMA), even in states recognizing same-sex marriages, civil unions, and domestic partnerships. Consequently, unmarried couples with assets exceeding the estate tax exemption face federal estate taxes upon the first partner's death, and potentially state death taxes, depending on their state of residence.

Tax Saving Techniques for Cohabiting Partners

Annual Gift Tax Exclusion

The annual gift tax exclusion permits tax-free gifts of up to $15,000 per recipient per year, with no cap on the number of recipients or their relationship to the donor. This exclusion is indexed to inflation and may increase over time. Gifts within this exclusion do not diminish the donor's $1 million lifetime gift tax exemption, and no gift tax return (Form 709) is necessary for these transfers.

Additionally, direct payments for a recipient's tuition or medical expenses are exempt from gift tax and do not count towards the $1 million lifetime gift tax exemption or the $15,000 annual exclusion. However, these payments must be made directly to the educational institution or medical provider and do not cover ancillary educational expenses or amounts reimbursed by insurance.

For couples with disparate incomes or wealth, these exclusions enable the wealthier partner to transfer assets to the less affluent partner, which can be particularly advantageous when the wealthier partner's estate exceeds the tax exemption threshold, and the less affluent partner's estate does not.

Lifetime Gift Tax Exemption

Beyond the annual exclusion, individuals can gift up to $1 million during their lifetime without incurring gift tax. Gifts exceeding the annual exclusion reduce the lifetime exemption on a dollar-for-dollar basis. The lifetime exemption does not increase over time, and any used portion reduces the available estate tax exemption at death. However, gifting property removes its income and appreciation from the donor's estate, potentially lowering estate taxes. Cohabiting partners can leverage this exemption to transfer wealth and reduce their combined estate tax burden.

Gifts to Irrevocable Trusts

Outright gifts may cause hesitation due to loss of control over the property. By gifting to an irrevocable trust, the wealthier partner can provide for the other while retaining control over the trust's remainder. For estate reduction, the trust must be irrevocable, and the grantor should not be a trustee or beneficiary. Trusts often include a "Crummey" power, allowing temporary withdrawal rights to qualify for the annual gift tax exclusion.

Irrevocable Life Insurance Trusts (ILITs)

Life insurance is a common tool for providing financial security to a surviving partner. While life insurance proceeds are typically income tax-free, they are considered part of the insured's estate and subject to estate taxes. An ILIT can own the policy, keeping proceeds out of the insured's estate and tax-free. However, if the insured transfers an existing policy to an ILIT and passes away within three years, the proceeds are included in the estate. This can be circumvented by having the ILIT purchase a new policy or by selling the policy to an ILIT designed as a grantor trust.

Before transferring a policy to an ILIT, it's crucial to ensure the trust has an "insurable interest" as per state law. Otherwise, the insurer may not be obligated to pay out. The insurable interest requirement typically applies only to the initial policy owner, not subsequent assignees.

The upcoming Part Three will discuss advanced estate planning strategies for high net worth unmarried couples.

Please note that this article is not intended for penalty protection.

Key Statistics and Insights

• As of 2021, the federal estate tax exemption is $11.7 million per individual, with a top tax rate of 40% (IRS).
• The annual gift tax exclusion for 2021 is $15,000 per recipient (IRS).
• According to a 2020 survey by Caring.com, only 42% of U.S. adults have estate planning documents such as a will or living trust (Caring.com).
• A study by Wealth-X found that in 2019, there were approximately 788,000 individuals worldwide with a net worth between $5 million and $30 million, highlighting the potential need for advanced estate planning strategies (Wealth-X).

These statistics underscore the importance of strategic estate planning, particularly for cohabiting couples who may not have access to the same legal protections as their married counterparts.