July 21, 2020
Joseph B. Colvin
Member, Stoll Keenon Ogden PLLC
On March 17, 2020, Gov. Andy Beshear signed HB 155 that includes the new Kentucky Community Property Trust Act, which is codified at KRS 386.620 – 386.624. The Act went into effect July 15, 2020. The Act permits married couples to create a community property trust under Kentucky law. This can provide an incredible planning opportunity for married couples.
State Law Property Regimes
There are two property regimes in the United States: common law property and community property. The vast majority of states have a common law property regime, which finds its basis from old English law. Nine states (Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington, and Wisconsin) have a community property regime, which finds its basis from old Spanish or French law. With the Act, Kentucky now joins three other common law property states (Alaska, South Dakota, and Tennessee) that have an optional community property regime.
Community Property Trust Creation
Under Kentucky law, a married couple may opt in to community property treatment by creating a trust that meets the requirements of the statute.
The requirements to create a community property trust are:
i. One or both spouses transfer property to a trust;
ii. The trust expressly declares that the trust is a Kentucky community property trust that meets the requirements of the Act;
iii. The trust has at least one trustee who is an individual who is a resident of Kentucky or a bank or trust company authorized to act as a trustee within the state and that trustee’s powers include (on an exclusive or nonexclusive basis) maintaining records for the trust and preparing or arranging for the preparation of any income tax returns that must be filed by the trust;
iv. The trust instrument is signed by both spouses even if only one spouse contributed property to the trust; and
v. The trust contains certain warning language from the Act at the beginning of the trust instrument.
One or both spouses may serve as trustee. In addition, each spouse may amend the trust regarding the disposition of that spouse’s one-half share of the community property in the trust upon a spouse’s death. Thus, this trust will typically replace or supplement a married couple’s revocable trust.
The two main benefits of a community property trust can be incredibly valuable.
First, the trust is created by a single, joint trust agreement and all assets may be titled in the name of that trust. This is similar to how a married couple may title jointly-held property outside of a trust. Typically, as part of estate planning in a common law property state, because of potential tax and trust administration issues, each spouse would have a separate revocable trust, meaning the husband would have a revocable trust and the wife would have a separate revocable trust. Then, the couple would have to decide which assets should be transferred to which trust. But the community property trust allows for just one trust, which can make administration of the trust simpler.
Second, section 1014 of the Internal Revenue Code provides that community property receives a full step up in basis upon the first spouse’s death. In a common law property regime, joint property only receives a basis step-up in half of the assets. A full basis step-up can permit a surviving spouse to sell assets to rebalance an investment portfolio and avoid capital gains tax on the sale, take losses from a business that were suspended due to lack of basis, or possibly take additional depreciation deductions on business property. Thus, the new basis can provide an immediate income tax savings to the surviving spouse upon the first spouse’s passing.
To illustrate, let’s assume a married couple has a joint investment account. At the time of the first spouse’s death, the fair market value of the investment account is $2,000,000. But, the tax basis of the account is only $1,000,000 as the couple were not making many trades in the account so as to not trigger income tax. If merely held as a joint account, the basis in the account for the surviving spouse would be $1,500,000 and thus the surviving spouse would still pay tax on $500,000 of gain if the spouse sells the assets in the account. If instead, the account was held in a community property trust, the surviving spouse’s basis in the account is $2,000,000 and the spouse can now sell all of the assets completely tax-free! This allows the spouse to freely rebalance the portfolio without worrying about income taxes as the investment objectives may be very different as a surviving spouse compared to a married couple.
As another example, let’s assume the wife worked at a company and received company stock through the years with negligible basis, or received the stock as a family gift with negligible basis. The value of the stock is now $5,000,000. The couple does not want to sell the stock as that would cause substantial income tax. If the stock is held in the wife’s account, then if the husband dies first, there is no change to the basis and the wife still has negligible basis in the stock. If the stock is held in a joint account, when either spouse dies the basis would be $2,500,000 and a sale would still cause substantial income tax. However, with a community property trust, regardless of which spouse passes first, the surviving spouse would receive a full step up in basis to $5,000,000 and can sell the stock completely tax-free! Again, this can allow the surviving spouse to greatly diversify their investments to substantially reduce their risk without having to worry about the income tax on the sale.
While there may be significant benefits to creating a community property trust, there are some considerations. First, the IRS has not ruled on whether any of the current state elective statutes result in a full basis step-up. IRS Publication 555 regarding community property notes that it does not address the Alaska, Tennessee, and South Dakota laws. But, there also have been no rulings or court cases since Alaska first passed its laws in 1998 indicating that full basis step-up is not permitted.
Second, a community property trust may change the division of assets if the couple were to get divorced. The concept of community property is that each spouse owns half of each asset. Thus, upon divorce, community property is divided equally between spouses. In contrast, non-marital assets, which is typically property owned by a spouse prior to marriage or received by gift or inheritance, are the property of only one spouse. If a spouse transfers non-marital assets to the community property trust, it is then available for division in the case of a divorce.
Third, each spouse can only control the disposition of one-half of the assets in the trust upon the spouse’s passing. Thus, if a spouse was wanting to give substantial assets to children or other beneficiaries instead of the surviving spouse, a community property trust might not be the best vehicle for that part of the planning.
Lastly, a community property trust can alter a creditor’s rights in a couple’s assets. In general, the assets of one spouse are not available to the creditors of the other spouse. With a community property trust, one-half of the assets in the trust are available to the creditors of a spouse, even if the assets were transferred to the trust by the other spouse. Thus, if creditors are a potential concern for one spouse or the other, the couple should carefully consider transferring assets to a community property trust.
In conclusion, the Act provides a significantly valuable planning opportunity for married couples by easing administration of a revocable trust and allowing for a full basis step-up to the surviving spouse. A community property trust can be a great alternative or supplement for revocable trust planning and married couples should look to take advantage of the new laws and explore the planning with their advisors.
Stoll Keenon Ogden’s Trusts and Estates practice attorneys are ready – as the firm has been for more than 120 years – to answer your questions about community property trusts or other financial-planning opportunities for your family.
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