Community Property Issues

There are currently ten states subject to community property or marital property (Alaska, Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas and Washington are community property; Wisconsin is a quasi-community property state). Life insurance obtained by one or both of the spouses during the marriage while domiciled in any of these states is typically community property. Essentially, this means each spouse, from inception, is the owner of one half of the policy.

This community property treatment can have adverse estate tax consequences. The noninsured spouse’s interest in the community’s property may be included in her estate. By extension, if community funds are used to pay premiums and the policy purchased with those premiums becomes community property, a noninsured non-grantor has made a gift of her interest. Coupled with the life income so often given to spouses by an insured grantor, the surviving spouse may have made a constructive gift followed by lifetime retention of income. This is a classic estate tax inclusion-type tax trap.20

The inclusion may be somewhat ameliorated by claiming a consideration offset for the actuarial value of the survivor’s life income interest. In other words, it may be possible to argue that the amount of the includable proceeds should be reduced by the consideration paid (i.e., the noninsured spouse gave up a remainder interest in his community share of the proceeds in return for a life income interest in the other share of the proceeds). But to avoid inclusion altogether:

  • do not give a grantor spouse a life income in the trust;
  • convert the insurance, prior to its transfer to the trust, to separate property of the insured; and
  • ensure that future premiums are paid using only separate property of the insured grantor spouse.

Some attorneys suggest that the couple deliberately classify the life insurance as the separate property of the insured spouse. The reason for this is to make it possible for that spouse to transfer it to the irrevocable trust. Mechanically, in some states this is accomplished with a waiver by the noninsured spouse of his rights. In other community property states, married persons may—by agreement or transfer and with or without consideration—change or transmute the character of their community property to separate property of either spouse. To be effective, a transmutation agreement must be in writing. Alternatively, the noninsured spouse’s rights can be sold to the insured spouse (in return for a payment from noncommunity funds) or transferred by gift. Once the life insurance policy has become separate property of the insured, the insured then (some time later) can transfer the insurance to the trust.

A similar problem arises with respect to the imputed (Table I) income from large amounts of group-term life insurance and Table 2001 income from noncontributory split dollar plans. In both cases, the imputed income is treated as community property, which is then deemed to be transferred (by the employee receiving that income) to the trust. This deemed transfer will result in the noninsured spouse being treated as a grantor. The solution is to make sure neither spouse is an income beneficiary of the trust.

Reproduced with permission.  Copyright The National Underwriter Co. Division of ALM

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