By: ROBERT L. SOMMERS - TAX MAN
THE INSTITUTION of marriage may be sacred, but not when it comes to our nation's income tax laws.
Unmarried couples usually do much better than their married counterparts on their federal income taxes. But what the tax man giveth in life, he taketh away at death: Unmarried coupled could pay dearly when it comes to estate taxes.
Consider the following example:
John and Sally, who are unmarried, purchased a home 20 years ago as joint tenants for $50,000 and paid off the mortgage in full 10 years ago.
Neither has retained any records relating to their purchase.
Assume when John dies the home is appraised at $1,000,000, and it comprises his total estate.
The home's entire value will be included in John's estate for federal estate tax purposes, unless Sally can prove her actual contributions to its purchase.
Because Sally retained no records, John's estate will include the entire value of their home. Consequently there will be a federal tax of approximately $153,000 and a tax lien will attach to the home.
Since Sally now owns the home as the surviving joint tenant, she becomes personally liable for the full amount of the estate tax. What a penalty -- one that could easily have been avoided.
Upon death, the decedent's estate may be taxed by the federal government, for the "privilege" of passing property to the decedent's beneficiaries. (California has eliminated its estate tax.)
A major goal of proper estate planning is to maximize each individual's Unified Estate and Gift Tax Credit, known as the Unified Credit, which prevents federal tax on the estate's first $600,000 of assets.
Since each U.S. citizen ad U.S. resident has a Unified Credit, a couple could correctly plan their combined estate to avoid taxes on $1,200,000 of assets.
Many unmarried couples own property together as joint tenants, a legal relationship that allows the surviving party to own the property entirely -- without the involvement of the probate court.
As the example of John and Sally illustrates, while joint tenancy makes transferring property simple, it can cause disastrous tax consequences: The deceased tenant is considered to have owned the entire property for estate tax purposes, unless the surviving tenant can prove that he or she contributed to the purchase of the property.
Consequently, careful records of each tenant's contribution must be maintained throughout the ownership.
Married couples have a distinct advantage when it comes to estate taxes through the combination of California's community property law, along with the federal unlimited marital deduction.
These rules are unavailable to unmarried couples; accordingly, if a decedent has an estate over $600,000, the IRS will assert an estate tax.
In this situation, the proceeds from life insurance might be used to pay the estate tax.
John and Sally could have avoided the above result if they each owned a separate 50 percent interest in their home as either tenants in common, as partners of a partnership or as members of a limited liability company.
Later, they could have conveyed each of their interests into two separate revocable living trusts. A revocable living trust would avoid probate. Additionally, John's 50 percent share of the home -- because one-half portion of a house cannot be easily sold -- is entitled to a reduction in value (a "minority interest discount") of from 10 percent to 30 percent of the actual $500,000 amount.
His estate could be valued at between $350,000 and $450,000, which is less than his Unified Credit; therefore, Sally would have received John's 50 percent interest in the home totally tax-free.
A revocable living trust is usually created by an individual "grantor" declaring that he or she holds property as trustee, in trust.
During his or her life, the grantor is also the primary beneficiary. Because it is "revocable," the trust may be amended or revoked at any time during the grantor's life.
The key to its successful use is the transferring of all assets held by the individual into the trust. Upon the grantor's death, probate is avoided on all assets held by the trust.
A revocable living trust has clear advantages over a will or joint tenancy for passing property at death.
Unlike the estate tax rules, both federal and California income tax laws provide unmarried couples with significant tax-saving opportunities, especially when they structure their investments with a partnership or a limited liability company.
Married couples may file a joint tax return, combining their income on one return.
A man and woman are considered married if, under state law, they are married by the last day of the year. (California does not recognize common-law marriages.)
There is, however, a significant financial penalty for some joint filers with larger incomes: If two individuals each earn $250,00 and are unmarried, neither is subject to the 10 percent surcharge on incomes over $250,000; however, a married couple with joint income over $250,00 is subject to the 10 percent surcharge.
Another disadvantage is that joint filers are jointly liable for the taxes, even if one spouse was at fault for any misreporting.
Unmarried couples may claim "head of household" filing status when they support a dependent.
Head of household status permits the same credits available to married couples, such as the earned income credit for the working poor, plus child and dependent care credits.
The dependency exemption is not based on marital status. If an unmarried couple (in which only one adult has any income) has a child, the income partner is entitled to head of household status and could claim both the child and other adult as dependency exemptions, a total of three exemptions.
Household expenses of cohabiting adults will ordinarily be regarded as a non-taxable sharing of resources. Wages, salaries and other income from personal services will be taxed to the person earning them.
Tax liability of cohabitants' property and investments, however, can be difficult to classify, unless the couple documents its situation. They could choose to hold property as tenants in common or as partners.
Tenants in common own a pro-rata share of the property -- all income and expenses are divided according to their respective shares.
In a partnership, the couple may provide for the allocation and distribution of income and expenses in any way they choose, provided their arrangement has "substantial economic effect" under the federal tax code.
Recently, California enacted the Limited Liability Company Act, which combines partnership flexibility with corporate limited liability protection.
When unmarried couples have substantial assets and investments, an LLC is ideal. Unlike a small business corporation (S corporation) -- which provides limited liability but lacks partnership flexibility and is restricted as to its shareholders -- the LLC contains no such limitations. This means a revocable living trust may be a member of an LLC.
Unmarried couples with substantial assets and investments should consider combining an LLC with two revocable living trusts.
For instance, a couple can place its active investment assets, such as rental real estate or business interests, into an LLC, with their revocable living trusts as members.
For maximum liability protection, a separate LLC can be formed for each active investment asset: for instance, if the couple owned three apartments, each building could be isolated within a separate LLC. The revocable living trusts would directly hold title to all non-active investment interests, such as bank accounts, stocks and bonds.
Using this dual approach, the couple will shield themselves against personal liability while providing maximum income tax flexibility.
Their LLC will maximize liability protection, while their revocable living trusts will avoid probate and minimize their estate tax -- since each trust will be funded with only 50 percent of the couple's assets, thereby helping each to keep their individual estate below the federal Unified Credit ceiling of $600,000 per person.
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**NOTE: The information contained at this site is for educational purposes only and is not intended for any particular person or circumstance. A competent tax professional should always be consulted before utilizing any of the information contained at this site.**