Overcoming the Boggs dilemma in community property states.

EXECUTIVE SUMMARY

* In planning to mitigate the limits imposed by Boggs, it is important to distinguish between community property and common law states.

* Under Sec. 2053(c), a plan participant can give a promissory note to his nonparticipant spouse in exchange for a waiver of community property rights in the former's pension plan.

* Sec. 2043(b) should not apply to a promissory note exchanged for a community property interest in a participant's pension plan.

In Boggs v. Boggs, the Supreme Court held that the Employee Retirement Income Security Act of 1974 preempted state law, thus disallowing the bequest of a nonparticipant spouse's community property interest in her participant spouse's pension plan. For spouses living in one of the nine community property states, this decision could spell disaster; if the nonparticipant spouse dies first with insufficient assets to fully use the AEA ($650,000 in 1999), it will be wasted. This two-part article explains an estate planning technique that may allow the nonparticipant spouse to overcome the limits presented by Boggs.

As a result of the Supreme Court's decision in Boggs v. Boggs,(1) many practitioners struggle with how to fully use a nonparticipant spouse's applicable exclusion amount(2) (AEA) when his primary asset is a community property interest in the participant spouse's pension plan. While many estate planning professionals hoped that relief would be provided through the clarification of community property rights and retirement benefits included in the Taxpayer Relief Act of 1997 (TRA '97),(3) this has not proven to be the case.

This two-part article proposes that residents of community property states consider using a promissory note from the participant spouse to the nonparticipant spouse to fully use the latter's AEA. Planning opportunities are discussed in detail; examples are included comparing the options available in community property states to those available in common law states. These strategies are additionally compared to the options available to plan participants who have rolled their retirement funds over into individual retirement accounts (IRAs).

The Boggs Decision

In Boggs, the Supreme Court held that the Employee Retirement Income Security Act of 1974 (ERISA) preempts state (in this case, Louisiana) community property laws to the extent they conflict with ERISA. The case involved a dispute over the ownership of Isaac Boggs' retirement benefits following the death of his first wife, Dorothy, in 1979. Dorothy bequeathed her community property interest in Isaac's undistributed pension plan to the couple's three sons. Following Dorothy's death, Isaac married Sandra. Following Isaac's retirement in 1985, he received various benefits from his employer's retirement plans, including a lump-sum distribution that he rolled over into an IRA, shares of stock from an employee stock ownership plan (ESOP) and a monthly annuity payment.

Isaac died in 1989; a dispute ensued over the ownership of his retirement benefits. The sons claimed that Dorothy had transferred a portion of her community property interest in Isaac's undistributed pension plan benefits to them, under Louisiana law. Sandra disputed the validity of that transfer, arguing that the ERISA preempted the sons' claim.

The Supreme Court was faced with two issues. First, could Dorothy, Isaac's first wife, make a testamentary transfer of her community property interest in Isaac's qualified joint and survivor annuity (QJSA)? The Court held that to the extent Louisiana law provided the sons with a right to a portion of Sandra Boggs' ERISA Section 1055 survivor's annuity, it was preempted. The Court further stated that the purpose of the QJSA provisions is to ensure a stream of income to surviving spouses; ERISA's solicitude for the economic security of surviving spouses would be undermined by allowing a predeceased spouse's heirs and legatees to have a community property interest in the survivor's annuity.

Second, the Court considered whether Dorothy could make a testamentary transfer of (1) her community property interest in undistributed monthly annuity payments, (2) an IRA and (3) ESOP stock. In addressing this issue, the Court described ERISA'S primary purpose as protecting plan participants and beneficiaries. Only in very narrow circumstances (e.g., the issuance of a qualified domestic relations order (QDRO)) is beneficiary status conferred on a nonparticipant spouse or dependent. Because Dorothy's sons were not plan participants or beneficiaries, ERISA did not permit them to share in Isaac's retirement benefits.

This position is further supported by the pension plan anti-alienation provisions. Under ERISA Section 1056(d)(1), each pension plan must provide that benefits under the plan may not be assigned or alienated. Thus, the Court concluded that, because the sons' only claim to the assets was through an impermissible alienation or assignment of Dorothy's benefits as a nonvested beneficiary, they had no interest in the retirement assets.

In understanding the effect of Boggs, it is important to realize both what the Court did and did not say. The Court did not state that assets in an ERISA-governed plan are the participant spouse's separate property; nor did it state that all of a nonparticipant's community property interests in the plan are extinguished. In fact, the Court recognized that ERISA acknowledges that a nonparticipant spouse has a community property interest in the participant spouse's plan (by discussing the surviving spouse annuity and QDRO provisions).

The Boggs Dilemma

The estate planning implications created by Boggs are dire when the nonparticipant spouse dies first. When that occurs, the participant's taxable estate will contain the nonparticipant spouse's community property interest in the participant's pension plan. Because the nonparticipant spouse cannot convey an interest in a pension plan by testamentary disposition, the participant's taxable estate will reflect a disproportionate share of community assets. In the most extreme circumstances, the nonparticipant spouse will be unable to fully use the $650,000 1999 AEA.

Even when other assets are sufficient to use all of the nonparticipant spouse's AEA, the total estate taxes paid on both estates could be significantly higher when 100% of the participant's retirement benefits are included in his taxable estate.(4) Fortunately, a planning opportunity exists for residents of community property states to avoid this result.

TRA '97

TRA '97 Section 1311 clarified that a nonparticipant spouse's community property interest in a participant spouse's qualified plan, IRA or simplified employee pension may qualify for qualified terminable interest property treatment if the nonparticipant spouse dies first. This provision applies to the estates of decedents dying after Aug. 5, 1997. While many practitioners had hoped that this provision would mitigate the implications of Boggs, this has not been the case. The TRA '97 Conference Report(5) clarified that this provision "is not intended to create an inference regarding the treatment under present law of a transfer to a surviving spouse of the decedent spouse's interest in an annuity arising under community property laws "Additionally, the Conference Report notes that this section is not intended to modify the result of the Supreme Court's decision in Boggs.

Community Property vs. Common Law

In planning to mitigate the limits imposed by Boggs, it is important to distinguish between community property and common law states; currently, there are nine community property states.(6) The treatment of marital assets varies significantly for common law and community property states. In community property states, property is classified as either community or separate property. Separate property includes (1) property owned before marriage or after dissolution of marriage, (2) property designated as separate property by a decree or judgment of a court, (3) property acquired by gift, bequest, devise or succession and (4) property designated as separate property by a written agreement between the spouses. Community property is any property that is not separate property. Each spouse has a present interest in all community property, and receives a one-half interest in title to the property when it is acquired. The titling of property is irrelevant in determining a spouse's community property interest.(7)

Conversely, in common law states, the spouse who holds tide to the property owns it. If only one spouse earns a wage and retains title to purchased property, all property (other than gifts and bequests to the non-wage-earning spouse) obtained during the marriage will be the separate property of the wage-earning spouse.(8)

To eliminate this outcome, most common law states provide for an "equitable" distribution of marital property on death or divorce. One such equitable distribution is dower.

Although most states have abolished it, dower grants a widow a life estate in lands acquired during the marriage or grants a certain percentage of lands acquired during marriage to the widow in fee simple. The "elective share" has largely replaced dower as the method for providing for surviving spouses. Under the Uniform Probate Code (which abolishes dower), the elective share permits a surviving spouse to take property either under the will of the deceased spouse, or to take a percentage of the deceased spouse's separate property (which increases based on the number of years that the couple was married). Both dower and the elective share grant a property interest to the surviving spouse only after the death of the first spouse.(9)

The time at which a spouse gains tide to assets creates an important difference between community property and common law states. For purposes of this article, this difference prevents a spouse who participates in a Sec. 401(k) plan in a common law state from exchanging a promissory note for the nonparticipant spouse's interest in the plan, because the latter has no current interest in the plan. In a community property state, the nonparticipant spouse has a current one-half interest in the plan and thus is able to "sell" that interest for a promissory note. As this article demonstrates, this distinction may make the difference between being able to use fully the AEA or not.

Using a Promissory Note

Basic Strategy

If a plan participant and his nonparticipant spouse are residents of a community property state, a planning opportunity exists to minimize the implications of Boggs. The plan participant can give a promissory note to the nonparticipant spouse in exchange for the latter's community property interest in all or a portion of the pension plan.

The note should be in an amount sufficient to allow the nonparticipant spouse to fully use his AEA. The note becomes a claim against the participant spouse's estate that is deductible under Sec. 2053 for estate tax purposes. On the death of the nonparticipant spouse, the unpaid balance of the promissory note is included in his estate.

Ideally, this transaction would not take place until sufficient plan assets existed to allow the nonparticipant spouse to fully use his AEA with one promissory note. If necessary, however, multiple promissory notes could be executed as plan assets increase. Additionally, multiple promissory notes may be necessary to use fully the AEA until it maximizes at $1 million of property in 2006.

Deductions from Gross Estate

The value of the taxable estate of the pension participant will be reduced under Sec. 2053(a)(3) for any claims against the estate permitted by the jurisdiction in which it is being administered. Sec. 2053(c)(1) limits such claims to those that were contracted for bona fide and for an adequate and full consideration in money or money's worth. Regs. Sec. 20.2043-1(a) provides that the transfer must have been made in good faith and the price must have been an adequate and full equivalent reducible to a money value. If the price was less than such a consideration, only the excess of the fair market value of the property (as of the applicable valuation date) over the price received by the decedent is included in ascertaining the value of his gross estate. In Est. of Tiffany,(10) the Tax Court stated that Regs. Sec. 20.2043-1 "is a reasonable implementation" of Sec. 2053.

The most common cases considering whether adequate and full consideration has been given for a promissory note deal with family members--usually, parents who have given a promissory note to a child without consideration. These cases provide insight into how consideration must be evidenced when a promissory note is exchanged for a nonparticipant spouse's community property interest in the participant spouse's pension plan. Key in establishing the validity of such a note is that it be contracted for bona fide and for adequate and full consideration. Under Est. of Tinny, the transaction must also show evidence of arm's-length dealing. This is particularly important in the case of a transfer between spouses, as the courts examine intrafamily transactions with heightened scrutiny.(11)

Numerous Tax Court cases have discussed the meaning of consideration for Sec. 2053 purposes. In Est. of Davis,(12) the court stated that consideration under Sec. 2053 is a statutory concept, not a common law one, and is used in its quantitative sense to mean "equivalent money value" The court further stated that the use of the term "consideration" evidenced Congress's intent to permit the deduction of claims only to the extent that they were contracted for a consideration which at the time either augmented the estate of the decedent, granted him some right or privilege he did not possess before or operated to discharge a then existing claim (such as breach of contract or personal injury). When a promissory note is issued in satisfaction of a non-participant spouse's community property interest in a participant spouse's pension plan, the latter gains the right to receive an increased level of future pension payments, as well as the right to any future investment appreciation on those funds. The plan participant thus receives a right not previously possessed through the issuance of the promissory note, which qualifies as adequate and full consideration under Sec. 2053. To the extent that the value of the promissory note is discounted to take into account the future taxation of pension payments, care should be taken to ensure that the assumptions regarding the taxability of these payments are reasonable, so that the loan qualifies under Sec. 2053.

Interestingly, an adequate interest rate is not required for a promissory note to be considered a valid deduction under Sec. 2053. In Est. of Ribblesdale,(13) the IRS argued that notes were not given for adequate and full consideration because the interest rate charged was not substantial and the security for the loans was inadequate. In response, the court stated that, to be bona fide, a loan does not require the payment of an interest rate similar to the rates of a commercial lender. Rather, the bona fides of a loan are primarily established by the intention of the parties that repayment will be made under the terms of the agreement. A promissory note executed between a plan participant and a nonparticipant spouse, therefore, need not bear a market interest rate, as long as both parties show their intention for the loan to be repaid.

Additionally, Sec. 7872 should not prevent the use of a below-market interest rate in a promissory note between spouses. Sec. 7872(a) imputes additional interest to certain loans in which the stated interest is less than the applicable Federal rate. In a loan between spouses, the below-market interest rate would likely be treated as a gift from one spouse to the other. Because married persons have no limit on the amount they may gift to each other, no tax would be due as a result of the below-market interest rate.(14)

Thus, under Sec. 2053(c), a plan participant can give a promissory note to his nonparticipant spouse in exchange for a waiver of community property rights in the former's pension plan. Because the note would be given from one spouse to another, the heightened scrutiny applicable to intrafamily transactions would apply. The court would examine the transaction to make sure that the note was given with the actual intent that it be repaid. If the court finds that the note was given simply to avoid taxes, it may be found to be an invalid deduction against the participant's estate.

Certain Marital Rights Not Deductible

Although Sec. 2053 allows claims that are contracted for adequate consideration, the waiver of certain marital rights is not deemed consideration. If Sec. 2043 applies, claims cannot be deducted against an estate, even if they are "bona fide and for adequate and full consideration" (as required under Sec. 2053). Under Sec. 2043(b), a relinquishment or promised relinquishment of dower or curtesy, or of a statutory estate created in lieu of dower or curtesy, or of other marital rights in the decedent's property or estate, will not be considered consideration in money or money's worth.

Herrmann

The recent case of Est. of Herrmann(15) narrowly defined Sec. 2043 while considering early broad interpretations. The estate deducted the value of a life estate in the decedent's apartment that he had granted to his widow under a prenuptial agreement. The issue before the court was whether the widow's life interest was a claim supported by "adequate and full consideration" under Sec. 2053(c) (1)(A). The court held that the surviving spouse did not give adequate consideration for the life estate when she waived the right to equitable distribution of the decedent's property in the event of divorce; thus, the life interest was not deductible for estate tax purposes. In this case, because adequate consideration had not been given for the life estate, a deduction from the husband's gross estate was not permitted under Sec. 2053. Herrmann should not preclude the deductibility of a promisory note given in exchange for a nonparticipating spouse's community property interest in the participant's pension plan, as long as adequate consideration is given for the note.

In formulating its opinion, the Herrmann court reviewed a trio of 1940s cases(16) that interpreted the meaning of "other marital rights in the decedent's property or estate" under Sec. 2043. The court found that the early cases interpreted the phrase broadly to include all rights that arise out of the marital relationship, including those that accrue on marriage or divorce. The IRS later announced(17) that it would not follow those cases "to the extent that they hold that the right of a divorced wife to support from a former husband during the joint lives of the parties is a marital right in his property or estate." Thus, a spouse's waiver of support rights could be found to be consideration under Sec. 2043(b)(1); the resulting claim could be deducted from the gross estate under Sec. 2053.

The Tax Court later adopted the same position in Est. of Glen.(18) The decedent had entered into a property settlement with his wife in which she released her right to one-third of his property on divorce. The principal issue was whether the wife's release of her rights could be regarded as "consideration in money or money's worth" for Sec. 2036 purposes. Because the IRS also relied heavily on Sec. 2043, however, the court addressed the applicability of that section.

The principal target of Sec. 2043, according to Glen, is dower and curtesy or substitutes therefor under local law. The court concluded that Sec. 2043(b) should be limited in its application to the release of rights that accrued to a surviving spouse on the decedent's death (i.e., dower, curtesy or similar rights in the property or estate of a deceased spouse). Sec. 2043(b) is not applicable to the relinquishment of a presently enforceable claim to an outright portion of a spouse's property on divorce. In a similar fashion, Sec. 2043(b) should not apply to the relinquishment of a nonparticipant spouse's presently enforceable claim to his community property share of a participant spouse's pension plan.

Carli

The position taken in Glen was reinforced in Est. of Carli.(19) The Tax Court held that, in a prenuptial agreement, a wife's relinquishment of her community property rights in her future husband's earnings during marriage constituted adequate and full consideration for the husband's promise to give her a life estate in their residence on his death if they remained married. In Carli, the widow's community property interest in her husband's future earnings was a presently enforceable right. This case is particularly significant, as it specifically considers a community property interest in assets not yet available to be a presently enforceable right. Although a nonparticipant spouse's community property share of a participant's pension is similarly not available immediately, this interest is also a presently enforceable right.

Based on the above case law, Sec. 2043(b) should not apply to a promissory note exchanged for a community property interest in a participant's pension plan. This interest, like all community property interests, is a presently enforceable right. Thus, to have a valid deduction against the participant's gross estate, Sec. 2053 must be met, as was discussed.

Conclusion

Part II of this article, in the September issue, will discuss alienation of pension plan benefits under Sec. 401(a)(13) and planning examples.

(1) Sandra Jean Dale Boggs v. Thomas F. Boggs, 117 S.Ct. 1754 (1997), rev'g 82 F3d 90 (5th Cir. 1996).

(2) Under Sec. 2001, the 1999 AEA is $650,000.

(3) See Sec. 2056(b)(7)(C), enacted by TRA '97 Section 1311.

(4) Due to the difference in marginal estate tax rates.

(5) H. Rep't No. 105-220, 105th Cong., 1st Sess. (1997), p. 741.

(6) Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington and Wisconsin.

(7) See generally, 15A Am Jur 2d, Community Property (Lawyers Coop. Pub. Co., 1976 and West Group, 1999 Supp.), [subsections] 19, 20, 25, 26, 56.

(8) See 41 Am Jur 2d, Husband and Wife (Lawyers Coop. Pub. Co., 1995), [sections] 23.

(9) See 23 Am Jur 2d, Descent and Distribution (Lawyers Coop. Pub. Co., 1983), [subsections] 118-120.

(10) Est. of Herbert C. Tiffany, 47 TC 491 (1967).

(11) See, e.g., Est. of Lulu K. Flandreau, 994 F2d 91 (2d Cir. 1993)(72 AFTR 2d 93-6710, 93-1 USTC [paragraph] 60, 137), aff'g TC Memo 1992-173.

(12) Est. of Ella T. Davis, 57 TC 833 (1972).

(13) Est. of Ava Ribblesdale, TC Memo 1964-177.

(14) In addition, on a joint return, the imputed interest income generally will be offset by the interest expense, but that may not always be the case (e.g., if the couple does not itemize or if they file separately).

(15) Est. of Herbert R. Herrmann, 85 F3d 1032 (2d Cir. 1996)(77 AFTR2d 96-2500, 96-1 USTC [paragraph] 60, 232), aff'g TC Memo 1995-90.

(16) See Est. of Arthur G. Meyer, 110 F2d 367 (2d Cir. 1940)(24 AFTR 503, 40-1 USTC [paragraph] 9313), cert. den.; Helvering v. U.S. Trust Co., 111 F2d 576 (2d Cir. 1940)(24 AFTR 981, 40-1 USTC [paragraph] 9429), cert. den.; and Vanderpoel Adriance v. Higgins, 113 F2d 1013 (2d Cir. 1940) (24 AFTR 570, 40-2 USTC 9627).

(17) Rev. Rul. 71-67, 1971-1 CB 271; see also Rev. Rul. 12367, 1946-2 CB 166.

(18) Est. of Robert Roger Glen, 45 TC 323 (1966).

(19) Est. of Joseph M. Carli, 84 TC 649 (1985).

Marjorie A. Rogers, Esq.

Sutin, Thayer & Browne, PC Albuquerque, NM

Eric C. Christensen, Esq.

Sutin, Thayer & Browne, PC Albuquerque, NM

Carol Mayo Cochran, CMA, CEBS, CPA 

Rogoff, Erickson, Diamond & Walker, LLP Albuquerque, NM

For more information about this article, contact Ms. Rogers at [phone] or Ms. Cochran at [phone].