Can A Special Trust Protect You?

Lots of people live together outside of marriage. And as marriage rates have declined, cohabitation rates have risen. While you might have love in your eyes, cohabitation can bring tax and legal risks. Perhaps a somewhat unusual, yet simple and inexpensive, application of an irrevocable trust might help address several of the issues you might face if you are in a cohabitation relationship.

What are some of the issues that might affect you? First, there might be tax issues. If you are supporting your partner outside of marriage, and perhaps even helping children of your partner, that might trigger gift tax. If your wealth level is great enough that could prove quite costly. A simple irrevocable trust might avoid the entire issue.

Case Study: Boyfriend is cohabiting with Girlfriend and pays for many of her living expenses and some of the expenses of her children from her prior marriage. He pays $5,000/month for her car lease, $2,000/month towards her health insurance and small amounts on other matters. The total annual payments for Girlfriend are about $85,000/year, and for her three children $10,000. Each person is allowed to make gifts to any person in the amount of $17,000/year. Any gifts beyond that amount must be reported on a gift tax return, Form 709, and if they exceed your exemption amount, a gift tax may be due at 40%. If you have used up your exemption on prior transfers, which many wealthy people have, this could be costly. If Boyfriend and Girlfriend marry instead of cohabiting gifts between them, assuming that the are both US citizens are of no import as the unlimited gift tax marital deduction would obviate any gift tax issues. But that is not the case here. So, $85,000 of gifts, minus the $17,000 annual exclusion (the amount you can gift to anyone without gift tax implications) = $68,000 of taxable gift in each year. At 40% that could be a $27,200 tax cost.

Solution to the Gift Tax Issue: If Boyfriend, instead of paying expenses directly and creating a gift tax problem, sets up a simple trust for Girlfriend and all her descendants, the issue can be avoided. The Girlfriend can be named as the sole trustee of the trust. From a tax perspective, if that is done, she should be limited to making distributions to herself that provide for her health, education, maintenance and support (called a “HEMS” standard). The Boyfriend can make a gift each year to the trust of $17,000 for each beneficiary. Let’s say the trust beneficiaries include: Girlfriend, her three children from a prior marriage (one of whom is married with a baby), that child (more generically the trust could include all descendants of Girlfriend as beneficiaries) and the spouse of any married descendant of the Girlfriend. That, in this case, totals six people so that Boyfriend can gift $102,000 to the trust each year. When that is done, each beneficiary would be given the right to demand a withdrawal of that gift, up to $17,000 (or whatever the annual exclusion amount is since it is inflation adjusted and lately has been increasing each year). If Boyfriend knows he will only spend $95,000 [$85,000 for Girlfriend and $10,000 for her children] in the current year the gifts can be limited to that amount. But he might out of precaution gift the maximum $102,000 this year, and let the excess of $7,000 [$102,000 maximum gifts to the trust minus $95,000 spent by the trust] accumulate in case in future years more might be needed. In order to make this plan work the trustee of the trust, in this example the Girlfriend herself, would send a written notice to each beneficiary letting them know the total amount contributed to the trust and how much they have a right to withdraw. In tax parlance these are often called “Crummey” notices, named after a case in which a taxpayer with the last name Crummey successfully used such a technique. Also, since there will have been no gift to any beneficiary in excess of the $17,000 annual exclusion amount (because that is the maximum each has the right to withdraw) there is no requirement for Boyfriend to even file a gift tax return, so that cost and hassle is avoided as well.

Thus, a simple, irrevocable, trust with Crummey powers, avoids all gift tax issues.

But in addition to tax issues there may be legal issues as well. If you are living with someone and don’t have a legally binding cohabitation agreement (some might refer to this as a living together agreement), you may be setting yourself up for a lawsuit or legal claim if the relationship ends. Having a binding legal agreement is not always so simple. First, state laws differ rather significantly on the effectiveness of such agreements, and the requirements to have them be binding. So you really should consult a lawyer in the state where you are living, and your partner should consult a different attorney. You might expect that to be binding each of you has to be represented by an attorney so that each party has advice as to the consequences of the agreement to them. The law might require some reasonableness or fairness in the arrangement reached. You might have to provide disclosures of your assets and financial condition to your partner in the process of obtaining an agreement. The result of all of this is that many people who cohabit don’t have binding legal agreements between them. In many cases couples, with love in their thoughts just doesn’t see any need for an agreement. Also, many couples just view hiring lawyers to negotiate a formal legal agreement as Kryptonite to their romance. Without that proper agreement, your partner might make an array of claims to seek financial redress if the relationship ends. Without proper legal measures both parties could become embroiled in costly and unpleasant litigation when the relationship ends.

Let’s go back to our case study above.

Case Study Continued: Previously we indicated that Boyfriend pays for many of Girlfriend’s living expenses and some of the expenses of her children from her prior marriage. He pays $5,000/month for her car lease, $2,000/month towards her health insurance and small amounts on other matters. That could be three checks a month for a total of 36 checks a year. Boyfriend is spending for her three children $10,000/year. Let’s say Boyfriend has been writing a check to each child each month to provide each with an allowance. That is 36 checks a year for the children. In total, Boyfriend is writing 72 checks a year. Let’s say this arrangement continues for 15 years and the relationship ends. At that point, since the couple has no agreement, Girlfriend sues Boyfriend for support and other payments claiming that Boyfriend promised to help support her and that in addition to the above payments, she lived with him and he covered all utilities, property taxes, and other home costs. Palimony claims, if permissible under state law, could be costly. The legal battle itself could become costly and contentious. The Boyfriend might be in a rather difficult situation to negate the Girlfriend’s claims given the massive number of checks he has written each year and the substantial, regular and ongoing support he has provided.

OK, so the better advice is likely to hire a family lawyer and have, state law permitting, a cohabitation agreement negotiated, written and signed. But, realistically that just doesn’t happen in many cases. Might there be a lesser but perhaps helpful step you can take? Yes. And the step we’ll explain below is the same as the step to avoid the gift tax issues. And, let’s say you to obtain a cohabitation agreement, you can add in this step as well to address the gift tax issues and support the cohabitation agreement as well. So, adding a trust to the plan, whether or not you have a cohabitation agreement, might be useful. But, since the laws on cohabitation differ so substantially from state to state, and might be quite fact dependent, always consult with a family lawyer in your state (as well as the estate planner you’ll need to craft the trust).

Possible Reduction of the Legal Issue: Instead of Boyfriend creating a paper trail of scores of ongoing checks year after year, that almost seem to support Girlfriend’s argument that there were promises of support, perhaps using the same identical trust discussed above to solve the gift tax issues, can also help deflect the potential legal issues. The Boyfriend can simply explain that his CPA advised him to use the trust approach to avoid costly gift tax issues. Now, if Boyfriend writes a check a year to the trust up to the maximum gift tax exclusion amount there will be one check a year instead of 72+. The Girlfriend will then decide how those funds can be allocated and paid and she will be the one making those decisions. The Boyfriend merely will have made a gift each year. Perhaps one modification to the somewhat simple gifting trust described above could be made. The trust agreement could expressly state that Boyfriend, by creating the trust, is making no commitment to future gifts and that any gifts made in future years are independent of any gifts in prior or later years. That would be at least a writing that confirms that Boyfriend is not making any commitment to ongoing financial support. The Girlfriend has to sign the trust document as she is named the trustee. She, as explained above, will also have control over the funds. The trust could (and might in other circumstances that such a trust might be used) state that the intent is that gifts to the trust qualify for the gift tax annual exclusion. That would clearly suggest a gift tax and estate planning motive for the trust. That too might be useful to counter a future claim that the trust was created to provide ongoing support. No, it was created as part of Boyfriend’s estate plan to avoid unnecessary gift tax costs.

As mentioned above, in addition to having an estate planning attorney create this particular trust, have matrimonial counsel review the draft trust agreement and perhaps offer suggestions on how to phrase some of the clauses that address the fact that there is no commitment, etc. Yes, having both an estate planning attorney and family law attorney involved will run up some bills, but those will likely pale in comparison to the cost and general unpleasantries compared to the entire matter ending up in litigation in the future.

Conclusion

Cohabitation, like many types of relationships, can trigger significant tax and legal ramifications. In the illustration above, a rather common cohabitation relationship scenario might be addressed with a somewhat unusual application of a rather common and simple irrevocable trust. There are often creative ways that common estate planning tools can be tweaked and repurposed to meet different circumstances and provide improved results.