We have all heard the story: Ellen and Anne are a couple; Ellen moves into Anne's house; Ellen cleans up the house, purchases groceries, and takes care of Anne's kids and pets; Ellen makes occasional payments to the bank for the mortgage; Ellen buys some furniture; Ellen and Anne can no longer get along; Anne kicks Ellen out with only the clothes on her back. Poor Ellen.
Could Ellen have done anything to protect herself in this situation? You bet. Ellen and Anne could have signed an agreement that determined, among other things, ownership of property, contributions for expenses, and division of property in the event that they break-up. Whether its two women, two men, or a man and a woman living together as partners, a "domestic partnership agreement" will provide each person with rights that would otherwise be unavailable under the law. This article will provide a definition of domestic partnership agreements, discuss some of the terms that should be included, and finally examine some important tax implications of this type of agreement. Because state law governs the interpretation and validity of contracts, this discussion is limited to Illinois law, with references to applicable federal income, estate, and gift tax laws.
WHAT IS A DOMESTIC PARTNERSHIP AGREEMENT?
A domestic partnership agreement is a contract entered into between two parties that defines the rights and duties owed by and to each other within the relationship. Absent the agreement, the parties have no legal relationship. Let me state that again: the agreement provides the only legal relationship between the parties. In fact, the Illinois Supreme Court has expressly held that cohabitation, by itself, does not create an economic interest or other equitable rights in a domestic partner's property.
Generally, courts will enforce a domestic partnership agreement where it provides for the ownership of property, parenting agreements or even a business partnership where the couple can show a valid business purpose. However, courts will not enforce an agreement that is based upon companionship, fidelity or the promise of sexual relations.
WHAT ARE SOME OF THE ISSUES THAT SHOULD BE DISCUSSED?
The provisions found within a domestic partnership agreement depend upon the scope of the agreement. For example, if the couple decides to create an agreement only about ownership of the house, then the asset list is short and the couple must decide, among other things, how mortgage payments and the sale of the house will be handled. By contrast, where the couple is involved in a business venture, the agreement may mirror a business partnership agreement, complete with allocations of profits and losses.
The following are some important provisions to be included in a domestic partnership agreement:
Names and addresses of the parties;
Description of the duties each party owes to the other;
Property covered by the agreement, including designations of separate and shared property;
Management of shared property, including purchasing and selling with a means to determine the value and resolution of valuation disputes; and
Dissolution of the relationship including events that trigger dissolution and the division of property.
WHAT ARE SOME OF THE IMPORTANT TAX PITFALLS?
There are three main areas that pose potential tax problems for domestic partners. The first involves gift tax issues. The Internal Revenue Code (the "Code"), permits each person to give up to $11,000 per year to as many individuals as he or she wishes without incurring gift tax. Once the $11,000 exemption is reached, then part of the person's applicable exclusion will be used.
The applicable exclusion permits a person to transfer a certain value of assets free of any gift or estate tax. (The exclusion from tax is really accomplished by way of a credit against the tax due on the applicable exclusion amount. The credit is known as the unified credit.) The applicable exclusion amount is $1,000,000 for gifts made in 2002. A person may use the exclusion to transfer assets during life, at death or both. The exclusion operates like a bank account. Any lifetime transfer in excess of the narrowly defined tax-free gifts (such as annual exclusion gifts or payments made directly to health care providers) result in a reduction of the person's applicable exclusion. When the "balance" has reached zero, the government will impose tax on any additional transfers. Under the current gift and estate tax regime, the tax imposed ranges from 37% to 55%.
Married couples enjoy additional benefits. The Code provides that gifts between spouses are not subject to gift tax. By contrast, unmarried couples cannot claim that deduction. Thus, where a couple is not married and one gives the other more than $11,000 in money or property, part of the donor's (the person who gives the gift) applicable exclusion will be used. If there is no applicable exclusion remaining, then the government will impose a gift tax on the amount in excess of $11,000.
One way to resolve this problem, where a business venture is involved, is to make the partner an employee of the partnership and provide reasonable compensation for the business services provided by that partner. A business venture could be as simple as ownership of investment real estate. Another way would be to meet the requirements for personal exemptions for unrelated dependents who are members of your household.
The second area involves interest-free and below-market rate loans. This situation usually arises where, in a document, one partner agrees to support the other while he is going to school and the student promises to repay the loan when he graduates and becomes employed. The Code classifies such a relationship as a debtor-creditor relationship, which causes two potential problems.
First, the Code, with some exceptions, recharacterizes the transaction and imposes a market-rate of interest on the loan. The interest is classified as income to the creditor, who is treated as though he received the interest and then made a gift of the interest to the debtor. Thus, the lender has taxable interest income and could have a taxable gift. Second, if the loan is not repaid, then the debtor is deemed to have realized income equal to the amount of the debt that was forgiven.
One way to solve this problem is to have the partner pay tuition directly to the educational institution thereby qualifying for an exemption to gift tax under the Code. Another option is to provide for a market rate of interest and have the creditor gift the amount of interest to the debtor.
The third area involves jointly held property. With jointly held personal property, such as a bank account or brokerage account, a gift between partners does not occur at the time the account is established. Rather, a gift occurs where the noncontributing partner withdraws assets from the account.
With jointly held real property, such as a house or apartment building, a gift occurs when the joint tenancy is created and one tenant does not make a contribution. In other words, if a person owns a house and decides to retitle the house in joint tenancy with her partner, but the new partner does not provide any cash at the time, then a gift has occurred and gift tax may be due.
Jointly held property also presents a potential problem for unmarried couples upon the death of one of the partners. Under the Code, the entire value of the jointly held property is included in the estate of the first partner to die unless the surviving partner can show that he contributed to the purchase of the property, he provided services (such as collecting rents), or made capital improvements to the property. The burden falls upon the decedent's estate to trace the assets by providing canceled checks, deposit slips, and other records.
Consequently, the deceased partner may now have a taxable estate for estate tax purposes. Absent proof of any contribution, the surviving partner, on the other hand, has the benefit of receiving a stepped-up basis for the entire property. A stepped-up basis means that the surviving partner's basis in the property has been raised to the fair market value of the property on the date of the decedent's death. Thus, when the surviving partner sells the property, he will pay less capital gains tax.
Domestic partnership agreements provide unmarried couples with an opportunity to protect their individual and shared interests. The drafting process permits each partner to discuss her concerns with the other so that the final document reflects a shared vision of their relationship. Where marriage is not an option, a carefully drafted agreement is an individual's only protection.
The Lane Report is a publication of The Law Offices of Marc J. Lane, a Professional Corporation. We attempt to highlight and discuss areas of general interest that may result in planning opportunities. Nothing contained in The Lane Report should be construed as legal advice or a legal opinion. Consultation with a professional is recommended before implementing any of the ideas discussed herein. Copyright, 2003 by The Law Offices of Marc J. Lane, A Professional Corporation. Reproduction, in whole or in part, is forbidden without prior written permission.