Joint Tenancy and Tax, Part II

Interesting outcomes where spousal ownership is involved

Previously, I wrote about some of the interesting tax outcomes that result when property is titled as joint tenants with right of survivorship. In Part I of this series, I focused primarily on non-spousal joint tenancy. There are, however, some interesting outcomes to note where spouses own property with rights of survivorship - either in a joint tenancy, or tenancy by the entirety.

In this article, I discuss some off tax outcomes that are often not anticipated in spousal joint tenancy. Note that this article does not address the tax and non-tax issues that can arise in the event of divorce, remarriage, or in a blended family situation. (For a good read about the non-tax perils of joint tenancy, with a dose of ethics and malpractice peppered in, see the Colorado Supreme Court’s 2016 opinion in Baker v. Wood, Ris & Hames.)

Income Tax

As with non-spouses, joint ownership of property (regardless of whether survivorship rights attach) lead to income taxation in proportion to ownership percentage. For spouses filing joint returns, this wouldn’t make much of a difference, but in situations where spouses choose to file separately, it may force 50/50 taxation of income. This can create unintended results, for example, where spouses own an interest in a closely-held business jointly.

In estate planning, survivorship rights often trump all other forms of transfer (subject to disclaimer rights, below). This can create an easy “shortcut” in estate planning, but notwithstanding the non-tax issues with outright bequests to a spouse, this can also limit some of the income tax planning available during life where 50/50 taxation is forced.

Where the rubber truly meets the road on the income tax side, however, is in analyzing the basis adjustment under IRC Section 1014 following the death of one spouse. We will discuss these outcomes below with respect to estate tax.

Gift Tax

Usually, the addition of a spouse to the title of an asset as a joint tenant does not generate gift tax liability due to the unlimited marital deduction. Care must be taken, however, to address the timing. The gift tax outcomes are also asset-specific, leading to some interesting outcomes.

Let’s take, for example, a situation where a couple plans to get married and has not yet tied the knot. One spouse-to-be adds the other to the title to the residence in anticipation of marriage. If the couple is not yet married at the time of the gift, can a gift tax marital deduction be claimed? The answer is no, as IRC Section 2523(a) requires spouses to be married at the time of the gift in order to claim a gift tax marital deduction. So, even if the couple gets married by the end of the year, the pre-marital change in title would at the very least create a gift tax filing obligation, leading to the need to value the residence in this example.

Speaking of value, one question that often flies under the radar is whether the IRS might force a valuation discount on a transfer to a spouse. While this is usually more of a concern for transfers at death, or titling between a spouse and a QTIP trust, it is still a possibility to be considered. Below, I will discuss the Nowell decision for estate tax purposes. But, in this regard, I think it is also helpful to call out another estate tax case, Warne v. Commissioner (T.C. Memo 2021-17), for the proposition that discounts can be forced in situations where 100% of property is divided between two charities. I don’t think it is out of the realm of possibility for the IRS to force a discount on a 50% transfer of a joint interest to a spouse, assuming that it is a completed gift. As I will explain below, however, this could have an interesting estate tax outcome.

The question of whether there is a completed gift becomes more complicated, both between spouses and non-spouses, where cash and securities accounts are involved. In such a situation, Treas. Reg. 25.2511-1(h)(4) stands for the proposition that no completed gift to such an account would occur until a non-contributing account holder makes a withdrawal. So, while pre-marital transfers of assets like real estate or business interests may not qualify for the marital deduction, that issue may be moot in the situation of simply adding a spouse-to-be to a bank or investment account in anticipation of marriage. As we will see below, it also creates interesting basis planning opportunities at the death of one spouse (especially the contributing spouse).

But, where joint accounts are transferred to an entity or revocable trusts, such action could sever the right of survivorship. This could create a trickle-down effect on the question of whether a gift is complete. Let’s take a situation where two spouses create a business entity, and transfer a joint account in exchange for respective 50% interests in the entity. The non-contributing spouse’s act of exchanging their account interest for a business entity interest could, in and of itself, be treated as a withdrawal of that cash followed by an exchange of that cash. This deemed withdrawal would complete the gift.

Where revocable trusts are involved, however, the right to revoke one’s transfer to the trust avoids completion of a gift until there is a loss of “dominion and control” under the principles of Treas. Reg. 25.2511-2. So, for example, if spouses were to transfer their account interests to a joint revocable trust (thus merging the joint account interests into a single account in the name of the trust and also possibly severing the right of survivorship), the retained rights of revocation likely would prevent a completed gift unless or until a non-contributing spouse received a distribution or withdrawal from the trust itself. However, a split of title between two single-grantor revocable trusts could complete the gift to another spouse depending on the circumstances and structure of the trust. Further, the grant of a testamentary general power of appointment or power of withdrawal to a non-contributing spouse under a revocable trust could be a completed gift of the contributing spouse’s one-half interest, depending on the type of asset(s) involved.

In situations where the marital deduction applies, why do we care about the possibility of completed gifts to a spouse? For one, it can affect the estate tax outcomes and basis adjustment as discussed below. Further, if either spouse makes a gift to a non-spouse during the year which triggers a gift tax filing obligation, all gifts must be reported. This can include interspousal completed gifts eligible for the gift tax marital deduction. A failure to report all gifts could cause an understatement of total gifts, which in the worst case can lead to an extension or loss of the three-year limitations period that is otherwise created when a gift tax return is filed. As noted in Smaldino v. Commissioner, T.C. Memo 2021-127, it can also create a situation where an intervening spousal gift is disregarded.

In addition, one must note that the gift of assets from a joint account by spouses is treated as a one-half gift from each of them. While this would avoid the need for a gift-splitting election under IRC 2513, it could trigger a filing obligation for both spouses depending on the size of the gift and what types of recipients are involved. It could also lead to allocation of GST exemption one-half by each spouse, regardless of whether a gift tax return is filed by each. Ironically, as I mentioned with a transfer to a business entity above, such an event could also complete a gift of an account to a non-contributing spouse - leading to a need for the contributing spouse to also report that gift to the non-contributing spouse on the gift tax return accompanying the gift of the account (or cash or securities from that account) to a third party.

Estate Tax

Unlike the non-spousal rule of IRC 2040, which tracks gross estate inclusion of joint tenancy property in proportion to contribution, spousal joint tenancy interests are included 50% in the gross estate as a default.

So, let’s assume one spousal joint tenant dies. In that case, they are deemed to own 50%, which is included in their gross estate. And, since the right of survivorship sends this interest directly to the surviving spouse, there is a corresponding marital deduction for this entire 50%. This transferred 50% interest also gets a basis adjustment under IRC Section 1014(b)(9).

In this situation, the surviving spouse was already the owner of the other 50% interest, which is not subject to gross estate inclusion. It is also not eligible for a basis adjustment, unless the property itself was treated as community property - in which case there could be a basis adjustment for the surviving spouse’s 50% interest under IRC Section 1014(b)(6).

Where things get interesting, however, are in the disclaimer rules - where we jump back to an analysis relating to each spouse’s proportionate contribution in a situation where there was no completed lifetime gift. Let’s say one spouse contributes 100% of the assets of an investment account, and during life adds the other spouse to the title of the investment account as a joint tenant. The contributing spouse dies, leading to a deemed transfer of 50% of the account to the surviving (non-contributing) spouse. Interestingly, the gift of the non-contributing spouse’s 50% interests received during life should be completed at that moment, but there does not appear to be any gift or estate tax reporting obligation in that situation unless there is a disclaimer.

In this situation, we turn our attention to Treas. Reg. 25.2518-2(b)(4)(iii), which only applies to a bank, brokerage, or other investment account. This Regulation generally provides that the transfer of all portions of the account for which a surviving spouse is not the contributor occurs at the death of the contributing spouse. Thus, assuming the other requirements for a valid disclaimer are met, the non-contributing surviving spouse can effectively disclaim more than 50% of the account if their contributions comprise less than 50% of the FMV of the account at the other spouse’s death. (An added requirement is that, under applicable state or local law, the contributing spouse must have had the unilateral right to withdraw all contributions.)

This is significant in a situation where the surviving spouse still benefits under the deceased spouse’s estate plan, as it can allow a basis adjustment to more than 50% of the account. The trade-off is that more than 50% of the account is included in the gross estate of the deceased spouse, and may use some of the deceased spouse’s applicable credit if the transfer to the surviving spouse does not qualify for the estate tax marital deduction. Further, this transfer generally requires the disclaimed property to pass through the probate estate, unless there is a POD or TOD to a revocable trust or testamentary subtrust attached which is effective at second (deemed) death.

This benefit is also subject to the other qualified disclaimer requirements under Treas. Reg. 25.2518-2(e)(2) - namely the inability of the surviving spouse to (1) “benefit” from the disclaimed property (other than a beneficial interest in a trust that is the taker in default) and (2) control the disposition of the disclaimed property in a transfer that is not subject to gift or estate tax. Generally, what this means is that the property must pass to a trust over which the surviving spouse does not hold a power of appointment, or unless a QTIP election is made with respect to the disclaimed property. But, a spouse can make distributions from the disclaimed property to themselves or to others as trustee so long as the distributions are limited by an ascertainable standard.

Finally, as noted earlier, care must be taken to consider the effect of joint ownership and even disclaimers on the estate tax value of a deceased spouse’s joint tenancy interest. For non-community assets not following the contribution/completed gift tug-of-war, there is no extra basis adjustment to be gleaned from a disclaimer. Instead, assets may pass to a bypass trust or QTIP trust.

In such a situation, especially where a QTIP trust is involved and the QTIP election is made, the surviving spouse will end up as the estate tax owner of both the QTIP assets and the surviving spouse’s one-half interest. But, the individual and QTIP interests may have to be valued separately in keeping with the Tax Court’s Memorandum Opinion in Nowell v. Commissioner (T.C. Memo 1999-15). Disclaimer strategy in this vein is a bit outside of the scope of this article, but nonetheless creates a dynamic that must be analyzed for tax effects at the surviving spouse’s death.

But, to close the loop on the Warne analysis above, it seems unlikely that a discount would be forced for a the estate tax value of a joint tenancy interest at first death - mainly because this could create, on paper, an artificial transfer of the discount to the surviving spouse that is somehow not counted in the gross estate (thus skewing the basis adjustment). The only way this could become a concern is if there is a disclaimer which has the effect of disqualifying the disclaimed interest from an estate tax marital deduction. But if a gift tax discount was, or could have been, forced during life, one must question whether a corresponding premium, based on the date-of-death FMV, is included in the deceased spouse’s gross estate.

While we are on that topic, however, I would be remiss if I did not bring up IRC Section 2056(d), which denies the estate tax marital deduction for a joint tenancy survivorship interest passing to surviving spouse who is not a U.S. citizen. For a non-citizen surviving spouse, the only way to apply the estate tax marital deduction is to direct property to a qualified domestic trust, or QDOT. Thus, where property is titled jointly and the surviving spouse is not a U.S. citizen, a qualified disclaimer may be the only path to a marital deduction. Even then, the disclaimed interest would have to pass as part of the deceased spouse’s probate estate to a QDOT, whether created as a testamentary trust under a will or as a subtrust of an inter vivos pourover trust.

Conclusion

Joint tenancy with rights of survivorship creates a handy “shortcut” to estate planning, especially in situations where there is no concern about a survivor controlling the survivorship interest. While I did not address the concerns where a blended family or the risk of remarriage are involved, these are often the concerns which discourage the use of joint tenancy. But, as noted in this article, there are several tax concerns and opportunities which must be addressed.