After the death of the first spouse, residents of community property states have a distinct income tax advantage over residents of separate property states. Assume that a couple's property is owned approximately equally between them. In a separate property state, this ownership could consist of entirely separate ownership of various assets, or joint ownership in the form of tenancy in common, joint tenancy with right of survivorship, or tenancy by the entirety. At the death of the first spouse to die, the basis of the decedent's assets (but not the decedent's spouse's assets) is adjusted to the fair market value of such assets at death (IRC section 1014(b)(1)). In a general growing economy, this adjustment is usually upward--thus the term "stepped-up basis" -- at death.

Contrast the above basis result to the adjustment provided in community property states. The decedent's one-half share of the community property is adjusted pursuant to IRC section 1014(b)(1), as described above, and then section 1014(b)(6) provides a similar adjustment for "property which represents the surviving spouse's one-half share of community property held by the decedent and the surviving spouse under the community property laws of any State, or possession of the United States or any foreign country, if at least one-half of the whole of the community interest in such property was includable in determining the value of the decedent's gross estate." Therefore, at the death of the first spouse, the basis of all community property, regardless of whether held by the decedent or the surviving spouse, is stepped up.

This lack of parity can produce significant income tax differences if the surviving spouse sells the assets during the period between the first spouse's death and the surviving spouse's death. In separate property states, one-half of the assets sold will produce capital gain that would have been completely avoided if the couple had instead lived in a community property state. Furthermore, the sale of assets during this period of the surviving spouse's lifetime is likely. The family business may need to be sold due to the decedent's lack of participation, or pursuant to an existing buy-sell agreement. Real property may be considered burdensome to manage. Market conditions may dictate the sale of assets before an expected downturn.  

A Remedy For This Unfairness:
An "Elect-In" Community Property System 

The goal of the Alaska Legislature is to allow taxpayers to obtain the above-described community property full step-up in basis, to the extent they so desire. A married couple may elect to treat all their property as community property. Alternatively, they can elect that only certain assets be treated as community property, leaving the balance of their assets as "individual property" (separate property). This election is accomplished by execution of a community property agreement or community property trust.

 
The Alaska Legislature Provided That Non-Residents of Alaska
May Use Alaska's Elect-In Community Property System
Through An Alaska Trust 

The Sponsor Statement for HB 199, which has become the Alaska Community Property Act, provides in part: 

The bill not only allows Alaska couples to enter into an agreement to have some or all of their assets treated as community property, but it also permits married persons who do not reside in Alaska to have their assets treated as community property under Alaska law by executing an Alaskan Community Property Trust. Such a trust must have an Alaskan trustee. It is anticipated that many married persons who reside outside Alaska will wish to label a portion, or all, of their assets as community property because they believe that it is a more appropriate method of owning their assets and they wish to obtain the income tax advantages which are available to community property upon the death of the first spouse. 

Some believe that community property represents a more fair and rational system of sharing the ownership of property during marriage because it essentially treats the marriage like a partnership: as assets are earned during the marriage, they are treated as owned 50/50 by the two partners (the husband and wife). Others believe community property is not a fair or rational system. Regardless of one's beliefs, it seems appropriate to allow Alaskans, and residents of other states, the freedom to choose the arrangement that is most appropriate for them.

The Alaska Community Property Act 

New Chapter 75 of Title 34 of the Alaska Statutes enacts the Alaska Community Property Act, effective May 23, 1998. This statute is based on the Uniform Marital Property Act (the Uniform Act), which has been adopted only by Wisconsin. However, unlike the Uniform Act, the Alaska act provides for an "elective" community property system. As a general rule, Alaska's established separate property system would apply to marital property. However, spouses may elect to have some or all of their property treated as community property. If both spouses are domiciled in Alaska, the election occurs through the execution of a community property agreement or community property trust. If one or both spouses are not domiciled in Alaska, then this election can be made by the spouses by transferring property to a community property trust.

The community property agreement and community property trust have many similar characteristics. They are written instruments, signed by both spouses, and enforceable without consideration. A bold-lettered notice must be placed at the beginning of the document advising the spouses that the agreement may have extensive legal consequences. Within an agreement or trust, the spouses may agree on (1) the rights and obligations in the property, notwithstanding when and where the property is acquired and located; (2) the management and control of the property; (3) the disposition of the property on dissolution, death, or another event; (4) the choice of law governing the interpretation of the trust instrument; and (5) any other matter that affects the property and does not violate public policy. In addition, in a community property agreement, the spouses may agree (1) on making a will, trust, or other arrangement; and (2) that upon the death of either of them, the property passes without probate to a designated person, trust, or other entity by nontestamentary disposition.

A community property agreement may be entered into before marriage, but only becomes effective upon marriage. Both a community property agreement and a community property trust may be amended or revoked by a later agreement or trust, without consideration. The agreement or trust cannot adversely affect child support. Extensive provisions are included to protect the rights of creditors of a spouse, and bona fide purchasers dealing with the spouses. An agreement or trust may not be enforced against a spouse who proves that the instrument was unconscionable when made or was not executed voluntarily, or that the spouse against whom enforcement is sought was not given a fair and reasonable disclosure of the property and financial obligations of the other spouse.

A community property trust is designed to be used by couples when one or both spouses are not domiciled in the state of Alaska. In order to provide a nexus with Alaska, a number of additional requirements are added. At least one trustee must be an individual domiciled in Alaska, or an Alaska trust company or bank. Other co-trustees may be nonresidents, and may include the spouses. The Alaska trustee's powers must include maintaining records for the trust on an exclusive or a nonexclusive basis and preparing or arranging for the preparation of, on an exclusive or a nonexclusive basis, any income tax returns that must be filed by the trust. The trustee must maintain records that identify which property held by the trust is community property. Appreciation and income of property transferred to a community property trust is community property if the terms of the trust so provide. With a few exceptions, a community property agreement or community property trust can vary any of the provisions of the Alaska Community Property Act.

A spouse has a present undivided one-half interest in Alaska community property. If a community property agreement provides that all property acquired by either or both spouses during marriage is community property, then the property of the spouses acquired during marriage and after the determination date (the later of the date of the marriage or the agreement or trust) is presumed to be community property. Further, when all property is agreed to be community property, the income earned or accrued by a spouse or attributable to property of a spouse during marriage and after the determination date is community property. Also, application by one spouse of substantial labor, managerial activity, or similar efforts on individual property of the other spouse creates community property of the other spouse attributable to such efforts if reasonable compensation is not paid.

Regardless of whether the community property agreement provides that all property acquired by either spouses during marriage is community property, property that is owned by a spouse at the time of marriage but before the determination date is not community property except as otherwise provided in the agreement. Similarly, property acquired by a spouse during marriage and after the determination date remains individual property if acquired by gift or inheritance; in exchange for other individual property of the spouse; from appreciation or income of the spouse's individual property; by a decree, community property agreement, or reclassification designating it as individual property; as a recovery for damages to property resulting from breach of the good faith requirement in matters regarding community property; or for personal injury.

On divorce, community property will be equitably divided between the spouses. If the words "survivorship community property" are used, then on the death of a spouse the ownership rights of that spouse vest solely in the surviving spouse by nontestamentary disposition. Mixing community property with property having another classification reclassifies the other property as community property unless the property that is not community property can be traced.

The general management and control of Alaska community property depends on title and agreement. A spouse acting alone may manage and control: community property held in that spouse's name alone; a policy of insurance owned by that spouse; deferred compensation benefits that accrue as a result of that spouse's employment; and community property held in the name of both spouses in the alternative. Community property held in the names of both spouses other than in the alternative is managed and controlled by both spouses acting together. Management and control of community property held in a trust us determined by the terms of the trust. An individual's right to manage and control does not include the right to make gifts to third parties, except for relatively nominal amounts. However, if both spouses report such a gift on their federal gift tax returns, or if the nondonor spouse consents to "split gifts" on the donor spouse's gift tax return, then this is treated as the spouses acting together in making the gift.

Issues To Consider 

Alaska's new elect-in community property system is the only such elect-in system now in effect in the United States. However, Oklahoma briefly experimented with a similar system during the period from 1939 through 1945. This was prior to the allowance of joint income tax returns in 1948. Under this prior elect-in system, a couple elected to have Oklahoma's new community property law apply to them. They each reported one-half of their income on their separate returns. The Internal Revenue Service challenged this splitting of income, arguing that one spouse was taxable on all of the income derived from his earnings. The U.S. Supreme Court, in Commissioner v. Harman, 323 U.S. 44 (1994), upheld the commissioner's position. The Supreme Court decision seems to focus on the distinction between a "consensual" and a "legal" (mandatory) community property system. The Court also stated: "The important fact is that the community property system of Oklahoma is not a system, dictated by State, as an incident of matrimony." (323 U.S. at 48.)

The Harman case, as discussed above, did not involve an adjustment of basis at death but rather the reporting of the income earned by both spouses. In 1948, Congress allowed the filing of joint income tax returns, which in effect provided the income tax reduction remedy that Oklahoma's elect-in system was attempting to achieve. Also in 1948, Congress approved IRC section 1014(b)(6), allowing full basis adjustment at the death of the first spouse to die. The proponents of the new Alaska act state that the legislative history underlying Congress's 1948 legislation does not reflect a distinction between consensual and mandatory community property systems. Therefore, they conclude that Congress intended the full-basis step-up to apply whether the community property system was elective or mandatory.

Perhaps the most significant weakness in the Harmon decision was pinpointed by Justice William O. Douglas, in his dissent. He stated that "in some of the so-called 'legal' [mandatory] community property states separate property of one spouse may be converted by contract or deed into community property or vice versa." (323 U.S. at 54.) Therefore, residents of these states (e.g., Washington and California) may elect in or out of the community property system. However, the IRS has not attempted to deny separate reporting of taxable income, nor the full basis adjustment of IRC section 1014(b)(6), to residents of such states. Interestingly, McCollum v. United States, 58-2 U.S.T.C. section 9957 (USDC Okla. 1958), allowed a full step-up in basis under the Oklahoma elect-in statute. However, the district court's opinion clouds its holding by apparently relying on Oklahoma's change in law after 1945 to a mandatory community property system.

The use of an Alaska community property trust by nonresidents adds an additional issue. Proponents of this legislation emphasize the Restatement's reliance on the law of the state designated in the instrument. (Restatement, Second, Conflict of Law sections 268 and 270.) The extent of the taxpayers' and their trust's Alaska contacts is also stressed.

Alaska residents and nonresidents alike will need to carefully evaluate whether "electing" to Alaska's community property system is advantageous. An analysis concerning the potential income tax benefits in regard to the couple's specific situation may well be the first step. However, of equal importance will be the nontax consequences of partially or fully adopting a community property system. Some couples may be attracted to the equality and other characteristics of the Alaska community property. Other couples may conclude that the nontax consequences of a community property system are not to their liking.