Cohabitation Agreement: Contributions and Taxes
Jan L. Warner
PREPARING FOR COHABITATION - WHAT YOU ABSOLUTELY NEED TO KNOW
DESIGNING YOUR AGREEMENT: CONTRIBUTIONS AND TAX ISSUES
| Frank, a human resources executive, divorced after ten years of marriage. He had a pension worth $60,000, a home with $75,000 equity, and other assets. Then he met Cathy, a divorced real estate agent, who, after a few months, moved in. Six months later, Frank found out that Cathy was more than $35,000 behind in child support payments and installment loans. Because he wanted the relationship to work, Frank borrowed the money, put a second mortgage on his house, and paid off Cathy's debts. When the real estate market slowed to a crawl, Frank found himself giving money to Cathy regularly and making Cathy's monthly child support payments. Then, one day, 18 months after they had met, Cathy was gone....and so was Frank's home.|
Now that you have seen just some of the problems that can arise, if you are entering what you expect will be a long-term relationship -- or if you are in the midst of a relationship that involves money and property -- you probably need a number of cohabitation documents to take care of the "what if's."
Divorce, alimony, division of assets, inheritance, and health care decisions are all creatures of state law written to serve traditional husbands and wives. Since these laws are not applicable to unmarried couples -- you have the unique opportunity to design and create your rights and obligations through written contracts which must be well-thought through, properly prepared, and tailored to your specific needs and intentions.
The cohabitation agreement is the cornerstone of your relationship and, therefore, must be prepared properly. For example, an agreement based upon sexual services is not legally enforceable; however, when it comes to dealing with the financial and property rights of your relationship, as an unmarried couple or "partnership," you have the right to establish and implement arrangements that will allow you to manage your on-going relationship, to dissolve your relationship if that becomes necessary, and to deal with the after-effects of the death of one or both of you.
Invariably, as with married couples, you and your partner will make both monetary (direct) and non-monetary (indirect) contributions to the economic good of your on-going relationship -- and each of you should receive credit for your contributions. In some instances, for example, one partner may give up a job to move or otherwise help foster the career of the other or, in addition to working a job, take care of the home. In others, one or both partners will bring inheritance, family gifts, income, and assets into the relationship. And in still others, partners will also be business associates.
You and your partner will pool your money, purchase property, improve property, and incur debt. The result: you and your partner will build a valuable estate that is not protected by either the inheritance laws of your state should one of you die or the divorce laws of your state should your relationship terminate for some reason. Because your contributions will build value, you and your partner must decide what goes in the "economic pot," how you each will be protected in case of death or termination of the relationship, and how to deal with a number of important issues, such as:
How will gifts and inheritances from families be treated? How will property purchased during the relationship be handled? Who will contribute what amount to the monthly living expense budget? What about gifts from one of you to the other? Who will be responsible for keeping budget?
Will you use joint, joint with survivorship, or separate accounts? How will property be titled? Who will be responsible for debts? Who will sign leases, bank notes, car loans, mortgages? How will the contributions of each be tracked? Should there be contracts to make wills?
How will the economic pie will be divided if your relationship ends? What will happen if one of you dies? How will children of a prior marriage be protected? Will either of you will receive support and, if so, how much, for how long, and will the obligation will be secured or funded by life insurance, assets, or an annuity? Are there tax consequences involved and how will they be dealt with? How will you resolve your disputes in order to avoid making your business a matter of public record?
Because your relationship is not traditional, there are many potential problems that must be recognized and dealt with. For example:
What if Jack and Jane acquire a $100,000 home to which Jack contributed 75 percent of the money. Jane contributed 25 percent of the money but, since she also takes care of the house, Jack and Jane have signed an agreement that provides for a 50%-50% division of the property if they terminate their relationship. If, as here, properties are owned in proportions which do not reflect the actual monetary contributions to its price, a very important question arises:
Is there a gift to the Jane who has received a share greater than his direct investment would warrant? Or will Jane be deemed to be receiving income for her services?
What if Jack and Jane pool their incomes and assets. Jack provides 90 percent of the income and therefore contributes 90 percent of the money to the property. Does this mean that Jane is receiving support or other income on which she will be taxed?
If there is to be a support obligation due from one partner to another upon termination of the relationship -- and there probably should be if one gives up a career or a job -- what should be the amount and for how long should the obligation continue? Since sexual relations is not an enforceable consideration, the agreement must recite appropriate reasons for payment of support -- such as housekeeping, secretarial help, decorating services, and so forth. And the tax consequences may be tricky because these payments would most likely be taxable to the recipient and not deductible to the payor.
In addition to your cohabitation agreement, if property is acquired during your relationship, you should probably consider co-ownership agreements which should include decisions such as: Who will leave the home if there is a split? How will options to purchase and sell be handled? If property is improved, then by whom, under what conditions, and how will the value be allocated? If debt is incurred, under what circumstances, by whom, and what happens if there is a split?
It is best to begin putting together your agreement as you are establishing your relationship. And remember: It is essential that courts be avoided through the use of mediation and arbitration clauses which should be thoroughly discussed with your lawyers.
The tax considerations affecting unmarried couples are complex and important. There is one important prerequisite that allows a couple to file joint income tax returns to benefit from favorable rates and deductions; to use gift-splitting opportunities to reduce gift taxes; and to benefit from the estate or gift tax marital deduction: They must be validly married under state law.
Since they have chosen not to marry, unmarried couples can not take advantage of these tax benefits; however, just as importantly, without proper planning, they may find themselves incurring income and gift tax obligations they did not anticipate. For example, partners who shift income or assets to each other, directly or indirectly, may generate income or gift tax liability. And, in some instances, employment taxes may be a factor to be considered.
The best way for you to try to avoid income and gift tax liability is to deal with the issues before you run into the problem. You can do this by negotiating a written co-habitation agreement after you and your partner receive advice from competent lawyers and tax experts.
As has been mentioned, in some coupling arrangements, both partners work and earn either equal or unequal incomes. When both work, one or both also contributes services to the good of the relationship. In other arrangements, one partner may work while the other stays at home. Depending on the situation, different taxation issues may rear their ugly heads. In this material....
Service Partner means the partner who contributes services to the good of the relationship, either on a full-time or part-time basis. In some instances, the service partner may be employed, but will earn less than the wage earning partner. In our examples, Jane will be the service partner.
Paying Partner means the partner who earns the majority of income that is used to support the relationship. In our examples, Jack will be the paying partner.
According to the tax code, "gross income" means all income from all sources in any form, including money, property, or services. After specific deductions and exemptions, if one partner receives income from the other, either directly or indirectly, that income will be subject to tax liability.
On the other hand, amounts received as "gifts" are not income to the receiver. For income tax purposes, a transfer or payment based on a moral or legal responsibility is not a gift while a payment or transfer made as a result of love or affection is a gift. A transfer or payment in exchange for sexual acts is not a gift.
With these basics in mind, unmarried couples usually enter into three basic types of arrangements which may or may not lead to tax consequences. In some instances, one arrangement may ripen into another, so continuing tax and other planning is essential:
Shared Expense Arrangement: If you and your partner are together solely to divide the cost of a home or apartment and make no exchanges of money or property. Here, there will be no tax consequences.
Service For Pay Arrangement: If Jack and Jane have an arrangement by which Jack (the paying partner) pays the expenses of the home and Jane (the service partner) performs agreed services. Here, even though Jack will not be able to deduct the payments, Jane will have income equal to the value of meals and accommodations. And if Jack transfers property to Jane for the services, Jane will have income equal to the fair market value of the property while Jack will be taxed just as if he had sold the property.
True Coupling Arrangement: If, however, Jack and Jane enter into a true "coupling" arrangement, including pooling their income and assets, the tax consequences will vary depending on the financial agreements Jack and Jane make.
If Jane is not employed at all and performs all services while Jack pays all expenses, Jane might have taxable income -- even though the homemaker in a marital relationship is not taxed.
Like married couples, when both are employed, unmarried couples often combine their income and assets and pay for all expenses from the pool. But unmarried couples can not divide their income for tax purposes, and they can not file joint tax returns. In a pooling situation, Jane -- with lower income than Jack -- will have the economic benefit of sharing in Jack's higher income which may be treated as either income or a gift to Jane.
Depending on the terms of the cohabitation agreement, Jack and Jane could make arrangements to share assets acquired during the relationship and to provide for support, if appropriate, should they separate. Without an agreement, Jane could bring suit in court against Jack to seek not only a fair division of assets, but also a sum as support.
Because of a special tax rule, exchanges of assets between husband and wife at divorce are generally not taxable events. But since this rule does not apply to divisions of assets between unmarried cohabitants at separation, there are very subtle, yet potentially important distinctions about (1) equally dividing the property as it is acquired, (2) each of you taking one-half of each asset at separation, and (3) each of you receiving one half of the value of the total assets at separation. And because the potential for gift tax liability exists upon transfers between co-habiting unmarried persons, you and your partner should review your situation with a qualified tax expert before you make your final plans.
We hope that you have benefited from this material that is intended to provide you with practical information so you can intelligently determine your options.
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