Why is it important to have a contract between spouses implementing the aggregate theory of community property?
First, what is the difference? California Probate Code Section 100 provides that upon the death of one spouse, one half of each asset belongs to the surviving spouse, and one half of each asset belongs to the deceased spouse. This is commonly known as the “prorate” theory of community property. And it can create problems.
For instance, pretend a husband (now deceased and hereinafter referred to as the “Decedent”) and wife own $2M of assets of which $1M is the value of their home, and the remainder is stocks. Under the default prorate theory, each spouse owns one half of each asset, and the estate should be distributed between the surviving wife and the Decedent’s estate accordingly. If this couple created the typical A/B trust, half of the home and half of the stocks will be distributed to each of the A and B trusts. The major potential problem with this is that should the surviving spouse sell the home years later after it has appreciated, any capital gain resulting from the sale which is attributed to the A trust (for tax purposes the alter ego of the surviving spouse) will receive the benefit of the $250,000 exclusion resulting from the sale of a personal residence (IRC Section 121) but any of the gain attributed to the B trust will not be so sheltered (because it does not meet the “ownership” rules required to qualify for Section 121 treatment).
Ideally the way to avoid this problem is to cause 100% of ownership of the home to be allocated to the A trust and equal value of stocks to be allocated to the B trust. However, making such an allocation without the benefit of an agreement adopting the “aggregate theory” of community property can technically create a potential income tax problem.
In my example, if no “aggregate theory” agreement exists, transferring 100% of the home to Trust A and 100% of the stocks to Trust B is an exchange, half of the home for half of the stocks. In the event the home and stocks have appreciated in value as of the date of the “exchange”, a taxable transaction has occurred, and each trust will be deemed to have made a sale of assets subject to taxation to the extent of the gain experienced.
However, if the couple has executed an agreement converting their community property to the “aggregate theory” a non-prorate distribution is not treated as an exchange and not subject to taxation.
The moral of the story, execute an aggregate theory community property agreement. It will provide greater flexibility.