During the past year, there has been a sweeping revolution occurring in America as 19 states have officially begun recognizing same-sex marriages. More states are continuing this trend one year after the United States Supreme Court declared unconstitutional Section 3 of the Defense of Marriage Act (DOMA) in the landmark case United States v. Windsor. The repeal of Section 3 of DOMA changes the federal landscape with regard to same-sex marriage and the benefits afforded to these couples. However, inconsistencies among different states result in a confusing patchwork of opportunities and obstacles. The changes in law substantially affect how same-sex couples must approach income, divorce, gift and estate tax planning.
Timeline of Same-Sex Marriage Ban and Legalizations by Effective Date of Laws
The Defense of Marriage Act
DOMA is a federal law that was passed on September 21, 1996 with overwhelming bipartisan support. The bill passed 342-67 in the House of Representatives and 85-14 in the Senate. Two key controversial parts of the bill were Section 2, which allows each state to decide whether or not to recognize the marriage of a same-sex couple, and Section 3, which defines marriage as a legal union between a man and a woman. While Section 3 was declared unconstitutional, Section 2 was not ruled upon by the Supreme Court. Subsequently, the recognition of a same-sex union remains at the discretion of each state.
As a result of the Supreme Court’s ruling in the Windsor case on June 26, 2013, the federal government is now compelled to recognize validly performed marriages between same-sex couples just as it recognizes marriages of opposite-sex couples. However, since Section 2 remains in effect, this causes inconsistencies among how the federal government and the different states apply various rules relating to benefits associated with being legally married.
The repeal of Section 3 of DOMA now provides legally married same-sex couples more than 1,100 benefits that were previously unavailable to them, including health insurance coverage, Social Security benefits, military benefits, immigration protection, and the right to be treated as married for federal tax purposes. This presents opportunities for income tax, divorce, and estate tax planning for same-sex married couples, although complications continue due to a lack of uniformity between state and federal laws.
Income Tax Planning
In the wake of United States v. Windsor, the Treasury Department and the IRS have revised their rules regarding the definition of “legally married”. Prior to the ruling, the IRS relied on the authority of state or foreign law, however, they now use a broader standard known as the “place of celebration” rule. Under this rule, the state where same-sex couples celebrated their marriage controls their filing status, regardless of whether or not the couple lives in a jurisdiction that recognizes same-sex marriage.
Beginning in 2013, married same-sex couples must elect to file their tax returns as either married filing jointly or married filing separately. This election helps to resolve several tax-related questions regarding charitable deductions and deductions for children and real estate. However, this may expose higher income couples to the “marriage penalty,” the alternative minimum tax, and the phase-out of deductions, thereby producing a larger total tax bill than that incurred by both members of a couple filing as single individuals. The option to file using a single status will no longer be available for same-sex married couples going forward.
In addition to the effect that combined incomes may have on a same-sex couple’s tax rate, additional consideration must be given to the following:
- Standard and itemized deductions. The standard deduction is a fixed dollar amount based on filing status. The deduction doubles to $12,200 for filing jointly compared to single or married filing separately. However, higher combined income may jeopardize the ability to deduct certain qualifying expenses, such as medical and dental expenses. Currently, expenses exceeding 10% of adjusted gross income (AGI) may be deducted.
- Employer-provided health insurance. Prior to the Court’s decision, the value of employer-provided health care benefits was considered taxable income. Now, same-sex married couples can exclude from taxable income the cost of employer-provided health insurance for their partners.
- Cafeteria plans and other fringe benefits. Tax-advantaged employer benefits were historically unavailable to same-sex couples. Now, provided an employer offers the option, same-sex married couples will have the ability to pay for certain benefits, such as insurance premiums, with pre-tax money.
- Sale of a home. When selling a home, a single taxpayer may shelter up to $250,000 in gains from income, while a married couple may shelter up to $500,000. The ability of married same-sex couples to file jointly will result in additional tax savings.
Other challenges include the potential to lose certain deductions and credits associated with combining incomes. A single individual may have previously been able to take the child tax credit, but now it could be phased out if a couple’s joint modified AGI reaches the phase-out level. Additionally, the adoption credit was widely used by same-sex couples; however, an individual cannot utilize the credit in order to adopt a spouse’s child. Further, an individual who was previously eligible to contribute to a Roth IRA based on income limits for a single person might no longer qualify to contribute based on spousal limitations.
These rules apply only to validly married couples; the Internal Revenue Service does not recognize domestic partnerships and civil unions as valid marriages.
For some same-sex married couples with a greater disparity in incomes, the ability to file joint tax returns may result in lower taxes. As such, there is an option to file amended income tax returns for the past three tax years.
Section 2 of DOMA creates complexities as states are not required to recognize same-sex marriages. Individuals living in certain states may have to file differently for state and federal purposes, resulting in a different set of tax implications. Prior to the Windsor ruling, each person in a same-sex marriage was required to file a separate federal tax return, however, some states with legalized same-sex marriage required or allowed couples to treat themselves as married for state tax return purposes. This resulted in the filing of numerous returns as well as additional costs. Now, post-Windsor, some states may still await guidance from a court order regarding amendment of filing requirements.
As with investments, taxes should not be a driving force, but if a same-sex couple considering marriage has some issues identified above, they might consider discussing their situation with a CPA prior to getting married to understand the economic impact on their union.
Unwinding a legal relationship is never simple, however, federal recognition of same-sex marriage creates a new set of challenges and financial consequences. Previously, a taxable event occurred if assets such as a home were transferred from one spouse to another. Now, property transferred due to divorce is not subject to income or gift taxes.
A spouse who is ordered by a court to pay spousal support (alimony) may now deduct those payments on his or her tax return, while the recipient-spouse recognizes these payments as income. Retirement assets may be considered marital property and, therefore, subject to a court ordered Qualified Domestic Relations Order (QDRO), allowing the retirement plan to be split without tax implications.
As with income tax planning, divorce might not be possible in states that do not yet recognize the legality of same-sex marriages. If income and asset levels vary dramatically or children are involved, couples should consider using prenuptial agreements. Since there remains a patchwork of state laws to consider, those considering divorce should consult an attorney who is experienced and knowledgeable with these issues.
Gift and Estate Tax Planning
Same-sex married couples are now able to take advantage of shielding more of their assets from federal estate taxes by using the unlimited marital deduction and portability option that were historically only available to heterosexual married couples.
Previously under DOMA, if one spouse wished to share their financial assets or transfer ownership in a house to his or her partner, that spouse would have to file a gift tax return if the dollar amount was greater than the annual gift exclusion (currently $14,000). Now, spouses can take advantage of the unlimited marital deduction which allows a same-sex married couple to amass assets up to $10 million without incurring a federal estate tax liability upon the passing of one spouse. In addition, married same-sex partners can now take advantage of gift splitting, which allows a gift given by a married couple to someone else to be considered as having been made one-half by each spouse. Same-sex married couples are also able to choose whether or not to file amended gift and estate tax returns for previous years.
Further, legally married same-sex couples are also able to take advantage of the benefits of inherited IRAs. When one spouse dies, the surviving spouse has the option to rollover the assets into his or her own IRA. This allows the survivor to have the option of postponing required minimum distributions until age 70½ and then stretching the payments over his or her own life expectancy, instead of treating these accounts as IRAs inherited by a non-spousal beneficiary.
It is important to note, however, that challenges remain since certain states still do not recognize the validity of same-sex marriages, and even states that do recognize these marriages may tax estates differently than federal law. In both of these instances, as well as scenarios where committed same-sex couples choose not to marry, appropriate estate plans are essential. It is crucial to establish powers of attorney that appoint partners as agents. Additionally, revocable living trusts are workable solutions to estate planning challenges because they are more difficult to contest than wills. Administration of trusts can be a daunting task, and it requires expertise in many subject areas. Wescott Trust Services provides trust solutions as a professional trustee and as an agent that assists trustees with the administration of trusts and estates.
Careful Decision-Making Moving Forward
The repeal of Section 3 of DOMA has created an opportunity for legally married same-sex couples to take advantage of income and estate tax laws previously unavailable to them, however, it has also created new challenges. Since many states still do not recognize the validity of same-sex marriages within their borders, the impact on taxes and estate planning varies from state to state. Same-sex couples, whether or not they are married, must pay close attention to their state’s requirements when making decisions regarding taxes and estate plans.
An original article authored by the advisors of Wescott Financial Advisory Group LLC
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