Oral argument in the case is scheduled for March 27, and the court's decision could affect federal rights for same-sex couples in connection with tax and estate planning issues.
Currently, a same-sex couple may be married under the law of the state where they live but they are still legal strangers under federal law.
In June 2012, the U.S. District Court for the Southern District of New York granted summary judgment to Edith Windsor and held that the $363,053 she was required to pay as executor of the estate of her wife, Thea Spyer, was improperly assessed because of the definition of marriage in the Internal Revenue Code required under DOMA (Windsor v. United States, 833 F. Supp. 2d 394 (S.D.N.Y. 2012); 110 DTR K-1, 6/8/12).
The Second Circuit Oct. 18, 2012, held that Section 3 of DOMA was unconstitutional, because it violates the Constitution's Equal Protection Clause (Windsor v. United States, 699 F.3d 169 (2d Cir. 2012); 202 DTR K-3, 10/19/12).
In December 2012, the Supreme Court granted certiorari to the government in its challenge to the constitutionality of Section 3 (236 DTR K-3, 12/10/12).
Tax Issues for Estate Planning
The Windsor case raises estate planning issues for same-sex couples because while a same-sex couple may be married under the law of the state where they live, they are still legal strangers under federal law.
Major tax items affected in estate planning for same-sex couples include the federal estate tax exemption, gift taxes, individual retirement arrangements, and issues regarding jointly held property, Melanie Lee of Lee Law Office PLLC in Richmond, Va., told BNA March 13. The federal unlimited marital deduction that allows a spouse to leave his or her entire estate tax free to the surviving spouse applies only to opposite-sex couples because of DOMA, Lee said.
The court may change this, said Lee, but for clients in states like Virginia that do not recognize same-sex marriage, it will continue to be a concern regardless—the Windsor case will only address Section 3 of DOMA but not Section 2, allowing states to continue to discriminate against same-sex couples.
Gift Tax Limitations
Lee noted that gift tax issues arise with same-sex couples when one partner transfers property to the other or into both names. Under current law each person can claim a lifetime gift exclusion on property valued up to $5.25 million without paying gift taxes, and the lifetime gift exclusion need only be applied to gifts above the annual gift exclusion of $14,000—“this amount can be doubled for a legally married couple to $28,000,” Lee said.
“Gifts between same-sex married couples are counted as regular gifts as if they are strangers,” said Lee.
For individual retirement accounts, Lee explained that the ability of a surviving spouse to roll over the assets of the IRA and defer distribution, which allows the asset to continue to grow tax free, is an option not available to same-sex couples.
“Currently same-sex married couples do not have the estate planning tax privileges heterosexual married couples have,” Vivian L. Holley of the Law Offices of Vivian L. Holley in San Francisco told BNA March 13. “This especially impacts both the couples whose estates exceed $5.25 million on the federal level, and as little as $1 million for some states, Holley said.
Holley also said that, because of DOMA, same-sex married couples are not entitled to the privilege of the unlimited marital deduction. If a same-sex spouse inherits his or her spouse's estate in excess of these, he or she will be subject to a tax that quickly reaches the 40 percent level.
“There are also issues involved with planning for cash flow because currently under DOMA a same-sex married spouse is not entitled to receive their spouse's Social Security benefits after death of the spouse, whereas a qualifying heterosexual spouse would be entitled to receive 100 percent of their spouse's benefits,” Holley said.
“Wealthy same-sex spouses do not have the flexibility that opposite-sex spouses enjoy in providing for each other during lifetime and after death,” said Lisa Monihan of Spieth, Bell, McCurdy & Newell Co. LPA in Cleveland.
Monihan said that an important result of the gift tax limitations rule is that when same-sex spouses share a household, or even a bank account, there could be gift tax consequences, and this is particularly important if one spouse is much wealthier than the other or is a much higher earner.
“Any expenses paid by one spouse on the other's behalf, any property purchased for or subsidized by one spouse for the other, and any funds contributed to a joint bank account that are later used by the other spouse are gifts for purposes of the federal transfer tax,” she said. The transactions count toward the annual exclusion, and any such transfers in excess of $14,000 per year count against the donor spouse's exemption amount.
“Similarly, any mandatory support or property settlement upon divorce, even if authorized by state law, could carry federal gift tax consequences,” Monihan said.
Gift-Splitting Option Denied
Opposite-sex spouses may “split gifts” so that one spouse may make gifts but for tax purposes the gift is treated as coming equally from both spouses, she said.
Monihan explained that this allows opposite-sex spouses to functionally pool their $5.25 million lifetime exemption amounts and their $14,000 annual exclusion amounts, allowing them to transfer $28,000 per recipient per year, and an additional $10.5 million over their joint lifetimes.
“Similarly, in the estate tax area, ‘portability’ allows a surviving opposite-sex spouse to use any unused portion of the first spouse's $5.25 million exemption, in addition to the $5.25 million exemption the surviving spouse has in his or her own right,” Monihan said.
These pooling mechanisms are useful where one spouse is very wealthy and the other spouse is less so, and they enable the spouses to provide for a common estate plan with maximum tax benefits without requiring that the wealthier spouse first give property to the less wealthy spouse, Monihan said. The pooling mechanism is particularly useful in blended families, she said, where the common goal is for the wealthier spouse to retain his or her property and, upon his or her death, to leave some or all of it to his or her children from a prior marriage, rather than to the subsequent spouse.
Monihan pointed out that same-sex spouses cannot aggregate their transfer tax benefits in this way.
Broader Impact With Retirement Accounts
“There are also income tax benefits enjoyed by opposite-sex spouses that are important in estate planning, which are much more important to less wealthy couples than the estate and gift tax benefits,” said Monihan, adding “the most significant income tax benefit relates to a person's individual retirement accounts, 401(k) accounts, 403(b) accounts, and 457(b) accounts.”
“These accounts provide valuable income tax benefits to the original account owner, and those benefits are also available to a surviving opposite-sex spouse who inherits the retirement account from the original account owner,” she said. Any other beneficiary, including a same-sex spouse, still enjoys some income tax benefits when he or she inherits a retirement account, but the benefits are much more limited than those available to an opposite-sex spouse, Monihan said.
State/Federal Filing Status
The legal relationship of same-sex couples also affects filing yearly state and federal tax returns. While some states recognize same-sex marriage, the federal government does not, resulting in the need for a same-sex couple to prepare two sets of federal tax returns, one to be used for federal tax filing based on the assumption the couple is not married, and another set based on the assumption the couple is married.
State returns are often based on the federal return, so if a couple lived in a state that recognized their marriage they would file their state return as married but then have to create separate returns or work around the federal return, Lee said. “Interestingly enough, the federal tax return doesn't ask for or request gender but filing jointly as married would be against the law,” she said.
“For same-sex married couples in California, they file a joint tax return in California but must file two individual tax returns for reporting income to the federal government,” Joel Loquvam of the Law Offices of Joel Loquvam in Beverly Hills, Calif., told BNA March 12. Loquvam explained that because California is a community property state, a “community property worksheet” is attached to the cover of each of the federal tax returns indicating why two “unrelated” individuals are reporting community property income.
“Interestingly enough, the federal tax return doesn't ask for or request gender but filing jointly as married would be against the law.”
Melanie Lee, Lee Law Office
“This results in higher fees being paid to a [certified public accountant], and much more complication for the taxpayer,” he said.
Holley also said that there are a multitude of tax filing issues for same-sex couples, beginning with the initial filing status. She used the example of California, where same-sex couples who are married may file a joint state tax return.
“For federal purposes, they are single, or at best, one is head of household, and they must file using a different status than on their state returns,” said Holley, and then, because of the discrepancy, there has to be an acceptable explanation for the discrepancy.” Similarly, the federal government might question declaring a dependent same-sex spouse as a “dependent” entitled to an exemption since they are “unrelated,” she said.
Complications of Transfers, Income Allocations
Holley gave another example when property changes title during a marriage or separation or divorce. “With a heterosexual marriage, property exchanges between spouses are treated as a nontaxable event, so, any gain in the value of the property over the time it is held is not reported or taxed,” she said. However, with a same-sex marriage, a property exchange between spouses is considered a sale to a non-spouse, so there are taxes due from the “seller” on any gain from the increased value of the property.
Monihan also pointed out there is a benefit for opposite-sex spouses who can work with tax return preparers or income tax return preparation software to file their federal and state income tax returns at relatively low cost. Monihan contrasted that to the process of preparing income tax returns for same-sex couples who are married in the eyes of their home state, but not the federal government, which could be time-consuming and would likely require the assistance of a professional who is experienced in tax return preparation for same-sex couples.
“Among other things, it is important to allocate income and deductions appropriately between the spouses; to do otherwise may cause a taxable gift, as well as any penalties associated with improperly prepared income tax returns,” Monihan said. The issue is compounded for couples who are required to file income tax returns in multiple states, some of which may recognize the marriage and some of which may not, she explained.
Monihan said that the issues in preparing gift and estate tax returns are less complex, for two main reasons. First, among the states that have a gift or estate tax, the state returns are generally less closely tied to the federal returns, and even where the federal return is a springboard for the state return, it is generally not difficult to accommodate the difference in marital status for federal versus state purposes. Second, as a general matter, only wealthy individuals are obligated to file federal estate and gift tax returns, she said.
The vast majority of individuals fall below the filing threshold so that only a state return is required, Monihan said, and for them, there is no issue with preparing the state return reflecting their status as a married couple.
Executive Branch Says DOMA Unconstitutional
In September 2012, the government filed the petition for certiorari in Windsor and noted that the U.S. attorney general had sent a letter to Congress stating that he and the president had determined that Section 3 of DOMA was unconstitutional as applied to same-sex couples who are legally married under state law (189 DTR K-1, 10/1/12).
“Section 3 of DOMA violates the fundamental constitutional guarantee of equal protection,” the government said.
The government noted that heightened scrutiny is applicable to a small number of classifications, and “the court has yet to determine whether classifications based on sexual orientation qualify.” The government also argued that gays and lesbians have been subject to a history of discrimination, and sexual orientation bears no relation to the ability to contribute to society.
Lee said that she believes the administration's position does not affect tax and estate planning. “As an advocate for my clients there is a distinct difference between a law being enforced and being overturned, and in tax and estate planning we have to educate clients and base planning on current law,” she said.
“Because of DOMA, 1,138 federal rights—which are freely available to heterosexual married couples—are denied to same-sex married couples,” Loquvam said.
He went on to say that, while the administration has stated that DOMA will not be enforced, it is hard to gauge what would happen if the court found DOMA constitutional because of the act's sweeping effect on the lives of same-sex married couples. These rights include such things as receipt of a deceased spouse's Social Security, rights under the Family Medical Leave Act, and inheritance rights with respect to IRAs, among others.
“Of course, every practitioner must decide for him- or herself how to advise clients on this matter, and I believe that the prudent course of action is to continue practicing as we have unless and until there is a definitive change in the law, because it is not appropriate to prepare long-range plans in reliance on short-term policy decisions that may change at any time,” said Monihan. Because there is no specific guidance from the Internal Revenue Service on the subject, Monihan said that “we would have no basis on which to advise clients to ignore DOMA in creating an estate plan.”
Monihan noted that the administration's decision not to enforce DOMA is a small part of what practitioners consider, but it must remember that a future president could reverse the policy of non-enforcement if DOMA survives. “In the meantime, we try to create plans that are as flexible as possible, meeting the client's goals while minimizing the tax impact,” she said.
Estate planning is a long-term proposition, but in the end the advice to clients is not to let the tax tail wag the family planning dog, she said. “I think it is noteworthy that despite the administration's stance, the Internal Revenue Service has not yet refunded the estate tax paid by Edith Windsor after her wife's death,” Monihan said.
Implications of Court's Decision
While it is difficult to predict the possible outcome of the case, if the court finds DOMA unconstitutional, any retroactive effect of the decision could present opportunities for practitioners to advise their clients on filling amended tax returns and requests for refunds of estate taxes.
“If the court holds Section 3 unconstitutional, I would predict there will be a number of amended returns filed for clients that are legally married in other states,” said Lee, “as DOMA affects thousands of federal statutes including retirements, pensions, Social Security. I doubt the complexities would go away quickly.”
Loquvam said that, from an estate planning perspective, if DOMA is found unconstitutional, married same-sex couples should be able to file amended tax returns and, arguably, get tax refunds, and be able to utilize joint trust plans, which means less paperwork and more flexibility.
If the court overturns DOMA, there is a question of whether the decision will have a retroactive impact or only a prospective impact, Holley said, and the court may or may not give some indication about retroactivity. “I believe that in order to undo the previous tax treatment, there must be an interpretation that DOMA was illegal from the beginning so retroactive remedies would be allowed,” she said.
“Since the administration is anti-DOMA in principle, I would think they would try to allow some remedies to correct DOMA's earlier inequities,” Holley said.
“If the court strikes down Section 3 narrowly, the ruling may effectively recognize same-sex marriage for federal purposes only for residents of the states that recognize same-sex marriage,” said Monihan. She said that in contrast, the court may rule more broadly that such a distinction for federal tax purposes is itself unconstitutional—that the relationship status of an individual for federal purposes cannot constitutionally depend on where that person resides at a particular time, and same-sex marriage will therefore be recognized for all federal purposes.
Amended Returns Could Raise Issues
“If Section 3 is found unconstitutional as to any group of taxpayers, it would be void ab initio and any tax paid by those taxpayers would have been paid improperly,” Monihan said. Generally, IRS has discretion to accept or reject amended returns, but may not reject them if doing so would be arbitrary or unjust, she said, and courts have interpreted this to mean that if a return is amended in good faith and within a reasonable time after the original return is filed, the Service should accept the amended return.
Also, if Section 3 is held unconstitutional, it is very likely that the estate of a deceased same-sex spouse who has already filed a federal estate tax return and for which the statute of limitations has not run (generally, three years after the return is filed or two years after the tax was paid, whichever is later) will be permitted to file an amended return, Monihan explained.
For older returns, there is a good argument that rejecting an amended return would be unjust under the circumstances, and the same considerations apply to same-sex spouses who have made lifetime gifts to recipients including a recognized same-sex spouse in excess of their $5.25 million exemption, and have paid gift tax on those excess gifts, she said.
“It is also possible that IRS will establish a procedure for estates to claim a refund, rather than amend the previously filed estate tax returns, similar to the procedure under tax code Section 2053 for protective refunds,” Monihan noted. She said that taxpayers who have made lifetime gifts using up some portion of their lifetime $5.25 million exemption and who have (or have not) filed federal gift tax returns may be in a better position, because of the structure of the federal gift and estate tax returns, these taxpayers may be able to adjust their taxable gift history on a prospective basis only, without having to amend prior returns.
“The advisability of this approach will depend, first, on the scope of the court's ruling, and second, on any guidance issued by IRS in this area,” she said.
Loquvam noted that IRS has a very proactive group in the Western region of the country that has worked with CPAs and tax professionals in responding to the changes brought about by same-sex marriage and the filing of joint returns on the state level and related individual returns on the federal level.
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