On June 26, 2013, the United States Supreme Court issued two landmark decisions on same-sex marriage. In United States v. Windsor 507 U.S. ___ (2013) (the “Windsor Decision”) the Defense of Marriage Act (“DOMA”), which barred the federal government from recognizing same-sex marriages, was found to be unconstitutional by the Supreme Court by a 5-4 vote. Additionally, in Hollingsworth v. Perry 507 U.S. ___ (2013) (the “Proposition 8 Decision”), the Supreme Court opened the door for same-sex marriages to resume in California.
It is important to note that the Windsor Decision and the Proposition 8 Decision do not require that same-sex marriages be recognized in states that do not already allow it. The Windsor Decision merely requires that the federal government treat same-sex couples as married if they reside in states or foreign jurisdictions that allow same-sex marriages. At the present, 13 states and the District of Columbia recognize same-sex marriages, highlighting the division of the states on this issue (see note 1). The Court’s decisions leave many issues unresolved and questions unanswered, but at the same time provide opportunities for planning for same-sex couples.
I. Case Summary
United States v. Windsor is essentially a tax case. Edith Windsor alleged that the federal government’s refusal to acknowledge her marriage to Thea Spyer, her partner of forty-four years, violated equal protection principles of the United States Constitution. As the surviving spouse and executor of Thea’s estate, Edith claimed she incurred over $360,000 in federal estate tax because the federal government pursuant to DOMA did not recognize her valid marriage under Canadian law. As a result, she was not permitted to take advantage of the unlimited federal estate tax marital deduction for property passing to her from Thea’s estate. The United States maintained (eventually without support from the Department of Justice) that DOMA was entitled to a presumption of constitutionality and that DOMA’s definition of marriage did not offend the equal protection clause. The two women lived in New York, where same-sex marriage is legal. Windsor won at the District Court level and before the Second Circuit Court of Appeals, paving the way for our country’s highest court to hear the argument on the constitutionality of DOMA.
At issue in the Windsor Decision was Section 3 of DOMA, which provides a definition of “spouse” as “a person of the opposite sex who is a husband or wife.” In its 5-4 majority decision written by Justice Kennedy, the Supreme Court declared Section 3 unconstitutional. While the effects are broad, the Supreme Court did not hold that all prohibitions on same-sex marriage violate the constitution, nor did the Supreme Court redefine marriage nationally. Instead, the Supreme Court respected the rights of the states to decide what marriage will be. For federal purposes, however, same-sex couples will now maintain the same status as opposite-sex couples; same-sex couples who are legally married and live in states which recognize same-sex marriages will be treated by the United States government as married, and will be afforded the same rights and protections as opposite sex married couples. These rights include well over 1000 possible benefits under federal law.
Notably, other parts of DOMA remain in effect including Section 2, which allows states which do not allow same-sex marriage to ignore the legal marriages or unions from other states around the country. This presents a conundrum for those same-sex couples who marry in a state which recognizes same-sex marriages and later move to a state where their union is not acknowledged.
At issue in the Proposition 8 Decision was a California law defining marriage as solely between a man and woman. In 2008, the California Supreme Court found that limiting marriage to opposite-sex couples violated the rights of same-sex couples under California’s constitution and could not be used to prevent same-sex couples from marrying. Voters overturned this decision via Proposition 8 in the November 2008 election. In 2009, two same-sex couples challenged Proposition 8 in the United States District Court for the Northern District of California. In August 2010, the District Court struck down Proposition 8 and in February of 2012, the Ninth Circuit Court of Appeals upheld the District Court’s decision.
In a separate 5-4 decision, the Proposition 8 Decision was dismissed for lack of jurisdiction by the Supreme Court. The Court declined to decide the merits and constitutionality of the voter-approved ban on same-sex marriage, and instead held that the appellants who supported Proposition 8 lacked the necessary standing to bring the matter before the Supreme Court. Effectively, the Supreme Court’s decision left in place the lower court’s determination that the state’s voter initiative to ban same-sex marriage was unconstitutional and therefore reinstates California as the thirteenth state to allow same-sex marriages.
II. Tax Planning Opportunities and Filings to Consider Now
Following the Windsor Decision, there are numerous opportunities and filings that should be considered both for same-sex couples and the family members of same-sex couples. While a number of issues require clarification, same-sex couples should consider the following.
A. Income Tax Issues:
i. Income Taxes for 2010-2013: For couples who were married in a U.S. state or a foreign country (see note 2) that permits same-sex marriage, and who continue to live in a state that permits same-sex marriage (“Qualified same-sex couples”) at the end of each applicable year, they may file or amend their tax returns for state and federal purposes as “married.” Married couples may file either jointly or separately. In general, joint filing tends to favor spouses when one makes significantly more than the other spouse. This is because the IRS treats each spouse as having earned one-half of the income so a couple may be able to take advantage of a lower tax bracket. However, if both same-sex spouses are high income earners, they will be subject to the same “marriage tax” (see note 3) that traditional couples face.
Qualified same-sex couples on extension for 2012 should file their taxes as either “married filing jointly” or “married filing separately” (see note 4). Qualified same-sex couples may want to amend their 2010, 2011 and if already filed, 2012 tax returns to reflect married status. As of yet, there has been no guidance from the IRS as to whether amending returns is voluntary or if it will be mandatory. At a minimum prior returns should be reviewed and draft returns prepared using married status to see if it is beneficial to file amended returns. Absent a protective filing for prior years, it is likely that the only years currently open for refund are 2010, 2011 and 2012.
ii. Withholding: If you earn wages as an employee (i.e. receive a W-2 at the end of the year), you may want to consider changing your filing status and claimed allowances on Form W-4, which may affect the amount of tax that is withheld from your paycheck. If you pay quarterly estimated income taxes, you may want to consult a tax advisor about whether to change the amount of these payments.
iii. Other Miscellaneous Tax Issues: Married couples filing jointly may combine both spouses’ income and expenses when computing credits and deductions. Therefore, both spouses may combine their qualifying medical and dental expenses to determine if they meet the adjusted gross income (“AGI”) limits (see note 5). Qualified same-sex couples will also no longer be penalized by having to pay income taxes on the value of employer-provided insurance to an employee’s spouse. Additionally, Qualified same-sex couples may be able to use pre-tax dollars to pay premiums on employer-provided health insurance for a spouse and may also now exclude gain from the sale or exchange of a principal residence up to the maximum of $500,000 if they file jointly.
iv. Divorce Transfers: Property transferred between Qualified same-sex spouses because of a divorce is no longer subject to income or gift tax. Previously under DOMA, when a married same-sex couple divorced, transfers of real estate and other assets were taxable events.
- Alimony: If alimony (sometimes called “spousal support”) or separate maintenance payments are paid to a Qualified same-sex spouse under a divorce, separation agreement or court order, the payments are deductible to the person making the payments on his or her tax returns (see note 6). The spouse or former spouse receiving the payments must report the payments as income.
- QDRO: Certain retirement assets in the name of one spouse may not be divided without a court-issued Qualified Domestic Relations Order (QDRO). For Qualified same-sex couples who divorce, certain workplace retirement plans belonging to one spouse can be assigned to the non-employee/former spouse on a tax-free basis. A former spouse who receives benefits paid under a QDRO generally must report the benefits as income. If the employee contributed to the retirement plan, then a prorated share of the employee’s cost is used to figure the taxable amount of the benefit.
- IRAs: The transfer of all or part of an interest in a traditional IRA to a spouse or former spouse, pursuant to a divorce decree is not considered a taxable transfer.
v. Grantor Trust Rules: Generally, trusts are taxed as either “grantor” trusts where the taxes are paid by the trust grantor, or “non-grantor” trusts, where the trust pays its own income taxes. One way to cause grantor trust status is to have a spouse as a beneficiary of the trust. With the Windsor Decision, trusts that were previously considered non-grantor trusts may now be treated as a “grantor” trust if a same-sex spouse is a beneficiary. Same-sex couples should consult with their legal advisors to see if the income tax status of any trusts may have inadvertently changed.
B. Estate & Gift Issues:
i. Unlimited Gifts: Historically, one of the planning difficulties for same-sex couples was transferring assets from one spouse to another. After the Windsor Decision, Qualified same-sex couples may, subject to certain limitations, freely transfer unlimited property from one spouse to another without gift tax. This is particularly beneficial where spouses want to re-title real estate jointly with survivorship rights to ensure the surviving spouse is not displaced upon the first death.
ii. Unlimited Marital Deduction: The Windsor case was ultimately about estate taxes. Where couples were married in a country or state that permits same-sex marriage, if an estate is probated in a state that permits same-sex marriage, then the surviving spouse can inherit the assets without paying estate tax using the unlimited marital deduction.
iii. Portability: Qualified same-sex couples can inherit any remaining unused “applicable exclusion amount” that shelters a set amount of a person’s assets from federal estate taxation (currently, $5.25 million). It is not necessary to provide for this in a last will and testament; the election is made on the deceased spouse’s estate tax return.
iv. Survivorship Life Insurance Policies and Annuities: Qualified same-sex couples can now easily obtain survivorship life insurance policies and annuities. These polices are especially beneficial if only one spouse is easily insurable.
v. Section 672© Applies: In many trusts, certain trustees may not be persons who are “related or subordinate” pursuant to Internal Revenue Code (“IRC”) Section 672© to either the grantor or the beneficiary of the trust. Where the trustee is a same-sex spouse, previously they were usually not considered related or subordinate. However, a review of current trust instruments should be undertaken to see if it is necessary to appoint a successor or co-trustee.
vi. Exercise POA to Spouse: A same-sex couple spouse may benefit from existing family trusts or estates. While a same-sex spouse could always benefit as a named beneficiary, often wills and trusts name a “beneficiary’s spouse” rather than a specific person as a permitted beneficiary. A same-sex spouse may also be included as a permitted appointee as a “spouse” under a power of appointment included in a will or trust document. Instruments should be reviewed to determine if these rights exist.
C. Planning No Longer Available to Same-Sex Couples:
i. Chapter 14 Applies: Many common estate planning issues could be avoided when planning for same-sex couples because Chapter 14 of the Internal Revenue Code did not apply to same-sex couples. In light of the Windsor Decision, same-sex couples now also need to be aware of the pitfalls of planning with the following: GRITs; QPRTs with the sale of residences and remainder interests; IRC Section 2701 compliant preferred partnerships; “vertical slice” investment fund, carried interest transfer planning, sales to Intentionally Defective Grantor Trusts; buy-sell agreements and family limited partnership agreements under IRC Section 2703; valuation problems under IRC Section 2704; and marital deduction mismatch problems.
ii. Grantor Retained Income Trust (“GRIT”): A GRIT permits a grantor to transfer assets to a beneficiary and retain the income stream from that asset. The goal is to freeze the value of the asset at the time of the transfer while permitting the growth and appreciation to occur outside of the grantor’s estate. Congress recognized the potential for abusing this type of transaction and passed Chapter 14 of the Internal Revenue Code which limited the usefulness of this transaction among family members and related parties. However, since same-sex couples were not considered “related”, this transaction was very effective for transferring property between same-sex spouses. Now that Qualified same-sex couples are considered married for federal purposes, they will no longer be able to use GRITs without application of Chapter 14.
iii. Qualified Personal Residence Trust (“QPRT”) and Residence Sales: This type of trust is designed to transfer the ownership of a residence to a trust beneficiary (i.e., a same-sex spouse) following the completion of a term of years during which the grantor is entitled to remain in the residence. The benefit is that real estate could be transferred at a low gift value. One negative issue with this planning is that the beneficiary receives the residence subject to carry-over tax basis and may incur a substantial capital gains tax on the subsequent sale of the residence. For same-sex couples, a common technique involved creating a QPRT and, prior to the end of the trust, having the grantor purchase the real estate back from the trust, leaving cash in the trust. Upon death of the grantor, the real estate would receive a step-up in basis. However, since Treasury Regulations specifically prohibit the grantor from buying the residence back when the trust beneficiaries are members of the grantor’s family, this technique will not work any longer where the Qualified same-sex spouse is the trust beneficiary.
III. Immigration Opportunities
DOMA and the federal government’s long-standing position that same-sex marriages are not recognized under federal law and therefore not eligible for federal benefits has been extremely detrimental to same-sex couples seeking immigration benefits. As an example, the United States allows U.S. citizens to sponsor their foreign national spouses. Prior to the Windsor Decision, foreign nationals married to same-sex U.S. citizens had to resort to other immigration options, such as employment-based sponsorship which is often lengthy and costly. In the post-DOMA world, U.S. citizens may now sponsor their same-sex foreign national spouse using follow to join provisions. Foreign nationals who are coming to the U.S. through employment-based or family-based sponsorship may seek derivative immigration status for their same-sex spouse. However, binational couples who resorted to creative ways to navigate the U.S. intolerant policies will now have to carefully consider their past decisions when making future immigration decisions.
Qualified same-sex couples using these immigration opportunities should consult with their tax advisors prior to completion of the immigration planning as citizenship and green card changes can have a significant impact on their income and transfer tax planning.
IV. Social Security & Pension Benefits
i. Social Security: Under the Windsor Decision, same-sex couples who live in states that permit same-sex marriage will be eligible for Social Security Spousal Retirement Benefits, Spousal Disability Benefits, Survivor’s Benefits, and Lump-Sum Death Benefits and those who live in states that do not recognize same-sex marriage will not receive those benefits.
ii. Spousal ERISA Rights: The Employee Retirement Income Security Act of 1974 (“ERISA”) provides special spousal rights with respect to payment of retirement benefits in the form of a joint and survivor annuity, and with respect to spousal consent to pay benefits to non-spouse beneficiaries for married participants in IRC 401(a) plans and other defined contribution plans.
iii. Beneficiary Designations: The IRC provides for special rules when a spouse inherits a continuing interest in an ERISA-qualified plan or individual retirement account. These rules may be used to stretch the payment period of pension benefits that are not available to a person other than the spouse. Special attention must be given to pension beneficiary designations and payment schedules.
V. Health Benefits
i. Health Care, COBRA: In states that permit or recognize same-sex marriages, group health care coverage and COBRA benefits will need to be offered to same-sex couples and families on the same basis as traditional families.
ii. Family Medical Leave Act: The Family Medical Leave Act looks to a person’s place of residence for determining benefits. Qualified same-sex couples who live in a state that permits same-sex marriage are qualified for coverage (see note 7).
VI. Open Questions
As the country tries to digest the Supreme Court’s decisions, further guidance from all three branches of government will be necessary and welcomed, as individuals and their advisors grapple with issues left open by the Supreme Court’s rulings. For example, is a retroactive refund from the IRS available because an employee paid extra taxes on the value of health benefits provided to his same-sex spouse? Conflict of laws analyses will need to be thoroughly examined since the decisions fail to address that the recognition of same-sex marriages will vary state to state. Each state has been left with the prerogative to determine what status to accord to same sex couples who want to solidify their relationships and which rights should accompany those relationships. But what happens if a same-sex couple is married in a state which recognizes same-sex marriages and moves to a state that either renders their marriage unlawful or is silent on the issue? Which governs, the principle of “place of celebration,” “place of residency,” or other measure? Other forms of “marital arrangements” were left unconsidered by the Windsor Decision. For example, how does one address the impact on civil unions, domestic partnerships, or similar state law or other country concepts? The full impact of the Windsor Decision will take years to ascertain as these and thousands of other questions are resolved. Same-sex couples are encouraged to maintain regular contact with their advisors to keep current with latest developments.
- Same sex couples can legally marry in California, Connecticut, Delaware, Iowa, Maine, Maryland, Massachusetts, Minnesota (on 8/1/2013), New Hampshire, New York, Rhode Island (on 8/1/2013), Vermont and Washington, the District of Columbia, and certain Native American tribal jurisdictions.
- Same sex couples may legally marry in Argentina, Belgium, Brazil, Canada, Denmark (excluding the Faroe Islands and Greenland), France, Iceland, Netherlands (excluding Aruba, Curaçao and St Maarten), Norway, Portugal, Spain, South Africa, Sweden, Uruguay (on 8/1/2013), New Zealand (on 8/19/2013, excluding Tokelau, Niue and the Cook Islands), and several parts of Mexico.
- “Marriage tax” happens because joint return income thresholds (i.e., the income level at which the next marginal tax bracket applies), while higher than unmarried individual return thresholds, are not twice as high. Thus, some high-earning married taxpayers, whether they file as “married filing jointly” or “married filing separately,” will pay higher rates of tax than they would if they were unmarried individual filers.
- Please consult with your personal tax advisor for individual advice regarding your tax filings.
- 7.5% of AGI in 2012 and 10% of AGI in 2013.
- Under DOMA, the spouse payming alimony could not deduct payments.
- Covered employees must have worked at least 1,250 hours during the prior 12 months and be employed by a private company with 50 or more employees or certain public employers.