Planning for Same-Sex Married Couples After the Fall of DOMA
After years of navigating the inconsistencies of state and federal law, the tax landscape for married same-sex couples was dramatically altered when the Supreme Court held unconstitutional a portion of the Defense of Marriage Act (DOMA). DOMA had two main effects. First, it defined marriage as a relationship between one woman and one man at the federal level. Therefore, most federal law, including federal tax law, did not recognize same-sex marriage. Second, it allowed states to ignore same-sex marriages performed outside their jurisdictions, which they could not otherwise do under the full faith and credit clause of the Constitution. In U.S. v. Windsor, this first function of DOMA that pertains to the federal definition of marriage and its attendant benefits, also known as Section 3, was struck down.
Edith Windsor and Thea Speyer, a New York couple, were married in 2007 in Toronto. When Speyer died in 2009, the federal government did not recognize the marriage, though the state of New York did. As such, Speyer’s estate was not able to use the federal marital deduction to shield Windsor’s inheritance from estate tax. Speyer’s estate owed nearly $400,000 in estate taxes as a result, and Windsor, as executrix of the estate, sued for relief by challenging the DOMA’s constitutionality.
The Supreme Court found for Windsor in a narrowly tailored decision, holding that Section 3 violated the due process and equal protection clauses of the 14th Amendment. The Court provided that a same-sex couple who was married in a jurisdiction that permits such marriages and who also resides in a jurisdiction that recognizes such marriages are entitled to all of the federal benefits and responsibilities that opposite-sex marriage confers. The Court did not strike down the provision that permits other states to ignore such unions and, as such, stopped short of functionally legalizing same-sex marriage for the entire nation.
The repeal of Section 3 is a meaningful change from a tax perspective, and there are a number of areas that should be reviewed by any same-sex couple that is legally married. The couple now has the right to file a joint federal tax return, which may result in a lower combined tax than the amount due as single filers. It should be noted, however, that the so-called marriage penalty may cause two high-earning spouses to pay more in tax by filing jointly. In addition to examining their upcoming filing status, same-sex couples should review their tax filings for years that are still open under the statute of limitations to see if amending to file jointly could result in a refund. Until the IRS rules, it is not clear whether Windsor will be applied retroactively, but a protective refund claim may be filed in the interim.
Now that the federal government will recognize same-sex marriages performed in recognizing states, the federal tax laws that pertain to divorce also will apply to those couples. Prior to Windsor, if a same-sex couple terminated their relationship and divided their property pursuant to a settlement agreement, they were not afforded the protections against negative gift and income tax consequences available to heterosexual couples. In addition, any alimony paid by a same-sex spouse was not deductible for that spouse. After Windsor, divorce has the same tax implications for all legally married couples.
Another crucial area to revisit is the couple’s estate plan. Existing plans should be reviewed and amended to take advantage of the unlimited marital deduction, which allows property to pass to the surviving spouse free from any estate tax. Surviving same-sex spouses can now roll-over a deceased spouse’s retirement plan on an income-tax-free basis. Gift and estate tax returns filed in prior years should be reviewed and possibly amended to apply the gift tax marital deduction for any transfers between same-sex spouses. Same-sex spouses who followed our recommendation from Appeals Court Allows Federal Estate Tax Marital Deduction for Same-Sex Couple, concerning use of the gift exemption via a trust that could qualify for the marital deduction if DOMA was subsequently overturned, should file a gift tax return and make the QTIP marital deduction election. Finally, if gifts were made to a same-sex spouse in trust, which would otherwise not have qualified for a marital deduction due to restrictions in the trust document, it may be possible to take back those gifts through a rescission due to a mistake of law.
Although Windsor makes clear the federal treatment of same-sex spouses residing in states that allow same-sex marriage, what is less clear is the treatment of those individuals who do not reside in states that allow same-sex marriage, but who were legally married in other jurisdictions. For example, if a same-sex couple legally marries in New York, but lives in or moves to New Jersey (a state that does not recognize same-sex marriage), what are the tax implications for federal purposes? While they would not be permitted to file a joint state return, they may be able to file a joint federal return. Until the IRS or a court formally rules, this issue remains an open question.
While stopping short of legalizing same-sex marriage in all 50 states, U.S. v. Windsor marks a dramatic change for same-sex married couples and their families by placing such couples on the same footing as heterosexual couples for federal tax purposes. This decision also provides certainty for some same-sex spouses, while at the same time muddying the water for others. We strongly encourage all married same-sex couples to revisit their tax filings and estate plans with their advisors to take full advantage of this new legal landscape. Significant income, gift and estate savings may now be available.