Press Room: Tax Release

November 01, 2012

Appeals Court Allows Federal Estate Tax Marital Deduction for Same-Sex Couple

The Second Circuit Court of Appeals recently allowed the estate tax marital deduction for a bequest to a same-sex spouse, thereby striking down a key provision of the Defense of Marriage Act. This decision, although not likely to be the last word on the subject, may provide a planning opportunity for same-sex married couples prior to year-end.

In 1996, Congress enacted the Defense of Marriage Act (DOMA) that defined “marriage” for purposes of federal law as the “legal union between one man and one woman as husband and wife.” Although some states and countries passed legislation permitting same-sex marriages, DOMA presumably had the effect of ignoring those marriages for federal tax, benefits and other purposes.

Under federal law, most bequests at death from one spouse to the other qualify for the estate tax marital deduction. Similarly, most gifts between spouses qualify for the gift tax marital deduction. Consequently, such bequests and gifts are not subject to tax. A presumed intent of DOMA is to disallow such deductions for transfers between same-sex married couples.

In the recent case, the Second Circuit Court of Appeals held that DOMA was unconstitutional for purposes of the estate tax marital deduction. In that case, the couple had been legally married in Canada, although they lived in New York. Upon her death in 2009, the decedent left her estate to her partner. After paying the federal estate tax as if no marital deduction was allowed, the estate sued for a refund claiming that the marital deduction sheltered the estate from the tax. Although President Obama had stated that his administration would not enforce DOMA, the courts allowed the Bipartisan Legal Advisory Group of the U.S. House of Representatives to intervene to defend DOMA’s constitutionality. Both the federal district and appeals courts ruled for the estate. Presumably, the same rationale would permit the gift tax marital deduction for lifetime gifts between the members of a same-sex marriage.

Although the Second Circuit’s decision currently is binding in the states that it covers (Connecticut, New York and Vermont), it is likely that the issue will be litigated in other states, with those courts’ decisions subsequently appealed to other courts of appeal. The issue ultimately may be brought before the Supreme Court for resolution and, if the Supreme Court upholds DOMA, the Second Circuit’s decision would be overturned retroactively. Until the judicial process is completed, the ultimate availability of the gift and estate tax marital deductions is uncertain.

Each person has an exemption that may be used to transfer wealth during life or at death to persons other than a spouse. Under current law, the exemption is $5 million, but it is scheduled to decline to $1 million for gifts and the estates of decedents beginning in 2013. Traditional planning utilizes this exemption and much has been written about the advisability of using the $5 million exemption via gifts to non-spouses before the end of this year.

Same-sex married couples in which one partner has property and is contemplating using his or her exemption via an outright gift to the other partner should consider a different approach. The distinction will be relevant if DOMA ultimately is ruled to be constitutional. An outright gift will consume the propertied spouse’s exemption and then the unspent portion will be subject to estate tax when the recipient subsequently dies. Instead, the gift could be made to a qualified terminable interest property trust (QTIP), which is explained below. The gift uses the propertied spouse’s exemption, but the unspent portion will not be subject to estate taxation when the recipient subsequently dies.

If DOMA is unconstitutional, there is no tax difference between the outright and QTIP approaches. In that event, both gift approaches qualify for the marital deduction and the unspent property will be subject to estate taxation at the recipient spouse’s death.

A QTIP trust must meet certain requirements imposed by the gift tax law. It must distribute its income annually (although it can be written to also permit or require principal distributions). It cannot benefit anyone other than the recipient spouse during his or her lifetime. Upon the recipient’s death, the trust’s remaining assets pass to whoever is designated in the trust instrument by the donor spouse. An election must be made in the donor’s gift tax return, which qualifies the gift for the marital deduction. If DOMA is unconstitutional, both the outright and QTIP gifts qualify for the gift tax marital deduction, so the gift is not taxable, but the unspent portion will be included in the recipient spouse’s taxable estate. If DOMA is constitutional, neither the outright nor QTIP gifts qualify for the marital deduction. But, the benefit of the QTIP is that it would avoid estate taxation at the recipient’s death since the gift to it did not qualify for the marital deduction.

For a discussion of other potential tax traps and opportunities in planning for same-sex married couples, please see our February 2012 newsletter article.