Tax Traps and Opportunities:  Planning for Same-Sex Marriage

On February 14, 2012, Washington State joined New York, Connecticut, Iowa, Massachusetts, New Hampshire, Vermont and the District of Columbia in recognizing same-sex marriage.

As of this writing, Maryland and Illinois are also considering similar legislation. In extending these legal rights to same-sex couples, some unique and challenging tax planning issues were also created.

Although marriage and its legal implications are governed by state law, for federal purposes the Defense of Marriage Act (DOMA) defines marriage as a relationship between one woman and one man. Therefore, most federal law, including federal tax law, does not recognize same-sex marriage. This inconsistency has a significant impact on planning for same-sex couples and can lead to some surprising and unwanted results.

Much of family wealth planning involves, to some extent, the unlimited marital deduction. This deduction allows an individual to transfer via gift of bequest unlimited assets to his or her spouse completely transfer tax free. Under DOMA, however, same-sex couples are not afforded this deduction. Aside from the obvious issues of not being able to give assets to your spouse free of gift or estate tax, there are some less obvious tax traps where state property law and federal tax law intersect. 

Most married couples own at least some property as joint tenants with a right of survivorship (referred to as Joint Tenants With Rights of Survivorship or JTWROS). This type of ownership creates gift tax implications that are usually ignored for married couples because of the marital deduction. For same-sex couples, however, these implications must be carefully considered. 

In the most obvious example, if the owner of property were to add a same-sex partner as a JTWROS, a gift of one-half the property’s value results. There is an exception to this rule for joint tenants of assets such as bank accounts where the contributing joint owner can revoke the account at any time. In such cases, no gift occurs until the non-contributing owner actually withdraws the funds. However, because of the property rights marriage creates in certain states, this exception may not apply.

In states such as New York, married joint owners with survivorship rights own property as tenants by the entirety. This type of ownership is the same as JTWROS with the exception that such account cannot be severed unilaterally. As a result, the mere creation of the account causes an immediate gift, the value of which is calculated actuarially. Likewise, in community property states such as Washington, the conversion of community property into separate property and vice versa also creates a taxable gift. Because of these unintended and often counterintuitive results, it is important that same-sex couples be aware of the rights created by various forms of property ownership. 

Along with these gift tax issues, joint ownership also creates estate tax complications for same-sex couples. Under the tax code, if a spouse dies owning property as a JTWROS, one-half of the property is deemed included in that spouse’s estate. That half then gets a step-up in basis and passes to the surviving spouse estate tax free. For unmarried joint owners, which includes same-sex married couples, not only is there no marital deduction, but it is presumed that the deceased joint tenant owned 100% of the property (or the funds used to purchase the property) and thus, 100% of the value is included in the estate unless evidence can be produced proving otherwise. To avoid this result, same-sex couples must maintain detailed records for all property owned jointly.     

Another area that can be problematic for same-sex couples is the generation-skipping transfer (GST) tax regime. In the case of unrelated people, any recipient of assets who is more than 37 ½ years younger than the person transferring those assets is considered to be more than one generation below that person and thus, the GST tax applies. For heterosexual couples, the age difference between spouses is meaningless because married couples are considered to be the same generation. If same-sex spouses are more than 37 ½ years apart however, an asset transfer can create not only gift or estate tax, but GST tax as well.   

There is one notable area in which DOMA does provide an advantage to same-sex couples. Prior to 1990, a common family wealth planning technique was to transfer an asset to the next generation but retain an income interest over that property for a term of years. As a result, the transfer value of the property was less than its full value. Savvy planners would intentionally select an asset that produced little actual income, making the true economic value of the retained interest a nominal amount. This transaction is known as the grantor retained interest trust, or GRIT. In response, the government introduced Sec. 2702 which states that this retained interest, unless meeting specific requirements, is ignored for valuation purposes so that the transfer value would be the asset’s full value. However, this section is only applicable to certain related parties, a statutorily-defined group which does not include same-sex couples. Therefore, the GRIT can be used to transfer assets between same-sex couples at a substantially reduced gift tax value. In addition, GRITs can also be used to transfer assets to a same-sex spouse’s child. 

As more states recognize same-sex marriage, the need for this specialized planning will continue to grow. Because of DOMA and the various and often differing state laws, traditional family wealth planning must be reexamined in this context and planners must consider all the potential pitfalls and opportunities in order to properly serve same-sex couples and their families.