As more states recognize same-sex marriage, more financial advisors will need to become well versed in the new federal tax and benefit landscape.
By Russell E. Towers, J.D., CLU, ChFC|March 26, 2014 at 08:06 AM
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On June 26, 2013, in a 5-4 decision, the U.S. Supreme Court ruled most of the Defense of Marriage Act (DOMA) to be unconstitutional. The result of this landmark case means that same-sex marriages enacted into law by any state will now be recognized for federal tax and benefit purposes.
The case, United States v. Windsor involved two New York women whose same-sex marriage was legally recognized by the state of New York. When one of the parties died, the IRS denied a federal estate tax marital deduction for the survivor and
accessed $363,053 in federal estate taxes on the taxable estate of the deceased. The U.S. Supreme Court found that DOMA violated the guarantee of equal protection and due process under the U.S. Constitution. The Court went on to state that the U.S. Constitution delegates no authority to the federal government on the subject of marriage and divorce.
Despite the ruling, the case does not require all states and state officials to recognize same-sex marriages. The Court let stand a provision of DOMA that permits a state not to recognize same-sex marriage. Therefore, many same-sex living arrangements will still be denied certain federal spousal benefits since 34 states currently do not allow same-sex marriage for their residents. The 16 states that currently recognize same-sex marriage are: California, Connecticut, Delaware, Hawaii, Iowa, Maine, Maryland, Massachusetts, Minnesota, New Hampshire, New Jersey, New Mexico, New York, Rhode Island, Vermont, and Washington. On June 1, 2014, Illinois will become the 17th state to recognize same-sex marriages.
It’s important to keep in mind that all states have certain residency requirements before couples may obtain a marriage license in that state. This residency requirement usually involves physically living in that state for a certain period of time and providing evidence of residency. So, a same-sex couple would have to play by the same rules as heterosexual couples
for purposes of satisfying the residency requirement of a state that also permits same sex marriage.
Once the state residency requirement is met, the marriage has been certified by either a civil or religious ceremony, and a marriage license has been issued, then the couple is considered to have been legally married and can move to any other state of their choice. This includes moving to another state that does not currently allow same-sex marriage. For all federal
tax and federal benefit purposes, this same-sex couple will be considered married. This is true even though the state they subsequently move to does not recognize same-sex marriage for any state law purposes.
For same-sex couples legally married in the 16 states permitting same-sex marriage, this also means that if these couples later divorce, they will be governed by the state laws of domestic relations and divorce in the state where they reside at the time of the divorce. These same-sex couples will have to negotiate property settlement agreements the same as heterosexual couples seeking divorce in that state. It should also be noted that the Windsor decision does not apply to so-called civil unions or domestic partnerships, which are permitted under certain state laws.
The Supreme Court decision in the Windsor case opened up a number of federal tax and benefit planning options to legally married same-sex couples in the 16 states that recognize such marriages. The federal tax and retirement benefit concepts that are now available for same-sex couples are:
Income tax filing flexibility: File Form 1040 U.S. Income Tax return as married filing jointly or as separate individuals. Same sex couples can now decide which tax filing regime will provide the lower amount of income tax liability;
IRA and Roth IRA spousal rollovers: Surviving spouses who are named as beneficiaries of a deceased spouse’s IRA or Roth IRA may do a “spousal rollover” into their own names and name a new beneficiary. This will allow a same-sex surviving spouse to do an IRA spousal rollover and defer any required minimum distributions until they reach age 70 ½; and
Nonqualified annuity rollovers: A surviving spouse who is a designated beneficiary may roll the nonqualified annuity into their own name, become the annuitant and designate a new beneficiary. This provision will allow a same-sex surviving spouse to continue the tax deferral of a non-qualified annuity all the way until the subsequent death of that same sex spouse.
Estate and gift taxes
Unlimited gift tax marital deduction: This will allow unlimited lifetime transfers of property between same-sex spouses who are U.S. citizens;
Gift splitting: A spouse has the option to allow the $14,000 gift tax annual exclusion and/or the $5,340,000 lifetime gift exemption to be used by the other spouse. This means the “split-gift” annual gift tax exclusion will be $28,000 and the “split-gift” lifetime gift exemption will be $10,680,000;
Unlimited estate tax marital deduction: Transfers of property at death to a surviving same-sex spouse who is a U.S. citizen will receive a 100 percent estate tax marital deduction. This was the specific issue decided in the United States v. Windsor case by the Supreme Court;
Portability for deceased spouse’s estate tax exemption:If elected on the Form 706 U.S. Estate Tax return, the surviving spouse may add any unused estate tax exemption of the deceased spouse to their own estate tax exemption to reduce or offset any federal estate taxes due at the death of the surviving same-sex spouse; and
Marital-credit shelter trust planning: Individuals may create a marital-credit shelter type of trust (aka A-B Trust, Family Trust, By-Pass Trust) to utilize part or all of the estate tax exemption/unified credit at the first death of the same-sex couple.
Presumably, this will also allow a QTIP (qualified terminable interest property) marital credit shelter trust to be utilized at the first death. A QTIP type of marital trust would allow the surviving same-sex spouse the right to receive only the income for life from the marital QTIP portion. The QTIP trust principal would pass to the remaining beneficiaries of the QTIP trust upon the death of the surviving same-sex spouse.
Social Security benefits
Social Security retirement benefits: Married same-sex individuals may choose between the larger of two potential benefits: A benefit based on their own work record or a benefit equal to 50 percent of their spouse’s Social Security benefit based on the spouse’s own work record;
Social Security survivor benefits: A surviving spouse can elect to take the larger of a Social Security benefit based on their own work record or a survivor benefit equal to the benefit the deceased spouse was receiving at death.
ERISA qualified plan benefits
Spousal pension benefits: Spousal benefit provisions of an employer’s qualified retirement plans (defined benefit, profit sharing, 401(k), etc.) and other welfare benefit plans should apply to same-sex spouses in the same way as are applied to heterosexual spouses;
Spousal pension benefit protection: The spouse of a participant in a qualified retirement plan must be the sole named beneficiary of the plan account unless the spouse has consented in writing to waive the right to receive any death benefit; and
Qualified domestic relations order (QDRO) or transfer incident to divorce (IRA): In a divorce decree, a court can award part of a spouse’s interest in the other spouse’s qualified retirement plan, 401(k) plan or IRA to be payable for their benefit.
But what happens when a same-sex couple is legally married in a state that recognizes same-sex marriage, but later moves their residence to a different state that does not recognize same-sex marriage? Will they lose their federal tax and benefit protections outlined above?
The U.S. Treasury Department and the IRS recently released Revenue Ruling 2013-17. This ruling addresses the topic of same-sex marriage, domestic partnerships, and civil unions, and how these relationships will be treated under federal law. The Windsor decision did not answer the question as to whether federal statutory law would look to the state where the same-sex couple was originally married or to their current state of residence.
Revenue Ruling 2013-17 answered a number of important issues related to federal law:
Same-sex couples legally married in a state that permits same-sex marriage will be treated as married for federal tax purposes whether or not they currently live in a state that recognizes same-sex marriage.
This federal tax treatment applies for all federal tax purposes, including income, gift and estate taxes and employee benefit plans.
The ruling does not apply to domestic partnerships and civil unions recognized under state law.
Future guidance will be issued by Treasury and IRS for the retroactive application of the Windsor case to other employee benefits and employee benefit plans.
In conclusion, the nationwide trend seems to be in the direction of more and more states legally recognizing same-sex marriage. Clearly, for federal tax and federal benefit planning purposes, same-sex marriage is a settled law based on the Supreme Court decision in U.S. v. Windsor and the issuance of Revenue Ruling 2013-17 by the IRS and the Treasury Department. Financial professionals will have to take this new tax and benefit planning landscape into consideration as they plan the financial affairs of legally married same-sex couples now and into the future.
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