State of the Same-Sex Union: A Tax Perspective

Over the last year and a half, there has been a whirlwind of activity affecting the legal rights of same-sex married couples. Same-sex couples and their advisors should be aware of the tax ramifications of these developments and the steps that can be taken to realize corresponding tax benefits, some of which are expiring soon.

The U.S. Supreme Court, in United States v. Windsor, 133 S. Ct. 2675 (2013), held that §3 of the Defense of Marriage Act (DOMA) was unconstitutional. Section 3 of DOMA, which was enacted in 1996, defined marriage for purposes of all federal laws to mean only “a legal union between one man and one woman as husband and wife,” thereby disallowing federal recognition of same-sex marriages. In Windsor, the surviving spouse of a same-sex couple sued for a refund of federal estate taxes paid by the deceased spouse’s estate. The couple was married in Toronto, Canada, and resided in New York, which recognized the validity of the marriage. The taxes would not have been payable had the estate qualified for the marital deduction, which was available for bequests to opposite-sex spouses only. By striking down §3 of DOMA, the Supreme Court, in effect, held that for purposes of applying federal law, same-sex married couples residing in a jurisdiction that recognizes same-sex marriages (recognition state) were to be treated the same as opposite-sex married couples. However, the Court did not decide the legal fate of same-sex married couples residing in a state, such as Florida, that does not recognize same-sex marriage (nonrecognition state).

The Windsor holding resulted in the extension of over 1,100 federal benefits, including several tax benefits, to same-sex married couples. However, a debate raged over whether federal benefits were available to same-sex married couples residing in nonrecognition states. In Rev. Rul. 2013-17, the U.S. Treasury Department and Internal Revenue Service ended the debate by adopting a “state of celebration” rule; for purposes of all federal tax laws, every same-sex marriage validly performed in a U.S. or foreign jurisdiction would be recognized, even if the spouses are domiciled in a nonrecognition state. The ruling also made clear that such tax treatment does not extend to unmarried individuals (same-sex or different-sex) in a registered domestic partnership, civil union, or other similar relationship recognized under state law.

Income Taxes

Federal Filing Option — Rev. Rul. 2013-17 set the ground rules for the filing status of same-sex spouses for their federal individual income tax returns. The ruling applies prospectively as of September 16, 2013.

Thus, starting with 2013, and for original 2012 returns filed on or after September 16, 2013, same-sex spouses must file their federal income tax returns as either “married filing jointly” or “married filing separately.” Married filing jointly typically is the more advantageous status because of certain limitations on deductions, credits, and exclusions that are imposed on married taxpayers who file separately. Depending on their particular situation, a same-sex couple who changes their status from single to married filing jointly might be subject to an increase in their aggregate federal income taxes (marriage penalty) or enjoy a decrease in their aggregate taxes. An increase in taxes is likely if both spouses have high incomes, and a decrease is likely if one spouse earns most of the couple’s income. Therefore, same-sex couples, particularly dual-income couples, may want to consider the income tax ramifications of marriage before walking down the isle.

For prior years, including 2012 returns filed before September 16, 2013, if the same-sex couple was married during the year, they may file an amended return to change their filing status from unmarried to married filing jointly or married filing separately. However, because married filing jointly status may result in a marriage penalty, an analysis of the couple’s particular situation is required before deciding to file amended returns. Furthermore, a claim for credit or refund is timely only if made within three years from the date the return was filed or two years from the date the tax was paid, whichever is later. Thus, for 2010 returns, the deadline to amend — April 15, 2014, or, if the original filing due date was extended, October 15, 2014 — has already passed, but the deadline to amend 2011 and 2012 returns is still open.

State Filing Issues

What about the recognition of marriage for state income tax purposes? Since the states traditionally defined “marriage,” each enacted statutes to regulate tax compliance consistent with its definitions. After Windsor, taxpayers are faced with complex and often confusing state compliance regimes. Though most states have issued guidance on how to file, many other matters have not been addressed. Moreover, there are pending court cases in many jurisdictions that could change the currently promulgated rules.

Couples residing in a state that only recently began recognizing same-sex marriage may question whether they are permitted to file amended state returns to claim a refund. Some states even require same-sex spouses to file amended state returns for years in which the state did not recognize the marriage, if the couple files an amended federal return.

Another area of confusion concerns situations when spouses reside in one jurisdiction but work in
another. Imagine the complexity if one spouse works in a state that prohibits a joint filing, such as Arizona, and the other spouse works in a state that requires a joint filing, such as California. Additionally, in some instances, it could be impossible to determine a state tax credit when the couple files both an income tax return in the state in which they reside and a nonresident return in a jurisdiction where they earn income.

When faced with the necessity of using different filing statuses at the federal and state level, taxpayers must also reconcile situations in which a deduction or credit allowed on a single return is different than that allowed on a married return. For instance, on a joint return, the capital loss deduction is limited to $3,000 per couple, but each single filer is allowed a full $3,000 deduction.

Seven states, including Florida, do not impose a state individual income tax.5 Nevertheless, taxpayers residing in those states need to understand what tax compliance may be required for other states in which they earn income.

The income tax rules of a majority of the states reference the Internal Revenue Code in some fashion to simplify the calculation of state taxes and to minimize the taxpayer’s burdens to fulfill the compliance. Thirty-one states6 and the District of Colombia reference federal adjusted gross income (AGI). Five states reference federal taxable income. Finally, there are seven states that have decoupled from the federal tax compliance regime and use their own state method to determine income tax. Five of those states require income to be recalculated, whereas two states assess their income tax only on interest and dividends.

As of this writing, marriage equality exists in 19 states and the District of Columbia.* Generally, when filing state income tax returns in these states, same-sex couples will use their federal filing status (usually married filing jointly). Thirty-one states, including Florida, have banned same-sex marriage through state laws, amendments to their constitutions, or both. There are pending marriage equality lawsuits in all of these nonrecognition states and in a number of the U.S. courts of appeals. An open issue is whether, in the nonrecognition states, same-sex spouses may use their federal filing status or are required to follow another compliance regime.

Twenty-five of the nonrecognition states impose a state income tax. These states use a hodge podge of income tax compliance methods.

A handful of states — Arizona, Kansas, North Dakota, Ohio, and Wisconsin — allow couples to split income from their joint federal return into two state returns, using a state-provided worksheet.

In defining “husband” and “wife,” Arizona statutes suggest cross referencing the I.R.C. Since there is no definition of “husband” and “wife” in the I.R.C., same-sex married couples must file Arizona state taxes as if they are single. Arizona’s Schedule S, Allocation of Income by Same-sex Couples Filing a Joint Federal Return, requires each taxpayer to determine his or her share of federal AGI. In addition, each taxpayer must file separate state returns, attach Schedule S, and use the single or head of household status, deduction, and tax rates. For couples that claimed Schedule A itemized deductions on their federal filing, each taxpayer who chooses to itemize on the state return must complete a federal Schedule A as if each taxpayer had filed a federal income tax return with the same Arizona filing status.

Kansas revenue statutes provide that “any term used in this act shall have the same meaning as when used in comparable context in the federal internal revenue code.” Nevertheless, although joint federal filers residing in Kansas must file a joint Kansas return, the Kansas Revenue Department has ruled that same-sex married couples must file their Kansas taxes as if they are single. The Revenue Department may be required to change its position based on the final outcome of Kitchen v. Herbert, 961 F. Supp. 2d 1181 (D. Utah 2013), affirmed, 13-4178 (10th Cir. 2014), stay granted, 134 S. Ct. 893 (2014).

Ohio taxpayers must file separate income tax returns indicating that Schedule IT S, Federal Adjusted Gross Income to be Reported by Same-gender Taxpayers Filing a Joint or Married Filing Separately Federal Return, supplements the Form IT 1040. The schedule is used by same-gender partners to re-determine their federal AGI, by allocating every line item as if they had filed using the single or head of household filing status. Finally, Ohio’s Department of Taxation indicated that even though the IRS permits the filing of amended federal returns to change filing status from single to married, no corresponding Ohio amended returns may be filed.

The instructions to Wisconsin’s Schedule S, Allocation of Income, indicate that even a member of a same-sex couple who used married filing separately status would need to complete the schedule if the amount of income would be different had the federal return been filed as single. Furthermore, Wisconsin requires the completion of Schedule OS, Credit for Net Tax Paid to Another State, to determine each spouse’s amount of credit. If both spouses had taxable income in another state, then each spouse may be able to claim a credit for tax paid to that other state on his or her separate Wisconsin return filed as single. The Wisconsin Department of Revenue also indicated that no amended returns may be filed when changing federal filing status.

Several states — Georgia, Idaho, Indiana, Kentucky, Louisiana, Michigan, Nebraska, North Carolina, Oklahoma, South Carolina, Virginia, and West Virginia — permit taxpayers to reference a pro forma or “dummy” federal return, reflecting single filing status.

The Kentucky Department of Revenue announced that the change in federal tax treatment has no effect on same-sex couples for Kentucky tax purposes. Same-sex couples legally married in a different state will be required to file separate Kentucky income tax returns. In accord, each taxpayer must provide the same federal income tax information on the Kentucky state return that would have been provided prior to the issuance of Rev. Rul. 2013-17. Similar to Kansas, Kentucky may be required to change its position if the state does not successfully appeal Love v. Beshear, 2014 WL 556729 (W.D. Ky. 2014).

In Michigan, although there is not a different rate structure, marital status is used to determine, inter alia, exemptions, eligibility for tax credits, and the taxability of employer-provided health care. Michigan statutes provide that taxpayers who file a joint federal return pursuant to the I.R.C. shall file a joint state return. However, a Michigan Treasury Department notice stipulated that its Income Tax Act limits a joint return to a married couple who are a “husband and wife.” Therefore, each same-sex spouse must separately report his or her Michigan AGI as a single filer.

North Carolina defines a “married individual” as one who is considered married as provided in I.R.C. §7703. Nevertheless, the North Carolina Department of Revenue has announced that same-sex spouses must file as if they are single. Such guidance conflicts with Bostic v. Schaefer, 2014 WL 3702493 (4th Cir. 2014), in which the Fourth Circuit (which includes North Carolina) struck down Virginia’s ban on same-sex marriage. ‘

Oklahoma defines joint return filers as those married individuals filing jointly and defines surviving spouse to the extent and in the manner that a surviving spouse is permitted to file a joint return under the I.R.C. provisions. However, pending the outcome of Bishop v. United States, ex rel. Holder, 962 F. Supp. 2d 1252 (N.D. Okla.), aff’d Bishop v. Smith, 2014 U.S. App. LEXIS 13733 (10th Cir. 2014), the Tax Commission’s position is that same-sex spouses must file as if they were single.

Alabama’s Department of Revenue has stated that, consistent with their constitution, same-sex couples cannot file joint income tax returns. Therefore, the regime requires spouses to apportion federal tax onto two single returns, using the ratio of each spouse’s federal AGI to the couple’s federal AGI. In addition, e-filers must use a specified web portal that does not depend on matching state and federal returns.

Colorado bans same-sex marriage, but recognizes civil unions and allows couples in civil unions (same-sex or different-sex) to file joint state tax returns. Missouri, pursuant to its constitution, does not recognize same-sex marriage, but Missouri’s governor issued an order that permits joint filing (although, eligibility for exemptions, deductions, and credits is uncertain).

Federal Estate and Gift Taxes

Windsor addressed the availability of the estate tax marital deduction to same-sex married couples. But, the marital deduction is just one of several important estate and gift tax benefits that are now available to such couples. Taxpayers and their advisers should be aware of these benefits and should consider amending estate and gift tax returns when appropriate.

Only returns for “open” tax years may be amended. For gift tax returns, which are due on April 15th (or, if extended, October 15th) of the year following the year in which the gift was made, the earliest year currently open is 2011. Estate tax returns are due within nine months (or, if extended, 15 months) of the decedent’s date of death. Therefore, the oldest estates for which estate tax returns are now open are for decedents dying after July 2010.

Unlimited Marital Deduction

The marital deduction permits a taxpayer, during life or after death, to transfer an unlimited amount of assets to his or her U.S. citizen spouse, without incurring estate or gift taxes. Prior to Windsor, if a married taxpayer left a bequest to his or her same-sex spouse, or made a gift to the spouse in excess of the gift tax annual exclusion ($14,000 in 2014), the bequest or gift reduced the taxpayer’s estate tax exclusion or lifetime gift tax exclusion (each of which is $5,340,000 in 2014). To the extent the exclusion was insufficient to shelter the bequest or gift, estate or gift tax was assessed. As a result of Windsor, bequests or gifts to a same-sex U.S. citizen spouse now qualify for the marital deduction, so that the bequest or gift will not be subject to transfer tax or reduce estate or gift tax exclusions. Therefore, taxpayers and their personal representatives should consider amending any open estate or gift tax returns that reflected a use of exclusion or tax due for bequests or gifts to same-sex spouses. In addition, same-sex married couples may now utilize marital deduction techniques, such as qualified terminable interest property (QTIP) trusts and qualified domestic trusts (QDOTs). They should have their wills and trusts reviewed by an estate planning professional to determine whether it is appropriate to incorporate one of these techniques (or others) into their estate plans.

Gift-splitting

Same-sex married couples, like their opposite-sex counterparts, are now permitted to split gifts, provided both spouses are U.S. citizens or residents. Gift-splitting is an election whereby spouses consent to treat their gifts to third parties as made one-half by each spouse. This, in effect, allows spouses to take advantage of their combined annual exclusions (in 2014, $28,000 per beneficiary) and their combined lifetime gift tax exclusions (in 2014, $10,680,000).

Portability

“Portability” of the estate tax exclusion is now available to surviving spouses in same-sex marriages. As noted above, under current law, each spouse has an estate tax exclusion of $5,340,000 (reduced by any exclusion used on lifetime gifts). If a decedent dies after December 31, 2010, without having used all of his or her exclusion, the unused portion (deceased spousal unused exclusion or DSUE amount) may be transferred to the surviving spouse. The DSUE amount may then be used to shelter the surviving spouse’s lifetime gifts from gift tax and, to the extent DSUE remains upon the surviving spouse’s death, to shelter his or her property from estate tax.

Portability is not automatic; it must be elected by a timely filed federal estate tax return for the first spouse to die. The due date of the estate tax return required to elect portability is nine months after the decedent’s date of death or the last day of the period covered by an extension (generally, six months, if an automatic extension is filed). However, many personal representatives and surviving spouses were not aware that a timely filed estate tax return was necessary to take advantage of portability. Furthermore, before Windsor, surviving spouses in same-sex marriages were operating under the assumption that portability was not even available to them.

Therefore, early in 2014, the IRS issued Revenue Procedure 2014-18, which provides an extension of time to file an estate tax return to elect portability. The extension is until December 31, 2014, and is available for estates of decedents dying in 2011, 2012, or 2013 for which an estate tax return was not filed or required to be filed (because the combined value of the gross estate and adjusted taxable gifts was less than the estate tax exclusion amount). Therefore, there are still a few weeks to take advantage of the extension.

State Transfer Taxes

Federal estate and gift taxes are not the only transfer taxes to think about. Many U.S. jurisdictions assess their own estate taxes on the estates of resident decedents and on property owned by nonresident decedents that is located in the jurisdiction. In addition, six states impose an inheritance tax — a tax on individuals who inherit from a deceased resident. The states with an estate tax allow an unlimited marital deduction for bequests to a surviving spouse, and the states with an inheritance tax-exempt property inherited by a surviving spouse. Thus, for same-sex spouses, the issue is whether the state will recognize their marriage for purposes of applying its estate or inheritance tax rules. The good news for same-sex spouses is that most of these states already recognize same-sex marriage, with the exception of Kentucky, Nebraska, and Tennessee.

State gift taxes are very limited. In fact, Connecticut is the last remaining state that imposes a gift tax. However, because Connecticut recognizes same-sex marriages and has an unlimited marital deduction, the tax does not apply to gifts between same-sex spouses.

Nontax Issues

Currently, under Florida law (and the laws of other nonrecognition states), there are a number of state-based, nontax benefits available to opposite-sex married couples that are not available to same-sex married couples. In Florida, these benefits include, to name a few, a surviving spouse’s right to inheritFlorida homestead property and to receive an elective share of a deceased spouse’s estate, as well the right of spouses to own property as tenants by the entirety (which provides certain asset protection benefits). A detailed discussion of these benefits is beyond the scope of this article. However, same-sex couples and their advisors should keep a close eye on any changes to Florida’s laws that affect such rights and revisit their estate plans in the event of such changes.

Conclusion

Though the Windsor decision effectively ripped the doors from the hinges of the federal benefits closet, same-sex spouses are still faced with complex and confusing state tax compliance regulations. It seems that it will take another U.S. Supreme Court decision, holding that all same-sex couples have the right to marry, to usher in a more perfect union.

*UPDATE: As of November 17, 2014, more than 30 states and the District of Columbia allow same-sex marriage. Visit CNN.com for an interactive map tracking same-sex marriage laws in the U.S.

This work was originally published in The Florida Bar Journal November, 2014 Volume 88, No.9. This work has been reprinted in Florida with the permission of The Florida Bar.