On November 6, 2012, Maine, Maryland and Washington State joined New York, Connecticut, Iowa, Massachusetts, New Hampshire, Vermont and the District of Columbia in recognizing same-sex marriage. 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, the Defense of Marriage Act (DOMA) defines marriage as a relationship between one woman and one man at the federal level. Therefore, most federal law, including federal tax law, does not recognize same-sex marriage. This inconsistency can result in surprising and unwanted results without careful planning. While DOMA is currently being challenged in the Supreme Court via the Second Circuit, it still may be upheld in whole or in part. Until the Court issues a decision, a married gay couple in the Second Circuit should proceed as though DOMA were good law, but could also file a protective claim and preserve the right to amend returns to reflect treatment consistent with that of married heterosexual couples. Furthermore, until DOMA is struck down, married gay couples in all jurisdictions must continue to plan around the issues raised herein.
Much of family wealth planning is anchored around the unlimited marital deduction. This deduction allows an individual to transfer via gift or bequest unlimited assets to his or her spouse completely transfer-tax free. DOMA, however, prevents federal recognition of same-sex marriages, rendering the marital deduction inapplicable. Aside from the obvious additional cost in gift and estate tax, there are some less obvious tax traps where state property law and federal tax law intersect.
Most married couples own some property as joint tenants with a right of survivorship (hereinafter JTWROS). This type of ownership creates gift tax implications that are usually ignored for married couples because of the marital deduction, but for same-sex couples these implications must be carefully considered.
A common example is as follows: if the owner of property adds 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 an account cannot be severed unilaterally. The mere creation of this 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 – as it currently stands, the marital deduction will not shield them.
Along with these gift tax issues, joint ownership also creates estate tax complications for same-sex couples. If a spouse dies owning property as a JTWROS, one-half of the property is deemed included in that spouse’s estate. That half receives a step-up in basis and passes to the surviving spouse estate-tax free. For unmarried joint owners, which includes same-sex married couples under DOMA, not only is there no marital deduction, but it is presumed that the deceased joint tenant owned 100 percent of the property (or the funds used to purchase the property) and thus, 100 percent 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 jointly owned.
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 as a matter of law. But if same-sex spouses are more than 37 ½ years apart, an asset transfer can create not only gift or estate tax but GST tax as well.
While the Supreme Court will hear same-sex marriage cases in March, it is unclear how narrowly the decision will be tailored. If DOMA is largely unaffected by the ruling, 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.
Carl C. Fiore is a Managing Director in the New York office of WTAS LLC. He has significant experience with tax and financial matters affecting entrepreneurs, executives and other high-net-worth individuals. Mr. Fiore’s primary practice areas are gift and estate planning as well as fiduciary income tax. He also has experience in federal and state income tax consulting and compliance for individuals, partnerships, fiduciaries, estates, corporations and private foundations. He is a lead member of the firm’s estate planning group, which has extensive experience in serving the estate, gift, and fiduciary tax consulting and compliance needs of corporate and private trustees as well as individuals.
Rebecca M. Gornbein is a Senior Manager in the Private Client Services group at WTAS. Her primary practice areas are federal and state tax consulting and compliance for individuals, fiduciaries and partnerships. She specializes in high net worth individuals and their families, including those with international exposure.
WTAS is one of the largest independent tax firms in the United States, providing a wide range of tax, valuation, financial advisory and related consulting services to individual and corporate clients across the country.