Estate And Gift Tax Considerations Post-Windsor

Wednesday, August 7, 2013 - 10:57

The Editor interviews Carl C. Fiore, Managing Director in the New York office of WTAS.

Editor: Please tell us about your background.

Fiore: I am an attorney by training, having received my LLM in estate planning from the University of Miami. I focus in the trust and estate area, and my involvement in planning for same-sex couples began with wealth transfers between same-sex couples and their families.

Editor: What choices did same-sex couples living in states that recognize same-sex marriage (“recognition states”) have before Windsor regarding their federal and state tax filing status?

Fiore: They really didn’t have a choice. Same-sex couples living in recognition states found themselves in an interesting situation: for both income and transfer tax, they were forced to file as married couples for state purposes but as single individuals for federal purposes.

Editor: Outline for us if you would the tax benefits for federal recognition of same-sex marriage for parties living in recognition states. In addition to lower marginal rates in most cases, what are some other benefits?

Fiore: There are tremendous benefits. For tax purposes, it was decided a long time ago that married couples would be treated as one economic unit, and as a result the tax law evolved such that economic interactions between spouses were supposed to move seamlessly.  DOMA effectively prevented this for same-sex couples.

The most obvious benefit is the ability to file joint returns – keeping in mind that, because of the so-called marriage penalty, in some situations filing a joint return could actually be a detriment. Many of the rate schedules and benefit phase-outs are more advantageous for married couples. For example, if one spouse is earning all the income, because of the graduated rates and phase-outs at higher income levels for married couples, that couple will end up paying less tax as a married couple than they would as individuals. On the other hand, if both spouses are earning around the same, even though the same rates and phase-outs apply as they did in the first example, they could end up paying more tax as a unit because those beneficial rates and phase-outs do not fully track two separate incomes.   

That said, most married couples will likely still find themselves in a better situation filing joint returns, especially when taking into account other tax considerations such as capital gains. If one spouse has capital loss and the other has a capital gain, they can offset each other. Likewise for passive activity loss: if one spouse has ordinary loss from investments that he or she can’t take against their other income because of certain limitations and the other spouse is generating passive ordinary income, these, too, can be netted on a joint return.

There’s also a benefit for couples who divorce. As I said before, the tax law evolved so that there were no adverse tax consequences from economic interactions between each spouse. The same is true in the divorce context. Therefore, the law says that there are no negative tax implications when property is exchanged as part of a settlement.  Before Windsor, a same-sex married couple that divorced could be taxed when property was exchanged as part of a settlement.

On the transfer tax side, far and away the biggest benefit is the marital deduction.  There are no transfer taxes when one spouse either gives during life or leaves at death property to the other, which is a tremendous benefit when you’re talking about wealth transfer. In Windsor, because there was no marital deduction, the estate had to pay $400,000 in taxes.  When you think about what $400,000 could be worth if a surviving spouse lives 10 years or more, this benefit becomes clear.

Another significant benefit on the transfer tax side is the ability to gift-split. If one spouse makes a gift, for tax purposes that gift can be treated as being made 50/50 by the spouses. As a result, both spouses can take advantage of their $14,000 annual exclusion regardless of who actually makes the gift, thereby allowing them to use less gift tax exemption, as well as potentially use less of their generation-skipping tax exemption.

Furthermore, if you have a retirement account or IRA, a surviving spouse can now roll that over completely tax-free into his or her spouse’s account instead of having to start taking money out of the IRA, which creates taxable income.

Another relatively new benefit is portability, which allows a surviving spouse to essentially take or use the deceased spouse’s unused estate tax exemption. Currently the estate tax exemption is $5.25 million. Surviving spouses can take on the deceased spouse’s exemption, resulting in an exemption of $10.5 million, which they can then use to make gifts during their life or to offset taxes when they die.

Editor: How do federal taxes depend upon a couple’s domicile state?

Fiore: That’s really the next big issue. Initially, when Windsor was decided, people thought that the decision not only resolved some fairness issues, but that it also cleared up some confusion about how same-sex couples would be treated. However, in reality, it created more confusion because now being a same-sex couple means something different depending on your domicile state. Furthermore, rules within some states remain unclear.

If you’re in a married same-sex couple in New York, it’s very clear that you are a married couple and that you will be treated exactly the same as other married couples for federal tax purposes going forward. But if you go to New York and get married, and then go back to your home state of New Jersey, which doesn’t recognize same-sex marriage, what do you do? Without further IRS or legislative guidance, you may still have to file as not married for federal tax purposes even though you are legally married.

Editor: How does filing jointly as a married couple differ from filing as a civil union or registered domestic partnership in states that recognize those legal equivalents of marriage?

Fiore: It depends state to state, and, again, Windsor brought some of this confusion to the forefront. For example, in 2007, the New Jersey legislature passed a civil union law that gave same-sex partners all of the benefits, responsibilities and obligations of marriage. So, even before Windsor, same-sex couples in New Jersey could file joint returns for state purposes (as well as enjoy all other married couple tax implications in New Jersey), but for federal purposes, they were not treated as married.

Windsor’s scope was a bit narrow: it only addressed marriage in states that recognized same-sex marriage and left out the permutations of “legal equivalents” of marriage – such as civil unions – that exist in non-recognition states. So, in states like New Jersey, no one’s quite sure what you can do for federal purposes. On the other hand, Illinois also allows civil unions, but you cannot file joint returns for state purposes in Illinois because their civil union is different from New Jersey’s. The next evolution of Windsor hopefully will speak to this quandary.

Editor: May same-sex couples file amended tax returns for previous years?

Fiore: That’s another interesting question, which is somewhat easier to answer because at least we know what time period we’re dealing with: generally you have a three-year statute of limitations in order to amend your return to claim a refund. From a legal standpoint, generally when the Supreme Court decides something is either constitutional or unconstitutional, this means that it has always been constitutional or unconstitutional. Therefore, one should be able to amend a return for as long as the statute of limitations is open.

Now, even though that may be the correct treatment, you don’t know for sure until the IRS or legislature actually tells you so. Probably the best thing to do is to go back, amend the return and file it. Once it’s filed, one way or another the IRS has to deal with it. Either they will process it and presumably issue a refund, or they will deny it. If they deny it, you have  the option of an administrative appeal through the IRS, as well as a judicial appeal if there’s enough at stake.

Editor: Do you have any advice for high-income same-sex couples living in recognition states regarding their gift and estate tax returns?

Fiore: The first thing I would do is go back and look at the old returns.  It probably makes sense to amend returns and claim a marital deduction on any transfer for which a marital deduction was not claimed.

Also, I would go back and review the actual gifts that were made. At the end of 2012, it looked like the $5 million estate tax and gift tax exemption was going to be reduced to $1 million, and many couples – both heterosexual and same-sex– thought they were in a use-it-or-lose-it situation. As a result, a lot of gifts were made, and a lot of trusts were set up. Many same-sex couples, although the real intention was transferring money to the spouse, created a trust that had a same-sex spouse and other beneficiaries – this being the best option in the absence of a marital deduction. 

As it turned out, the $5 million exemption was not reduced, and now, post-Windsor, same-sex couples have found themselves in a less-than-optimal situation. There may be a way to undo such a gift through a legal remedy known as recission by mistake of law. If the spouse’s intention really was simply to transfer money to his or her spouse – not to make a gift into the trust and use the exemption– then a recission by mistake of law might be an avenue to consider.

Editor: What about those couples living in marriage-equality battleground states?

Fiore: While it’s hard to predict what will happen, it seems that the momentum is moving towards recognition of same-sex marriage. I would give the same advice: if there would be a tax benefit, go back and amend the returns. Once you file an amended return, you keep the statute open until the IRS makes some determination.  As a practitioner, I’d much rather get a call from a client who tells me, “I got a letter from the IRS, and they’re denying the amended returns and will not issue a refund” – to which we can respond – than to hear from a client who tells me, “My state recognizes same-sex marriage, but the statute of limitations has passed on some open returns. We should have filed amended returns.”

I would also recommend revisiting any estate plans that were set up and consider incorporating a marital deduction, then reexamining other estate plan documents – such as power of attorney and healthcare proxies – on which a same-sex couple may have been reluctant to name a spouse as agent.

Editor: It’s interesting how this is bringing taxes into a big civil rights issue.

Fiore: There’s virtually nothing you can do that doesn’t have some tax implication. And once you start putting numbers to real-life events, it becomes rather obvious that one group is not being treated the same as another group. Money is something everyone can understand. When you – by virtue of being in a heterosexual couple – don’t have to pay $400,000 when your spouse passes away, while another person – by virtue of being in a same-sex couple – does have to pay this amount, it’s easy to see in a real, tangible way how people are being treated unequally. 

Please email the interviewee at carl.c.fiore@wtas.com with questions about this interview.