United States v. Windsor: A New Direction in Planning for Same-Sex Couples
On June 26, 2013, the U.S. Supreme Court in United States v. Windsor1 overturned Section 3 of the Defense of Marriage Act ("DOMA"), which had defined marriage as a union between a man and a woman.2 As a result, married same-sex couples who live in a state that recognizes their marriage are now treated as married under federal law.3 Windsor does not, however, require that all states permit or recognize same-sex marriage.4 Further, the language of the decision suggests it does not apply to couples who are parties to a civil union or domestic partnership, nor to couples who reside in a state that does not recognize same-sex marriage. In addition, because the Court found Section 3 unconstitutional as of its enactment in 1996, the effective date of the resulting legal changes remains uncertain. In spite of these unknowns, Windsor offers enough guidance to dramatically shift personal and tax planning strategies, both for same-sex couples and for third parties who wish to provide for them.
What Has Changed
Provisions of federal law applicable to married persons now apply equally to married same-sex couples living in a jurisdiction that recognizes their marriage. With respect to tax and estate planning issues, some of the most significant changes for these couples include the following:
1. Federal Income Taxes
Married taxpayers who are not separated must file their returns as "married" persons.5 Before Windsor, married same-sex couples were required to file federal income tax returns as either "single" persons or as "head of household." Post-Windsor, the married couple must file income tax returns either as "married filing jointly" or "married filing separately." For couples with a disparity in income, this may result in substantially lower taxes, but dual high-income couples will likely pay more tax. Couples for whom filing as "married" results in income tax savings may amend recent tax returns. An amended return that makes a claim for refund can be filed within three years of the date of filing the original return or two years from the date the tax was paid, whichever is later. Significantly, however, there is no obligation to file amended returns, and taxpayers should be aware that filing amended returns may subject the returns to further scrutiny regarding income and deductions reported.6
2. Estate and Gift Tax Planning
Couples who fall within the Windsor class of married couples now enjoy the favorable federal transfer tax benefits afforded all married couples for wealth transfer planning, but also are subject to the restrictions applicable to planning for related parties:
- Marital Deduction Planning. The federal gift and estate tax unlimited marital deductions are now available to these couples. Previously, gift and estate tax would have been imposed on the transfer of assets between the spouses as though they were unrelated persons. Assets can be transferred between them, outright or in trust, effectively deferring transfer tax to the death of the survivor.7 This allows the couple to rearrange ownership of assets to minimize transfer taxes, obtain creditor protection and plan appropriately for the survivor's liquidity needs.
- Portability. Portability permits a surviving spouse to use the predeceasing spouse's unused federal estate tax exclusion to make additional gifts tax-free or reduce the survivor's estate taxes upon death.
- Community Property Interests. Couples in community property states that recognize same-sex marriage will now receive a full step-up in basis for income tax purposes on community assets at the first spouse's death.8
- Disclaimers. A surviving spouse may disclaim certain property interests while retaining other interests in the same property, unlike other beneficiaries, who cannot retain any interest in disclaimed assets. Particularly with trust planning, disclaimers are a useful post-mortem planning tool.
- Spousal Election. Prior to Windsor, a surviving spouse could take advantage of a state level right of election (a right to receive a share of the deceasing spouse's property) in some states, but could not take advantage of the associated federal estate tax benefit from the marital deduction. After Windsor, the spousal election may provide appropriate planning for the surviving spouse without a potentially disastrous estate tax impact.
- Insurance Planning. The availability of the marital deduction and portability may impact life insurance planning, as the burden of the estate tax can now be deferred until the surviving spouse's death. Consequently, "second-to-die" policies may now be more appropriate than single life policies.
- Lifetime Gifting. Windsor impacts couples who contemplate lifetime gifting. Married couples now may "split gifts" to third parties. Previously, if one spouse had significantly greater wealth, he or she was limited to the annual exclusion and unified credit, without the ability to use the spouse's exclusions and credit.
- Generation-Skipping Tax Planning. Post-Windsor, there are additional options to maximize the generation-skipping tax planning for the remainder beneficiaries by fully applying both spouses' exemptions to the trust planning. This is especially valuable if one spouse has significantly more assets than the other.9 A reverse-QTIP election can be made with respect to a marital trust for the surviving spouse, and the surviving spouse can allocate GST exemption to the non-exempt marital trust.
- Grantor Trust Planning. Irrevocable trusts that include the spouse as a beneficiary are treated as grantor trusts for income tax purposes, with the result that the donor continues to be legally responsible for the income recognized by the trust. The donor's payment of taxes is a tax-free gift, as trust assets are not diminished by income taxes, nor are the beneficiaries burdened by the tax. After Windsor, there are additional opportunities for planning with grantor trusts for same-sex married couples. Conversely, those who have already created irrevocable trusts naming a spouse as trustee or as a beneficiary should confirm that grantor trust status is not inadvertently created because of Windsor.
- Previous Planning with Techniques Not Available to Related Parties. Prior to Windsor, same-sex couples could take advantage of estate planning techniques not available to couples treated as married for federal tax purposes. Popular techniques to transfer wealth included residence trusts, common law GRITs, loans without adequate interest and shareholder agreements that did not comport with the requirements of §2703. These techniques should no longer be used for couples who fall within the Windsor decision. For domestic partners and married persons living in a state that does not recognize their union, these techniques should not be used until further guidance is received from IRS.
3. Marriage & Divorce: Prenuptial and Postnuptial Agreements and Property Settlements
- Amendments to Prenuptial and Postnuptial Agreements. Many agreements governing the relationships of same-sex couples incorporate provisions to address the prior unavailability of certain income tax benefits in unwinding their legal relationships. Some agreements may require amendment if the change in tax laws results in unintended consequences.
- Alimony and Property Settlement on Divorce. Federal recognition of a couple's marital status provides clarification of the treatment of certain payments:
- alimony may now be deductible to the payor spouse and taxed as income to the payee spouse, or may be treated as a non-income producing event at the election of the parties
- lump sum property settlements may now be made without recognition of gain, so long as they meet the other requirements of the Code
- Qualified Domestic Relations Orders (QDROs), which divide retirement benefits on divorce, are now available
Working Through the Uncertainty
Windsor's narrow application leaves several practical questions for same-sex couples, regardless of whether they live or own property in a jurisdiction that recognizes their marriage, civil union or domestic partnership. The IRS promised additional guidance in the following message on June 27, 2013:
We are reviewing the important June 26 Supreme Court decision on the Defense of Marriage Act. We will be working with the Department of Treasury and Department of Justice, and we will move swiftly to provide revised guidance in the near future.
Until then, Windsor's application beyond its narrow holding is uncertain. On its face, the Windsor decision turns on state law recognition of marriage, and is limited to marriage. According to the decision, the definition of "marriage" between a man and a woman was always unconstitutional. These points raise numerous questions, including:
- Whether a married couple would no longer be treated as married upon moving to a jurisdiction that does not recognize same-sex marriage, resulting in a "musical chairs" approach to taxation.
- Whether a couple that has entered a civil union or domestic partnership is deemed "married" under federal law, particularly if the state statute provides that those parties are afforded the same legal benefits as spouses. There are indications the IRS may take an expansive view for the sake of uniformity. In private guidance, the IRS indicated pre-Windsor that parties to an Illinois civil union, for example, are "not precluded from filing [income tax returns] jointly."10 Similarly, the IRS has ruled that California registered domestic partners should each report their income as would a married couple living in that state.11
- Whether third parties who make gifts to spouses of their descendants might be making generation-skipping tax transfers, depending on whether the spouse is recognized as a spouse or not. It is not clear whether the law of the state of the donor (i.e., the creator of the trust), the donee or the trust would apply for this determination. Furthermore, it is not clear whether the determination would be made at the time the interest is created or at the time of a trust distribution.
- Whether those who would have been entitled to federal benefits in the absence of DOMA may claim them retroactively and, if so, what that process will be.
What to Do Next
Although many questions remain, Windsor does provide an initial framework to guide same-sex couples and their families in the planning process:
- Those couples to whom the case clearly applies should file their income tax returns as married taxpayers and, if appropriate, may amend prior returns. Other same-sex couples may file separately and file a concurrent protective claim for refund, notifying the IRS that they may claim a refund pending changes in tax law or other legislation. The same is true for gift and estate tax returns where the interest transferred would qualify for the marital deduction.
- All same-sex couples should revisit estate planning documents for marital deduction planning to the extent appropriate, and in particular, to review clauses governing the source for payment of tax.
- Windsor does not automatically recognize all same sex partners as spouses. Families who wish to provide this recognition in their estate plan must incorporate explicit language into their relevant instruments. While this will not change the tax impact of the plan, it will ensure that those who are intended to be beneficiaries will receive their share of the estate.
- Consider the need for amendment of prenuptial or postnuptial agreements. Even if tax considerations suggest the benefit of amending prenuptial agreements or creating a postnuptial agreement, the couple may be unwilling to reopen such discussions limited to tax issues. In addition, the requirements for such agreements are heavily dependent on state law.
Windsor is widely regarded as a landmark case. Its practical application will become clearer over time. In addition to the changes discussed in this alert, the decision affects retirement benefits, social security benefits, immigration status, veterans' or military spousal benefits, and multiple other federal laws and programs. For more information about how Windsor affects tax and other issues, please contact the authors of this alert or your Holland & Knight lawyer.
1 570 U.S. ____ (2013).
2 1 U.S.C. §7.
3 Prior to Windsor, such marriages were recognized for state purposes (such as probate and state and local taxation), but not for federal purposes (such as social security and federal taxation).
4 Fourteen jurisdictions currently recognize same sex marriage: California, Connecticut, Delaware, Iowa, Maine, Maryland, Massachusetts, Minnesota (effective August 1, 2013), New Hampshire, New York, Rhode Island (effective August 1, 2013), Vermont, Washington and the District of Columbia.
5 The determination of whether an individual is married is made at the close of the taxable year.
6 Although taxpayers have a legal duty within any applicable statute of limitations to pay the correct tax, neither the Internal Revenue Code nor the Treasury Regulations require taxpayers to unilaterally correct tax return submission errors or omissions. Instead, the regulations provide that, upon discovering an error or omission involving an understatement of income or an overstatement of deductions, a taxpayer "should" file an amended tax return and pay any tax due. As of this date, it is not clear that the IRS will in fact issue refunds.
7 This is only true if the donee-spouse is a U.S. citizen. The law restricts marital deduction transfers to all non-citizen spouses.
8 In addition, same-sex married couples who live in community property states that recognize same-sex marriage (California and Washington) must split income earned evenly between the spouses, unless the couple has opted out of community property treatment or has a prenuptial agreement. While DOMA was in effect, this rule also applied to Nevada, which recognizes civil unions. See also footnote 11.
9 For couples where there is a disparity in age that exceeds 37 1/2 years, there will no longer be exposure to the GST tax for gifts during life or at death to the other spouse, as they will be treated as being of the same generation. In addition, no adverse GST impact will apply to gifts to a son-in-law or daughter-in-law who is more than 37 1/2 years younger than the donor.
10 See, e.g., 750 ILCS 75/20, governing civil unions in Illinois.
11 PLR 201021048, requiring that each partner follow community property rules and report one-half of the income of both partners on their respective income tax returns.
To ensure compliance with Treasury Regulations (31 CFR Part 10, §10.35), we inform you that any tax advice contained in this correspondence was not intended or written by us to be used, and cannot be used by you or anyone else, for the purpose of avoiding penalties imposed by the Internal Revenue Code.
Information contained in this alert is for the general education and knowledge of our readers. It is not designed to be, and should not be used as, the sole source of information when analyzing and resolving a legal problem. Moreover, the laws of each jurisdiction are different and are constantly changing. If you have specific questions regarding a particular fact situation, we urge you to consult competent legal counsel.