Editor: Theodore J. Sarenski, CPA/PFS, CFP, AEP
Update: On Aug. 29, 2013, the IRS issued the first guidance regarding the tax treatment of same-sex married couples. For more information, see, "All Legal Same-Sex Marriages to Be Recognized for Tax Purposes, IRS Says."
According to the 2010 U.S. Census, there are more than 130,000 married, same-sex couples in the United States. Presently, they have the right to marry in 13 states and the District of Columbia. Up to now, planning for clients in same-sex marriages has been a “belt and suspenders” approach.
Their issues are addressed with “layers” of planning: revocable living trusts, limited liability companies, management trusts, grantor retained income trusts (GRITs), IRA trusts, and the like. Though these same-sex couples do not have the same benefits as traditional married couples, appropriate planning can achieve benefits that are reasonably close. This column provides practitioners with an overview of the impact of the recent decision by the Supreme Court striking down a key provision in the Defense of Marriage Act (DOMA), P.L. 104-199; a preliminary checklist of areas to be addressed with same-sex clients; and a discussion of the issues involved.
On June 26, the Supreme Court rendered a decision in Windsor, No. 12-307 (U.S. 6/26/13). In this decision, the Court held Section 3 of DOMA unconstitutional. Section 3 of DOMA reads as follows:
In determining the meaning of any Act of Congress, or of any ruling, regulation, or interpretation of the various administrative bureaus and agencies of the United States, the word “marriage” means only a legal union between one man and one woman as husband and wife, and the word “spouse” refers only to a person of the opposite sex who is a husband or a wife.
The Windsor case arose from a claim for an estate tax refund. Edith Windsor and her spouse, Thea Spyer, were partners for 40 years. They were legally married in 2007, in Ontario, Canada. They were residents of the state of New York at the time of their marriage, as well as at the time of Thea Spyer’s death in 2009. Spyer left her entire estate to her spouse, Windsor.
Their marriage was legally recognized under New York state law at the time of Spyer’s death. Because their Canadian marriage was valid, they held the status of spouses under state law. However, as a result of DOMA, they were not recognized as spouses under federal law.
The absence of federal recognition of their marriage meant Spyer’s estate was required to pay a federal estate tax of $363,053, even though all of her assets went outright to Windsor. If their marriage had been recognized by federal law, no federal estate tax would have been due because the transfer would have qualified for the federal estate tax deduction for marital transfers. Windsor paid the estate tax and then brought a refund suit. Her claim was that DOMA violated her Fifth Amendment rights under the U.S. Constitution: “No person shall be . . . deprived of life, liberty, or property, without due process of law; nor shall private property be taken for public use, without just compensation.”
The Supreme Court found Section 3 of DOMA unconstitutional. However, it is important to note, the court did not legalize same-sex marriages. The court did provide that a same-sex couple, married and residing in a state that permits such marriages, is considered married for purposes of federal law.
Additionally, the ruling does not address a same-sex couple who are married in a state that permits such a marriage and then move to a state that does not recognize same-sex marriage. Also not addressed by the court are situations involving parties to a state-sanctioned civil union or a registered domestic partnership. The ruling does not establish a constitutional right to same-sex marriage.
This decision does, however, affect more than 1,000 federal laws that apply to married individuals. It affords same-sex married couples, who are married and reside in a state that recognizes same-sex marriages, the same federal rights and obligations as heterosexual married couples.
As a result of the DOMA ruling, same-sex couples face a host of planning issues—or opportunities—from Social Security benefits to portability in estate planning. The ruling states that same-sex couples are entitled to the same federal benefits as opposite-sex couples. As a result, one would think that planning for same-sex couples would be less complicated. On the contrary, it makes planning more complicated.
Yes, federal benefits are immediately extended; but with more than 1,000 laws affected, it may take some time to fully implement the changes. Federal agencies will need to review and modify rules and regulations. Additionally, employers will need to review and revise their policies, benefits, and paperwork. Same-sex couples now have new choices, and consequences, that will need to be considered when developing and executing an integrated financial plan. Finally, planning should anticipate (as much as possible) other areas, such as tax law, which will require additional rule-making before same-sex couples are treated equally (for tax purposes).
It is critical to address these issues as part of comprehensive personal financial plan. The AICPA’s Proposed Statement on Standards in Personal Financial Planning Services states: “PFP is the process of identifying personal financial goals and resources, designing financial strategies, and making personalized recommendations (whether written or oral) that, when implemented, assist the client in achieving these goals.”
Checklist of Items to Be Addressed
The Content Specification Outline for the AICPA Personal Financial Specialist Exam is an excellent starting point for a checklist of items to be addressed for clients who are affected by the DOMA ruling. While there are more than 100 topic areas that may be addressed, far too many to discuss in this column, there are 11 main subject areas. Paring the list further, there are four critical areas: income tax planning, financial independence, employee benefits, and estate planning. These items should be included in every financial planning review. The items presented for consideration are by no means exhaustive and are intended as a beginning point, rather than an end.
Note: All of the following recommendations presume the relevant tax and federal regulations have been corrected to reflect the striking down of DOMA.
Income Tax Planning
Of all the areas of the checklist, this one has generated the most interest from clients of the author’s firm who are affected by this ruling. They are asking questions about this year’s return as well as previous years’ returns.
Example: P and A are a same-sex married couple. Had they been able to file their 2012 Form 1040, U.S. Individual Income Tax Return, jointly, their federal refund would have been $7,100. Filing separate individual returns, they paid $57,000 in income tax. Two of the greatest opportunities for same-sex married couples are an amended return or a protective claim.
Amended return: Both state and federal returns for open years should be amended to correct information that will alter the tax calculations. Returns may be amended to correct filing status, dependents, income, deductions, or tax credits. For example, one spouse could have had capital losses on investments in years past that the other spouse’s gains could offset if they had been permitted to file joint federal returns.
Protective claim: When the right to a refund is contingent and may not be determined until after the time period for amending returns expires, a taxpayer can file a protective claim for refund. The claim is often based on current litigation (constitutionality); expected changes in tax law; and other changes in legislation or regulations. A protective claim preserves the right to claim a refund when the contingency is resolved.
Generally, two main entities provide benefits to a surviving spouse—employers and the federal government. Benefits provided by employers run the usual gamut: life, disability, health insurance, and the like. Then, there are the federal benefits, which include Social Security, veterans benefits, and Federal Employees Retirement System pensions.
Since 1939, Social Security has provided benefits for a spouse and minor children of a retired worker (dependent’s benefits) and survivor’s benefits for a family in the event a worker who qualifies for benefits dies prematurely.
Survivor benefit: When an individual dies, his or her surviving spouse may be eligible for Social Security benefits if the surviving spouse is age 60 or older, age 50 or older and disabled, or any age if he or she is caring for the decedent’s child who is younger than age 16 or disabled and entitled to Social Security benefits on the deceased individual’s work record.
Divorce: If an individual is divorced, his or her ex-spouse may qualify for Social Security benefits based on that individual’s earnings. Generally, a divorced spouse must have been married to the individual for at least 10 years and have been divorced at least two years. Additionally, the divorced spouse must be at least age 62, unmarried, and ineligible for an equal or greater benefit based on his or her own earnings or someone else’s earnings.
Death benefit: There is a one-time death benefit of $255 paid to the decedent’s surviving spouse or minor child.
The Retirement Equity Act (REA) of 1984 is directly affected by Windsor. REA amended the Employee Retirement Income Security Act (ERISA). REA’s changes to ERISA include:
- Qualified pension plans must provide automatic survivor benefits and allow for waiver of survivor benefits only if the participant and the spouse consent.
- Pension plans may obey certain domestic relations court orders requiring them to make benefit payments to a participant’s former spouse without violating ERISA’s prohibitions against assignment or alienation of benefits.
QPSA/QJSA: These are annuity benefits for qualified plans when a participant dies pre- or post-retirement. The qualified preretirement survivor annuity (QPSA)/qualified joint and survivor annuity (QJSA) is a form of a death benefit paid as a life annuity to a participant’s surviving spouse. In the case of a QPSA, the participant must have been vested in his or her retirement plan benefits, have died before retirement, and have a surviving spouse.
QDRO: A qualified domestic relations order (QDRO) is a domestic relations order that creates, or recognizes, an alternate payee’s—former spouse, child, or other dependent’s—right to receive, or assigns to an alternate payee the right to receive, all or a portion of the benefits payable to a participant under a retirement plan.
Spousal consent: In a defined benefit or money purchase plan, the retirement benefit must include a survivor’s benefit. If the participant chooses not to elect the survivor’s benefit, both the participant and the participant’s spouse must sign a written consent to the alternative payment method. In a defined contribution plan, if a participant wishes to select a beneficiary, other than his or her spouse, the spouse must consent by signing a waiver. The spouse’s signature must be witnessed by a notary or plan representative.
Surviving spouse/inherited IRA: A surviving spouse has two options (a third option, beneficiary, is usually not elected with a surviving spouse) with an inherited IRA: (1) treat it as his or her own IRA by designating himself or herself as the account owner or (2) treat it as his or her own by rolling it over into his or her IRA.
Family and Medical Leave Act (FMLA): The FMLA entitles eligible employees of covered employers to take unpaid, job-protected leave for specified family and medical reasons with continuation of group health insurance coverage under the same terms and conditions as if the employee had not taken leave to care for a child, spouse, or parent.
Health benefits: Because of DOMA, employers that allow an employee to add his or her same-sex spouse to a health plan had to impute income to the employee for federal income tax purposes equal to the fair market value of health coverage provided to the same-sex spouse. (Premiums companies pay for health insurance coverage for married spouses, however, are not taxable to the employees.) Additionally, DOMA precluded same-sex married couples from sharing the same benefits in health care flexible spending accounts, health savings accounts, and health reimbursement arrangements.
Estate planning is the genesis of the Windsor case because the loss of the unlimited marital deduction precipitated the litigation. Estate and gift tax returns and asset titling provide many opportunities for personal financial planning (PFP) practitioners to be of service to clients.
Marital deduction: The marital deduction allows an individual, upon death, to transfer an unlimited amount of assets to the surviving spouse free from estate tax. The marital deduction is an estate preservation tool because assets can be distributed to surviving spouses without incurring estate or gift tax liabilities.
Gifts: The federal government imposes a gift tax on certain lifetime transfers made by any individual. This gift tax does not apply to transfers between spouses (unless one spouse is not a U.S. citizen). There is no limit to the amount of assets that can be transferred between spouses.
Gift splitting: Before the repeal of Section 3 of DOMA, only opposite-sex married couples were allowed to “split” gifts. A split gift is a gift made to a third party, in which the gift is considered as made one-half by each spouse. Gift splitting allows a married couple to “double” the annual gift tax exclusion amount. Each spouse must agree to split the gift.
Portability: The American Taxpayer Relief Act of 2012, P.L. 112-240, made permanent the concept of portability of the unused portion of a spouse’s estate tax exemption. Portability allows the estate of a surviving spouse to use the unused portion of the applicable exclusion amount of the predeceased spouse. This transfer to the surviving spouse is available only if elected by the executor of the estate of the first-to-die spouse.
Amending/protective claim: The same as they should do with income tax planning, advisers should consider amending estate tax returns when appropriate to correct information that will alter tax calculations. A protective refund claim may also be used. The Windsor case provides an excellent opportunity to preserve the right to claim a refund.
Tenancy by the entirety (TBE): Tenancy by the entirety is a special kind of ownership that is similar to joint tenancy but is available only for married couples (there are few exceptions). TBE is primarily used as a form of asset protection because the creditors of one of the spouses cannot force a sale of the property to
collect on a debt. Also, when the first person dies, the survivor automatically receives title to the entire property without a probate court proceeding.
Advisers should immediately—if they have not already done so—reach out to their clients who are married same-sex couples. The first order of business is to determine the impact of the Windsor decision on their current plans. These couples will need to determine whether they can take the position that they have a “lawful marriage” under federal law. Were they married in a state that recognizes same-sex marriages? Do they now reside in that state or in another state that recognizes same-sex marriages?
The repeal of Section 3 of DOMA is, to quote Shakespeare’s character Ariel in The Tempest, “a sea-change.” The very nature and substance of what PFP practitioners do has been irrevocably transformed. This is not a transitory event.
PFP practitioners have seen the tides in financial planning come and go: The estate tax has been amended numerous times; insurers are always creating new products; and employee benefits are at best amorphous. Now that the Supreme Court has mandated that all “lawful marriages” must be recognized, the very basis for many recommendations to clients in same-sex marriages has crumbled like castles in the sand.
Clearly, the issues created by the Court’s decision are matters that are best addressed by an objective, integrated financial plan. Each selection in a decision tree of financial choices brings with it consequences, some intended, some unintended. The Court’s decision is a case in point.
The justices in the Windsor case did not address the provision of DOMA that allows states to refuse to recognize same-sex marriages performed in other states. The court also did not address the impact of its decisions on civil unions, domestic partnerships, or similar state law concepts, which will lead to further uncertainty in planning for same-sex couples.
Theodore J. Sarenski is president and CEO of Blue Ocean Strategic Capital LLC in Syracuse, N.Y. Thomas Tillery is vice president and CCO of Paraklete Financial Inc., in Kennesaw, Ga., and is pursuing a Ph.D. in financial and retirement planning from the American College of Financial Services in Bryn Mawr, Pa. Mr. Sarenski is chairman of the AICPA Personal Financial Planning Executive Committee’s Elder Planning Task Force and is a member of the AICPA Advanced Personal Financial Planning Conference Committee and Financial Literacy Commission. For more information about this column, contact Mr. Tillery at firstname.lastname@example.org.