Journal of Financial Planning: July 2012
Robin L. Knowles, Ph.D., CFA, is an assistant professor of accounting at Texas State University-San Marcos.
Stanley Veliotis, Ph.D., CPA, LL.M., is an assistant professor of taxation at the Fordham University Schools of Business.
Executive Summary
- Despite recent changes in many states allowing same-sex marriage, the preparation of a sound financial plan for non-traditional couples continues to be more complicated than for traditional couples. To provide the best financial plan to clients, advisers must be aware of the complex financial and legal issues facing same-sex couples.
- Two individuals who are “married” receive beneficial treatment in several financial areas as compared to two unmarried individuals who form a household. Examples include an unlimited marital deduction for estate tax planning, lower income tax liability when the couple has disparate income levels, and access to Social Security survivor benefits and other spousal benefits provided in workplace benefit plans.
- However, marriage is not defined at the state level where federal law applies. Under the federal Defense of Marriage Act (DOMA), same-sex couples are viewed as unrelated parties, not as a married couple.
- This article reviews how federal law and state law will apply to the more significant income tax, estate tax, and health and welfare benefit plan issues that clients are likely to consider in connection with their financial plan.
The definition of marriage is evolving. As shown in Table 1, seven states and the District of Columbia now allow same-sex couples to marry. Two additional states, Maryland and Washington, have passed legislation that will allow same-sex marriage in the near future unless court challenges block their implementation.
In states that allow same-sex marriage, these married couples enjoy the same protections as traditional married couples vis-à-vis state law. Several other states have statutes regarding civil unions or domestic partnerships. However, by constraining the definition of marriage to couples of opposite gender, the federal Defense of Marriage Act (DOMA) restricts the protections same-sex couples receive under federal law. In other words, where federal statute applies, same-sex couples, even if formally recognized as married under state law, are still viewed as two unmarried and unrelated individuals for federal purposes. Advisers preparing or reviewing a client’s financial plan need to identify and address when a benefit or other preferential treatment requires a federal interpretation of “spouse” and when an individual state’s definition would instead govern.
Health and Welfare Benefit Plans
Employer-provided benefit plans are regulated at the federal level by ERISA, whereas insurance companies are regulated at the state level. As a result, employers whose benefit plans are self-funded are governed at the federal level (and thus DOMA preempts the state definition of spouse), whereas benefit plans that are insured are governed by the state regulations applicable to insurance companies. Therefore, companies sponsoring self-funded plans are not obligated to offer equivalent benefits to their employees in non-traditional relationships. While this may appear to run afoul of state laws that prohibit discrimination based on sexual orientation, such state laws are preempted by ERISA.
COBRA benefits can be used to provide health insurance in the event of divorce or death of the employee’s opposite-sex spouse or after the employee leaves employment and before the opposite-sex spouse qualifies for Medicare benefits. However, whether the same-sex spouse can elect to receive COBRA benefits is decided at the benefit plan level; COBRA does not obligate the plan to provide continuation benefits.
Qualified defined benefit plans that are governed by ERISA treat married and unmarried persons differently. Qualified plans must provide a pre-retirement survivor annuity, and at retirement they must provide a joint and survivor annuity to married employees unless the spouse consents to another option. An employee in a same-sex marriage who is retiring may also elect a joint and survivor annuity option that will cover the spouse after the employee dies. However, in this case the same-sex spouse does not have the same protections as the opposite-sex spouse in that the same-sex spouse’s consent is not required before the retiring employee can elect the higher, single-life annuity payment.
The monthly Social Security spousal benefit is the greater of 50 percent of the spouse’s benefit while the spouse is alive and 100 percent of the spouse’s own Social Security benefit afterward. However, because Social Security is a federal program, DOMA’s definition of spouse does not permit the same-sex spouse to receive the spousal benefit or any Social Security benefits based on their spouse’s employment history. On the other hand, workers’ compensation programs are state-run programs and therefore, in states that recognize same-sex couples, there may be a death benefit available to the spouse if the employee dies from a compensable injury.
Federal government employees who qualify for a pension from the Civil Service Retirement System or the Federal Employees Retirement System will not be considered married for the purposes of eligibility under these programs. However, when the employee retires there is a one-time option to elect an insurable interest annuity, which can name the same-sex spouse as the beneficiary. The beneficiary of an insurable interest annuity must be able to show that, in the event of the death of the retiree, the beneficiary would suffer a financial loss. The election to add a beneficiary to the annuity will reduce the benefit payment amount, depending on the difference in age between the retiree and the beneficiary.
Income Tax—Filing Status
When filing federal income tax returns, same-sex spouses do not have the option to use the “married filing jointly” (MFJ) filing status. The filing status determines which tax rate schedule is used to calculate the amount of taxes owed for a given amount of taxable income. Whether same-sex couples will pay more in combined income taxes compared to couples using the MFJ filing status will depend primarily on whether one partner earns significantly more than the other. This is partly because the MFJ rate schedule calculates the tax liability as if both parties earn the same amount of income and therefore both income streams benefit from the lower marginal tax rate brackets for the lower income levels. Thus, in settings in which one partner makes a far larger amount than the other, same-sex couples will usually pay more in federal income taxes than opposite-sex married couples.1 If one partner is able to claim the other as a dependent (which is difficult, as detailed below), it is possible to use the more favorable head-of-household tax rate schedule.
This “un-marriage penalty” disappears in community property states2 where each partner is deemed to earn half of the combined household income. As state law determines how income is recognized between married couples, in community property states the lower-earning spouse will be deemed to earn half the income of the higher-earning spouse. In addition, the higher-earning spouse will be deemed to earn half of the lower-earning spouse’s income. Note that DOMA overrides state law as to the definition of marriage, but it does not override state law as to the determination of income. In other words, state law related to community property may deem both parties to be evenly earning what in reality only one party is earning. The income that is shifted to the lower-earning spouse will likely push that spouse over the income limits that would have allowed this spouse to be claimed as a dependent (discussed below) on the tax return of the higher-earning spouse.
Many tax law benefits depend on the taxpayer’s adjusted gross income (AGI). These thresholds are often doubled for opposite-sex couples who use the MFJ filing status for their federal tax return. For example, a single taxpayer may deduct student loan interest if AGI is below $75,000. However, the AGI threshold is doubled to $150,000 for couples who file using MFJ on their federal return. Qualified tuition has a similar pattern ($80,000 single versus $160,000 MFJ). Therefore, in settings in which the taxpayers have disparate amounts of income they may be penalized by not having access to the MFJ filing status. Even in cases in which the AGI threshold for returns filed using MFJ is not twice what it is for the single filing status, it is often significantly higher. For example, the child tax credit ($1,000 per dependent child) starts to phase out once AGI exceeds $75,000 for a single taxpayer; the amount is $110,000 for returns filed MFJ. A similar example of alternative calculations that depend on the filing status is the gain on the sale of a primary residence. Single taxpayers may shield $250,000 in gains from taxation, whereas the amount excluded is doubled for taxpayers filing MFJ.
The discussion above presumes tax law that is currently in effect as of 2012. In 2013, tax rates are expected to revert to the pre-“Bush tax cut” rates, which included a reduction in the so-called marriage penalty. In addition to a return of the marriage penalty found in the tax tables for taxpayers filing MFJ, starting in 2013, under The Patient Protection and Affordable Care Act, additional taxes3 are levied on married taxpayers with over $250,000 AGI. These additional taxes don’t affect single filers until their AGI is over $200,000. Thus, a same-sex couple that separately reports under $200,000 AGI but together have more than $250,000 AGI will benefit from the fact that they are not treated as married for federal tax purposes. At the time of this writing, the Affordable Care Act is under review in the Supreme Court, with the possibility that parts or all of it may be struck down. For years after 2012, advisers should confirm the latest law for relevant tax rates. The remainder of the tax discussion below is not affected by the Bush tax cut expiration or by the Affordable Care Act.
Income Tax—Dependency
Recall that the federal government views same-sex couples as two unrelated individuals. For an unrelated person to qualify as a dependent on another taxpayer’s return, he or she must live with the taxpayer and have gross income less than the exemption amount (which is $3,700 for 2011 tax returns). This income limit would surely be surpassed for clients who live in a community property state. In other words, as noted above, in community property states, if one partner earns all the income, the other partner will be deemed to earn half the income and thus likely surpass the income threshold to qualify as a dependent.
If the gross income reported on the lower tax return is less than the sum of the standard deduction and the personal exemption (which is $9,500 for 2011 tax returns), then a portion of this “tax-free income” provided by the personal exemption and standard deduction is wasted, as neither taxpayer uses this benefit to lower their tax liability.
Aside from the loss of shielding income from taxes as described above, same-sex spouses also lose the ability to deduct medical expenses and qualified tuition expenses (or take education credits) for their non-dependent spouses. Also, the employee may only exclude amounts from a flexible spending account or health reimbursement account used for himself or herself and dependents from taxable wages. However, amounts spent for a non-dependent, same-sex partner are not excluded from taxable wages. Similarly, health insurance benefits provided by an employer to an employee’s same-sex spouse are reported as part of the employee’s taxable earnings. The IRS will impute income to the employee for the value of the benefits provided to the same-sex partner.
Retirement contributions to an IRA are generally not allowed unless the taxpayer has earned income; an exception is the spousal IRA when the other spouse has earned income (and other requirements are met). However, again, taxpayers in a same-sex marriage will not be able to shield income from current taxes by contributing to a spousal IRA. In addition, non-spouse beneficiaries have less flexibility when it comes to inherited IRAs. For example, non-spouse beneficiaries cannot make any new contributions to the IRA. They can make a trustee-to-trustee transfer as long as the IRA into which amounts are being moved is set up and maintained in the name of the deceased IRA owner for the benefit of the surviving partner as beneficiary. IRS rules allow beneficiaries of self-directed IRAs to take payments stretched over their life expectancy. Treatment for inherited 401(k) plans is similar to that of non-spousal inherited IRAs.
Divorce-Related Tax Issues
In the event that the marriage ends in divorce, certain tax issues may arise. For example, alimony payments reduce taxable income of the paying taxpayer and increase taxable income of the receiving taxpayer. This arrangement generally has the effect of transferring income between ex-spouses tax efficiently by reducing income of the taxpayer in the higher marginal tax bracket and transferring it to the ex-spouse in the lower marginal tax bracket. However, alimony payments from same-sex divorces are not deductible for federal income tax purposes and may in fact be considered a gift, further reducing the lifetime limit or even triggering taxable gifts. In the same manner, property settlements upon the dissolution of an opposite-sex marriage would not trigger income taxes. However, a property settlement in the divorce of same-sex couples could result in appreciated assets being deemed to have been sold for the value of the obligation being extinguished (the property settlement). This could trigger a gain or loss for tax purposes and have possible tax implications.
Estate and Gift Tax
Perhaps the largest tax exposure for same-sex spouses is related to the gift tax liability generated when one spouse supports the other spouse. Any taxpayer who transfers more than the annual gift exclusion amount ($13,000 in 2011) to another individual for tax purposes must file a gift tax return. While exceptions exist for amounts expended to satisfy legal support obligations related to a dependent (for example, a minor child), a same-sex spouse likely does not qualify for this provision. However, gift taxes do not apply to direct payments made by the donor to a school or medical provider for another person’s qualified education or medical needs, whether or not the student or patient is a dependent. Thus, same-sex couples should be concerned about gift taxes for support other than education and medical bills.
If taxable gifts made over a lifetime accumulate to an amount that is greater than the limit, a gift tax will likely be due. Amounts gifted to the same-sex spouse can be counted toward the lifetime exclusion limit to the extent more than $13,000 is gifted or provided in any year (the annual exclusion limit is subject to revision periodically). The lifetime federal exclusion limit for combined inter vivos gifts and death transfers is currently $5 million. Unless Congress changes the limit, it will revert to $1 million January 1, 2013. If significant annual support is contemplated along with a sizable asset transfer, this lower exclusion limit could be reached quite easily. Note that in 2010 the IRS initiated an enforcement effort to identify unreported transfers of assets between unrelated individuals. Clients should not ignore the requirement to file a gift tax return (IRS Form 709) for annual gifts over the annual limit, even if a tax is not currently triggered.
Estate Planning and Trusts
Married couples often choose to title property in joint name. A common joint ownership approach is joint tenancy, under which the surviving owner inherits the deceased joint owner’s share, without necessity of a will or probate. This does not present gift tax issues because of the unlimited transfer tax exemption between opposite-sex spouses. However, titling property as joint tenants is more complex for same-sex couples (as it is in many settings, such as with friends and relatives other than a spouse), and care should be taken to maintain evidence of the financial contribution each has made to the purchase. Otherwise, the IRS may deem that a taxable transfer has occurred upon adding the same-sex spouse’s name to the property. For example, if the wealthier partner adds the same-sex partner’s name to the joint tenancy ownership of a valuable asset with no consideration given by the other partner, this can be seen as a taxable gift.
An estate has an unlimited marital deduction for transfers to opposite-sex spouses. This includes the use of a bypass trust that pays income to the surviving spouse for life. However, again, this is not available for same-sex spouses and thus results in a dramatic difference in how estates are taxed. Therefore, careful estate planning, especially through the use of trusts, is essential for same-sex couples. While trusts that are revocable may offer some legal benefits (including a reduced likelihood of being contested), they typically do not provide tax benefits. Accordingly, we will focus on irrevocable trusts.
Split interest trusts could be a viable estate planning tool for same-sex couples. For example, a grantor retained income trust (GRIT) is one pre-death tool that can help lower the value of the estate. A GRIT pays all the income of the trust to the grantor (for example, the wealthier spouse) for a term of years. Any property remaining in the trust after the term ends is paid to the remainder beneficiary (the other spouse). Property that is expected to highly appreciate is an ideal asset to fund the GRIT. GRITs work best if the grantor outlives the term of the GRIT, in which case the value of the GRIT is excluded from the estate. If the grantor does not outlive the term, the estate is not taxed any worse than it would have been otherwise. At one time GRITs were used by traditional married couples, but changes in tax law have removed GRITs from their financial planning menu. In this case, DOMA provides a benefit to same-sex couples by not treating them as married. Grantor retained annuity trusts (GRATs) are also a very useful estate planning tool for any couple (opposite-sex or same-sex); our focus here is on which estate planning strategies are uniquely different for same-sex couples.
To facilitate the payment of estate taxes, a common approach is to purchase life insurance. For example, a 10-year level premium term life policy with a $5 million death benefit for a 50-year-old healthy female is approximately $4,000 per year; a similar policy for a healthy 50-year-old male is approximately $5,000 per year. Life insurance proceeds are not taxable for income tax purposes. However, life insurance, over which the decedent has “incidents of ownership” at death, is included in the gross estate for estate tax purposes. To avoid this problem, consider employing an irrevocable life insurance trust (ILIT) with a “Crummey provision” included in the language of the ILIT, and structure the amount of annual life insurance premium so that it is lower than the annual gift tax exclusion amount ($13,000 in 2011, as noted above). Such ILITs typically require that the ILIT maintain all incidents of ownership in the life insurance policy, such as the right to surrender, revoke, assign, pledge, or borrow against the policy, and even to amend the beneficiary designation. Such an ILIT will not be considered part of the gross estate of the wealthy spouse who set it up for the less-wealthy spouse. However, one must proceed with caution in the event that the living expenses the wealthier spouse pays (when added to the life insurance premium) trigger gift taxes, as discussed above.
A qualified personal residence trust (QPRT) can be used to transfer the shared residence to a beneficiary at the value assessed at the time of the transfer. A term of years (ideally to end before the grantor’s life) is provided during which the grantor has the right to occupy the premises and thereafter the remainder interest goes to a beneficiary. While the creation of a QPRT is considered a gift, the value is far lower than the outright value of the house because of the fact that the grantor is able to stay in the house. A QPRT has tax advantages if the grantor survives the trust’s term; otherwise, the entire value of the QPRT’s interest in the residence at death is included in the grantor’s taxable estate. In this case the tax advantage of the QPRT is lost, although the parties are no worse off than if the QPRT had not been established. However, there is a concern that a trust will not qualify as a QPRT if, for example, someone other than a spouse or dependent occupies the home without paying rent (other than in the capacity of a guest of a grantor who enjoys full occupancy rights). Therefore, same-sex couples, who presumably live together, should be careful when seeking to employ QPRTs in their estate planning.
Conclusion
Financial advisers will need to carefully consider the changing regulatory landscape for non-traditional couples. Sources of income generally relied on for retirement support are not always available to these clients. For example, Social Security spousal benefits will not be available, while COBRA benefits might be available because they are determined at the benefit plan level and are not prohibited under DOMA. Death benefits could be available under state-run workers’ compensation programs.
Same-sex couples with disparate levels of income will likely be subject to higher marginal tax rates by not being allowed to use the more favorable “married filing jointly” tax rates. These couples are also more likely to lose some valuable tax deductions that are eliminated or phased out for higher adjusted gross income levels, whereas couples who can file MFJ are allowed higher AGI levels before the deductions are lost or phased out.
On the other hand, where both partners earn a high AGI, same-sex couples are more likely to avoid some taxes associated with the Affordable Care Act that are levied for single taxpayers with AGI over $200,000 and on married couples with $250,000 AGI. Here, the ability for each to use the single AGI hurdle, which is higher than half of the MFJ hurdle, is likely to reduce their combined income taxes.
Estate planning is an especially complex area that should be carefully considered for couples with disparate levels of assets and income. Significant annual support by the wealthier spouse could trigger the need to file a gift tax return. When titling assets and property in joint name, clients should be careful to document each spouse’s contribution to the purchase to avoid the IRS later deeming that a taxable transfer has occurred. And clients should be made aware that the unreported transfer of assets is an area of increased enforcement by the IRS. Same-sex couples can consider using a grantor retained interest trust, which is an estate planning tool no longer available to opposite-sex couples. The benefits of a qualified personal residence trust are also worth exploring.
Advisers should also monitor the status of DOMA, which as of this writing is the subject of litigation in the Federal Court of Appeals in Massachusetts to address a claim that it violates the equal protection clause of the Constitution and the rights of states to legislate the definition of marriage.
Endnotes
- For example, if one partner has $180,000 taxable income and the other partner has $20,000 taxable income, their total tax using the single status schedules for 2011 is $46,872 ($44,297 + $2,575). If they had filed MFJ, their tax would have been $44,070. Notice how the single tax of $44,297 on $180,000 is more than the MFJ tax on $200,000. Also, the joint marginal tax rate (MTR, the tax rate due on the next dollar of income) would be 28 percent, while, for the higher-earning partner, the single MTR is 33 percent. Similar results apply even at lower levels (for example, total single status tax for a partner with $80,000 and another partner with $10,000 is $17,200, whereas it would have been $14,750 if MFJ).
- Community property laws exist in Arizona, California, Idaho, Louisiana, New Mexico, Nevada, Texas, Washington, and Wisconsin, while Alaska allows spouses to elect the application of community property rules (Hoffman and Smith 2012, pp. 4–19 to 4–20).
- The Affordable Care Act initiates a 2.9 percent income tax surcharge on investment income and a 0.9 percent Medicare surcharge on wages (or self-employment income) for married taxpayers with over $250,000 AGI or for single taxpayers with over $200,000 AGI.
References
Hoffman, W. H., and J. E. Smith. 2012. South-Western Federal Taxation: Individual Income Taxes, 2012 Edition. Mason, OH: South-Western.
Human Rights Campaign. 2012. “Same-Sex Relationship Recognition Laws: State by State.” www.hrc.org/resources/entry/same-sex-relationship-recognition-laws-state-by-state.
NYTimes.com. 2012. “Same-Sex Marriage, Civil Unions, and Domestic Partnerships.” Times Topics. http://topics.nytimes.com/top/reference/timestopics/subjects/s/same_sex_marriage/index.html.