Even as the debate over legally recognizing same-sex relationships continues, many such unions are being created in which income, expenses, assets and liabilities are shared, but generally without legal recognition of property and other rights accorded heterosexual marriages, federally and in most states. These unions create unique challenges and opportunities for the accounting profession to assist same-sex spouses and domestic partners in navigating the complexities of the Tax Code and in developing a sustainable financial plan.
Currently, six states as well as the District of Columbia issue marriage licenses to same-sex couples, and seven other states have laws allowing civil unions or domestic partnerships that provide the equivalent of spousal rights, according to the National Gay and Lesbian Task Force (see Exhibit 1). In her 2010 Annual Report to Congress, National Taxpayer Advocate Nina Olson recognized that one of the most serious problems facing U.S. taxpayers is the unanswered federal tax questions resulting from the various state domestic partnership laws. Other factors making the tax status of same-sex marital couples and partners difficult and uncertain include the federal Defense of Marriage Act and the lack of an IRS mechanism for linking the returns of domestic partners. According to Olson’s report, the U.S. government reports there are 64,000 citizens in same-sex marriages and 175,000 in same-sex domestic partnerships that are recognized by various states. The government further estimates there are more than 1 million couples living in same-gender households (whether or not legally recognized by their jurisdiction), of which more than 20% are raising children. Thus the dimensions of the issue begin to come into perspective.
Until more of the tax and other legal uncertainties and difficulties they face are resolved, same-sex spouses and partners will need guidance in taking consistent positions to minimize their tax burdens. On Sept. 19, members of both chambers of Congress wrote IRS Commissioner Doug Shulman, saying they considered legislation necessary but also urging the IRS to take immediate action to reduce unnecessary burdens and ensure fair and equitable application of tax laws for these taxpayers, particularly in community-property states.
INCOME SPLITTING AND ITEMIZED DEDUCTIONS
The benefits of income splitting enjoyed by most married heterosexual couples via the joint return filing option is not generally available for same-sex partners on their federal returns. However, same-sex couples registered as domestic partners in California, Nevada and Washington (or married in California during the period such marriages were legally recognized, between June 16, 2008, and Nov. 5, 2008) must split their income on separate returns, due to the combination of community property laws and state legal recognition of property rights under domestic partnerships, including homosexual unions. Pursuant to informal guidance issued in 2010, the IRS now requires couples in these states to report 50% of their combined community income on each spouse or domestic partner’s individual federal return (see Private Letter Ruling 201021048, Chief Counsel Advice 201021050; IRS Publication 555, Community Property (which includes an income division worksheet); and questions and answers recently posted on the IRS website).
In some circumstances, income splitting can result in a decreased federal tax burden. Couples with large disparities in income between spouses or partners may save significant amounts in taxes. For example, assume one spouse or partner earns $200,000 as an attorney and the other earns $40,000 as a teacher. Assuming each claims the standard deduction and one exemption, the federal tax savings in 2011 would be nearly $2,800 (see Exhibit 2). In other circumstances, however, mandatory income splitting may have negative effects, such as when one partner receives Social Security benefits that are 50% or less taxable, and having to recognize half the other partner’s income increases the taxable percentage of benefits to the maximum 85%.
It should be noted that same-sex spouses in a non-community-property state such as Massachusetts are neither required to split their income for federal tax purposes nor can they elect to do so.
Same-sex couples may accomplish income shifting in non-community-property states in ways long used by traditional families. One domestic partner or spouse hiring the other can be an effective technique, assuming the partner is actually involved in the business, the compensation is reasonable in view of qualifications and responsibilities, and the business offers such benefits to other employees in a nondiscriminatory manner. In such a case, the benefits are fully deductible, including health insurance, retirement plan contributions, child care subsidies and life/disability/long-term-care insurance.
Regardless of where the same-sex couple lives, they can enjoy a benefit denied to those whose marriages are recognized at the federal level. “Double dipping” with the standard deduction and itemized deductions has long been prohibited for married couples filing separately, but since same-sex couples generally each file single or head-of-household status, they are free to load itemized deductions onto one partner’s return with the other partner claiming the standard deduction, or both may itemize. Generally, the person who has the obligation should pay the expense out of “separate funds.” Payments out of a joint account can meet this requirement if both partners make significant deposits to the account. However, payments from a joint account for certain property-related items may not be held to be from separate funds (see Higgins, 16 T.C. 140). How the property is titled may be significant.
Not covered here is the ability of couples to file state income tax returns jointly in states that permit it.
Hiring a spouse or domestic partner may have more than income-shifting advantages. The temporary (2010 only) deduction of health insurance for self-employment tax purposes has expired (Sec. 162(l)(4)). However, it may be possible to prolong this benefit if a business owner subject to the self-employment tax establishes a health insurance plan that offers coverage to domestic partners. The owner can decline the coverage personally but have the spouse/partner elect family coverage. The spouse/partner will be subject to income and FICA tax on the imputed income (see below), but the owner avoids the self-employment tax on his or her insurance because the family insurance coverage and the FICA tax on the imputed income are deductible.
More than tax benefits may be connected with the self-employment/health insurance issue. A CPA told one of the authors she suggested how a same-sex couple might maneuver around the loss of health insurance. Both partners were self-employed with no employees. One partner survived cancer, but the insurance company denied the renewal of her single-member health coverage. The couple was advised to establish an LLC from which both businesses then operated. The LLC with two employees then qualified for guaranteed-issue group health insurance coverage.
An estimated 22% of American employers, including 53% of Fortune 500 companies, extend health insurance benefits to the same-sex partner of an employee (see “Unequal Taxes on Equal Benefits,” The Williams Institute). But these employers do so at a higher payroll tax expense and an increased administrative burden, because they must report the value of the benefits provided to the domestic partner as imputed income on the employee’s Form W-2. To offset the tax cost on imputed income, companies such as Bank of America, Google, Cisco Systems, Facebook, Discovery Communications and others are offering to “gross up” the employee’s salary so that the net pay is equal to that of an identically salaried married employee.
Some same-sex couples may seek to have children by surrogacy. Since medical expenses are deductible only if paid or incurred to affect a structure or function of the body, costs of in vitro fertilization have generally been held deductible only where necessary to overcome infertility. The Tax Court ruled in Magdalin (T.C. Memo. 2008-293, aff’d (1st Cir. 2009)) that expenses incurred “in fathering children through unrelated gestational carriers via the in vitro fertilization of an anonymous donor’s eggs using [the taxpayer’s] sperm” are not deductible. Surrogate parenting expenses are also not eligible for the adoption credit, as discussed below.
Since same-sex couples adopt children at a higher rate than heterosexual couples, CPAs should be familiar with the law in advising clients. Domestic adoption costs range from $5,000 to $40,000, but the adoption tax credit (currently refundable) can offset these costs. The maximum credit is $13,360 in 2011, and the full credit amount may be taken for special-needs children even if the adoption-related expenses do not rise to that level. (The credit amount is currently scheduled to revert to a maximum of $6,000 for tax years beginning after Dec. 31, 2012, along with elimination of most of the credit’s other beneficial provisions.)
Although this credit is not available to a taxpayer adopting a spouse’s child (a traditional stepparent), the lack of recognition of same-sex unions at the federal level means the adoption credit can be used in both first- and second-parent adoptions for same-sex couples. Adoption is time-consuming and costly, but it is an essential step for full parental rights. Otherwise, the nonadoptive parent has no permanent legal standing, regardless of the level of support provided to the child. Adoption not only gives the child two parents but also protects both parents in the event of a breakup. For an adoptive child of both parents, either parent can seek child support or legal rights to the child.
In the case of parenting via surrogacy, the adoption credit is denied (Sec. 23(d)(1)(B)). Thus, the adoption expenses related to the partner who provided biological material (sperm or egg) are not eligible for the credit. However, expenses related to a second-parent adoption are deductible to the parent with no biological connection, regardless of surrogacy.
A head-of-household return for one of the partners is usually advisable when there are children. Normally, it is advantageous to have the higher-earning spouse/partner make the head-of-household election. However, it is conceivable that putting a child or children on the return of the lower-earning spouse to avoid the phaseouts or phase downs of certain credits (for example, the earned income credit, child credit, child and dependent care credit) may be worth considering. It is essential to have the division of expenses related to the maintenance of the household and support of the child clearly documented to support the election.
Risk-management planning takes on additional importance with same-sex partners. When same-sex partners adopt, they maintain the same risks as opposite-sex married couples with children, with a key distinction: Life insurance proceeds fall into the estate of the owner of the life insurance. Consequently, there are important planning discussions with respect to creation, beneficiaries and ownership of trusts to hold life insurance. Also, disability income and long-term-care planning take on additional importance.
RETIREMENT BENEFITS AND TRANSFER TAX PLANNING
The unlimited marital deduction is not available for same-sex couples. Thus, gifts above $13,000 are subject to the gift tax. When couples share common expenses, a taxable gift may result if one partner contributes over $13,000 more than the other partner, unless the excess is paid directly to educational or medical institutions. In any event, couples are advised to clearly document how income and expenses are shared.
Sharing of assets can also trigger a gift tax. If a partner owning property puts the other partner on the deed as a joint tenant with right of survivorship, a gift has occurred. This result can be avoided with an incomplete gift such as an agreement that the property passes at death or some other contingency. With proper planning, property tax and gift tax consequences can be minimized. A short-term opportunity may be present in the recent increase in the unified credit to the equivalent of a $5 million gift. The estate tax impact of this temporary provision (which expires Dec. 31, 2012) may be augmented by the use of a trust. For example, assume $5 million placed in trust is valued at $7.5 million in 10 years. A surviving spouse/partner would inherit the $7.5 million with no gift or estate tax consequences.
Same-sex couples must tread carefully in the matter of retirement accounts. Social Security benefits are not passed on to surviving domestic partners, but in some cases, IRA and 401(k) accounts can be rolled over. IRS Publication 590, Individual Retirement Arrangements (IRAs), states that proceeds may pass to a nonspouse beneficiary via a trustee-to-trustee rollover “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 nonspouse] as beneficiary.” Employer-sponsored 401(k) and 403(b) retirement accounts may also roll over according to this rule, although the plan sponsor is not required to offer the direct rollover option to nonspouse beneficiaries. Unless such provisions are followed to the letter, the tax-deferred accounts have to be cashed out upon the death of the IRA owner and are subject to immediate taxation. Also, the fact that the law generally favors biological relatives in the absence of a will or trust places a premium on estate planning for same-sex couples. Since a will can be contested, a revocable living trust may provide a more secure way for domestic partners to provide for a survivor.
DIVORCE OR TERMINATION OF SAME-SEX MARRIAGE OR DOMESTIC PARTNERSHIP
Dissolution of same-sex marriages or domestic partnerships may present unusual complexities but is generally procedurally similar to that of heterosexual marriages in terms of state family law. Implications under federal tax law, of course, are vastly different. For example, the gift tax possibility noted above may become a factor in distribution of property upon the dissolution of the marriage or domestic partnership unless the transfer is made in satisfaction of a palimony or other valid legal claim. Local law may even determine the amount of these transfers. For example, California couples who have been registered domestic partners for 10 or more years are subject to a 50% division of community assets upon dissolution of the domestic partnership.
Alimony between same-sex spouses or domestic partners is not deductible and may also have gift tax consequences if the annual amount exceeds $13,000.
Laws designed to guide how a couple’s assets should be split do not govern when the state does not recognize the marriage or grant equivalent spousal rights. Some states grant limited rights that don’t rise to the level of equivalency. Protections for the less-well-off partner and child support cannot be assumed. The current patchwork of laws erects barriers for some couples seeking a divorce. For example, a same-sex couple legally married in Iowa but living in Georgia would have to move to a state that recognizes same-sex relationships and establish residency there before filing for divorce. It is important for the financial planner to work closely with counsel to ensure that, upon dissolution, the key assets that contain beneficiary designations are appropriately modified, and in some cases, such as life insurance, are appropriately owned to minimize the potential impact of estate taxation.
COHABITATION AGREEMENT AN OPTION
Same-sex couples who live in states where marriage or domestic partnership is not an option or who wish not to take that step may want to consider a cohabitation agreement. Such agreements fall under contracts law rather than family law and are recognized by the courts, assuming the document reflects the clear intent of the partners. The document should address the conditions under which the couple will live, share expenses, split assets and share custody and support of children. These agreements do not offer any tax advantages other than documenting a couple’s positions for tax filing purposes.
With registered domestic partnerships or cohabitation agreements, same-sex couples can achieve a greater degree of legal recognition of their union, including protection of their mutual rights and an ability to better plan for shared financial resources and responsibilities, including taxes. CPAs who are attuned to these possibilities and willing to think creatively amid the many still uncharted areas of law and practice will be better equipped to assist the growing number of such couples as their clients.
Income splitting for same-sex couples can only be perfectly accomplished in certain community property states. In other states, planners have to be creative in shifting income to a lower-bracket return.
The self-employed may find tax and other benefits in the health insurance area, but employees utilizing domestic partner benefits offered by their companies are subject to tax on imputed income.
Both partners may use the adoption credit .
Couples in states that do not recognize their unions may want to consider a cohabitation agreement.
Asset and expense sharing can trigger the gift tax, but the temporary increase in the unified credit ($5 million) may present planning opportunities.
Sandy Johns (email@example.com) is owner of Revolution Financial Solutions in Nashville, Tenn. Larry Maples (firstname.lastname@example.org) is a professor of accounting at Tennessee State University in Nashville, Tenn.
To comment on this article or to suggest an idea for another article, contact Paul Bonner, senior editor, at email@example.com or 919-402-4434.
- “Defense of Marriage Act: What Should Same-Sex Couples Do?” Tax Insider, May 12, 2011
- “Advising Same-Sex Marriage Couples: Estate Planning Pitfalls and Opportunities Revealed,” Wealth Management Insider, Sept. 22, 2011
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