Since the Supreme Court decision in U.S. v. Windsor, which ruled that the federal government must recognize legal same-sex marriage, and more recently in Obergefell v. Hodges, under which the Supreme Court ruled that all states must perform and recognize same-sex marriages, a larger number of same-sex couples have married. However, many couples choose to retain their domestic partnership status or to not marry. Below we explore the various effects the Supreme Court rulings have had on tax and estate planning for same-sex couples.
Often the biggest shock to same-sex couples who choose to marry is the non-neutrality of income taxation. Married taxpayers reach the highest marginal rates of income tax at far less than double the income of a single taxpayer. For 2019, single taxpayers will pay the highest marginal rate of income tax of 37% on all income earned over $510,300. Married couples reach the 37% rate on all income collectively earned over $612,350 —just $102,050 more than the income of a single taxpayer. This counterintuitive result and inequity has long made marriage a non-neutral decision for income tax purposes.
This taxation, commonly referred to as the “marriage penalty” does not apply to civil union spouses and domestic partners due to the federal requirements that their income tax returns be filed as single individuals, thus, for these couples marriage is income tax neutral. Conversely, the rates do have the ability to create a marriage bonus, which is most often the case when one spouse has very little or no income.
The American Taxpayer Relief Act of 2012 implemented a new federal law: portability. If the executor of an estate timely files a decedent’s federal estate tax return, any unused federal estate tax exemption will be transferred to the surviving spouse. This unused exemption will be used by the surviving spouse’s estate in addition to the federal estate tax exemption in the year of his or her death.
For 2019, the federal estate tax exemption is $11,400,000 per individual. Therefore, married same-sex couples are able to shield $22,800,000 from estate tax. If a same-sex couple’s spouse recently passed, this is an issue to discuss with your estate planning attorney because this may result in significant federal estate tax savings.
Expanding the Tax Advantages in Estate Planning: Unlimited Marital Deduction, QTIP, QDOT
Federal law allows spouses to give an unlimited amount of assets by gift or inheritance to a spouse. This allows deferral of payment of federal estate taxes until the death of the second spouse. There is no maximum that can be passed to a spouse that would trigger any taxes.
The unlimited marital deduction only applies to spouses who are both U.S. citizens. If there is a non-U.S. citizen spouse in a marriage, a non-citizen surviving spouse must pay federal estate taxes on an estate above the federal estate tax exemption. A Qualified Domestic Trust (QDOT) allows a U.S. citizen spouse to pass assets to a non-U.S. Citizen spouse to defer federal estate taxes. Without the ability to utilize QDOTs, the transfer of assets to a married non-citizen spouse could trigger federal estate taxes, even though the assets are distributed in accordance with the terms of the predeceased spouse’s trust. A QDOT allows the predeceased spouse to defer all federal estate taxes until both spouses have died while retaining control over where his or her estate is distributed after both spouses die.
A Qualified Terminable Interest Property Trust (QTIP trust) allows a deceased spouse to create a trust upon his or her death that grants a life estate for the surviving spouse without incurring federal estate taxes. This trust is then included in the surviving spouse’s estate for purposes of federal estate taxes, but is distributed according to the testamentary wishes of the first spouse to die. Essentially, a QTIP Trust is a hybrid trust; it is includable in the surviving spouse’s taxable estate, but is distributed according to the predeceased spouse’s wishes. The surviving spouse can not amend the QTIP Trust. This type of trust again utilizes the unlimited marital deduction.
These laws now expand estate planning opportunities for same-sex couples.
The Windsor decision changes the default rules for intestate succession because the Court decided not to review the Proposition 8 ruling in California. If you die without a Will or Living Trust, your estate is distributed pursuant to intestate succession, which is codified in the California Probate Code.
For same-sex couples who do not have estate planning, if you are not legally married or registered domestic partners, upon your death, your assets would not be distributed to your partner.
Joint Tenancy vs. Community Property
If you do not have a written estate plan, you may own property in joint tenancy with your partner. A characteristic of joint tenancy is that each person owns an undivided 100% interest in the property, so upon the death of one owner (the owners can be friends, siblings, partners; it does not matter), the other person on title automatically owns the property by right of survivorship without any probate proceedings.
What people do not consider are the tax implications. Upon an individual’s death, all assets in the deceased person’s estate receive a “step-up” or “step-down” in cost basis. With an asset held in joint tenancy, the property only receives a step-up or down in the decedent’s half of the asset, which could result in significant taxes on the survivor’s half if the property is later sold.
On the other hand, if property is owned by spouses, they have the option of owning the property as community property with right of survivorship (CPWROS). In this case, upon the death of a spouse, the entire property receives a step-up or down in cost basis, which may result in significant tax savings if the property is later sold.
In California, both registered domestic partners and married same-sex couples may hold property as community property. Reviewing your current deed to your home or other real estate to see how title is held may present enormous income tax savings potential.
Beneficiary Designations: Spousal Rollovers
The expansion of the definition of a spouse under federal law allows same-sex spouses to take advantage of certain benefits for spouses relating to beneficiary designations on IRA’s, 401(k)’s, etc. Spouses can roll over a deceased spouse’s IRA into their own IRA. For any other individual beneficiary, a spousal rollover is not an option. The ability of married same-sex couples to execute a spousal rollover could result in significant income and tax savings.
Surviving spouses may also be entitled to the deceased spouse’s pension. Additionally, when a spouse retires, the non-employed spouse will be eligible to continue on the retiring spouse’s health plan through the Consolidated Omnibus Budget Reconciliation Act (COBRA).
Due to significant changes in the laws, married and non-married same-sex couples should review their estate plan to ensure optimal taxation. In order to review your estate plan, please call our office or e-mail Anne Rosenthal, who authored this article, at [email protected] with any questions.