As the April 15th filing deadline approaches, there are important changes to note. When the U.S. Supreme Court struck down the Defense of Marriage Act (DOMA) on June 26, 2013, a number of important tax issues were raised and potential refund opportunities were created for same-sex married couples and their employers.
Enacted in 1996, DOMA barred the federal government from recognizing same-sex marriages for the purpose of any federal laws, rules or regulations. In United States v. Windsor, 570 U.S. ____, 133 S. Ct. 2675, 11 AFTR2d 2013-2385 (2013), the Supreme Court held that Section 3 of DOMA is unconstitutional because it deprives same-sex married couples of equal treatment under the Fifth Amendment.
Same-sex marriage is currently permitted in seventeen states and in the District of Columbia. Although neither North Carolina nor South Carolina authorize or recognize same-sex marriages, there are implications for same-sex couples living in the Carolinas.
During the past few months, the Internal Revenue Service (“Service”) and the Department of Labor have announced that they will use a “state of celebration” standard for recognizing marriages. See generally Revenue Ruling 2013-17, 2013-38 I.R.B. 201 (08/29/2013) and related Answers to Frequently Asked Questions (“FAQ”) on the IRS website. Consequently, any same-sex couple that was legally married in a state that authorized their marriage will be treated as married for federal tax purposes, regardless of whether the couple lives in or is domiciled in a state that does not recognize same-sex marriages. These developments have significant tax and benefit implications, including the following:
Affected couples are now required to file jointly or married filing separately, and may not file as single or head of household.
Affected couples and their employers can exclude the value of spousal health care benefits for payroll and income tax purposes.
Employers must extend certain features of pension, health and welfare benefits to recognized same-sex spouses.
Affected couples are treated as spouses for estate and gift tax rules and exemptions.
Income Tax Considerations
Filing Status. Same-sex spouses generally must file using either a married filing separately or a joint filing status for tax year 2013 and going forward. For tax year 2012 and all prior years, same-sex spouses who file an original tax return on or after September 16, 2013 (effective date of Revenue Ruling 2013-17) must file using a married filing separately or a joint filing status. Thus, if either or both spouses have failed to file original required returns, they are now relegated to a married filing separately or a joint filing status. For tax year 2012 and all open prior years, same-sex spouses who filed their original returns (single or head of household) before September 16, 2013 may choose (but are not required) to amend their federal tax returns to file using married filing separately or joint filing status. This latter point could be very beneficial to the same-sex spouses as explained below.
For example, assume that a same-sex couple was married in 2009 (in a state that authorized their marriage – the first state was Massachusetts allowing same-sex marriages beginning in 2004) and that they had previously filed single individual tax returns for the years 2010 through 2012 in a timely manner in compliance with DOMA, then said couple can now file amended returns, Forms 1040X, for these years using joint filing status. Further assume that one spouse’s earned income was $35,000 and the other spouse’s earned income was $75,000 from either salary or wages. Using a joint filing status, standard deduction and two exemptions, said couple would be entitled to a refund of approximately $839 in each of these years or $2,517 in the aggregate, plus statutory interest. This is considered to be a “marriage bonus.” However, there also exists a “marriage penalty” in some circumstances.
Unfortunately, the federal income tax laws as well as the tax rates are not neutral when it comes to marriage. For example, if each spouse had salary or wage income of $100,000 in 2013, they will pay approximately $865 more in income taxes than they would have as two single individuals. Generally, couples earning approximately the same income will owe more tax filing jointly than filing single; and couples with a wide variance in income will benefit by filing jointly until their combined income exceeds approximately $240,000. The Tax Policy Center has a marriage bonus and penalty tax calculator at www.taxpolicycenter.org. It would behoove a same-sex couple to use this calculator in order to determine whether they would be entitled to any refunds by filing Forms 1040X in all open years, i.e., 2010 through 2012. If the couple had timely filed returns for the year 2010 on or before April 15, 2011, then as a general rule they must file an amended return (1040X) on or before April 15, 2014. Said couple may also want to contact a CPA for additional assistance and guidance.
Children and dependents. Under DOMA, only the biological or legally adoptive parent was permitted to take exemptions for the same-sex couple’s children. Post-Windsor, legally married same-sex couples may file joint returns. Thus, the question of who may claim the child as a dependent will become the same as for heterosexual couples. If the child is a qualifying child under I.R.C. § 152(c) of both same-sex spouses (who file using the married filing separate status), then either parent may claim a dependency deduction for the child.
With respect to adoption, it should be noted that in states where same-sex adoption was permitted, there was one situation in which a same-sex couple could claim a credit that a heterosexual couple could not: when a taxpayer adopted the legal child of his or her same-sex partner. Post-Windsor, a taxpayer who adopts the child of his or her same-sex spouse may not claim an adoption credit since the credit is not permitted for expenses incurred in adopting the child of a spouse.
Workplace benefits. Prior to the Windsor decision, if an employee elected to have health insurance benefits for a domestic partner, the cost of the partner’s coverage was generally considered imputed taxable income to the employee. Further, the employee’s pretax dollars could not be used to pay the premiums. Efforts to alleviate this inequity in states that recognize same-sex marriage have become unnecessary since the married same-sex partner is now recognized as a spouse.
If an employer provided health coverage for an employee’s same-sex spouse and included the value of that coverage in the employee’s gross income, the employee can file an amended return, Form 1040X, claiming a refund for all years for which the period of limitations is open. The employee may claim a refund for income taxes paid on the value of coverage that would have been excluded from income had the employee’s spouse been recognized as the employee’s legal spouse for tax purposes. See FAQ # 10. This item would be in addition to the reduction of the income taxes because of the “rate change” due to joint filing status.
Moreover, if an employer sponsored a cafeteria plan that allowed employees to pay premiums for health coverage on a pre-tax basis, and the employee purchased coverage on an after-tax basis for the employee’s same-sex spouse under the employer’s health plan, the employee may claim a refund for income taxes paid on the premiums for the coverage of the employee’s spouse via a Form 1040X. See FAQ # 11. Again, this item would be in addition to the reduction of the income taxes because of the “rate change” due to joint filing status. Generally, a taxpayer may file a claim for refund for three years from the date the return was filed or two years from the date the tax was paid, whichever is later.
In the situations described above, the employer may claim a refund of, or make an adjustment for, any excess social security taxes and Medicare taxes paid on benefits for an employee’s same-sex spouse. See FAQ # 12. The requirements for filing a claim for refund or for making an adjustment for an overpayment of the employer and employee portions of social security and Medicare taxes can be found in the Instructions for Form 941-X, Adjusted Employer’s Quarterly Federal Tax Return or Claim for Refund.
Qualified retirement plans. For purposes of satisfying the federal tax laws, a qualified retirement plan must treat a same-sex spouse as a spouse as of September 16, 2013. While Revenue Ruling 2013-17, supra, allows taxpayers to file amended returns that relate to prior periods with respect to many issues, this rule does not extend to matters related to qualified retirement plans. The Service has not yet provided guidance regarding the application of Windsor to qualified retirement plans with respect to periods before September 16, 2013.
Estate and Gift Tax Considerations
Bequests to surviving spouses. Under federal law, a deduction is generally allowed for the value of bequests to a surviving spouse, regardless of the amount involved. This marital deduction makes it possible for spouses to leave assets to each other without incurring a federal estate tax obligation. Post-Windsor, surviving same-sex spouses are now eligible for the same marital exemption that is available for heterosexual couples. Further, the “portability” section of the tax code now applies to same-sex married couples as well, which means that with proper planning, the second spouse to die can use the other spouse’s unused federal estate tax exemption.
Transfers between spouses. For heterosexual couples, there is no limit on the amount of money or property they can transfer between themselves on a tax-free basis. Under DOMA, each same-sex partner was limited to transfers of money or property of $13,000 per year, and gifts beyond that amount would trigger an immediate gift tax or went toward the partner’s lifetime gift tax exemption. Under current law, same-sex spouses can make unlimited gifts to each other without having to be concerned about gift taxes or filing gift tax returns. Same-sex couples now can split gifts, too.
Individual Retirement Accounts (“IRAs”). As Individual Retirement Accounts, IRAs do not have the same spousal privileges and requirements that bind employer plans such as 401(k)s. Nevertheless, same-sex couples will enjoy some easing of IRA restrictions. Most importantly, a surviving spouse can roll an inherited IRA to his or her own name with no tax implications. The process for proceeds of a decedent’s IRA to pass to a non-spouse beneficiary tax-free is complicated and can result in significant tax consequences if not followed to the letter. Post-Windsor, same-sex couples will have the same simplified rollover rules that are available to heterosexual couples. With respect to contributions, individuals with no earned income cannot contribute to IRAs. However, if one spouse received taxable compensation during the year and the couple files a joint return, then the spouse that has earned income can contribute to an IRA on behalf of the spouse with no earned income. Thus, if one same-sex spouse works while the other stays at home, both spouses can make contributions to IRAs, subject to applicable limitations. Finally, after age 70½, IRA owners must take taxable required minimum distributions (“RMDs”). An IRA owner with a spouse more than 10 years younger can take smaller RMDs, which leaves more money in the tax-deferred IRA.
State-Specific Issues – North and South Carolina
Under DOMA, same-sex couples who lived in a state that assessed income tax and recognized their marriage faced an added complication: they had to file their state taxes as married and their federal taxes as either single or head of household. Because the Service will use the “state of celebration” rule, legally married same-sex couples will be treated as married for federal tax purposes even if they are domiciled in a state that does not recognize the validity of same-sex marriages.
This aspect of the Windsor ruling will have important consequences for legally married same-sex couples who live in states such as North Carolina and South Carolina that do not recognize their marriages. Specifically, the lack of congruence between the couple’s federal and state tax returns means that they will have to file a joint return or use the “married filing separately” status for federal purposes, but will need to file as two individuals for state purposes. Because most states take a number from the federal return as the starting point for determining state taxation, these same-sex couples will need to prepare two “pro forma” individual federal returns to determine the initial number to use on their state returns.
For example, on October 18, 2013 the North Carolina Department of Revenue released Directive PD-13-1, which advises legally married same-sex couples who file a federal return as married filing jointly or married filing separately to “complete a separate pro forma federal return for North Carolina purposes with filing status of single, or, if qualified, head of household or qualifying widow(er) to determine each individual’s proper adjusted gross income, deductions and tax credits allowed under the Code [Internal Revenue Code] for the filing status used for North Carolina purposes, and then attach a copy of the pro forma federal return to the North Carolina return.”
Similarly, on February 3, 2014 the South Carolina Department of Revenue issued Revenue Ruling 14-1. Similar to the guidance provided by the North Carolina Department of Revenue, the South Carolina Department of Revenue directed legally married same-sex couples who file a federal return as married filing jointly or married filing separately to prepare a separate pro forma federal returns for South Carolina purposes, and complete the pro forma federal returns using a filing status of single or, if qualified, head of household.
The aforementioned Directive PD-13-1 (North Carolina) and Revenue Ruling 14-1 (South Carolina) with respect to the filing of individual returns (single or head of household) for same-sex married couples can be found on their respective websites at www.dornc.com and www.sctax.org.