DOMA Case Could Result in Tax Reform for Gay Families
Same-sex couples across the country could benefit at tax time should the U.S. Supreme Court allow the federal government to recognize their marriages and other legal unions.
The court is expected to rule this month on whether Section 3 of the federal Defense of Marriage Act is unconstitutional. That portion of the anti-gay law passed by Congress and signed by former President Bill Clinton bars federal agencies from granting numerous rights heterosexual married couples receive to those same-sex couples in state sanctioned marriages, as well as domestic partnerships or civil unions.
This prohibition is particularly felt during tax season, as legally coupled same-sex partners cannot file joint tax returns with the Internal Revenue Service, causing some couples to pay higher taxes. They are also fiscally dinged tax-wise if one spouse’s employer covers the health care for the other spouse, as the IRS considers those medical benefits as taxable income.
Some employers have increased the pay of their LGBT employees to offset the increased federal taxes on their benefits, but the higher income triggers additional taxes owed to the state. (San Francisco instituted a law this year to gross up the pay of LGBT city workers impacted by the unfair tax rules while legislation is pending in Sacramento not to have the state view the benefits as taxable.)
"The Defense of Marriage Act imposes undue and unequal tax burdens on married same-sex couples and their children, and this decision would be a significant advancement in remedying the economic inequity facing these families," Andrew Cray, a policy analyst on the LGBT Research and Communications Project with the Center for American Progress, told the Bay Area Reporter.
Several years ago the IRS did implement a rule covering those same-sex couples living in states with community property laws, such as California, in order to try to provide some equitable treatment to LGBT households. The IRS required the couples to divide their income from wages as well as from a business or real estate holdings they co-owned equally among themselves and then file separate returns.
Rather than being a simple solution, the rule change resulted in overly complicated tax preparation procedures for many same-sex couples. It was so confusing that the online tax preparer TurboTax no longer was equipped to handle the tax returns for those couples impacted by the rule change.
Many found out that splitting their community property resulted in their need to start seeing professional tax preparers rather than do their taxes themselves. Those who had been using accountants saw increased fees as now it took creating three different federal returns and one for California couples, as the state allows same-sex couples to file jointly for state tax purposes, to figure out if they owed additional federal taxes or were due refunds.
In some instances, couples who had been filing separate federal tax returns and received refunds now owed thousands of dollars in unpaid taxes once a portion of their spouses’ pay was added to their income.
Many of these unfair taxation issues would disappear, predict LGBT advocates, due to a ruling by the U.S. Supreme Court striking down Section 3 of DOMA.
"It is expected that following the decision, the IRS will instruct married same-sex couples to file their taxes as ’married’ rather than as ’individual’ or ’head of household.’ This brings with it two significant benefits," Cray wrote in an emailed response to questions.
The first, explained Cray, is that complications that have faced same-sex couples around the process of filing taxes, claiming children, or claiming various deductions "may be reduced or eliminated through the ability to file a joint return."
Second, if married same-sex couples are able to file jointly, they could owe less taxes, added Cray, because "their income tax levels will be calculated appropriately based on their household income, rather than being treated differently from other married couples, and potentially resulting in a greater tax payment than for other couples."
On a recent conference call to discuss the possible outcomes of the case, known as U.S. v. Windsor, Nicole M. Pearl, a Los Angeles-based partner at the law firm McDermott Will and Emery LLP with extensive experience in estate and tax planning for gay, lesbian, and unmarried couples, said a decision against DOMA’s Section 3 would be retroactive, meaning that same-sex couples could amend their prior tax returns going back to 2010 to see if they overpaid their federal taxes.
"So all same-sex couples that have already married, because they live in states that allow that, can go back and amend prior tax returns for the years that are still open," said Pearl, the author of The Effect of Same-Sex Marriage Laws on Estate Planning. "This is generally going to be three years, their past three years of returns, and this can be a benefit or a detriment depending on their financial situation, but there is no duty to amend the returns."
Pearl recommended that all same-sex couples, either married or in registered domestic partnerships, speak to their accountants or other advisers to determine if amending their returns would make sense for them. Those who are not married, for whatever reason, should also ask themselves if they are now interested in marrying, she added.
"Maybe some couples haven’t even thought about that and couples who have registered as domestic partners in states that allow that or entered into civil unions are probably going to want to obtain a formal marriage license because even if the Supreme Court goes all the way and says that it’s unconstitutional to deny same-sex couples the right to marry, that doesn’t necessarily convert every existing domestic partnership or civil union into a valid legal marriage," said Pearl.
The Windsor case specifically had to do with the issue of estate taxes. When Edith Windsor’s wife, Thea Spyer, died the IRS would not allow Windsor to take the routine marital estate tax deduction that allows for heterosexual married widows to delay paying the tax until after they die. Instead, the agency demanded that Windsor pay more than $360,000 in taxes on the estate she shared with her spouse.
If the court rules favorably in the case, then Pearl recommends that same-sex couples review and possibly amend their estate plans to ensure they qualify for all of the available tax exemptions.
She pointed out that since same-sex couples did not qualify for the federal marital deduction and were not focused on delaying the taxes owed until the death of the second partner, "estate planners for same-sex couples were focusing instead on making sure that there’s no double tax so that assets aren’t taxed once when the first spouse passes away and then again at the second death."
Couples may also want "to relook at any premarital cohabitation or domestic partnership agreement," added Pearl, "because most of those were probably drafted at a time that we didn’t know what the income tax effect of divorce would have on same-sex marriages."
A decision against DOMA would likely take effect immediately, said Pearl, though she predicted the IRS would need some time to issue new regulations to deal with the tax implications of such a ruling.
Cray predicted that any guidance from the IRS would come before the deadline for filing 2013 taxes next April. He advised same-sex couples thinking about getting married, particularly if the court also strikes down California’s voter-approved ban against same-sex marriage in a separate case it will decide, to wait to see what the IRS’s response to the DOMA ruling is and to seek personalized advice on their tax filings.
"While federal taxes should not be a barrier to entering into a marriage or expressing commitment and love, marriage may bring with it some changes to what the couple will owe in taxes," he noted. "Every couple’s financial situation is unique, and identifying the best steps to take for these couples and their families will require an individualized assessment of their income and economic situation."