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The recent decision of the Massachusetts Supreme Judicial Court in Goodridge v. Department of Public Health may well turn out to be revolutionary, but it did little for the moment to change the tax rules for same-sex marriages. The federal Defense of Marriage Act provides: “In determining the meaning of any Act of Congress, or of any ruling, regulation, or interpretation of the various administrative bureaus and agencies of the United States, the word ‘marriage’ means only a legal union between one man and one woman as husband and wife, and the word ‘spouse’ refers only to a person of the opposite sex who is a husband or a wife.” If the Defense of Marriage Act is constitutional-as we must assume it to be, barring a constitutional challenge, for the time being-parties to nontraditional intimate household arrangements (even where sanctioned by state law in marriage statutes as in Massachusetts after Goodridge) cannot take advantage of those parts of the federal tax law that turn on marital status. This means that parties to same-sex relationships cannot file joint income tax returns, elect to split gifts, qualify spousal gifts and bequests for the estate- or gift-tax marital deductions, qualify for nonrecognition of gain on interspousal sales, receive employment benefits on a tax-preferred basis or take advantage of numerous other tax benefits that are triggered by spousal status. On the other hand, it also means that parties to same-sex relationships will not be subject to certain disadvantages. They will not have to file income tax returns with a “married filing separate” status or pay the so-called marriage penalty; this means that some same-sex spouses may pay less federal income tax by reason of the Defense of Marriage Act. Further, many transactions deny tax benefits to taxpayers by reason of spousal or other family relationship. Provisions disallowing losses on transactions between related parties and rules attributing ownership of companies to a person by aggregating such a person’s interests with those owned by related parties will not apply to same-sex spouses or unadopted descendants of same-sex spouses. This means that even if same-sex marriages were recognized for federal tax purposes, a few taxpayers would not be better off. Same-sex spouses will not have spousal rights under the Social Security Act or the Retirement Equity Act, since these are federal rights. The loss of these rights will hurt many families, but it may help a small number since married status may reduce total Social Security benefits when both spouses are fully covered. Goodridge should give same-sex couples the right to file a joint return for Massachusetts tax purposes, but in a flat-rate system, the benefits of a joint return will be quite limited, consisting mainly of the ability to apply otherwise unused (or less optimally used) credits, losses and exemptions of one spouse to offset the other spouse’s income or tax. Even if the Defense of Marriage Act means that the federal tax rules have not changed, Goodridge will change the landscape as to property, inheritance, divorce and other areas governed by state law. State recognition of same-sex marital status will mean that same-sex surviving spouses will have the same inheritance rights as heterosexual spouses: namely, the right to an intestate share, the right to administer an intestate estate and the right to claim a statutory share if provisions for the surviving spouse are inadequate. These statutory rights pose tax traps that underscore the need to have good estate plans that are tailored to individual circumstances. Owning the family home jointly might make sense generally, especially with the creditor protection given to tenancies by the entirety in Massachusetts, but the creation of a joint tenancy in real estate will have gift-tax consequences. All these problems come with the overlays of the possibility of divorce. Another component of the Defense of Marriage Act purports to trump the full faith and credit clause of the Constitution by allowing other states not to recognize same-sex marriages. In many cases, a prenuptial agreement will be appropriate not only to protect spouses against bitter property fights in the event of divorce and disruption of estate plans, but also to ensure that carefully tailored plans will not be upset by a move to another state. A well-drawn prenuptial agreement should be drafted with a view to enforceability as a palimony agreement in the event it has to be enforced in another state. For most taxpayers, unmarried status will be a tax detriment. Same-sex households typically function as a single economic unit in much the same way as traditional spousal relationships. Same-sex spouses are in a position much like that which prevailed for all married persons before 1948, the year the joint federal income tax return arrived to produce a tax-planning revolution in noncommunity-property states. Before 1948, taxpayers in common law property states sought to minimize their tax burden by shifting income between spouses. In this way, spouses would attempt to equalize the marginal rates; this is something that may have been more meaningful in a world in which the top bracket was 91% (as it was in 1948) than it is today with much more compressed rates, but it is still a significant concern. Equalization was then, and may now be, accomplished by shifting income to the low-income spouse and shifting deductions to the high-income spouse, for example by having the higher-income spouse employ the lower-income spouse in the high-income spouse’s business, paying generous returns on monies invested with, or loaned to, the higher-income spouse’s business, providing income-earning opportunities to the low-income spouse or generating deductions on the high-income spouse’s return by having the high-income spouse make the family charitable contributions or pay the taxes and mortgage interest on the family home if the high-income spouse is an owner. For the most part, practical considerations such as gift-tax issues, alternative minimum tax and reasonable compensation limitations on deductions may limit the effectiveness of these devices. This is not to say one shouldn’t try, because the savings may make it worthwhile. But these devices are, in effect, self-limiting. Charitable gifts, for example, have a cost and should not be given just to save taxes even if tax benefits mean people can afford to give more. Similarly, no one will want to pay more than the required interest and taxes. Not everyone can take a spouse into a business and, when possible, may have to limit spousal participation. There are many tax rules designed to prevent taxpayers from assigning or shifting income from a high-income spouse to a low-income spouse. Residences pose issues Ownership of the family residence may be a harder decision. If the richer spouse owns the residence, it may be a case of the rich getting richer, since residential real estate has been booming. On the other hand, ownership by both spouses will often provide both spouses with a sense of security, achieve the creditor protection of a tenancy by the entirety, share appreciation, achieve flexibility in use of homeowner deductions and maximize nonrecognition of gain on a sale of the residence. The downside is the gift tax both on creation of the joint ownership and the payment of costs of debt service and improvements. Many employee tax benefits are based on a spousal or dependency basis. Health benefits provided by an employer to a party to a nontraditional marriage will be taxable unless the nonemployee spouse or domestic partner is a dependent. In order to qualify the nonemployee spouse or domestic partner as a dependent, the employee will have to provide more than 50% of the support of the dependent spouse. Similar support principles apply to children of the domestic partner or same sex-spouse. All such “unrelated” dependants must be members of the taxpayer’s household for the entire year. Special problems for the rich Estate-planning tax problems are very serious for wealthy same-sex spouses because of the absence of the ability to make unlimited interspousal gifts. In this case, the absence of a marital deduction means that tax-free gifts will be limited by the per-donee annual exclusion (currently $11,000). Furthermore, the lifetime unified credit gift-tax exemption of $1 million is not scheduled to increase. Staying within the limits may not be easy. Parties to same-sex unions may not split gifts. Gift splitting makes the effective exemptions $22,000 and $2 million for traditional married couples, and many gifts may be made inadvertently in a household where expenses are managed jointly. No gift occurs when money goes into a joint bank account, but a gift occurs when more money is taken out by a joint account holder than the joint account holder put in. It might make sense to have partners contribute equally to an account for household expenses shared on an equal basis and otherwise keep separate accounts. Joint real estate arrangements may be even more insidious. A gift is made on the creation of the ownership if one owner pays for more than his share. The problem comes up again every month thereafter with mortgage payments. The problem for estate planning is as bad or worse. Heterosexual spouses enjoy an effective per-donee annual exclusion of $22,000, and the unlimited marital deduction allows them to defer all tax until the death of the second spouse. By using a so-called credit shelter or bypass trust, they can effectively double the unified credit estate-tax exemption, which increased to $1,500,000 in 2004 (with further increases scheduled in future years). Eventually the lifetime exemption is scheduled to go to $3,500,000 (effectively $7 million) before the estate tax disappears for one year in 2011. The loss of the second exemption could cost same-sex married persons’ heirs up to $1,575,000 in tax. Leverage exemptions Since same-sex couples may have lesser effective exemptions, a premium is placed on leveraging those exemptions so as to shift wealth from the wealthier spouse to the poorer spouse. There are many strategies for leveraging exemptions. These include the use of “Crummey powers,” powers of withdrawal given to many people, which are not currently exercised. These powers may be given to a group that could include the poorer spouse and the respective natural and adopted children, siblings and nieces and nephews of the spouses-which could be a large group. If the group had 10 members, for example, $110,000 could be added to a trust for the benefit of the group each year. The benefits could be distributed (after withdrawal rights lapse) on a discretionary basis to the poorer spouse and the children or be used to pay insurance premiums to establish a large fund after the death of the donor spouse. Other strategies could involve the use of grantor retained interest trusts (GRITs) or charitable remainder trusts (CRTs). A qualified personal residence trust (QPRT) works just like a GRIT except that the grantor retains the use of the family home instead of the income for the term, and the house can then pass to the poorer spouse and/or children. A variation on the CRT is a charitable lead trust (CLT), whereby a charity gets the benefit for a term and then the trust passes to the individuals whom the donor wishes to benefit. These trusts leverage lifetime exemptions by reducing the taxable gift by the actuarial value of the retained interest in the case of the GRIT or QPRT or the charitable interest in the case of the CRT or CLT. Another strategy is to give interests in property that may be subject to a valuation discount due to factors such as lack of ready marketability, lack of management control or other normally undesirable attributes, which may not affect intrinsic values in the long term. Examples include interests in closely held businesses, minority interests, entities with undesirable tax attributes, such as personal holding companies, or entities that are subject to regulatory or contractual restrictions limiting transferability. Valuation discounts can leverage exemptions by giving the gift a gift-tax value that is less-sometimes substantially so-than its intrinsic value. Good planning can mitigate the effects of the diminished exemption, but cannot eliminate the disparate treatment given to same-sex marriages. Death and taxes Same-sex marriages face a further estate tax hurdle; same-sex surviving spouses will have the same inheritance rights as heterosexual spouses, but these statutory rights will not qualify for a marital deduction and preclude the use of CRTs and other devices that leverage exemptions. Same-sex spouses will more than ever need to have good estate plans that are tailored to their individual family and property circumstances. In many cases, a prenuptial agreement will be appropriate not just to protect spouses against bitter property fights in the event of divorce, but also to ensure that carefully tailored estate plans will not be upset by a spouse electing to take a statutory share. After the advantages and disadvantages are quantified and all the damage-control strategies put into effect, same-sex spouses are likely to be paying more taxes than heterosexual couples. The surcharge may range from a few dollars to many hundreds of thousands of dollars if the Defense of Marriage Act is ultimately upheld as constitutional (assuming that a constitutional challenge to it is brought before the courts). Since the Goodridge case is based on due process and equal protection, eventually the tax rules for same-sex and traditional marriages may be the same. Until that time, same-sex spouses will face special, in many cases unique, issues requiring sophisticated tax planning and be forced to pay taxes that damage control cannot avoid. The tax treatment of same-sex and heterosexual spouses is clearly disparate, with same-sex couples being in a less advantageous position. This difference may be a significant factor in the current debate on same-sex marriage. Howard D. Medwed is a partner and chairman of the tax group of Boston’s Burns & Levinson. He has more than 30 years of experience as a tax lawyer in all fields of business, personal and estate-tax planning, with an emphasis on structuring transactions and ongoing business and personal arrangements to promote tax efficiency in combination with the attainment of nontax goals.

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