Same-Sex Couples and Taxes
By Roberton Williams :: March 25th, 2013
The 1996 Defense of Marriage Act (DOMA) was not primarily a tax law but it certainly affects the federal taxes that same-sex couples pay. In fact, taxes are the basis for the second of the two cases concerning same-sex marriage that the Supreme Court will hear this week.
Although the federal government generally recognizes state laws concerning marriage, DOMA requires the federal tax code treat all same-sex couples as unmarried. That standard applies to both the estate tax and the income tax. While the Supreme Court will be reviewing an estate tax case, Windsor v. United States, its ruling will likely affect both taxes.
The estate tax issue is this: Under DOMA, same-sex couples cannot take advantage of the unlimited deduction for bequests to spouses or share the doubled exemption that benefits federally-defined married couples.
New Yorkers Thea Clara Spyer and Edith Windsor married in Toronto in 2007 because their home state didn’t allow same-sex marriage. New York did recognize their status when Thea died two years later, but the IRS didn’t. It denied Clara the estate tax’s spousal exemption, resulting in a tax bill of more than $360,000. Lower courts subsequently ruled that denial unconstitutional and the federal government has appealed. In an extra twist, the Justice Department is not arguing the appeal—the House of Representatives is making the case.
The estate tax is small potatoes—in 2013 fewer than 4,000 estates will exceed the $5.25 million threshold for owing tax and few of those will involve same-sex couples. The income tax is where the action is: The Congressional Budget Office has estimated that hundreds of thousands of same-sex couples face different income tax bills because of DOMA.
The effect can be good or bad for a couple’s pocketbook. Marriage can reduce a couple’s income tax liability—yielding a “marriage bonus”—typically when spouses have markedly different incomes. Or marriage can increase their tax bill—a “marriage penalty”—usually when their incomes are similar. David Weiner and I explained all the details in a 1997 CBO paper.
But under DOMA, same-sex couples are not considered married and thus must file as individuals (or heads of household if they have dependents). They don’t suffer marriage penalties but neither can they benefit from marriage bonuses.
The IRS has made matters even more complicated. Under its regulations, same-sex couples in community property states that recognize their marriages, civil unions, or domestic partnerships must split their incomes (with some exceptions for income from assets owned separately). Each therefore pays income tax on half the total. The IRS rules create odd tax situations—I'll explain some of those tomorrow.
The income-splitting requirement is based on a 1930 Supreme Court decision, Poe v. Seaborn, that affirmed income splitting for married couples in community property states (but not in non-community property states—see Lucas v. Earl). The result: The progressive rate structure of the federal income tax means income splitting combined with individual filing can only create marriage bonuses.
That’s the situation facing same-sex couples in three community property states, Washington (which recognizes same-sex marriage) and California and Nevada (which recognize domestic partnerships). If the court strikes down DOMA for tax purposes, many same-sex couples in those states will face higher tax bills. In other states that recognize same-sex relationships, couples may face bonuses or penalties. And in the many states that don’t recognize such relationships, nothing would change unless the court requires states to recognize same-sex marriages.
States that allow same-sex marriages, civil unions, or domestic partnerships for tax purposes could give people in those relationships the federal tax savings from income splitting even if the court upholds DOMA. They could use the same approach some non-community property states used right after World War II: establish community property rights for tax purposes only. After a number of states did exactly that, Congress created joint filing in 1948.
The Supreme Court will render such action moot if it strikes down DOMA. And if that happens, many same-sex couples will celebrate, even if it means that some will pay higher taxes.