Alan S. Gassman & Danielle Creech: Federal Estate Tax Planning for Same Sex Couples

By Alan S. Gassman, Esq. and Danielle Creech, Esq.

Federal Estate Tax Planning

For more affluent married couples federal income, estate and gift tax planning will provide the most important financial differences when a couple decides whether or not to be married.

Internal Revenue Service Ruling 2013-17

On August 29, 2013, the IRS ruled that same sex couples will be considered as married for federal income, estate and gift tax purposes, for 2013 filings and for amending past returns based upon the normal amendment statute of limitations that prevents any change for tax years Any same sex marriage legally entered into in one of the 16 states that allow same sex marriages, the District of Columbia, or a foreign jurisdiction having legal authority to sanction same sex marriages is covered under this ruling, without regard to whether one or both spouses live in a state or other jurisdiction that recognizes their marriage.

The IRS pronouncement in Revenue Ruling 2013-17 indicated that individuals who have entered into alternative relationships to marriage, such as domestic partnerships, civil unions, and other non-marriage state or foreign country relationships will not be considered as married for federal income tax purposes. The ruling provides that as of September 16, 2013, all qualified retirement plans are required to recognize same sex spouses for purposes of spousal inheritance rights and spousal rollover benefits.

Internal Revenue Service Ruling 2013-17

Since estate tax exclusion portability became available to taxpayers in 2011, the personal representative of the first dying spouse’s estate needed to file a Form 706 (the estate tax return) after the death of the first dying spouse in order to appropriately make the portability election for the surviving spouse. This Form 706 needed to be filed within nine (9) months following the date of death of the first dying spouse, unless the personal representative filed for and was granted an automatic six (6) month extension to this deadline.

However, a great number of personal representatives and surviving spouses were not aware of this deadline or otherwise did not file the Form 706 in order to take advantage of any unused estate tax exclusion amount that remained at the death of the first dying spouse.

The IRS recently issued Revenue Procedure 2014-18, which provides for an extension of time for the personal representative of the first dying spouse to file a Form 706 with respect to the first dying spouse’s estate for the sole purpose of electing portability. This Rev. Proc. generally allows the personal representative until December 31, 2014 to file a Form 706 for the first dying spouse’s estate if the first dying spouse died after December 31, 2010 and on or before December 31, 2013, and if no estate tax return was required to be filed for the first dying spouse because the first dying spouse died with assets with a value less than their estate tax exclusion amount.

Under Rev. Proc. 2014-18, the taxpayer is entitled to relief under Treasury Regulation §301.9100-3, which allows the personal representative to file a Form 706 for the first dying spouse in order to take advantage of such spouse’s unused estate tax exclusion amount. This Rev. Proc. only applies if the taxpayer is the personal representative of the estate of a decedent who (1) has a surviving spouse; (2) died after December 31, 2010 and on or before December 31, 2013; and (3) was a citizen or resident of the United States on the date of death. Further, this Rev. Proc. only applies if the personal representative is not required to file an estate tax return because the first dying spouse’s assets were less than his or her estate tax exclusion amount upon his or her death or if the taxpayer did not timely file an estate tax return to elect portability.

When filing Form 706 pursuant to this Rev. Proc., the Form 706 must be complete and properly prepared in accordance with Treasury Regulation §20.2010-2T(a)(7) (i.e., it must be prepared in accordance with the instructions to the Form 706), and it must be filed on or before December 31, 2014. Additionally, the following language must be included at the top of the Form 706 in capital letters: “FILED PURSUANT TO REV. PROC. 2014-18 TO ELECT PORTABILITY UNDER §2010(c)(5)(A)”.

If the above requirements are satisfied, then the personal representative will be considered to have timely filed the Form 706 to elect for portability to apply, and the personal representative will receive an estate tax closing letter acknowledging receipt of the decedent’s Form 706.

The impetus for this Rev. Proc. is the recent Supreme Court case of United States v. Windsor, in which the Supreme Court struck down Section 3 of the Defensive of Marriage Act to provide that a law defining “marriage” as a legal union between one man and one woman as unconstitutional. After the Windsor decision, the IRS released Revenue Ruling 2013-17 to provide the IRS’ interpretation of the Internal Revenue Code vis-a-vis taxpayers’ marital status in light of the Windsor decision. This revenue ruling held that for federal tax purposes the terms “spouse,” “husband and wife,” “husband,” and “wife,” include an individual married to a person of the same sex if the individuals were lawfully married under state law, and the term “marriage” includes such a marriage between individuals of the same sex.

Rev. Proc. 2014-18 provides a good analysis of the legal effect of Windsor and Revenue Ruling 2013-17 on the tax law, and indicates that this Rev. Proc. is significantly based upon the outcome in the Windsor decision and the IRS’ interpretation of the Internal Revenue Code as a result thereof.

Nevertheless, the benefits afforded by this Rev. Proc. are available to provide relief for late portability elections for opposite sex surviving spouses as well as same sex surviving spouses.

This Rev. Proc. did not address the situation where a surviving spouse has previously filed a Form 706 late, and the Form 706 was not accepted for the purposes of electing portability due to the late filing. It seems that in this case the surviving spouse would simply need to re-file the Form 706 (assuming that it was properly completed and appropriately prepared) with the magic capitalized words on top of the first page in order to take advantage of this other relief provided by this Rev. Proc.

Therefore, for some personal representatives and surviving spouses who neglected to timely file a Form 706 to take advantage of portability, Rev. Proc. 2014-18 provides a second chance.

Amending Prior Tax Returns

Revenue Ruling 2013-17 notes that under Internal Revenue Code Section 6511 same sex married couples have the option of amending their prior tax returns by going back to the earlier of (a) three years from the time the return was filed or (b) two years from the time the tax was paid, whichever is later. Same sex couples may also choose to leave the prior returns intact and not amend one or more prior tax years.

This gives same sex couples some very good choices for income tax planning purposes, but we expect that there will be legislation and/or litigation that will determine whether returns going back further than the normal limits described above will be amendable. Many same sex clients feel that it is blatantly unfair that they paid more tax than they should have and are unable to amend further back than three years, while others feel that it is very fair that they get the best of both worlds, for they can either amend or not amend. We expect additional political jockeying and possible litigation over whether the equal protection clause is violated if same sex couples are not allow to amend back as many years as they would like.

Any gift tax return that involved a transfer to a spouse that used up any portion of the donor spouse’s estate tax exemption should probably be amended to regain the exemption amount, unless there are other items on the gift tax return that are best not re-opened, such as large gifts with questionable values to non-spouse individuals, because amending a gift tax return gives the IRS three years after the date of the amendment to revisit all aspects of the gift tax return amended. We may see possible legislation changing this as well. Could people be denied a tax right and be punished by undergoing increased audit risk as the result of amending returns to get moneys or allowances back that they would have been entitled to as a matter of federal law in the first place?

Almost all affluent married same sex couples (or couples where one spouse is affluent) will want to go to an experienced income tax advisor with the right software, to help determine what years they should amend and what years they should not amend.

Estate and Gift Tax Advantages of Marriage

Before the IRS issued Revenue Ruling 2013-17, a same sex couple would not receive full married couple benefits under the estate and gift tax and income tax laws unless they were (1) married in a state that recognized same sex marriages and (2) resided in a state that also recognizes same sex marriages.

Before this decision we published an article entitled “Why Many Affluent Same-Sex Couples Will Be Leaving Florida and Where They Should Go”. Fortunately, the landscape changed quickly in the right direction.

As the result of Revenue Ruling 2013-17, couples can marry in any of the jurisdictions discussed above which authorize this and have full federal tax law benefits (and the benefit of having no state income tax or inheritance taxes) in states that do not recognize same sex marriages.

Individuals in same sex relationships who expect to be subject to federal estate taxes will want to consider several significant advantages that marriage brings:

  1. The estate tax exemption is presently $5,340,000, and will increase with the Consumer Price Index (CPI), which generally runs 0.5-1% under the inflation rate. If the value of investments will double every 10 years, as it has in the past for many taxpayers, then a great number of Americans will be subject to federal estate tax in years to come.
  2. Any gift exceeding $14,000 per year, per person results in the requirement to file a gift tax return, and reduces the applicable allowance on a dollar for dollar basis.
  3. One spouse can make a large gift and have it be considered to come one-half from the other spouse, if the other spouse will sign a “split-gift” consent return. Therefore, a wealthy spouse can make a large gift to descendants and have it be considered to come from the less wealthy spouse, to in effect use his or her exemption.
  4. Gifts or amounts left upon death to a non-spouse can trigger gift tax or estate tax when the exemption has been used. The tax rate is 40%.
    There is an estate tax marital deduction for assets that pass directly to a surviving spouse, or into a special trust that is required to pay all income to the surviving spouse for his or her lifetime.
  5. There is also a portability allowance that allows a surviving spouse to add the unused exemption allowance of a deceased spouse to his or her own, if certain requirements are met. These requirements are that (1) the estate of the first dying spouse files an estate tax return permitting the portability allowance to exist, (2) the allowance is limited to the amount of estate and gift tax exemption not used by the first dying spouse, (3) the surviving spouse will lose the portability allowance if he or she remarries, and then if the next spouse dies first and leaves no exemption or a smaller exemption.
    It is important to note that the portability amount does not grow with the Consumer Price Index, and it is therefore often much better to fund a “credit shelter trust” for the surviving spouse that can benefit him or her without being subject to federal estate tax on death, notwithstanding that the trust can grow significantly during the lifetime of the surviving spouse.
  6. Marital Deduction and QTIP Trust

Estate and Gift Tax Hypotheticals

The several different primary tax differences that will occur for same sex married couples could perhaps be best explained by the following hypothetical:

First Example

George has a net worth of $15,000,000, and his partner, Sam, has no assets other than significant retirement benefits that he uses to pay his expenses.

George would like to leave $5,000,000 to Sam and $10,000,000 to his (George’s) children, but would also like to avoid federal estate tax.

Assume that George has a $5,000,000 estate tax exemption (even though the exemption increases with the Consumer Price Index each year and is presently $5,340,000 in 2014 – We are sparing the reader the complexity of using that uneven number).

If George dies without being married, then his estate tax would be 40% of $10,000,000, which is $4,000,000.

If George marries Sam and then dies, there will be a $5,000,000 marital deduction for what goes to Sam. Thus, instead of George’s taxable estate being $15,000,000, it will only be $10,000,000. George’s estate tax will be $4,000,000, a savings of $2,000,000 (40% of $5,000,000).

If George marries Sam, and makes a gift of $4,000,000 to a trust for his children (that George might be a potential beneficiary of if the trust is established in an asset protection state like Nevada, Delaware, or Alaska), and Sam signs a split-gift return, then the gift will be considered to have come $2,000,000 from Sam and $2,000,000 from George. Under this circumstance, George’s estate tax allowance would be reduced to $3,000,000 but he has gotten $4,000,000 plus the future growth thereon out of his estate.

When George then dies, leaving $5,000,000 to Sam, and his remaining $6,000,000 to his children, there would be an estate tax of only $1,200,000, so the gift with Sam’s help saves $800,000 in estate tax. ($11,000,000 – $5,000,000 = $6,000,000. $6,000,000 – his $3,000,000 exemption = $3,000,000. $3,000,000 x 40% is $1,200,000. But $6,000,000 – his $1,000,000 exemption if no split gift with Sam = $5,000,000 x 40% = $2,000,000).

If George’s gift to the special trust had been $10,000,000, then there would be no estate tax in our example because Sam and George would have each used their $5,000,000 allowances and what goes from George to Sam on George’s death passes estate tax free.

In addition to the above, George can only gift $14,000 to each child per year while unmarried without reduction of his $5,000,000 exemption. If George and Sam are married, and George has two children, they could gift a total of $56,000 a year. These gifts would reduce neither George’s nor Sam’s lifetime exemption amounts.

This can help keep future growth in George’s assets outside the reach of the estate tax system.

Second Example of Lifetime Gifting

Suppose that instead George has a $10,600,000 estate, and that the exemption amount has increased with the CPI to $5,600,000 and will continue to go with the CPI as it does under present law.

Assume that George is now satisfied with leaving the children $5,600,000, and would like the remaining $5,000,000 to be held for Sam’s lifetime benefit.

George can die, leaving the children $5,600,000, and leaving $5,000,000 in a trust to benefit Sam for his lifetime benefit without being subject to federal estate tax on Sam’s death. This trust is called a QTIP trust and can qualify for the estate tax marital deduction on George’s death if it pays all income to Sam.

On Sam’s subsequent death, there will be no estate tax unless the combined value of the assets he owns on death, and the assets in the marital deduction trust at the time of his death exceeds Sam’s remaining estate tax exemption amount. If Sam dies a few years after George, then it is very likely that George’s children will be very glad that this happened, because instead of paying $2,000,000 of estate tax on the $5,000,000 they lose out on getting the income for a few years, but there may be no federal estate tax liability on Sam’s estate.

Based on the above and, of course, their love, George sees it as an absolute no-brainer to marry Sam, but only after Sam signs a domestic partnership agreement.

While this law is still untested, it appears as though a domestic partnership agreement will be binding on a same sex couple regardless of whether their state of residence currently recognizes same-sex marriage. This is discussed in more detail below.

Third Example

What if Sam dies before George and they are married?

Then, if Sam’s will permits this and he has no assets, or all of his assets go to charity, George can have whatever is left of Sam’s $5,340,000 estate tax exemption (if Sam dies in 2014) added to George’s to reduce George’s estate tax by 40% of $5,340,000 on his eventual death ($2,316,000). Wow, George should find someone about to die soon and marry them for this reason alone! Yes, this is happening throughout the US.

Alternatively, whether or not George and Sam are married, George can give Sam a special power to appoint up to the amount of Sam’s estate tax exemption from assets held under George’s revocable trust to a trust that can benefit George and his children and not be subject to estate tax on George’s death. This way George could have effective use of Sam’s unused exemption without marrying Sam. This technique is not 100% guaranteed to work, but has been approved by IRS Private Letter Rulings granted to individual taxpayers and commented upon favorably by a number of estate tax planning authorities.

Generation Skipping Tax Implications

The federal generation skipping tax system prevents more than a certain amount of assets being held to benefit a donor’s children without being taxed at their demise.

For example, if George has a $20,000,000 estate and wishes to leave everything to his descendants, he would be able to have $5,340,000 pass into a trust in 2014 that would benefit his children without being taxed at their level (or go directly to the grandchildren), but anything above that would have to be subject to federal generation skipping tax, which is a 40% tax imposed in addition to the estate tax.

If George marries Sam and Sam has nominal assets, then in 2014 George could leave $5,600,000 worth of assets to a trust for his children that will not be subject to estate tax or generation skipping tax when each child dies, and the remaining $14,600,000 to a QTIP marital deduction trust (like the one described above) that would pay income to Sam, and would not only have the use of whatever remains of Sam’s $5,340,000 (plus increases for future CPI adjustments) for estate tax purposes, but also for generation skipping tax exemption purposes.

Therefore, if Sam dies 10 years later and the $14,600,000 worth of assets that were generating the income for Sam are then worth $15,000,000, and assuming that Sam’s other assets do not exceed $5,340,000 in value (or higher based upon CPI increases after 2014), George’s grandchildren will pay no estate tax or generation skipping tax on the death of their parents.

Alternatively, George could make a $5,000,000 gift to a trust for children, and if Sam allows the gift to be considered as having come 1/2 through him by filing a split gift consent on a gift tax return, then George will have only used $2,500,000 of his estate tax and generation skipping tax exemptions. If George later divorces Sam and leaves these assets into a trust system for his descendants, the estate tax and generation skipping tax savings will be based upon the tax rates multiplied by whatever the $2,500,000 grows into before George’s death.

We thank Henry Lee, Esquire of the Howard and Howard law firm in Detroit, Danielle Creech, Esq., and also Kylie Caporuscio, Esq., and India Ingram, J.D. for their work on our outline.

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