Same Sex Marriage Tax Tips and Explanation

We have been receiving questions about how the new supreme court decision about gay marriage changes the typical tax return.  Below is a detailed description of many different topics and what to think about during the tax year.  

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Abacoa CPAs

Since the Supreme Court's 2013 Windsor decision (Sup. Ct. 2013)], same-sex couples, who are legally married under state or foreign laws, are treated as married for federal tax purposes just like any other married couple. The Supreme Court's Obergefell v. Hodges decision, (Sup. Ct. 6/26/15)] (issued in late June) now requires all states to license and recognize marriages between same-sex couples. Specifically, the decision states that same-sex couples can exercise the fundamental right to marry in all states, and that there is no lawful basis for a state to refuse to recognize a lawful same-sex marriage performed in another state.

This means that same-sex couples, who are legally married in any state, are now allowed to file joint state income tax returns wherever they reside. They are also entitled to the same inheritance and property rights and rules of intestate succession that apply other legally married couples. Therefore, same-sex couples should now be able to amend previously filed state income and inheritance tax returns for open years to reflect married status and claim refunds. Furthermore, these couples likely need to rethink their estate and gift tax plans.

Note: The ruling does not impact individuals in registered domestic partnerships, civil unions, or similar formal relationships recognized under state law, but not denominated as a marriage under the laws of that state. These individuals are still considered unmarried for federal and state purposes. However, these state-law "marriage substitutes" might be eliminated now that all states must allow same-sex marriages. Individuals in these relationships can now obtain marriage licenses, get married, and thereby qualify as married individuals for both state and federal tax purposes. 

Here are some thoughts about the impact of Obergefell .

State Income Tax Implications of Obergefell

Since the Supreme Court's 2013 Windsor decision, members of same-sex married couples generally can and must file federal tax returns as married individuals (starting with the 2013 tax year, and for earlier years if the original return was filed after 9/15/13). However, members of married same-sex couples who live in states that did not previously recognize same-sex marriages had to file state income tax returns as unmarried individuals. This caused added complexity and expense in filing state returns. For example, some states that did not recognize same-sex marriages required affected individuals to prepare "dummy" federal returns showing unmarried status in order to reconcile the numbers reported on their state returns.

Obergefell essentially makes the Windsor decision applicable for state tax purposes, as well as for federal tax purposes. In other words, members of same-sex couples, who are legally married under the laws of any state, are now considered married for both state and federal income tax purposes, regardless of where they live. Going forward, this means that legally married same-sex couples will file state income returns just like any other legally married couple.

The exact mechanics on how states that don't already recognize same-sex marriages will handle this change for previously filed returns remains to be seen. However, married same-sex couples should evaluate whether it is advantageous to file amended returns for open years when they previously weren't allowed to file state income tax as married individuals. (As you know, filing joint returns is not always beneficial.)

Other state income tax implications of being married can include:

• The decision to itemize deductions or claim the standard deduction for state income tax purposes.
• Eligibility for various state income tax deductions and credits that were not previously available due to stricter income phase-out rules for unmarried individuals.

Impact on Estate, Trust, and Gift Taxes

Now that same-sex marriages are considered legal for both federal and state purposes, estate, trust, and gift tax benefits are available for all married same-sex spouses. Terms that previously applied only to married persons of the opposite sex or same-sex spouses legally married in jurisdictions that recognized such marriages now apply to all married persons, regardless of the couple's domicile or sexual orientation.

Expanded Eligibility. The estate, trust, and gift tax benefits now available to all married couples include the following:

• Marital Deduction . If all requirements are met, spouses are entitled to claim the unlimited marital deduction for lifetime gifts or transfers at death. For states that impose a state estate or inheritance tax, most allow an exemption for bequests to spouses, which now includes a same-sex spouse. Although a marital deduction has been available to same-sex couples who were married in states that recognized the marriage for federal estate tax since 2013 (after the Supreme Court's ruling in Windsor ), the deduction is now available at the state level, too—even for the states who previously did not recognize the marriage as legal.
• Portability Election. All same-sex spouses are now eligible to make the portability election to transfer the deceased spouse's unused estate tax exclusion to the surviving spouse. The surviving spouse can use the exemption carryover to reduce gift tax during life or estate tax for transfers at death. This election permits both spouses to maximize their estate exclusion amounts, regardless of who dies first. The portability election was discussed in TAM–1741.
• QTIP Election . All same-sex spouses can now use a Qualified Terminable Interest Property (QTIP) trust election to qualify for the marital deduction. A QTIP election ensures that the deceased spouse's assets are available after his or her death to care for the surviving spouse, yet allows the decedent to determine who receives the property when the surviving spouse dies.
• Elective Share Right. All same-sex surviving spouses can now claim his or her elective share of the deceased spouse's estate, regardless of the provisions of the deceased spouse's will.
• Gift-splitting. Allsame-sex spouses, if both consent,can electto treat gifts made by one spouse as if they were made one-half by each spouse. With gift-splitting, the amount of the annual exclusion gifts (i.e., those not subject to gift tax) can be doubled. In 2015, if the gift-splitting election is consented by both spouses, annual exclusion gifts of up to $28,000 per donee can be made.
• Qualified Domestic Trusts (QDOTs). All same-sex spouses can create a QDOT, which is a trust that can qualify for the marital deduction when the surviving spouse is not a U.S. citizen.

Potential Drawbacks. Although most of the expanded estate, trust, and gift tax implications for same-sex marriages are positive, a few drawbacks apply in these situations, including the following:

• Transfers to Grantor Retained Income Trusts (GRITs) . A GRIT is created by a grantor by placing property in trust for the benefit of a remainder beneficiary, while retaining the income from the trust assets for the grantor's life or a term of years. This has the potential to save transfer taxes on property that is likely to appreciate. Unfortunately, GRITs can't be used in family transfers. Because same-sex spouses are now considered family members in all jurisdictions, this planning opportunity is no longer available to them.
• Transfers or Sales by Qualified Personal Residence Trusts (QPRTs) . A QPRT is an irrevocable trust created by the grantor to hold his or her residence for a specified period, after which the residence is transferred to the remainder beneficiaries (usually his or her children). If the grantor is likely to be subject to estate tax, transferring a home to a QPRT, rather than an outright gift during his or her life or a transfer at death, can save significant transfer taxes. To qualify as a QPRT, the trust must meet certain requirements, one of which is that the trust cannot sell or transfer the residence, directly or indirectly, to the grantor or the grantor's spouse during the retained term of the trust, or at any time after the retained term interest that the trust is a grantor trust. Here again, because a same-sex spouse is now considered the grantor's spouse in all jurisdictions, a sale of the residence by the trust to a same-sex spouse is no longer allowed.

Taking Advantage of Benefits Not Previously Allowed. Now that the estate, trust, and gift tax benefits are available to all married same-sex couples, those who were not considered legally married before the Supreme Court's ruling in Obergefell should be able to claim them. For example, the executor of a deceased same-sex spouse's estate should consider making the portability election by filing an estate tax return (even if not otherwise required to file because the filing threshold is not met). The opportunity to take advantage of these benefits should be incorporated into the couple's planning by updating their estate documents. Certain trusts that were created for the same-sex couple may no longer be necessary, including Irrevocable Life Insurance Trusts (ILITs) set up to cover federal and/or state death taxes that may no longer apply due to the marital deduction or the portability election.

Married same-sex couples may wish to amend their previously filed federal and state estate and gift tax returns (assuming the statute of limitations has not expired) to claim benefits for which they were previously not eligible. For example, if the deceased spouse made gifts during his or her lifetime or at death to a same-sex surviving spouse, there may be an opportunity to file an amended gift or estate tax return to claim the unlimited marital deduction. This could potentially reduce the amount of applicable exclusion that was used and may result in a refund of any gift or estate tax paid. Or, if one spouse made a large gift (one that exceeded the annual exclusion amount, which for 2015 is $14,000) to someone other than his or her spouse, the married same-sex couple may choose to amend prior gift tax returns to take advantage of the gift-splitting election.

Nontax Implications of Obergefell

In Obergefell , the Supreme Court noted that other implications of an individual's marital status include spousal privilege in the law of evidence; hospital access; medical decision making authority; adoption rights; the rights and benefits of survivors; birth and death certificates; professional ethics rules; campaign finance restrictions; workers' compensation benefits; health insurance; and child custody, support, and visitation rights.

Obergefell also impacts social security benefits. Prior to the Obergefell decision, a same-sex couple that was married in one state and resided in another state that did not recognize same-sex marriage was not be able to receive social security spousal and survivor benefits because the place of residence of the same-sex spouses was controlling for social security benefits. Consequently, same-sex couples that were legally married in one location but moved to another where the marriage would not be recognized were not eligible for spousal and survivor social security benefits as a couple.

Because of the decision in Obergefell, same-sex couples are eligible for spousal and survivor social security benefits, regardless of the state in which they reside. Whether this change will be retroactive is not certain. Practitioners should be alert to further guidance from the Social Security Administration about the possibility to claim benefits retroactively for a same-sex couple who was already married but couldn't claim social security spousal or survivor benefits because their state of residence didn't recognize the marriage until after the Obergefell decision.

Conclusion

Since the Supreme Court's 2013 Windsor decision, same-sex couples lawfully married under state law have been recognized as married for federal tax purposes regardless of where they live. However, not all states allowed for or recognized marriages of same-sex couples. In Obergefell, the Supreme Court puts this issue to rest—all states must license and recognize marriages between same-sex couples. All that is left now is the states and other government agencies to provide the details on how they will implement this decision, especially with regards to its retroactive impact. Going forward it's pretty easy. A legally married couple is a legally married couple—period. Legally married same-sex couples probably need to revise their estate plans to account for this change.

Jupiter Divorces typically involve children. Here is what you need to know for taxes

The divorce rate is at an all time high in our area and we continually run into issues with recently divorced parents trying to claim their children.  Below is detailed look at what to do while you are going through the separation process and how easy it is to make a mistake and have a larger tax bill.  

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Serving Jupiter and Palm Beach Gardens

How to Properly Claim your Children after Divorce

IRC Sec. 152 contains a definition of qualifying child that is used to determine eligibility for a number of potentially valuable federal income tax breaks. IRC Sec. 152 also includes rules for determining when a divorced or separated parent can treat a child as that parent’s qualifying child. Usually, a child is the qualifying child of the parent with whom the child resides for the greater number of nights during the year.  That parent is termed the custodial parent, and he or she can generally claim the tax breaks associated with the child. The other parent is called the noncustodial parent, and he or she is generally left out in the cold.

However, IRC Sec. 152(e) provides a special rule that allows the custodial parent to release to the noncustodial parent the right to claim the designated child as a dependent. This, in turn, allows the noncustodial parent to claim certain tax breaks associated with the child. Let’s call this special rule the noncustodial parent rule. In the right circumstances, it can be worth significant bucks to a noncustodial parent..

Here are the basics on how the noncustodial parent rule works and why it’s important, along with some recent developments.

How the Noncustodial Parent Rule Works

Under the noncustodial parent rule, a child is the qualifying child of the noncustodial parent if all the following five tests are passed for the calendar year in question.

1. Support Test. The child receives over half of his or her support from the parents.

2. Divorced or Separated Test. The child’s parents are divorced or legally separated under a decree of divorce or separate maintenance, they are separated under a written separation agreement, or they lived apart at all times during the last six months of the year.

3. Custody Test. The child is in the custody of one or both of the parents for over half the year.

Warning: According to Reg. 1.152-4(c), the custody requirement can only be met if applicable state law gives 1 or both parents the right to physical custody of the child. Generally, there is no such parental right after a child reaches the legal age of majority (age 18 or 21 in most states). Therefore, it may be impossible to meet the custody requirement for an older child. If the custody requirement is not met, the noncustodial parent rule cannot possibly apply, and the question of who can claim the child as a dependent must be decided using the “regular” rules under IRC Sec. 152. That determination will also affect who can claim the various other child-related tax benefits discussed in this article.

4. Written Declaration Test. The custodial parent signs a written declaration releasing to the noncustodial parent the right to claim the child as a dependent for the year. According to Reg. 1.152-4(e), the declaration must (1) be an unconditional release of the custodial parent’s claim to the child as a dependent for the years the declaration is effective, (2) name the noncustodial parent to whom the exemption is released, and (3) specify the years it is effective. A declaration is not unconditional if it requires the noncustodial parent to satisfy any condition, including being current on child support payments. The declaration is generally made by having the custodial parent sign IRS Form 8332

(Release/Revocation of Release of Claim to Exemption for Child by Custodial Parent). Alternatively, the required written declaration can be made on another document that conforms to the substance of Form 8332.

 Warning: When Form 8332 is not used, the required written declaration must be made on a separate document that is executed for the sole purpose of releasing to the noncustodial parent the right to claim the child as a dependent for one or more years. This rule means that a written declaration cannot simply be included within the text a court order, decree, or separation agreement. [See Reg. 1.152-4(g), Example 18.] However, written declarations that were executed on or before 7/2/08 are still okay, as long as they complied with the rules in effect at the time they were executed.

5. Return Attachment Test. The noncustodial parent attaches to his or her Form 1040 for the applicable year a copy of the signed written declaration (Form 8332 or the equivalent).

 Why the Noncustodial Parent Rule Is Important

When all of the preceding five tests are passed, the noncustodial parent is eligible for the following tax breaks with respect to the child to whom the noncustodial parent rule applies (assuming all the other qualification rules for these breaks are also met).

1. Section 152 Dependency Exemption Deduction. For 2015, this deduction is $4,000 (subject to phaseout for higher-income parents). IRS Notice 2006-86 says the deduction for a child to whom the noncustodial parent rule applies always belongs to the noncustodial parent.

2. Section 24 Child Tax Credit. This credit is $1,000 per eligible child (subject to AGI-based phaseout).

This outcome is explicitly provided for by statute because the child tax credit can only be claimed for a child who is the taxpayer’s qualifying child and for whom the taxpayer can claim a dependency exemption deduction.

3. Section 25A Education Tax Credits. A parent can claim the American Opportunity or Lifetime Learning Credit for qualified tuition and related expenses incurred for a child for whom that parent can claim a dependency exemption deduction. Therefore, when the noncustodial parent rule applies to a child, the noncustodial parent can claim a Section 25A credit for that child’s education expenses, and the custodial parent cannot.

4. Section 221 Student Loan Interest Deduction. A parent can claim a deduction for up to $2,500 of qualified education loan interest expense incurred for a child who is that parent’s qualifying child under the Section 152 rules. Therefore, when the noncustodial parent rule applies to a child, the noncustodial parent can claim the Section 221 deduction for interest paid on education loans taken out for that child, and the custodial parent cannot.

5. Section 222 Tuition Deduction. Assuming this break is extended (it expired at the end of 2014), a parent can claim a deduction for up to $2,000 or $4,000 of qualified tuition and related fees for a child for whom that parent can claim a dependency exemption deduction. Therefore, when the noncustodial parent rule applies to a child, the noncustodial parent can claim the Section 222 deduction for qualified tuition and fees paid for that child, and the custodial parent cannot.

6. Other Tax Breaks. Whether or not the noncustodial parent rule applies to a child, both parents can generally take advantage of the following tax breaks: (1) itemized deductions for that child’s medical expenses, (2) HSA contributions based on that child’s status as a dependent, (3) tax-free reimbursements for that child’s medical expenses under IRC Secs. 105(b) and 106(a), and (4) tax-free treatment for employee discounts and no-additional-cost services provided to that child].

This rule applies as long as: (1) the parents together provide over half of the child’s support for the year, (2) the child is in the custody of one or both parents for over half the year, and (3) the child meets the definition of a qualifying child of one of the parents under IRC Sec. 152(4). However, if these conditions are not satisfied, and the noncustodial parent rule doesn’t apply to the child, the aforementioned tax breaks are off limits to the noncustodial parent.

Some Tax Breaks Are Strictly Off-limits for Noncustodial Parents

Even when the noncustodial parent rule applies, the noncustodial parent cannot claim head of household status based on a child to whom the noncustodial parent rule applies. Also, a noncustodial parent is not entitled to the child and dependent care credit under IRC Sec. 21, earned income credit under IRC Sec. 32, or income exclusion for dependent care assistance benefits under IRC Sec. 129 for a child to whom the noncustodial parent rule applies. (See Notice 2006-86.) These breaks generally belong to the custodial parent. In any case, the noncustodial parent cannot claim them based on a child to whom the noncustodial parent rule applies.

Importance of Obtaining Signed Form 8332 to Activate Noncustodial Parent Rule

In the facts underlying the Tax Court’s 2014 Swint decision, Lisa Swint had filed a joint 2009 federal income tax return with her husband, Tommy Swint, who had fathered a child in a previous relationship. In

1998, an agreed entry between Tommy (the noncustodial parent) and the child’s mother (the custodial parent) was filed with the Common Pleas Court of Montgomery County, Ohio, Juvenile Division. The agreed entry allowed Tommy to claim the child as his dependent and claim the related child tax credit—as long as he remained current on his child support obligations. Neither party signed the agreement.

After an audit of the now-deceased Tommy’s joint 2009 federal income tax return with Lisa, the IRS disallowed the dependency exemption and child tax credit claimed on the return. The now-widowed Lisa took her case to the Tax Court where she argued that the agreed entry filed with the Common Pleas Court was sufficient to meet the written declaration requirement rules that were in effect at that time and that

Tommy’s child could therefore be claimed as a dependent on the joint 2009 return.

The Tax Court sided with the IRS by concluding that the agreed entry was insufficient for two reasons.

First, it was not signed by the custodial parent (the child’s mother). Second, the agreed entry did not unconditionally release the custodial parent’s (mother’s) right to claim the child as a dependent. Instead, the release was conditioned on Tommy staying current on his child support obligations. The fact that Tommy did stay current did not help his cause because the issue was whether the custodial parent’s release was unconditional. Since it was not, the case was closed in favor of the IRS.

Note: The pre-7/3/08 written declaration rules that were applicable to the Swint case were not exactly the same as the current written declaration rules. The important thing to understand is that the very-similar current rules must be met for a noncustodial parent to claim the child-related tax breaks.

In the facts underlying the Eighth Circuit’s 2014 Armstrong decision, the taxpayer’s court-ordered divorce decree awarded him the dependency exemptions for his two children, who lived with his ex-wife, as long as he stayed current on his child support obligations. However, the court order did not require the ex-wife to provide the taxpayer with a signed Form 8332. Although the taxpayer made his child support payments as required, the ex-wife never provided him with a signed Form 8332. The Eighth Circuit concluded that the court order did not unconditionally establish that the ex-wife would not claim dependency exemptions for the children or that she would provide a signed Form 8332. Therefore, the taxpayer was not entitled to claim the exemptions for the two children.

Custodial Parent Can Unilaterally Negate Noncustodial Parent Rule

According to Reg. 1.152-4(e)(3), the custodial parent can unilaterally revoke an earlier release to the noncustodial parent of the right to claim a designated child as a dependent. In other words, a signed Form

8332 previously provided to the noncustodial parent can be nullified later on by the custodial parent. This unilateral revocation rule effectively allows the custodial parent to yank from the noncustodial parent the federal income tax benefits associated with the noncustodial parent rule, with or without cause. The regulation says a revocation is allowed even when the divorce papers clearly stipulate that the custodial parent must release to the noncustodial parent the right to claim the designated child as a dependent. [See

Reg. 1.152-4(e)(3) and 1.152-4(g), Example 20.]

How to Make Revocation. A revocation is accomplished by attaching to the custodial parent’s Form 1040 a copy of Form 8332 (or a successor form issued by the IRS). Alternatively, a revocation can be made with a separate document that conforms to the substance of Form 8332 (or a successor form) and that is executed for the sole purpose of revoking an earlier release to the noncustodial parent of the right to claim the designated child as a dependent.

Tax Years Affected by Revocation. A revocation must specify the year or years for which the revocation applies, and a copy must be attached to the custodial parent’s Form 1040 for each year that the revocation applies. A revocation for all future years is treated as taking effect starting with the first year after the year during which the revocation is executed.

Noncustodial Parent Must Be Notified. The custodial parent must provide the noncustodial parent with written notice of the revocation or make reasonable efforts to provide such notice. The revocation cannot take effect any earlier than the year after the year in which the custodial parent provides notice to the noncustodial parent (or makes reasonable efforts to provide such notice). The custodial parent must keep a copy of the revocation and evidence of delivery of the required notice to the noncustodial parent (or attempts to deliver such notice).

Conclusion

In divorce situations, potentially valuable child-related tax breaks can be up for grabs between the two parents. The noncustodial parent rules can be very beneficial for the noncustodial parents of the world. That said, it is critical for the noncustodial parent to obtain a signed Form 8332 from the custodial parent.

Experience shows that it is best to obtain the signed Form 8332 while all the other divorce-related papers are being signed and exchanged because cooperation later on