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Friday, June 28, 2013

Cain: The Less Obvious Tax Consequences from the Fall of DOMA

CainPatricia Cain (Santa Clara), The Less Obvious Tax Consequences that Arise from the Fall of DOMA:

We are all familiar with the concept that if you are married you get to file joint returns. And many of us realize that doing so does not always produce a benefit. That is because for two earner couples at the high end, as well as for low income couples who enjoy the benefit of the Earned Income Tax Credit, taxes will increase. But there are more subtle consequences as well. I think of these consequences as the “transition issues” that arise because of past transactions, entered into while DOMA was in effect, but creating current tax issues now that DOMA is gone.

Consider a same-sex couple who has divorced and entered into a property settlement and support agreement. The tax rules that apply to spouses have not applied to these couples in the past because of DOMA. Now they will. Section 71 of the Internal Revenue Code defines alimony as taxable to the recipient and deductible by the payor under Section 215, but only if the payment qualifies as “alimony” under Section 71. If the divorcing spouses do not want the payment to be taxable to the recipient, they can include a provision in the agreement that states that the payment is not taxable. But failure to include such a provision automatically makes the payment taxable. Many such agreements are silent on this point and, in such cases, the default rule (presuming taxable alimony unless the parties explicitly agree otherwise) ought to apply. This would make the payments taxable under Section 71 and deductible under Section 215. I fear that too many family lawyers in the LGBT community have ignored the tax impact of divorce under Sections 71 and 215, because they assumed the rules did not apply to them. But now they do. That should mean that, going forward, those payments are taxable income to the recipient and deductible by the payor. If that is not what the taxpayers intended, will the IRS provide relief?

There is a related problem regarding property settlements under Section 1041. When same-sex spouses have divorced under DOMA, many family and tax lawyers assumed that the property settlement was a taxable event under the 1961 Supreme Court opinion in U.S. v Davis. I have argued for years that there are solid arguments for claiming those property divisions are not taxable events, especially when they involve substantially equal divisions of community property. But tax lawyers are often a conservative lot and same-sex couples tend to fear the IRS, producing a tendency to report any potential gains as taxable. I assume that for those spouses who have done so, and are lucky enough to have divorced within the three year statute of limitations period, there is the possibility of amending returns and reporting the transaction as not taxable. But what should happen to those divorced same-sex spouses who do not or cannot amend? Remember that the rule under Section 1041 is that any property transferred incident to divorce takes a carryover basis. Does this mean that the IRS can take the position in a post-DOMA year that because Section 1041 should have applied at divorce, the taxpayer now must use carryover basis upon disposition of the property? That position could create a higher gain in the year of disposition. Again, guidance from the IRS is needed and taxpayer relief seems justified in this situation.

Finally, consider the divorcing couple in a case in which Spouse A’s retirement plan was partly assigned to Spouse B at divorce. We have seen a number of these cases in California where the claim against the retirement plan is a community property claim. If the plan is not covered by ERISA, it has been possible to obtain a “Domestic Relations Order” (DRO) ordering the distribution to Spouse B. However, because of DOMA, the order is not a QDRO (Qualified Domestic Relations Order). The tax result in such a case is that Spouse A, the employee, is taxed on the income, rather than Spouse B, the recipient. Can A amend if the statute has not yet run and claim that the distribution was not taxable income to A? Will the Service immediately go after B to require B to report the income as taxable even though B reasonably relied on the law in effect in the year of distribution to claim that the distribution was not taxable?

And then there is the ever pervasive question of who counts as married. If the IRS elects to treat only those persons residing in recognition states as married, what happens in our above examples? For instance, what happens if the divorce occurs in a recognition state (which generally it must under state family law rules) and then the alimony recipient moves to Georgia? Does the taxable alimony become nontaxable because she crossed a state line? It shouldn’t, but who knows. There are so many questions the IRS must face now that DOMA has fallen. I can’t wait to see the answers.

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Comments

I'm hoping someone can answer a 'simple' tax question for me. Same sex couple marries in a recognition state. They move to a non-recognition state. Can someone cite a Code or reg. section or a rev. rul. that says they cannot file a joint 1040? After all, if two young folks (hetero) married in a state where very young marriage is allowed, and then moved to a state with higher minimums, they would be able to file jointly? I just have not been able to find authority for the statement I see in all the newspaper reports that says my same-sex couple cannot file a joint 1040.

Posted by: eli bortman | Jun 29, 2013 4:00:25 AM

The IRS ruled back in the 50's (I think) that a taxpayer's filing status for purposes of the federal income tax depends on the taxpayer's marital status in the state in which he/she resides on the relevant date (which is December 31 for purposes of the income tax). The IRS has followed this rule for a very long time. They would have to change their ruling policy in light of the Windsor decision. Also, whether or not you are correct in your example of the very young married couple depends on whether the state of residence would recognize their prior marriage in another state. Probably most states would (I'm guessing). If so, the IRS does, too. But most state with mini-DOMAs explicitly prohibit recognizing same sex marriages celebrated in other states.

Posted by: Mitchell S. Fishman | Jul 1, 2013 1:52:22 PM