August 19,2011

With more states passing or considering legislation legalizing same-sex marriage, tax practitioners are paying close attention to the growing complexities and discrepancies between state and federal tax laws involving marriage.

The problem stems from the Defense of Marriage Act (Pub. L. No. 104-199), which defines marriage as between a man and a woman for federal purposes. For federal tax purposes, same-sex married couples do not qualify for federal tax benefits. However, in states that have passed legislation legalizing or recognizing same-sex marriage, domestic partnerships, and civil unions, these couples do get the same tax benefits as opposite-sex married couples. About 20 states have some kind of law legalizing or recognizing same-sex marriages, partnerships, or unions.

With this disconnect between federal and state tax laws, practitioners and advisers are struggling to figure out which rules to apply, Elda Di Re, tax partner in personal finance at Ernst & Young LLP in New York, told BNA.

In New York, which passed a marriage law earlier in the summer, couples are heading to the alter and not thinking about the tax complexities that face them, she said. By next tax season, these couples will be looking at a more complicated and time-consuming tax process.

Complications With Income Taxes

The complexities of how couples file income taxes vary depending on the relevant state’s laws and how much the state relies on federal tax law. Because most state tax laws reference federal tax laws, couples in so-called “recognition” states must complete two sets of documents, tax practitioners told BNA.

On their state tax returns, individuals in recognition states have to start with federal adjusted gross income. But because same-sex couples have to file individually for federal tax purposes, they must complete the individual tax returns plus a mock federal return, completed as if they were filing jointly. Even if couples file married but separate on state tax returns, they are still using a married filing status, which is different from a single status, Patricia Cain, professor at Santa Clara University Law School in Santa Clara, Calif., told BNA.

“Part of it is just the hassle of having to do that extra return,” Cain said. Tax preparers most often charge more because they have to do twice the work. Most practitioners do not recommend taxpayers attempt to file their own taxes, which is more complicated and time-consuming for same-sex couples.

A number of law firms cater to the gay and lesbian community, and may be more expensive but worth the money, Anthony Brown—who heads Albert W. Chianese & Associates’ nontraditional family and estates divisions in New York—told BNA.

“It’s confusing to practitioners, it’s confusing to the couples, but ultimately in the end, it all points to one conclusion and that is that eventually the federal government will honor these marriages,” Brown said.

The disconnect involves some of the most populous states like California and New York, “so we’re talking about a huge number of taxpayers,” even though not all of the states with same-sex marriage laws have income taxes, Cain said.

Adoption Credit, Insurance Also Problematic

The tax issues facing same-sex married couples go beyond filing status.

Some same-sex couples have had trouble recouping costs of adoptions using the federal adoption tax credit, Brown said. Surrogacy costs, for example, are not covered under the adoption credit. Same-sex couples may also find they have more requirements than opposite-sex couples to claim the benefit, as the Internal Revenue Service is “really looking into it in a way they never have before,” Brown said.

Employers in recognition states or those that provide health insurance to domestic partners have an additional burden because health benefits for partners or same-sex spouses are not taxed at the state level but are federally, Cain said. Some employers have begun repaying the federal taxes on those benefits to employees to be more equal to their opposite-sex counterparts, who do not have to pay federal tax on insurance for spouses.

To add to the confusion for same-sex couples and tax practitioners, IRS has given little guidance for how to deal with issues in community property states like California, Washington, and Nevada, Cain said. Return preparers are unsure of how the rules actually apply in these states.

IRS released a publication in December 2010 to answer some of the questions about community property states but the complexity remains, practitioners said.

Estate Tax Eligibility Important

Being able to pass on property to spouses or partners on death without paying state estate or inheritance taxes is a big benefit for same-sex couples in recognition states, Brown said. In New York, the threshold for passing property to a non-spouse was $1 million, which was easy to surpass if the couple owned property in New York City, Brown said. Now, the spouses can transfer an unlimited number of assets to their surviving spouse on death.

For wealthy same-sex couples there is an advantage to living in a state that recognizes their marriage if there is an estate tax, he said. “There are definite issues where marriage really does offer protection, and it’s a real protection,” Brown said. “It’s a protection that really benefits society in general.”

Varying Degrees of Recognition Add to Complexity

Tax preparers have to be aware of the different treatments of civil unions, domestic partnerships, and same-sex marriages on the state level, practitioners said. Some states have watered-down civil union legislation and how that affects taxes depends on the language in the legislation, Brown said.

Some tax provisions or benefits, for example, specify “spouses,” which may not apply to civil unions, he said. In New York, where marriages were recognized before the state passed its law, same-sex married couples were still unable to file jointly on the state level, Cain said.

This difference will be particularly important on the federal level if the law ever changes, Cain said. Much of the Internal Revenue Code is based around benefits of marriage and uses the term “spouse.”

IRS Can Take Step to Clear Questions

Although IRS lacks authority to eliminate the federal tax issues without changes to the law, it can take some steps to clear up confusion, practitioners said. The agency could start by making sure it applies the law the same, Cain said.

“The law is very confusing. A lot of lay people don’t understand the real effect of the Defense of Marriage Act and now it seems there are people in the Internal Revenue Service that don’t understand the effect of the Defense of Marriage Act,” she said.

Since the law passed in 1996, the federal government has issued little guidance on how it applies the law to each state, Di Re said. In a letter sent to IRS Commissioner Douglas Shulman in June, several senators from states with same-sex marriage or domestic partnership laws asked IRS to provide guidance for couples faced with the complex task of filing state and federal returns.