Tax and Pension Considerations in Same-Sex Divorce Actions

New York is one if the very few U.S. jurisdictions, other than those states that have actually authorized same-sex marriage (Connecticut, Iowa, Maine, Massachusetts, New Hampshire and Vermont), to have given full faith and credit to same-sex marriages validly performed in other jurisdictions. Now that New York courts have explicitly recognized same-sex marriages validly performed elsewhere ' both in those U.S. states that permit such marriages and in non-U.S. jurisdictions such as Canada (see, e.g., Beth R. v. Donna M, 19 Misc. 3d 724 (Sup. Ct. N.Y. Cty. 2008) and C.M. v. C.C., 21 Misc. 3d 926 (Sup. Ct. N.Y. Cty. 2008)) ' we can expect a growing number of same-sex couples, validly married somewhere else, to follow their heterosexual counterparts into New York's divorce courts.

For several reasons, however, same-sex divorce involves complexities not usually seen in more traditional matrimonial actions. These complexities arise because of the interplay of state law, which typically governs familial relationships, and U.S. federal law, which substantially determines the tax and pension consequences of marriage and divorce. The federal Defense of Marriage Act (DOMA) denies spousal status to same-sex couples, even if their marriages are valid, and thus such couples cannot be treated as married for income-tax and other federal purposes. In addition, DOMA explicitly permits states to deny full faith and credit to the actions of other jurisdictions with respect to same-sex married couples. Therefore, the portability of New York same-sex divorce settlements and decrees, along with provisions for child custody, support and spousal maintenance, to other states is extremely problematic.

So far, more than 40 states have used their authority under DOMA to deny full-faith and credit to same-sex marriages validly contracted elsewhere. Until and unless Congress repeals DOMA, or the U.S. Supreme Court eventually rules, in any one of several pending lawsuits (the two furthest advanced of these are both pending in federal court in Massachusetts, one filed by the Gay and Lesbian Defenders and Advocates in March, the other by the state's Attorney General, Martha Coakley, in July), that same-sex marriage is a federal Constitutional right, attorneys handling same-sex divorce cases in New York will need to be wary of the additional pitfalls along the way. These attorneys and their law firms would be well-advised to include practitioners with up-to-date knowledge of the same-sex-specific tax and estate issues as part of their clients' legal teams.

Let's consider here the differing tax and related consequences of same-sex divorce, as compared to traditional divorce decrees and settlements. In addition, let's look at some measures that attorneys can propose to their clients to ameliorate, if not entirely eliminate, the negative consequences of the federal legislation and the potential non-recognition of New York same-sex divorces by other jurisdictions.

Income Tax Consequences

Both marriage and divorce occupy a sometimes-favored status under the Internal Revenue Code (IRC). Married couples may file joint returns, which sometimes ' though not always ' result in lower taxes than if they filed separately. (Dual-income married couples may actually suffer a “marriage penalty.”) Property transfers between spouses are generally not taxable events. In the event of divorce, any property settlement will generally not result in taxable gains, and the divorcing spouses have the option to treat alimony or maintenance payments as taxable to either the payor or payee spouse, in whatever way will suit their tax-planning objectives.

However, under Sec. 3 of DOMA, “marriage” means only a legal union between one man and one woman as husband and wife, and the word “spouse” refers only to a person of the opposite sex who is a husband or a wife. Thus, none of the 179 provisions of the Internal Revenue Code for which marital status is relevant apply to same-sex couples. In fact, an unintended consequence of Congressional passage of DOMA is that, according to the Congressional Budget Office, in a report issued in 2004, (Congressional Budget Office, The Potential Budgetary Impact of Recognizing Same-Sex Marriages, June 21, 2004. Available at http://www.cbo.gov/doc.cfm?index=5559&type=0), income tax revenues would actually increase if DOMA were repealed, because of the impact of the “marriage penalty” for dual-income couples and other tax advantages to same-sex couples, as discussed below. Nonetheless, many same-sex couples would benefit from the ability to file joint returns, the ability to transfer property between spouses without recognizing taxable gain, and, in particular, the ability to structure divorce settlements for maximum tax advantage.

Under IRC ' 1041, no gain or loss is recognized on transfers of property between spouses or former spouses, provided the latter transfers are “incident to a divorce.” Since DOMA bars same-sex couples from using ' 1041, that means transfers between same-sex spouses are taxable events, whether during the marriage or as part of a divorce. Sometimes this can be a good thing. For example, one same-sex spouse can sell appreciated property to his or her spouse on the installment method and defer recognition of gain until the purchasing partner makes payments on the installment note. The purchasing partner can then turn around and sell the asset to a third party without triggering recognition of the gain ' and, presumably a capital-gains tax ' to the household. If they were treated by the IRC as spouses, IRC ' 453(e) would require that the gain be recognized at the time of the sale to a third party. Similarly, same-sex couples can recognize built-in losses on one spouse's assets by selling those assets to the other spouse. Opposite-sex married couples are denied that loss recognition until the assets are sold to third parties. And the combined standard deductions, deduction phase-out limits and other tax thresholds tend to be higher for same-sex couples than for couples who are “married” within the meaning of the IRC. Similarly, same-sex couples can effectively double the $1 million limit on mortgages and the $100,000 limit on home equity loans that qualify for the mortgage interest deduction.

Another tax benefit that is particularly relevant for same-sex couples is that each spouse in a same-sex relationship may claim a $10,000 adoption credit under IRC ' 23 when they adopt a child. A heterosexual married couple adopting a child would only be entitled to a single $10,000 credit. As New York County Surrogate Kristin Booth Glen pointed out in Matter of Adoption of Sebastian, 879 N.Y.S. 2d 677 (2009), adoption of a child by one or both parents is often the only means to ensure that both same-sex parents are recognized as such in any jurisdiction. The availability of a double adoption tax credit makes the process a bit easier.

Of course, failure to be recognized as spouses under the IRC has negative consequences as well. For example, matrimonial lawyers are used to dividing marital property without concern for the tax consequences, since Sec. 1041 of the IRC eliminates the need for recognizing taxable gain when the property is transferred from one divorcing spouse to another. In addition, in the typical divorce scenario, maintenance payments may, under IRC ' 71, be made taxable to either spouse, provided the right words are used by the lawyers and that the payments fall within specified limits to avoid “front-loading” that makes the payments appear more like a property settlement than like ongoing maintenance. Neither of these IRC sections applies to same-sex couples, so attorneys handling the division of property for such couples need to be aware of the tax basis of the property being transferred, and the likely tax effects ' principally unintended recognition of gain or loss ' of property transfers incident to the divorce.

Even if marital property is jointly titled, it will, because the parties are not treated as spouses under the IRC, be considered for many tax purposes to belong to the spouse whose money was used to purchase the asset. Thus, for example, if Lisa and Debra purchase a house together, using Lisa's funds, and in a subsequent divorce the house is awarded to Debra, Lisa will have a capital gain or loss equal to the difference between the value of the house at the time of the transfer and its original cost. Alternatively, Debra's original half-interest in the house could be treated as a gift from Lisa, with the result that Lisa would be taxed on only half the appreciation as of the date of the divorce. This result would involve using some of Lisa's lifetime gift tax exemption.

In addition to the income-tax consequences of a property division upon divorce, same-sex couples need to bear in mind the potential estate and gift-tax consequences of transfers of property before, during and upon the dissolution of a marriage. Small transfers (up to $13,000 in 2009) have no such consequences; they are simply not gifts for federal tax purposes. But larger transfers, to the extent that they are not treated as transfers for fair market value (and it is not clear that all transfers incident to a same-sex divorce would be so treated for federal tax purposes) will have the effect of reducing the transferor's lifetime estate and gift tax exemption amount. This may well be an important consideration for some wealthy divorcing same-sex couples. While IRC ” 71 and 1041 change the federal common-law rules for property transfers between spouses, those rules might still apply to same-sex couples. Most such transfers would likely be treated as gifts, with the possible exception of court-ordered support.

It is extremely unclear, in the absence of any recent case law, whether spousal maintenance would qualify as support. In any event, equitable distribution of marital assets by same-sex couples will almost certainly involve some “elements” and “gifts” for federal purposes.

Pension Considerations

Under the federal Employee Retirement Income Security Act (ERISA), any division of pension funds between divorcing spouses may be made in a tax-free manner only by means of a qualified domestic relations order (QDRO). For a same-sex divorcing couple, a QDRO will not be available, because of DOMA's limiting definition of what is a marriage for federal law purposes. That leaves a divorcing same-sex couple with several less-than ideal possibilities, if retirement accounts form a significant portion of the marital assets, and if a division of those accounts is an essential part of the divorce settlement.

One possibility is that the payor spouse could withdraw funds from a retirement account and transfer them to the payee spouse. That would involve two tax bills, however. One would be for the income tax on the withdrawal and another ' assuming the payor spouse were under age 59 and a half ' for the tax penalty on early retirement account withdrawals. Since it should be a cardinal rule of divorce practice never to leave any money on the table for the tax authorities, this is not a good solution.

Alternatively, the parties could include provisions in the settlement agreement or order requiring the payor spouse to maintain the payee spouse as a beneficiary of the retirement account, in much the same way that divorce agreements and orders often include a requirement for one spouse to maintain insurance for the benefit of the other spouse and children. While that approach would delay access to the funds in the account, it would at least provide the payee spouse with some security for the future. Such a provision would not, however, afford the payee spouse direct access to the retirement accounts if and when he or she needed funds. Also, naming the ex-spouse as a beneficiary of the retirement account would, upon the death of the payor spouse, result in the addition of the account to the decedent's taxable estate, a result that would not occur if the marriage were recognized by the federal government.

Conclusion

Because of the recent advent of same-sex divorce in New York, there have been few court decisions to provide guidance on the tax consequences of such divorces. In addition, as yet, there has been no guidance from the Internal Revenue Service as to the impact of DOMA on the tax treatment of same-sex marriage and, especially, divorce. Until the rules are much clearer, or until DOMA is repealed or declared unconstitutional by the Supreme Court, matrimonial practitioners in New York need to proceed with extreme caution in structuring same-sex divorce settlements.

Stephen A. Zorn is Special Counsel to Mayerson Stutman Abramowitz, LLP, in New York. Leigh B. Kahn is a partner at the firm.

New York is one if the very few U.S. jurisdictions, other than those states that have actually authorized same-sex marriage (Connecticut, Iowa, Maine, Massachusetts, New Hampshire and Vermont), to have given full faith and credit to same-sex marriages validly performed in other jurisdictions. Now that New York courts have explicitly recognized same-sex marriages validly performed elsewhere ' both in those U.S. states that permit such marriages and in non-U.S. jurisdictions such as Canada ( see, e.g., Beth R. v. Donna M , 19 Misc. 3d 724 (Sup. Ct. N.Y. Cty. 2008) and C.M. v. C.C. , 21 Misc. 3d 926 (Sup. Ct. N.Y. Cty. 2008)) ' we can expect a growing number of same-sex couples, validly married somewhere else, to follow their heterosexual counterparts into New York's divorce courts.

For several reasons, however, same-sex divorce involves complexities not usually seen in more traditional matrimonial actions. These complexities arise because of the interplay of state law, which typically governs familial relationships, and U.S. federal law, which substantially determines the tax and pension consequences of marriage and divorce. The federal Defense of Marriage Act (DOMA) denies spousal status to same-sex couples, even if their marriages are valid, and thus such couples cannot be treated as married for income-tax and other federal purposes. In addition, DOMA explicitly permits states to deny full faith and credit to the actions of other jurisdictions with respect to same-sex married couples. Therefore, the portability of New York same-sex divorce settlements and decrees, along with provisions for child custody, support and spousal maintenance, to other states is extremely problematic.

So far, more than 40 states have used their authority under DOMA to deny full-faith and credit to same-sex marriages validly contracted elsewhere. Until and unless Congress repeals DOMA, or the U.S. Supreme Court eventually rules, in any one of several pending lawsuits (the two furthest advanced of these are both pending in federal court in Massachusetts, one filed by the Gay and Lesbian Defenders and Advocates in March, the other by the state's Attorney General, Martha Coakley, in July), that same-sex marriage is a federal Constitutional right, attorneys handling same-sex divorce cases in New York will need to be wary of the additional pitfalls along the way. These attorneys and their law firms would be well-advised to include practitioners with up-to-date knowledge of the same-sex-specific tax and estate issues as part of their clients' legal teams.

Let's consider here the differing tax and related consequences of same-sex divorce, as compared to traditional divorce decrees and settlements. In addition, let's look at some measures that attorneys can propose to their clients to ameliorate, if not entirely eliminate, the negative consequences of the federal legislation and the potential non-recognition of New York same-sex divorces by other jurisdictions.

Income Tax Consequences

Both marriage and divorce occupy a sometimes-favored status under the Internal Revenue Code (IRC). Married couples may file joint returns, which sometimes ' though not always ' result in lower taxes than if they filed separately. (Dual-income married couples may actually suffer a “marriage penalty.”) Property transfers between spouses are generally not taxable events. In the event of divorce, any property settlement will generally not result in taxable gains, and the divorcing spouses have the option to treat alimony or maintenance payments as taxable to either the payor or payee spouse, in whatever way will suit their tax-planning objectives.

However, under Sec. 3 of DOMA, “marriage” means only a legal union between one man and one woman as husband and wife, and the word “spouse” refers only to a person of the opposite sex who is a husband or a wife. Thus, none of the 179 provisions of the Internal Revenue Code for which marital status is relevant apply to same-sex couples. In fact, an unintended consequence of Congressional passage of DOMA is that, according to the Congressional Budget Office, in a report issued in 2004, (Congressional Budget Office, The Potential Budgetary Impact of Recognizing Same-Sex Marriages, June 21, 2004. Available at http://www.cbo.gov/doc.cfm?index=5559&type=0), income tax revenues would actually increase if DOMA were repealed, because of the impact of the “marriage penalty” for dual-income couples and other tax advantages to same-sex couples, as discussed below. Nonetheless, many same-sex couples would benefit from the ability to file joint returns, the ability to transfer property between spouses without recognizing taxable gain, and, in particular, the ability to structure divorce settlements for maximum tax advantage.

Under IRC ' 1041, no gain or loss is recognized on transfers of property between spouses or former spouses, provided the latter transfers are “incident to a divorce.” Since DOMA bars same-sex couples from using ' 1041, that means transfers between same-sex spouses are taxable events, whether during the marriage or as part of a divorce. Sometimes this can be a good thing. For example, one same-sex spouse can sell appreciated property to his or her spouse on the installment method and defer recognition of gain until the purchasing partner makes payments on the installment note. The purchasing partner can then turn around and sell the asset to a third party without triggering recognition of the gain ' and, presumably a capital-gains tax ' to the household. If they were treated by the IRC as spouses, IRC ' 453(e) would require that the gain be recognized at the time of the sale to a third party. Similarly, same-sex couples can recognize built-in losses on one spouse's assets by selling those assets to the other spouse. Opposite-sex married couples are denied that loss recognition until the assets are sold to third parties. And the combined standard deductions, deduction phase-out limits and other tax thresholds tend to be higher for same-sex couples than for couples who are “married” within the meaning of the IRC. Similarly, same-sex couples can effectively double the $1 million limit on mortgages and the $100,000 limit on home equity loans that qualify for the mortgage interest deduction.

Another tax benefit that is particularly relevant for same-sex couples is that each spouse in a same-sex relationship may claim a $10,000 adoption credit under IRC ' 23 when they adopt a child. A heterosexual married couple adopting a child would only be entitled to a single $10,000 credit. As New York County Surrogate Kristin Booth Glen pointed out in Matter of Adoption of Sebastian, 879 N.Y.S. 2d 677 (2009), adoption of a child by one or both parents is often the only means to ensure that both same-sex parents are recognized as such in any jurisdiction. The availability of a double adoption tax credit makes the process a bit easier.

Of course, failure to be recognized as spouses under the IRC has negative consequences as well. For example, matrimonial lawyers are used to dividing marital property without concern for the tax consequences, since Sec. 1041 of the IRC eliminates the need for recognizing taxable gain when the property is transferred from one divorcing spouse to another. In addition, in the typical divorce scenario, maintenance payments may, under IRC ' 71, be made taxable to either spouse, provided the right words are used by the lawyers and that the payments fall within specified limits to avoid “front-loading” that makes the payments appear more like a property settlement than like ongoing maintenance. Neither of these IRC sections applies to same-sex couples, so attorneys handling the division of property for such couples need to be aware of the tax basis of the property being transferred, and the likely tax effects ' principally unintended recognition of gain or loss ' of property transfers incident to the divorce.

Even if marital property is jointly titled, it will, because the parties are not treated as spouses under the IRC, be considered for many tax purposes to belong to the spouse whose money was used to purchase the asset. Thus, for example, if Lisa and Debra purchase a house together, using Lisa's funds, and in a subsequent divorce the house is awarded to Debra, Lisa will have a capital gain or loss equal to the difference between the value of the house at the time of the transfer and its original cost. Alternatively, Debra's original half-interest in the house could be treated as a gift from Lisa, with the result that Lisa would be taxed on only half the appreciation as of the date of the divorce. This result would involve using some of Lisa's lifetime gift tax exemption.

In addition to the income-tax consequences of a property division upon divorce, same-sex couples need to bear in mind the potential estate and gift-tax consequences of transfers of property before, during and upon the dissolution of a marriage. Small transfers (up to $13,000 in 2009) have no such consequences; they are simply not gifts for federal tax purposes. But larger transfers, to the extent that they are not treated as transfers for fair market value (and it is not clear that all transfers incident to a same-sex divorce would be so treated for federal tax purposes) will have the effect of reducing the transferor's lifetime estate and gift tax exemption amount. This may well be an important consideration for some wealthy divorcing same-sex couples. While IRC ” 71 and 1041 change the federal common-law rules for property transfers between spouses, those rules might still apply to same-sex couples. Most such transfers would likely be treated as gifts, with the possible exception of court-ordered support.

It is extremely unclear, in the absence of any recent case law, whether spousal maintenance would qualify as support. In any event, equitable distribution of marital assets by same-sex couples will almost certainly involve some “elements” and “gifts” for federal purposes.

Pension Considerations

Under the federal Employee Retirement Income Security Act (ERISA), any division of pension funds between divorcing spouses may be made in a tax-free manner only by means of a qualified domestic relations order (QDRO). For a same-sex divorcing couple, a QDRO will not be available, because of DOMA's limiting definition of what is a marriage for federal law purposes. That leaves a divorcing same-sex couple with several less-than ideal possibilities, if retirement accounts form a significant portion of the marital assets, and if a division of those accounts is an essential part of the divorce settlement.

One possibility is that the payor spouse could withdraw funds from a retirement account and transfer them to the payee spouse. That would involve two tax bills, however. One would be for the income tax on the withdrawal and another ' assuming the payor spouse were under age 59 and a half ' for the tax penalty on early retirement account withdrawals. Since it should be a cardinal rule of divorce practice never to leave any money on the table for the tax authorities, this is not a good solution.

Alternatively, the parties could include provisions in the settlement agreement or order requiring the payor spouse to maintain the payee spouse as a beneficiary of the retirement account, in much the same way that divorce agreements and orders often include a requirement for one spouse to maintain insurance for the benefit of the other spouse and children. While that approach would delay access to the funds in the account, it would at least provide the payee spouse with some security for the future. Such a provision would not, however, afford the payee spouse direct access to the retirement accounts if and when he or she needed funds. Also, naming the ex-spouse as a beneficiary of the retirement account would, upon the death of the payor spouse, result in the addition of the account to the decedent's taxable estate, a result that would not occur if the marriage were recognized by the federal government.

Conclusion

Because of the recent advent of same-sex divorce in New York, there have been few court decisions to provide guidance on the tax consequences of such divorces. In addition, as yet, there has been no guidance from the Internal Revenue Service as to the impact of DOMA on the tax treatment of same-sex marriage and, especially, divorce. Until the rules are much clearer, or until DOMA is repealed or declared unconstitutional by the Supreme Court, matrimonial practitioners in New York need to proceed with extreme caution in structuring same-sex divorce settlements.

Stephen A. Zorn is Special Counsel to Mayerson Stutman Abramowitz, LLP, in New York. Leigh B. Kahn is a partner at the firm.