In 1996, after the state of Hawaii began recognizing the marriages of same-sex couples, Congress passed the Defense of Marriage Act (DOMA), Pub. L. No. 104-199, 110 Stat. 2419 (codified at 1 U.S.C. § 7 and 28 U.S.C. § 1738C), to prevent same-sex couples from receiving the benefits afforded to heterosexual spouses under federal law. Under DOMA, federal laws providing benefits to “married” individuals or a “spouse” are to be strictly interpreted to not include same-sex unions. Even after DOMA, however, federal law—including federal law regarding transfer taxation—is applied with many questions of property ownership being determined at the state level. As a result, same-sex spouses and registered domestic partners in community property law states would appear to be able to achieve a number of the same benefits afforded to heterosexual spouses by the federal estate and gift tax marital deductions, but same-sex spouses in common law property states cannot.
Common Law Property vs. Community Property
For purposes of determining whether a decedent had an interest in property that would be subject to the estate tax under IRC § 2033, or whether a decedent’s transfer during life constituted a taxable gift for purposes of IRC § 2501, the initial determination is generally made by referring to the applicable state law on ownership of property. For this reason, differences in state law over property ownership can result in substantially different outcomes under the Internal Revenue Code. One example of a difference in state law that can significantly alter a taxpayer’s liability to the IRS is the difference between common law property and community property.
The majority of states follow a common law property regime. In common law property states, property acquired by spouses during the marriage can be acquired and owned individually by one spouse or jointly by both spouses. The wages earned by one spouse during the course of the marriage are treated for federal tax purposes as the individual property of the spouse who earned the wages. Similarly, real estate titled in the name of one spouse will be treated as the individual property of that spouse for federal estate and gift tax purposes.
By contrast, nine states follow a community property law regime, including Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington, and Wisconsin. Alaska uses common law property ownership as the default rule, but spouses are allowed to make a statutory election to own property as community property. In a community property law state, generally all property acquired during the marriage is owned equally by both spouses. For example, the wages earned by one spouse during the course of the marriage are community property and taxed one-half to the spouse who earned the wages and one-half to the non-earning spouse. Real estate that is acquired during the marriage and titled in the name of only one spouse also is community property and will be treated for federal transfer tax purposes as being owned one-half by the spouse whose name appears on the title and one-half by the other spouse. Commingled property is treated as community property, as is any separate property converted to community property under an agreement between the spouses.
The Federal Estate and Gift Tax Marital Deduction
For federal estate and gift tax purposes, property passing to a spouse generally passes tax free by virtue of the estate and gift tax marital deductions, subject to limited exceptions. Under IRC § 2056, the value of a decedent’s taxable estate is reduced by the value of any property included in the gross estate that passes to a surviving spouse (“marital deduction”). Similarly, under IRC § 2523, the amount of a donor’s taxable gifts is reduced by the value of any interest in property transferred to the donor’s spouse.
A major benefit provided by the estate and gift tax marital deductions is that, for spouses with unequal amounts of wealth, the wealthy spouse can effectively use the other spouse’s applicable exclusion amount. For spouses in community property law states who accumulate substantial wealth before the marriage, or who acquire separate property during the marriage by way of a gift or inheritance, the estate and gift tax marital deductions allow the wealthier spouse to transfer to the other spouse as much property as is necessary to fully use each spouse’s applicable exclusion amount. For the community property of the spouses, the estate and gift tax marital deductions are less consequential, as ownership of one-half of all community property will be vested in each spouse already. For spouses owning property under the laws of a common law property regime, however, the estate and gift tax marital deductions are especially significant because, absent the availability of a marital deduction, the entire amount of any transfer to a spouse would be taxable. The distinction between the federal tax treatment of a transfer of common law property versus community property was the primary motivation for the enactment of the estate and gift tax marital deduction and, as discussed below, would appear to provide same-sex spouses and registered domestic partners the opportunity to achieve many of the same estate and gift tax benefits afforded to spouses whose marriages are recognized for purposes of federal law.
History of the Marital Deduction
Before 1942, the estate of a decedent domiciled in a common law property state transferring property to a surviving spouse would incur a substantially higher tax liability than would the estate of a decedent who was domiciled in a community property law state, as illustrated by Example 1.
A and B were married at the time of A’s death in 1940. A’s entire applicable exclusion amount had been exhausted during A’s lifetime. After payment of all deductible expenses, A’s personal net worth is $2 million. On A’s death, one-half of the entire estate of A passes to B, and the other half passes to A’s descendants.
If A and B in Example 1 were domiciled in a common law property state, A’s taxable estate would have likely been $2 million. If, however, A and B were domiciled in a community property law state and A’s entire net worth consisted of community property, ownership of one-half of A’s property would have been vested in B by operation of law, and A’s taxable estate would have only been $1 million.
As a result of the disparate federal transfer tax treatment of spousal transfers of common law property and community property, and to lessen the federal transfer tax burden resulting from property transfers between spouses, six common law states adopted community property law regimes between 1945 and 1947. In response, the federal estate and gift tax marital deductions were enacted in 1948, allowing a spouse in a common law property state to transfer up to half of the spouse’s property to a surviving spouse free of estate or gift tax. After the enactment of the estate and gift tax marital deductions, all six states reverted back to their previous common law property regimes. The Economic Recovery Tax Act of 1981 created unlimited estate and gift tax marital deductions, allowing spouses to make unlimited transfers of common law property or interests in community property free of estate or gift tax.
The Defense of Marriage Act
DOMA was passed largely in response to the Supreme Court of Hawaii’s validation of gay marriage. In Baehr v. Lewin, 852 P.2d 44 (Haw. 1993), the Hawaii Supreme Court reversed and remanded a state circuit court opinion affirming the constitutionality of a state law preventing the issuance of a marriage license for a same-sex couple. The following trial in state circuit court was held September 10, 1996, and DOMA was passed by Congress and signed by President Clinton less than two weeks later on September 21, 1996.
Among other things, the provisions of DOMA mandate that federal laws (including the Internal Revenue Code) providing benefits to “married” individuals or a “spouse” are to be strictly interpreted to not include same-sex unions. In particular, section 3 of DOMA provides that
in determining the meaning of any Act of Congress, or of any ruling, regulation, or interpretation of the various administrative bureaus and agencies of the United States, the word “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.
Under IRC § 2056, the federal estate tax marital deduction applies to property passing from the decedent to a “surviving spouse,” and, under IRC § 2523, the federal gift tax marital deduction is made available to a donor transferring property to “the donor’s spouse.” Thus, the effect of DOMA for purposes of the federal estate and gift tax is to prevent any transfers to an individual of the same sex, even if recognized as a “spouse” under state law, from qualifying for the federal estate or gift tax marital deduction.
IRS Rulings on Community Property of Same-Sex Spouses and RDPs
Adding to the complications created by the provisions of DOMA, prohibiting same-sex spouses from being recognized as spouses for purposes of federal law, the IRS released three rulings on May 28, 2010, concluding that property owned by a registered domestic partner (RDP) as community property should receive the same federal tax treatment as community property owned by heterosexual spouses. The three rulings are PLR 201021048, CCA 201021049, and CCA 201021050. The primary rationale for the rulings is cited in both PLR 201021048 and CCA 201021050: “Applying the principle that federal law respects state law property characterizations, the federal tax treatment of community property should apply to . . . registered domestic partners.”
PLR 201021048 involved a same-sex couple who filed as RDPs under California law. The facts recited in the letter ruling were that California law provided RDPs with the same rights and obligations of heterosexual spouses—including ownership of property as community property—and that, like heterosexual spouses, RDPs could enter into an agreement to modify or avoid the application of the community property laws, which the RDPs had not done. In addition to concluding that the taxpayer was required to report on his individual federal income tax return one-half of any income treated as community property for state law purposes, the IRS also ruled that the requirement to report half of the taxpayer’s earnings as the property of his RDP “does not result in a transfer of property by Taxpayer to his partner for federal gift tax purposes under § 2501 of the Code,” citing Poe v. Seaborn, 282 U.S. 101 (1930), as support for the conclusion that such vesting occurs by operation of law. Although the scope of the ruling was limited to the federal tax treatment of the taxpayer’s earned income treated as community property under state law, consistency would seem to require that the IRS treat community property as being owned one-half by each RDP for federal estate tax purposes as well. In addition, the rationale applied to community property owned by RDPs also would apply logically to community property owned by same-sex spouses.
Both CCA 201021049 and CCA 201021050 followed the application of federal tax treatment of community property to RDPs. In CCA 201021049, the IRS concluded that the IRS could consider the assets of a taxpayer’s RDP when determining whether to accept a taxpayer’s offer in compromise. CCA 201021050 provided that RDPs that previously filed their returns in accordance with the earlier Advisory Memorandum, which did not require an RDP to report one-half of any income treated as community property, had the option to file amended returns but were not required to do so.
The DOMA Disparity
Just as the federal estate and gift tax regimes before 1948 resulted in a disparity between the federal transfer tax burdens of spouses in common law property states and community property law states, DOMA would seem to create a similar disparity for transfers between RDPs and same-sex spouses. Example 2 below provides an illustration.
C and D have filed as Registered Domestic Partners in a community property law state. C and D have not entered into any agreement to modify or avoid the application of the community property laws of their state. C earns substantially more income than D over the course of their Registered Domestic Partnership. C dies on December 1, 2011. After payment of all deductible expenses, C’s entire net worth consists of $10 million of community property attributable to C’s earnings. On C’s death, one-half of C’s estate is vested in D and the other half passes to a trust for the benefit of C’s nephew.
If the estate tax liability of C’s estate is determined in accordance with the rationale of the three IRS rulings, then the one-half vesting in D will be treated as having vested by operation of law and no federal estate or gift tax will be necessary to complete D’s ownership of the property. The half of the estate vesting in D will have effectively been transferred to D and removed from C’s gross estate without making any transfer subject to estate or gift tax, and C’s applicable exclusion amount can be used to prevent the other half from being subject to estate tax. This result would seem to be achievable in California, Nevada, or Washington, the three community property law states that also allow for same-sex couples to enter into a registered domestic partnership.
If C and D were instead same-sex spouses married under the laws of a common law property state that recognizes gay marriage, C’s gross estate would most likely include all $10 million worth of property, of which $5 million would be subject to estate tax after the use of C’s applicable exclusion amount.
The conclusions made in the IRS rulings leave many questions unanswered. Because the scope of the rulings is limited to the federal taxation of earned income treated as community property for state law purposes, the outcome could readily be distinguished from the federal tax treatment of commingled property, or property acquired before the same-sex union treated as community property under an agreement. Similarly, the federal taxation of property voluntarily converted to community property under the opt-in provisions of Alaska law would clearly be outside the scope of the IRS rulings.
The rulings issued by the IRS are not without some weaknesses. If the applicability of a state’s community property laws is contingent on whether the same-sex spouses or RDPs enter into a written agreement, the choice to forego such an agreement could be construed, at least arguably, as a voluntary transfer subject to the federal gift tax. Although Poe v. Seaborn, 282 U.S. 101 (1930), and United States v. Malcolm, 282 U.S. 792 (1931), are cited in PLR 201021048 as authority for the proposition that ownership of assets as community property occurs by operation of law as opposed to a voluntary transfer, neither Poe nor Malcolm addresses the possible application of the federal gift tax (although it should be noted that both cases were decided before the enactment of the estate and gift tax marital deductions in 1948, and the issue does not appear to have been raised by the IRS). Finally, even though the IRS and the courts have shown a great amount of deference to state law when determining the nature of a taxpayer’s interest in property, the Supreme Court’s decision in United States v. Craft, 535 U.S. 274 (2002) (cited in CCA 201021049), is a stern reminder that such determinations are not absolute. In Craft, the IRS held that tenancy by the entirety property owned by a taxpayer, immune from creditors’ claims under state law, was nonetheless an interest in property to which a federal tax lien could attach.
This apparent disparity in the federal transfer taxation of property owned by same-sex couples in common law property states and community property law states is just one of the many legal complications created by DOMA. The federal taxation questions resulting from the enactment of DOMA may soon be moot, however, as the constitutionality of DOMA has been called into question by multiple federal courts, and U.S. Attorney General Eric Holder has announced that the Department of Justice will no longer defend the constitutionality of DOMA. Nonetheless, so long as the provisions of DOMA and the rationale of the aforementioned IRS rulings stand as the legal precedent for determining the federal transfer taxation of property owned by same-sex couples, same-sex spouses and RDPs in common law property states will bear a substantially higher federal transfer tax burden than their counterparts in community property law states.