Advising same-sex couples with U.S. ties

A recent U.S. Supreme Court decision opened up new planning opportunities for same-sex couples with U.S. ties.

The June 26, 2013 decision in United States v. Windsor invalidated a key provision of the Defense of Marriage Act (1996). Previously, the federal definition of marriage applied only to heterosexual couples. Now, it includes legally married same-sex couples, and applies equally to American couples who tie the knot outside the U.S.

Shortly after the decision, the IRS announced the tax implications: “Same-sex couples will be treated as married for all federal tax purposes, including income and gift and estate taxes. The ruling applies to all federal tax provisions where marriage is a factor.”

Here are some practical examples of how the changes work, and how your clients can benefit.

Read: Help LGBTQ couples overcome financial hurdles

Filing

Take a U.S.-citizen couple that moves to Canada for employment reasons and soon gets married. Prior to Windsor, “they would be forced to file to IRS on a married-separate basis, and that would expose them to much higher rates and a lower threshold of deductions and exclusions,” notes Terry Ritchie, director of cross-border wealth services at Cardinal Point Capital Management in Calgary.

Now, not only can they file married-joint and access those rate and deduction benefits, they can also submit amended returns going back to 2010.

Wealth transfer

Under pre-Windsor rules, only married heterosexual couples could transfer unlimited wealth to each other on a tax-free basis. Individual taxpayers and married same-sex couples, by contrast, would trigger gift tax if they gave more than $14,000 annually. (All dollar amounts in USD.)

Ritchie notes it’s possible to sidestep the tax by filing a gift-tax return, and this is what same-sex couples did prior to Windsor (individuals have to do the same). U.S. rules grant a lifetime gift-tax exclusion linked to the current $5.34-million estate-tax exemption. This allows taxpayers to gift more than $14,000 tax-free—but the excess chips away at the $5.34- million exemption. He illustrates how that worked pre-Windsor with the example of Sarah and Shareen. They want to hold $100,000 of Sarah’s money jointly to avoid probate in Ontario. If Sarah puts that money in an investment she owns with Shareen, $86,000 ($100,000 minus $14,000) is taxable. “And the rate for gift tax is the same as the estate tax: 18% to 40%.”

Read: Single or married? Why you can’t hide from CRA

Sarah files a gift-tax return to avoid the tax; the $86,000 is then applied against her estate-tax exemption, reducing it from $5,340,000 to $5,254,000. “For many, it’s not that big a deal,” says Ritchie, “because the exemption is so high. But it can impact long-term planning, and any time you have to file to IRS, it’s a hassle.”

The Windsor ruling changes that. Individual taxpayers still have the $14,000 limit, but Sarah and Shareen are now on the same footing as their heterosexual counterparts. They can hold that $100,000 jointly, or gift each other as much as they want, without having to file to IRS or reducing their estate-tax exemptions.

Read: Estate pitfalls for common-law partners

Principal residence exemption

Ritchie notes another income-tax-reducing opportunity previously unavailable to married same-sex couples. Take Jonathan, a U.S. citizen who relocated to Vancouver and married Samir, who has no U.S. ties. They bought a house for $500,000 and, after five years, sold it for $2 million and moved to Calgary. “For Canadian tax purposes, it didn’t mean a thing because we have the personal residence exemption,” he says. “But U.S. rules only allow a $250,000 capital gains exemption that Jonathan can apply against this principal residence. So there’s a significant U.S. capital gains hit.”

Many aren’t aware, adds Ritchie, that there’s a way for married couples to reduce the burden. Now that same-sex couples are married in the eyes of the law, they can take advantage of this method. Under U.S. law, you can treat your non-U.S.-citizen spouse as a U.S. resident for income-tax purposes. This would allow Jonathan to double the $250,000 exemption. But there’s a catch: Samir would effectively become a U.S. resident for tax purposes, and that’s permanent. That means, every year, Samir would have to file U.S. returns on his worldwide income and comply with U.S. resident tax requirements. Ritchie says advisors should only recommend this option if the benefits outweigh the costs, which include yearly filing expenses.

Read: Time for same-sex couples to reexamine finances

He notes that when both spouses are U.S. citizens, they can benefit from Windsor’s impact on portability rules, previously available only to heterosexual married couples. Introduced for the 2011 tax year, portability allows a surviving spouse to take advantage of her deceased spouse’s unused estate-tax exemptions. Here’s how it worked for heterosexual married couples before portability: Beverly’s estate is $7 million; Vito’s is worth $2 million. For simplicity, we’ll round off the estate-tax exemption to $5 million (instead of the current $5.34 million). Vito dies, and because he’s well short of the limit, his $2 million goes Beverly with no estate tax. Beverly dies a month later, but now her estate’s worth $9 million. That’s $4 million over the limit. “Prior to portability we had to get funky in our estate planning,” says Ritchie. “Instead of Beverly getting the $2 million directly, she would get it in the form of a spousal rollover or some other trust.”

With portability, Vito’s unused $3-million exemption goes to Beverly. So Beverly’s exemption goes from $5 million to $8 million. That means if she died the day after Vito, her estate would have to pay tax on $1 million instead of $4 million. Legally married same-sex couples can now benefit from portability in the same way, no matter where they reside. The Windsor decision also gives same-sex couples new immigration opportunities. Previously, if Jonathan (U.S. citizen) and Samir (Canadian) wanted to relocate from Calgary to Austin, Tex., Jonathan couldn’t sponsor Samir for a green card. The ruling allows him to sponsor Samir; after three years, Samir could naturalize and become a U.S. citizen.

By Dean DiSpalatro, senior editor of Advisor Group.