Taxes and the LGBTQ Community

Professor Patricia A. Cain of the Santa Clara University School of Law discusses the unique tax challenges faced by members of the LGBTQ community in the past and today.

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Credits
Host: David D. Stewart
Executive Producers: Jasper B. Smith
Showrunner: Paige Jones
Audio Engineer: Jordan Parrish
Guest Relations: Christa Goad

Transcript

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David D. Stewart 0:01

Welcome to the podcast. I'm David Stewart, editor in chief of Tax Notes Today International. This week: equal marriage, equal penalty. Tax touches everything. Eight years ago, it was a tax case that struck down part of the Defense of Marriage Act and cemented a major victory on the path to marriage equality in the United States. In United States v. Windsor, Edith Windsor, the surviving spouse of a same-sex couple in New York, sought to claim the federal tax exemption on her partner's estate, but was denied. The Supreme Court struck down Section 3 of the act as unconstitutional, paving the way for married same-sex couples to receive federal tax benefits, such as filing joint tax returns. This ruling and others over the past several years have put married same-sex couples on the same footing as other married couples, but the LGBTQ community still faces tax challenges. Here to talk more about this is Professor Patricia Cain with the Santa Clara University School of Law, who specializes in taxation and estate planning for same-sex couples. Pat, welcome to the podcast.

Patricia A. Cain 1:04

Glad to be here, Dave.

1:05

So let's start from the beginning. Could you walk us through some of the tax challenges same-sex couples have had with tax law prior to the Windsor ruling?

Patricia A. Cain 1:14

Well, prior to the Windsor ruling, of course, there was no recognition of status between two people, even if they were married to same-sex partners. Even if they were married or say in Vermont, they were members of a civil union. So they were treated like strangers under the law. Of course, that's how we've been treated throughout history. And so it's the same sort of issues, you live together, but we pay the mortgage. Who gets to take the mortgage interest deduction? You have income. Whose income is it? If I live with someone who pays the rent and I don't, is the payment of the rent support to me? Or is it income to me or is it a taxable gift perhaps? And there's really not a lot of clear guidance by the IRS. Never has been and still isn't today. Although they have litigated some of these cases involving opposite sex couples where they've claimed that a woman living with a man, if he pays for her, maybe he's paying her for domestic services or perhaps even for some other things. And that would make it be income to her. And there are a handful of cases where often the taxpayer wins by saying, "No. He's paying that out of love and affection, and therefore it's a gift, and gifts are excluded from income." So we faced a lot in our history, a lot of the same kinds of problems that opposite sex, unmarried couples have faced. But then it was even harder because people got married. In Massachusetts you could get married in 2004. You could register as a civil union, and as partners in Vermont in the year 2000. And there you were treated, for tax purposes at the state level as though you were married, but not at the federal level. So that created a real burden, just in terms of reporting your income. It was a burden. Those are the main things before Windsor.

David D. Stewart 3:01

So could you tell me a bit about the effects that the Windsor decision had on married same-sex couples?

Patricia A. Cain 3:07

Well, the Windsor case was a real breakthrough. I mean, it was a pure tax case because it was only about the marital deduction under the estate tax. GLAAD — gay and lesbian advocates and defenders — had a case in the pipeline much longer than Windsor, where they had six or seven plaintiffs making various federal claims and complaining specifically that DOMA, the Defense of Marriage Act passed in 1996, was unconstitutional and should not be applied to these married same-sex couples. But Edie Windsor's case got to the Supreme Court first, and I kind of love it that it was a pure tax case. I get to teach it in my tax classes. It's great. So what the court held was in fact that the Defense of Marriage Act was unconstitutional, but only as applied to the federal government because that was the only issue before the case. There was another issue about applying it at the state level. So all of a sudden federal agencies had to comply with this new ruling. Most of the federal agencies came out with rulings fairly quickly after the decision was handed down, saying that they were going to recognize it. The big question was which marriage is the federal government going to recognize? What if I'm married in Massachusetts, but I'm living in Texas, which doesn't recognize my marriage? Will the federal government recognize it anyway? And all of the other federal agencies — other than the IRS — spoke first and said, "We're going to recognize marriages based on the place of celebration." So if you entered into a valid marriage and one of those handful of states that recognizes same - sex marriage, it doesn't matter where you live, where you're domiciled, we're going to apply a place of celebration rule. The decision was handed down June 26. Everybody was kind of hanging by tender hooks over the summer to see what the IRS would do. Some people had extensions on their tax returns, which would be due in October, and they wanted to know how they were supposed to file. I just reread an article I wrote about this and I said, "There we were waiting for the long awaited revenue ruling from the IRS." Well, the revenue ruling came down August 29. That's just basically two months after the decision. We certainly felt that we were longly awaiting for it, but that's pretty record speed for the IRS because their ruling was really a lot more complicated, involved a lot more issues than the other federal agencies did. They had to decide not only place of celebration, which is what they decided, but they had to decide things like the retroactivity. Should Windsor be applied retroactively? And what would that mean? I have to praise the IRS in this revenue ruling. It's Rev. Rul. 2013-17. Now most of it is codified in regulations, but they did their best to be as fair as possible. They said that it was place of celebration. That certainly was what employers wanted. They said, "We can't keep track of all of the employees. We have employees in many different states. If they're married in some states, you're going to treat it as marriage and in other states you're not? We can't really administer that kind of plan." So it was an ease of administration decision. It was a just decision because these people really were married. Of course, I have to do a sidebar here. A lot of these people of course had gotten married in places like Massachusetts, but now we're living in Texas and they couldn't get divorced. I mean, you've heard of wedlock. This was true wedlock because Texas didn't recognize same-sex marriage, and so it would not allow a same-sex married couple to get a divorce. And the problem of course with tax law is that if you're married, you have to file as married. Too bad. You can't get divorced, but until you get a divorce, you really are married. So you might not have been living with your spouse for the past four years, but now suddenly you're supposed to file a joint tax return. And if you can't do that, you could married filing separately, but that's really kind of a bad status to be filing in. It's rarely helpful to the taxpayer, so that was a problem. The IRS couldn't take care of that because it couldn't do anything about state law. Now, the other thing is that I thought that individuals who were in registered domestic partnerships, or civil union partnerships, should be treated as married at the federal level. I think primarily because none of the other federal agencies were willing to do that, the IRS was not either. I had written a number of memos that had gotten through to the chief counsel. I remember when I had an ABA meeting that fall, I got to meet one of the coauthors of the revenue ruling and I shook his hand and I said, "I love your revenue ruling." And he looked me straight in the eye and he said, "Yes, except for one thing. You really do think we should treat RDPs as married." And that's the moment when I knew all of those memos that I didn't know whether they were reaching the right desk or not at the IRS apparently did so. But they've refused to recognize RDPs as married because they say the state doesn't recognize them as married. Well, the state of course had to say they weren't married because in California we had this thing called Prop. 22 that would not allow same-sex marriage. So for registered domestic partnerships to be valid, you had to argue in court that they were not marriages. And of course today they're given all the same rights and responsibilities of marriage, were subject to the community property regime, which the IRS recognizes the regime of property. They recognize property rights of RDPs and CUPs. They just don't recognize the status. So you're strangers to each other under the tax law, but your joint property rights are recognized. Your family rights, other than the relationship between the two partners are recognized. So you might have stepparent status to your partner's child, which can count for tax purposes in a number of ways. So there's some confusing things, but what I liked most — and this is my best example from the revenue ruling of how fair I thought the IRS was being — they made their announcement in August. They said it would not become effective until September 16. So anyone who still had not filed their return for that year had that much time to determine whether to file jointly or singly. They gave you the option, even though the opinion was that DOMA was unconstitutional and always had been unconstitutional, it was retroactive. But they were not going to force any taxpayer to treat themselves as married if the taxpayer said, "That's to my detriment." Why? Because all of us had pretty much relied on the fact that the IRS said we weren't married. And we had all filed tax returns based on that. And it's not always an advantage to file as married. So the IRS was as flexible as possible in giving people the ability to determine if you'd already filed a tax return singly because you couldn't file married before Windsor, and you thought you'd be better off filing jointly. You could amend within the statute of limitations period, which is basically three years, you could amend and file as joint. The flexibility was quite, quite astonishing to me and it was just an indication of how fair the IRS was being with respect to this issue.

David D. Stewart 10:22

Now of course, things didn't stand still very long. About two years after the Windsor decision, we got the Obergefell v. Hodges decision. Can you tell me about this case and its impact for same-sex couples and tax law?

Patricia A. Cain 10:32

Well, there's probably less effect for tax law. I mean, it's mainly a rights opinion. It gave everybody in every state the right to marry the person of his or her choice. So it's really a huge constitutional decision in giving that right to everyone. So now, if you had been married in Massachusetts years ago, but we're living in Texas, now because of a Obergefell, Texas had to recognize your marriage. There are some interesting side effects to that. I mean, you might've been living in Texas and married, but Texas didn't think you were, so you didn't realize it but all of that property that you were accumulating over the years you've been married and not recognized, well that's presumptively community property now. Because property rules follow your marital status. And so there were some consequences that people didn't really think about, but I don't think of them as really negative consequences. The big surprise I think was for so many people after Windsor — and now they find that out when they get married anew in their state that suddenly recognizes their marriage — that it's not always good tax-wise to be married. There's a thing called the marriage tax penalty. The IRS goes crazy every time I say that. They get up and pound the table and say, "We don't tax marriage." And of course they don't; it's Congress that does. Congress has enacted a number of provisions in the Internal Revenue Code that make a distinction between single taxpayers and married taxpayers in a negative way. So I think a lot of same-sex couples who — well even opposite sex couples as well, but you think they've had longer to think about it than same-sex couples have — have been surprised at the cost of being married for tax purposes.

12:14

So what sort of costs are involved in the marriage penalty? How does this end up costing both married and same-sex couples more?

Patricia A. Cain 12:21

Well for married couples, there are a couple of things. First of all, we have a joint return. Not that we ever decided as a country, that the best policy was to have a joint return. We've never done that. We did it solely because of historical kind of artifact. Back in 1930, there was a Supreme Court case called Poe v. Seaborn that said couples in community property states owned their income 50/50. So the husband only had to report 50 percent of typically his income, and the wife, who typically didn't have any income, would report the other 50 percent. Well on a single rate of taxes, progressive, you can see that the husband's top 50 percent that used to be taxed at the top brackets suddenly gets moved to the wife's lower bracket. So community property couples were saving all kinds of taxes because they could split their income for tax purposes. And if you weren't in a community property state, you couldn't do that. You'd be surprised how many states suddenly decided, "Oh, we should become community." In fact, Pennsylvania became a community property state for at least three months. New York was on the verge of becoming a community property state solely for tax purposes. When Congress in 1948 enacted the joint return, which took care of it, all couples whether they're in a community property state or not file jointly, and they all pay the same amount of taxes. They kind of split the brackets basically for the joint return. But there's another thing about the joint return. It carries with it joint and several liability. A lot of people don't understand this. So if I'm married to a deadbeat who doesn't report his or her income and then the IRS discovers it, even if I didn't know anything about it, they can come after me for the tax bill. So there's a risk in filing a joint return. And I hate that risk. Now we've gotten rid of some of the problem by enacting innocent spouse provisions, but sometimes those are hard to apply. So that's a downside, but the other things are treating a married couple, even though there are two taxpayers both are earning income as one taxpayer obviously causes some built-in penalties. The most obvious one to me is the most recent reduction of the state and local tax deduction, SALT deduction it's often called. It's limited to $10,000. So if you have a husband and a wife, or a wife and a wife, or a husband and a husband in a state like California where you're both earning decent incomes, then your probably each paying more than $10,000 in state income taxes because our taxes are so high, you are limited between you to a deduction of $10,000. If you were not married, each one of you would get a deduction of $10,000. We have the same problem with the brackets. Now, the lower brackets they fixed back in the Bush years. I give Congress credit for that. At the lower brackets, they've taken out the marriage tax penalty. But if you look at the top brackets, I'll give you what's stated in the code; it's been adjusted upward for inflation. I'm not sure I have the current numbers off the top of my head. But in the code, if you're a single individual paying taxes, you don't reach the top bracket until you hit $400,000. If you are a married couple together you reach that bracket at $500,000. So two single taxpayers making $400,000 each never reach the top bracket, but a married couple with each earning $400,000 pays higher taxes on that last $300,000. That's built into the tax brackets — treating married couples differently. The same thing with the mortgage interest deduction. Now you can deduct interest on quailified mortgage debt on your principal residence up to the extent of $750,000 of debt. It used to be $1 million, but the Trump bill from several years ago changed that, lowered it to $750,000. If you're a single individual, you deduct the amount on $750,000. If you're a married individual, you're treated as one taxpayer between you, you can only deduct the interest on $750,000. Capital losses, the same thing. Each individual can deduct up to $3,000 of capital losses against ordinary income. If you're a married couple between you, you can deduct $3,000 against ordinary income. And it even hurts people at the lower brackets because of the aggregation of spousal income. Social Security is not taxed if you are a very low bracket or low-income person. But if you marry someone who has income, now, we're going to judge whether you're taxed by the aggregate income and suddenly you're taxed on your Social Security. If you're above a certain level, only 50 percent of your Social Security is taxed. But if you marry someone above you, you're probably now going to have 85 percent of your Social Security taxed. The same with the EITC, the earned income tax credit, which is there to benefit lower-income taxpayers, but spousal income is aggregated. And so you start losing the benefit of that tax credit, to the extent that your aggregate income is too high, even though the individual person who would otherwise, if single, be entitled to a high credit has low income. In fact, it was kind of amusing. There was a Republican legislator in Congress who complained about Biden's proposals in the proposed tax law because it was going to create this marriage tax penalty for low-income people with the EITC. And of course, the problem is that was built into the code years before Biden ever became president. Of course, I will say Biden is continuing the trend. He keeps talking about no household will pay higher taxes if they earn less than $400,000. Well, we don't tax households. We tax individual taxpayers. And if you're married, you're typically treated as one taxpayer. So you are going to be taxed if your household income as a married couple is above $400,000 even though your individual income might be below that. So those are just a few examples of the marriage tax penalty that I can think of.

David D. Stewart 18:26

Now earlier, you were talking about registered domestic partnerships in the pre-Obergefell context. Are there still issues for that group?

Patricia A. Cain 18:33

There are. It's less in somewhat. One of the big issues in my mind had been — first of all, they're treated like spouses under state law. So when they split up, they're subject to support obligations and divisions of property just like spouses are, and we don't have any published tax authority about how these people are taxed. Now I asked the IRS some years ago to issue a ruling of sorts that would make it clear that alimony payments were not taxable to the recipient. Because I thought under old law, it was not, but not everybody was in agreement with me. And their reaction was nobody gets registered domestic partner status anymore because they can get married. But that's just not true. There are people who are opposed to marriage, who don't want to be married for a number of reasons, different reasons, and they still have RDP status. We don't need a ruling from the IRS anymore. The one good thing about the Trump tax bill a couple of years ago was that it did repeal the rules on alimony for married couples, making it clear that alimony is never taxable whenever it's received. But there's been less guidance on things like property divisions. I think property divisions should not be taxable, but the statute that says they're not taxable only applies to spouses. So RDPs and civil union partners can't rely on that. I think they're not taxable in community property states because if you equally divide community property, we have old case law that says that's not a taxable event. But if you have some separate property creep into that division, now you've got a potentially taxable event. But we have no guidance from the IRS on that. The other is support. When you pay support to someone else, it can be a taxable gift. But it's not if you are legally obligated under state law to make that payment. So this is good. The IRS has never ruled directly on it, but it's pretty clear that that is the established rule. And so if you were in a registered domestic partnership where you have an obligation of support and you are supporting your partner, it should not be a taxable gift. It's an open question out there if you're not under a legal obligation to support, just a moral obligation or contractual obligation. "Come live with me and I'll support you." That's a contract. In that case, the support payments are now open to that question of whether or not it's income to the recipient or a gift under income tax law. The definition of gift for income tax law is detached and disinterested generosity. I tell my students, "Does anybody do anything out of detached and disinterested generosity?" I mean, we all have reasons for acting, but my argument is if it really springs from love and affection, it probably is a gift under the income tax. And therefore it's not taxable as income. But the definition of a gift for gift tax purposes is different. If I don't receive adequate compensation and money, or money's worth in exchange for what I transfer, then I've made a gift. So it's possible, and people including IRS agents have taken the position that if you are supporting an unmarried partner or unregistered partner, that support is a taxable gift. Now you have to do a heck of a lot of support these days to get over the $11 million plus exemption. But this was a real issue back in the days when the exemption was $600,000 or $1 million. And we don't know. It may be going down again. So this could become an issue as well. So that's a place in which, at least under tax law, it's good to be in a registered domestic partnership to avoid the question of gift tax. Bad to be in an unregistered, unmarried situation because all of those huge payments are questionable.

David D. Stewart 22:30

So are there any issues still left outstanding that need to be addressed for the LGBTQ community?

Patricia A. Cain 22:36

Well, there always are. And some of them prop up when we're not expecting them. I mean, I do think that tax issues are not the most important today. This kind of religious right to discriminate is probably forefront, and transgender issues are also forefront. Oh, I should mention the IRS originally took the position that the payment of medical expenses for gender reassignment surgery were not deductible as medical expenses. They were akin to — can you believe this? — cosmetic surgery and therefore were not deductible because cosmetic surgery is not deductible, even though it involves an operation. And so we had a Tax Court case. GLAAD represented the taxpayer and took it to the Tax Court. It went to the full Tax Court, not just one Tax Court judge, which is typical of Tax Court cases. This was deemed important enough to have the entire bench review it. And so we have — I didn't count before this — but it must be six to nine different opinions in this case. And some of them were pretty shocking, kind of overruling the medical experts who say this surgery is necessary, and therefore it should be deductible as a medical expense. That's how the court came out. It is disturbing, some of the dissenting opinions. But that's been settled now at least in the transgender community, that whatever you have to pay for gender reassignment surgery, which can be a lot in an MTF, a male-to-female transition, is at least deductible for tax purposes. I have a friend who told me, "I never would have deducted it. That's why we all write books about our transition in order to pay for the surgery." I guess the big question for me is how to treat, I'll call them Marvin payments. If you're not married and you're not in a registered domestic partnership, you still have certain rights because of your cohabitation status or your commitment status. The state of Washington is way ahead of everyone here. They actually recognize the status of being in a committed, intimate relationship. They used to call it a meretricious relationship. And once you've satisfied that requirement, when the relationship dissolves either during lifetime or at death, each partner is entitled to half of the property that was acquired during the term of the relationship. I call it quasi-community property because it's divided 50/50. Washington is a community property state. You don't have any vested rights in the property though until the moment that the relationship dissolves. So how is that treated? Is that treated the same as a split of real community property, which should not be taxed? Or will the IRS say, "Well, it's not really community because you didn't have a vested right in it before you got it at dissolution." And if you're not in Washington, then you have a lesser claim. I called them Marvin claims based on the 1976 Marvin case out of California, Marvin v. Marvin, which was a breakthrough in many ways. I mean before Marvin, enforcement of any contract between an unmarried couple was very difficult. Often the court would say, "We can't enforce this contract. These people are living in sin. They're living outside of marriage. It would be against public policy to enforce any agreement they had concerning their cohabitation." Marvin changed that, and it's been imported in almost every state. There are some holdout states — Illinois is the worst — that won't recognize any rights. The original case in Illinois was a woman who thought she was married to her husband. They raised two children together. She sued for divorce. And he said, "By the way, hon, remember we never got married." And the court said, "That's right. You don't get anything. We won't apply Marvin to give the wife who is being dispossessed of any property." Fortunately, most states are not like that and they are willing to enforce these agreements or contracts. Some of them have to be expressed. Some of them could be implied. But the real question is — so I enforced my contract rights and I get half the house. Maybe I get some payments for the car that I thought was mine, but it turns out it's not. So I get some cash payments and some property. What are the tax treatments of that? We've got property and cash transfers. There is only one case — and it's amazing to me how often this happens, that there is only one reported tax case out there — and it's from 1999. It's called Reynolds. Reynolds v. Commissioner. And it was an opposite sex couple. When they split up, they'd been together quite some time. He agreed to make regular cash payments to her and she didn't report them as income. She said they were gifts. The IRS audited her and said, "No, they're not. They're income because he's just paying you for all of those years of domestic services that you gave him." Interestingly, the Tax Court rejected both arguments and came up with what I'd like to think is the right conclusion — although a lot of my tax colleagues think it's pretty far out. And that is that she was simply getting the property she was entitled to. That over the term of her relationship, she had built up equitable claims to all of the property that was acquired by the couple. And so when she split up, she wasn't getting anything new. She was just cashing in on her prior claim to property by getting a cash payment. And since no one in the case could show that her basis in her property claims was lower than the amount of cash she received, then there's no tax. That makes sense to me. This is not like two strangers bargaining for cash for property. This is a unit that has lived together as a unit for a long period of time, and now they're settling up all of their claims, and walking away separated. That just doesn't seem to me the right time to impose a tax. We don't do it for married couples. We used to, but now we have a statute. Well, we've had the statute since the early 1980s, and often we don't do it for registered partners. So I'm not sure why we shouldn't find a way to expand this tax coverage to unmarried couples who end up in these situations. Because if you read the census, there are a lot of unmarried couples out there. In fact, married couples are now in the minority on the census. So we've got a lot of taxpayers out there that have no guidance from the IRS. Now the IRS may say, "We can't do it because there's no law there. Congress needs to do something." And I don't think we can wait for Congress to do something about this issue. I think it would be helpful if the IRS gave some guidance based on the law that is there.

David D. Stewart 29:15

Well Pat, this has been fascinating. I want to thank you for being here.

Patricia A. Cain 29:18

I enjoyed it immensely. I always love talking about this topic.

David D. Stewart 29:24

And now, instead of coming attractions, a special announcement. The submission period for the Christopher E. Bergin Award for Excellence in Writing will be closing soon. This annual award recognizes superior student writing on unsettled questions of tax law and policy. Eligible students must be enrolled in an accredited undergraduate or graduate program during the academic year. Submissions are due by June 30, 2021. Visit taxnotes.com/students for more details. That's taxnotes.com/students. That's it for this week. You can follow me online at @TaxStew, that's S-T-E-W. And be sure to follow @TaxNotes for all things tax. If you have any comments, questions, or suggestions for a future episode, you can email us @podcast@taxanalysts.org. And as always, if you like what we're doing here, please leave a rating or review wherever you download this podcast. We'll be back next week with another episode of Tax Notes Talk.