Same-sex taxes if DOMA dies

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From a financial standpoint, same-sex married couples have much to gain - and some to lose - if the Supreme Court overturns the federal Defense of Marriage Act.

The high court decided on Dec. 7 to hear two cases challenging federal and California laws that define marriage as a union between one man and one woman.

The federal case challenges Section 3 of DOMA, which prevents the recognition of same-sex marriage at the federal level for all purposes including Social Security, taxes and immigration. Overturning this section would not automatically make same-sex marriage legal in every state, but the federal government would recognize the marriages in states where they are legal.

The second case challenges Proposition 8, a voter-approved initiative that prevents same-sex couples from getting married in California. California recognizes same-sex marriages that were legally entered into before Prop 8 took effect in November 2008. If the court overturns Prop. 8, same-sex couples could legally marry in California again, but it would not have a big financial impact unless the court also rules that DOMA is unconstitutional.

Many same-sex couples are aware of the benefits they would get if the court strikes down DOMA, such as becoming eligible for Social Security spousal benefits and getting a foreign-born spouse on the fast track for permanent resident status.

But "it's not a panacea of benefits. There are advantages and disadvantages," says Nanette Lee Miller, a partner with accounting firm Marcum.

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On the downside, most higher-income couples would pay more income taxes and some middle-income couples would have a greater portion of their Social Security benefits taxed. Some could also lose need-based scholarships or welfare benefits when their incomes are combined.

The biggest benefits happen "at the end of a relationship, upon death or divorce," says Frederick Hertz, a lawyer and author of Nolo's "Making It Legal."

Here's a look at some of the financial implications if DOMA is overturned:

Income taxes: Same-sex couples would have to file their federal tax returns as married filing jointly or married filing separately. (The latter seldom results in a lower tax.) Today, they must file as singles or head of household. For many, joint filing will result in higher taxes.

For many years, many married couples have paid more income tax on a joint return than as two singles. The tax code imposes a higher tax on married couples under the assumption they can live more cheaply than two individuals.

One exception: If two spouses have a large disparity in incomes, they often pay less tax after getting hitched.

The Bush-era tax cuts temporarily eased the marriage penalty and erased it for low- to middle-income couples, but it still exists for higher-income ones. At around $150,000 in combined taxable income, "you start to pay a marriage tax penalty," says Pat Cain, a tax-law professor with Santa Clara University.

If the Bush tax cuts expire after Dec. 31, the old harsher marriage penalty comes back for all.

In California, legally married same-sex couples and registered domestic partners must file their state tax return as married, filing jointly or separately. But they still must file their federal tax returns as singles or head of household.

However, instead of reporting separate incomes on their federal return, they must each report half of their community property income. This cumbersome income-splitting rule was the result of an Internal Revenue Service decision in 2010. It also applies to same-sex couples in Washington and Nevada, which have same-sex unions and community property laws.

Although it's a pain (and expensive) to get their tax returns done, many higher-income same-sex couples pay less under this scheme than they would as two individuals or a married couple. "It's an ironic windfall to same-sex couples," Hertz says.

This windfall would go away if DOMA is overturned.

Amended returns: If DOMA is thrown out, same-sex couples would not have to amend past tax returns - but they could if filing as a married couple would have helped them. The deadline for filing an amended return is generally three years from the due date (April 15) or, if you got an extension, the date you filed.

The Supreme Court is expected to issue a decision in June. Same-sex couples who filed a 2009 tax return on or before April 15, 2010, and want to amend it if DOMA is overturned might want to file what's known as a protective claim before April 15, 2013. This won't make sense for most couples in California because of income-splitting, but it could in other states that allow same-sex marriages, says Miller. For details, consult a tax expert.

Health benefits: Many employers let employees cover their same-sex spouse or domestic partner in their group health insurance plan, but the employee must pay income tax on the value of the partner's coverage. Employees do not pay this tax when they cover their opposite-sex spouse. If DOMA is overturned, same-sex couples would not have to pay it either.

They could amend past tax returns to recover the taxes paid, but the tax preparation fees could outweigh the benefit.

Social Security: If DOMA falls, same-sex couples would most likely be entitled to the same Social Security spousal benefits as married couples.

While they are both alive, each spouse gets a benefit based on his or her work record. However, if one spouse - say, the wife - never worked or has a much lower benefit than her husband, she could get up to half of her husband's full-retirement-age benefit, in lieu of her own. When her husband dies, she could get up to 100 percent of his benefit.

Today, same-sex couples cannot get spousal benefits.

On the downside, some middle-income couples will pay more tax on their Social Security benefit if they file a joint return.

If you file as an individual, you will pay tax on up to 50 percent of your benefit if your income is higher than $25,000 and on up to 85 percent of your benefit if your income is higher than $34,000.

But if you file a joint return, you will pay tax on up to 50 percent of your benefit if your combined income is higher than $32,000 and on up to 85 percent if your income is higher than $44,000.

Estate tax: When someone dies, he or she can leave a certain amount of assets free of estate tax. This amount has gradually risen to $5.12 million, but if the Bush tax cuts expire as scheduled on Dec. 31 it plunges back to $1 million. Anything over this amount is subject to a steep estate tax.

Married couples, however, get a privilege known as the unlimited marital deduction. When the first spouse dies, he or she can leave an unlimited amount to the surviving spouse estate-tax free. Same-sex couples don't get this benefit.

One case the Supreme Court agreed to hear involves Edith Windsor, who married her longtime partner Thea Spyer in Canada but lived in New York when Spyer died in 2009. Spyer left her estate to Windsor, who paid about $363,000 in federal estate taxes. Windsor sued to recover the tax on the grounds that she was entitled to the unlimited marital deduction, but the IRS denied the refund because she was not Spyer's spouse under DOMA.

If the court rejects DOMA, same-sex spouses would get the unlimited deduction.

Divorce: When opposite-sex married couples divorce and split up their assets, it's a nontaxable event. But when same-sex couples split, the division of assets could trigger taxes.

"Suppose we own a house together. I want to buy him out with cash. He could potentially have a taxable gain" if his profit exceeds $250,000, says Chris Kollaja, a partner with accounting firm A.L. Nella.

And if one spouse pays alimony to the other, the one who pays it cannot deduct it on his or her taxes if it was a same-sex marriage. If it was an opposite-sex marriage, alimony payments are tax deductible.

The real "gorilla in the room" is what happens to retirement plans when same-sex couples divorce, Kollaja says. In a straight marriage, if a judge orders the husband to give half of his retirement account to his wife, the wife can roll it over tax free into her own retirement account.

In a same-sex divorce, the tax treatment is not the same. The transfer is more complicated and could trigger income taxes and even a penalty. If DOMA is overturned, same-sex couples can divorce just as easily as straight ones.