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Wells Fargo Advisors LGBT Insight: Awaiting a Supreme Court Decision on the Defense of Marriage Act

Kyle Young, First Vice President – Investment Officer with the Accredited Domestic Partnership Advisor designation, Wells Fargo Advisors, LLC in Short Hills, N.J., addresses the unique financial challenges faced by same-gender partners. This is the fourth article in a continuing series. Click here to watch his presentation from DiversityInc’s Innovation Fest!

Kyle Young, Wells FargoMarch marked a historic step for the LGBT community, as the U.S. Supreme Court heard oral arguments for two potentially landmark cases related to marriage equality.

Decisions from the high court are expected sometime in June. Until then, we remain in a state of limbo regarding the complex set of financial- and estate-planning concerns of same-sex couples. The complexities of this planning are further complicated by today’s existing patchwork approach to marriage equality.

Although the total number is shrinking, the majority of U.S. states still do not offer any type of relationship recognition for same-sex couples. And for those 21 states that do, rights are fairly limited in scope to state-level benefits only. Additionally, the federal government is restricted from recognizing any of these unions due to the Defense of Marriage Act, a federal law defining the term “marriage” as a union between one man and one woman.

At the center of one of the two cases heard last month, United States v. Windsor, is an 83-year-old woman from New York named Edith Windsor. Edie and her partner of 40-plus years, Thea Spyer, wed during a trip to Toronto in 2007. At the time of Thea’s passing in 2009, the State of New York did not yet allow same-sex couples to marry; however, it did recognize unions entered into in other jurisdictions. But because the federal government did not honor their union in the same manner, Edie was required to pay a federal estate tax on the assets inherited from Thea—a bill that totaled a hefty $363,000!

A comparison with an opposite-sex married couple would reveal a starkly different outcome. If Thea were Theo, Edie’s husband of 40-plus years—or even one year, for that matter—the assets inherited by Edie would have been free of any estate tax. So there was a $363,000 difference based solely on whom Edie married.

Lack of Federal Recognition

The U.S. Tax Code includes a provision known as the unlimited marital deduction. This allows opposite-sex spouses to pass an unlimited amount of assets to one another, both during life and upon the death of the first spouse. This deduction is not available to same-sex spouses because there is no federal recognition of their unions.

At the very least, a very basic understanding of federal and state estate and inheritance taxes is absolutely critical for LGBT couples. When an asset is left to anyone other than a federally recognized spouse, these taxes must be considered. A lack of knowledge in this area can prove to be an extremely costly mistake, as evidenced by Edie Windsor.

Thankfully, estate and inheritance taxes are only imposed on assets over a certain value.

As it stands today, the federal estate tax has a $5.25 million exclusion amount. Assets under this exclusion pass to your partner tax-free. Assets over this exclusion will incur a 40 percent federal estate tax. The sheer size of this exclusion, only made permanent in January of this year, will greatly limit the number of individuals who will need to worry about this tax moving forward.

State Policies Affect Greater Numbers

A far greater number of individuals will face state-level estate and inheritance taxes. Although tax rates generally are lower—10 to 20 percent on average—each state is left to determine whether they will impose these taxes on unmarried couples, a category many same-sex couples fall into by default. Some states have both an estate and an inheritance tax, some states have only one, and some states have neither.

According to the Human Rights Campaign, for the 18 states, plus the District of Columbia, that offer comprehensive relationship recognition to same-sex couples, these state-level estate and inheritance taxes are not imposed as the legal relationship exempts the taxes from applying, just as married opposite-sex couples are exempt.

In addition to having an understanding of the state-level taxes for your state of residence, I recommend thinking about how these taxes may apply in the event of an upcoming life change.  For instance, if you plan to move to another state upon retirement, if your employer plans to relocate you to another state, or if you plan to acquire property in multiple states, the potential negative impacts of these final taxes must be considered.

Strategies to Limit Tax Exposure

A few things to consider as you navigate this discussion with your partner:

    • What is the value of your individual estate (retirement accounts, investments, real-estate holdings, life-insurance policies owned by you, art collections, etc.)?
 
  • Is the value of your individual estate under the federal exclusion limit?
    • If not, what planning has been done to assure that your partner has liquid assets to satisfy this tax liability upon your passing?
  • Does your state of residence impose estate and/or inheritance taxes? If so, is your individual estate under the allowed exclusion level?
    • If not, what planning has been done to assure that your partner has liquid assets to satisfy this tax liability upon your passing?

If you determine that a tax liability will exist upon your passing, you may consider having your partner purchase a life-insurance policy on your life. In doing so, your partner is assuring that upon your passing, he or she will receive a death-benefit payment in the amount of the potential tax liability. Having liquid cash to satisfy the tax liability will preserve the assets you pass along.  This is even more important if the majority of your assets are tied up in real estate and/or retirement accounts, both of which are semi-illiquid assets and both of which carry their own tax liabilities to liquidate.

If life insurance is not an option, due to either the expense or a medical issue that limits your ability to get coverage, you may want to consider “equalizing your estates.” This is a process by which the partner with a larger asset level uses annual exemption amounts and begins to shift assets to the partner with a smaller asset level. The objective here is for both partners at the time of passing to have estate sizes under the applicable estate-tax exclusion levels while not impacting the total value of combined assets.

When properly implemented, these strategies can be highly effective in reducing the impact of estate and inheritance taxes. This is an ideal time for the professionals in your life—your financial advisor, your estate-planning attorney and your CPA—to coordinate efforts on your behalf to help you and your partner work through these complex discussions.

The U.S. Supreme Court has in front of it an opportunity to change the course of this discussion.  Along with Edie Windsor, we as a nation await those decisions. But whether DOMA is upheld or overturned, education and preparation remain of the utmost importance for all LGBT couples.

Wells Fargo Advisors is not a tax or legal advisor. Wells Fargo Advisors, LLC, member SIPC, is a registered broker-dealer and separate nonbank affiliate of Wells Fargo & Company, No. 25  in the DiversityInc Top 50.

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