Taxes And The LGBTQ Community

In this episode of Tax Notes Talk, 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.

This transcript has been edited for length and clarity.

David D. Stewart: 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: Glad to be here, Dave.

David D. Stewart: 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: Prior to the Windsor ruling, there was no recognition of status between two people, even if they were married to same-sex partners or members of a civil union. They were treated like strangers under the law. Of course, that’s how we’ve been treated throughout history.

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?

There’s really not a lot of clear guidance by the IRS. There never has been, and there still isn’t today. They have litigated some of these cases involving opposite-sex couples. They’ve claimed that in the case of a woman living with a man, if he pays for her domestic services or perhaps even for some other things, that would make it income to her. 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.”

We faced 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 2000. You were treated for tax purposes at the state level as though you were married, but not at the federal level. That created a real burden in terms of reporting your income. 

David D. Stewart: Could you tell me a bit about the effects that the Windsor decision had on married same-sex couples?

Patricia A. Cain: The Windsor case was a real breakthrough. It was a pure tax case because it was only about the marital deduction under the estate tax. GLAD, 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 Windsor’s case got to the Supreme Court first. I kind of love it that it was a pure tax case. I get to teach it in my tax classes. The court held that DOMA 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.

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?

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.” If you entered into a valid marriage in one of those handful of states that recognizes same-sex marriage, it doesn’t matter where you live or where you’re domiciled, we’re going to apply a place of celebration rule.

The decision was handed down June 26, 2013. Everybody was hanging by tenterhooks over the summer to see what the IRS would do. Some people had extensions on their tax returns 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.”

The revenue ruling came down August 29, 2013. That’s 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. Their ruling was a lot more complicated and involved a lot more issues than the other federal agencies did. They had to decide not only place of celebration but also things like the retroactivity. Should Windsor be applied retroactively? What would that mean?

I have to praise the IRS in this revenue ruling, which is 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, which was certainly 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.” It was an ease of administration decision. It was a just decision because these people really were married.

A lot of these people had gotten married in places like Massachusetts, but now were living in Texas and they couldn’t get divorced. This was true wedlock because Texas didn’t recognize same-sex marriage, so it would not allow a same-sex married couple to get a divorce.

The problem with tax law is that if you’re married, you have to file as married. Until you get a divorce, you really are married. 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.

If you can’t do that, you could married file separately, but that’s really a bad status to be filing in. It’s rarely helpful to the taxpayer. The IRS couldn’t take care of that because it couldn’t do anything about state law.

I thought that individuals who were in registered domestic partnerships (RDPs) or civil union partnerships should be treated as married at the federal level. But 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 American Bar Association meeting that fall, I got to meet one of the coauthors of the revenue ruling. I shook his hand and I said, “I love your revenue ruling.” 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.” That’s the moment when I knew all of those memos were reaching the right desk at the IRS.

But they’ve refused to recognize RDPs as married because they say the state doesn’t recognize them as married. The state had to say they weren’t married because in California we had Prop. 22, which would not allow same-sex marriage. For RDPs to be valid, you had to argue in court that they were not marriages. Today they’re given the same rights and responsibilities of marriage, and are subject to the community property regime.

The IRS recognizes the regime of property. They recognize property rights of RDPs and civil union partners (CUPs). They just don’t recognize the status. 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. You might have stepparent status to your partner’s child, which can count for tax purposes in a number of ways.

There are 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 — was that they made their announcement in August. But they said it would not become effective until September 16, 2013. Anyone who still had not filed their return for that year had that much time to determine whether to file jointly or singly.

Even though the opinion was that DOMA was unconstitutional and always had been unconstitutional, they gave you the option. 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. We had all filed tax returns based on that. It’s not always an advantage to file as married.

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, and file as jointly. The flexibility was quite astonishing to me. It was an indication of how fair the IRS was being with respect to this issue.

David D. Stewart: 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: There’s probably less effect for tax law. It’s mainly a rights opinion. It gave everybody in every state the right to marry the person of his or her choice. It’s really a huge constitutional decision in giving that right to everyone. Because of Obergefell, if you had been married in Massachusetts years ago but were living in Texas, Texas had to recognize your marriage.

There are some interesting side effects to that. You might’ve been living in Texas and married, but Texas didn’t think you were. You didn’t realize it, but all of that property that you were accumulating over the years you’ve been married and not recognized is presumptively community property now. Property rules follow your marital status. There were some consequences that people didn’t really think about.

The big surprise I think for so many people after Windsor was 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.” Of course they don’t; it’s Congress that does.

Congress has enacted a number of provisions in the Internal Revenue Code that makes a distinction between single taxpayers and married taxpayers in a negative way. I think a lot of same-sex couples — even opposite-sex couples as well — have been surprised at the cost of being married for tax purposes.

David D. Stewart: 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: 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. 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. 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. Community property couples were saving all kinds of taxes because they could split their income for tax purposes.

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.

The joint return 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 split the brackets 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. 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. There’s a risk in filing a joint return. I hate that risk. We’ve gotten rid of some of the problem by enacting innocent spouse provisions, but sometimes those are hard to apply. That’s a downside.

The other thing is treating a married couple 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, the SALT deduction it’s often called. It’s limited to $10,000.

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 you’re probably each paying more than $10,000 in state income taxes because our taxes are so high. You are limited between both of 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. 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. 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. 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. You can deduct interest on qualified mortgage debt on your principal residence up to the extent of $750,000 of debt. It used to be $1 million, but the Tax Cuts and Jobs Act 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, you can only deduct the interest on $750,000.

It’s the same thing with capital losses. Each individual can deduct up to $3,000 of capital losses against ordinary income. If you’re a married couple, you can deduct $3,000 against ordinary income. It even hurts people at the lower brackets because of the aggregation of spousal income.

Social Security is not taxed if you are in the very low bracket or a 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. 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 earned income tax credit, which is there to benefit lower-income taxpayers. Spousal income is aggregated. 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 President 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. The problem is that was built into the code years before Biden ever became president.

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. If you’re married, you’re typically treated as one taxpayer. 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. 

David D. Stewart: Earlier, you were talking about RDPs in the pre-Obergefell context. Are there still issues for that group?

Patricia A. Cain: There are. One of the big issues in my mind had been that they’re treated like spouses under state law. When they split up, they’re subject to support obligations and divisions of property just like spouses are. We don’t have any published tax authority about how these people are taxed.

I asked the IRS some years ago to issue a ruling that would make it clear that alimony payments were not taxable to the recipient. I thought under old law it was not, but not everybody was in agreement with me. Their reaction was nobody gets RDP status anymore because they can get married. But that’s just not true. There are people who are opposed to marriage or who don’t want to be married for a number of reasons, and they still have RDP status.

We don’t need a ruling from the IRS anymore. The one good thing about the TCJA 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. 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. 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. This is good. The IRS has never ruled directly on it, but it’s pretty clear that that is the established rule.

If you were in a RDP 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?” 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. 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 or money’s worth in exchange for what I transfer, then I’ve made a gift. 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.

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. We don’t know. It may be going down again. This could become an issue as well.

That’s a place in which, at least under tax law, it’s good to be in a RDP to avoid the question of gift tax. But it’s bad to be in an unregistered, unmarried situation because all of those huge payments are questionable.

David D. Stewart: Are there any issues still left outstanding that need to be addressed for the LGBTQ community?

Patricia A. Cain: There always are. Some of them pop up when we’re not expecting them. 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.

The IRS originally took the position that the payment of medical expenses for gender [confirmation] surgery were not deductible as medical expenses. They were akin to cosmetic surgery, and therefore were not deductible because cosmetic surgery is not deductible, even though it involves an operation.

We had a Tax Court case. GLAD 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. We have six to nine different opinions in this case.

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. Some of the dissenting opinions are disturbing.

But that’s been settled now in the transgender community that whatever you have to pay for gender reassignment surgery, which can be a lot in 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 what I call Marvin payments. If you’re not married and you’re not in a RDP, 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.

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.

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?”

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.

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 like Illinois 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. He said, “By the way, honey, remember we never got married.” 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 what are the tax treatments? Say 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 from 1999. It’s called Reynolds v. Commissioner. It was an opposite-sex couple. They’d been together quite some time. When they split up, 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. They said she was simply getting the property she was entitled to. Over the term of her relationship, she had built up equitable claims to all of the property that was acquired by the couple. When they split up, she wasn’t getting anything new. She was just cashing in on her prior claim to property by getting a cash payment.

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 couple 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. We’ve had the statute since the early 1980s. Often we don’t do it for registered partners. 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. 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.

We’ve got a lot of taxpayers out there that have no guidance from the IRS. The IRS may say, “We can’t do it because there’s no law there. Congress needs to do something.” 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: Well, Pat, this has been fascinating. I want to thank you for being here.

Patricia A. Cain: I enjoyed it immensely. I always love talking about this topic.