On the heels of the Supreme Court decision in U.S. v. Windsor earlier this summer, the IRS has issued a ruling that clarifies the treatment of same-sex spouses for purposes of federal tax law. For nonprofits, the ruling should be a prompt to take a look at and potentially update some of their policies.
Background on Windsor and Tax Treatment
As background, in Windsor, the Supreme Court held that Section 3 of the Defense of Marriage Act is unconstitutional because it violates the principles of equal protection. The Court concluded that the section “undermines both the public and private significance of state-sanctioned same-sex marriages.”
The IRS ruling holds that, for federal tax purposes:
- The terms “spouse,” “husband and wife,” “husband” and “wife” include an individual married to a person of the same sex if the individuals were married under state law, and the term “marriage” includes such a marriage between same-sex individuals;
- The IRS recognizes a marriage of same-sex individuals that was validly entered into in a state whose laws authorize the marriage of two individuals of the same sex, even if the married couple then moves to a state that does not recognize the validity of same sex marriage; and
- The terms “spouse,” “husband and wife,” “husband” and “wife” do not include individuals who have entered into a registered domestic partnership, civil union or other similar formal relationship under state law that is not a marriage under state law, and the term “marriage” does not include such formal relationships.
This position is in line with previous guidance from the IRS on marriage and state law, which was issued in the context of common law marriages. The IRS has long held that individuals who enter into a common law marriage in a state that recognizes common law marriage are treated as married for tax purposes, even if they ultimately moved to a state that does not recognize common law marriage. Policy goals including uniformity, stability and efficiency underlie this decision to base treatment on the state where the marriage occurs, rather than state of domicile—goals that take on more significance given our increasingly mobile society.
Implications for the Nonprofit Sector
More than 200 tax code provisions and related regulations include the terms “spouse,” “marriage,” “husband and wife,” and the like. Many individual rights and benefits, such as ability to file joint returns and utilize certain tax-free transfers in the context of gift and estate tax, hinge on marital status and have been the focus of much discussion.
However, Windsor and the IRS ruling also have an impact on organizations, including nonprofits. One affected area that may not immediately come to mind is related-party transactions. For both public charities and private foundations, there are restrictions and limitations around transactions between the nonprofit and insiders/disqualified parties such as directors and officers, and excise taxes can be imposed if these restrictions are not followed. The terminology differs, as public charities are subject to rules on excess benefit transactions and intermediate sanctions under Section 4958, and private foundations are subject to self dealing rules under Section 4941. However, in both cases, marital status comes into play in determining whether someone is an insider or disqualified party—the spouse of a director would be considered an insider/disqualified party, for example, and business entities owned in large part by that director’s spouse would also be considered insiders/disqualified parties.
For example, if a public charity currently is considering a sale of an asset to a director’s same-sex spouse, assuming the two were married in a state recognizing same-sex marriage, the charity would need to comply with federal tax rules to avoid making an excess benefit transaction—essentially, it would need to ensure that the transaction was at fair market value, was approved by disinterested directors, and was documented. However, if the same transaction were contemplated earlier this year (before Windsor and the IRS ruling), the same-sex spouse wouldn’t have been considered a spouse for such purposes (though the nonprofit still would need to take care in evaluating the transaction). For private foundations, the self-dealing rules are even stricter, and will prohibit certain transactions regardless of reasonableness or fair market value.
In light of Windsor and the IRS ruling, then, nonprofits should take a look at and potentially update their policies addressing related party transactions to clarify that certain same-sex spouses will be covered. If a nonprofit requires directors and officers to fill out an annual questionnaire in order to assist in identifying and managing potential conflicts, that questionnaire also should potentially be updated. In addition, nonprofits should keep a current list of insiders/disqualified persons, and will want to update that list accordingly.