Community Property Rules and Registered Domestic Partners Tax Advisor
01 April 2012
EXECUTIVE SUMMARY
- California, Nevada, and Washington allow same-sex couples to enter into registered domestic partnerships. These laws in general provide registered domestic partners the same legal benefits and burdens as married couples. In community property states, RDP status subjects the partners to community property rules.
- Although federal law does not treat an RDP as a married couple for tax purposes, the IRS has ruled that for tax years after 2006 community property rules should apply to RDPs, and that for years beginning after 2009, RDPs must report their income on their returns under these rules. For years 2007 through 2009, RDPs can, but are not required to, amend their returns to reflect community property treatment.
- Unlike married couples, RDPs that treat self-employment income as community property must always split that income between the partners in calculating self-employment tax. Depending on the circumstances, this may or may not be beneficial from a self-employment tax standpoint.
- To split estimated tax payments between RDPs, each partner must submit a separate estimated tax voucher and payment. A joint payment in one partner’s name cannot be split.
The income tax ramifications of changes in states’ laws allowing same-sex couples to register as domestic partners could change how these couples file their state individual income tax returns. And, more significantly, a recent IRS ruling regarding registered domestic partners (RDPs) in California changes how RDPs in California file their federal income tax returns. 1 On May 28, 2010, the IRS issued Chief Counsel Advice (CCA) 201021050, 2 which requires California RDPs to split their community property income and earnings on their federal individual income tax returns effective with tax years beginning in 2010. The IRS updated Publication 17, Your Federal Income Tax , and Publication 555, Community Property , to formally extend these rules to RDPs in Nevada and the state of Washington. 3
A need to understand these rules is not limited to practitioners in California, Nevada, or Washington. It is common for taxpayers living in these states to use practitioners with offices in a noncommunity property (common law) state. Additionally, RDPs living in one of these three states may move to a common law state taking with them property they acquired while they were domiciled in the community property state. Most common law states recognize the character of property acquired while domiciled in a community property state.
Overview
In 1999, California passed Assembly Bill 26, which provided for registered domestic partnerships between two adults of the same sex or between persons over the age of 62. This legislation created a system for domestic partners to register with the California Secretary of State by filing a Declaration of Domestic Partnership. The law did not change the character of property or any interest in property owned by either domestic partner or both of them prior to the date of filing the declaration. At that time, property that other-wise became community property after marriage (e.g., wages) did not become community property for two individuals in a registered domestic partnership.
On September 19, 2003, California passed the California Domestic Partner Rights and Responsibilities Act of 2003, 4 which became fully operative on January 1, 2005, and extended the rights and duties of marriage to persons registered as domestic partners. The law made California’s community property rules applicable to registered domestic partners from the date of registration. These were such sweeping changes that the law did not go into effect until over a year after it passed to give the Secretary of State time to send letters to previously registered domestic partners notifying them of the new provisions. 5
Although California’s community property rules applied to assets owned and acquired by registered domestic partners, the law did not change the character of earned income to community property and did not change the way registered domestic partners filed their California income tax returns. 6 Domestic partners were required to use the same filing status for their California income tax returns that they used on their federal income tax returns or that they would have used had they filed federal income tax returns. Earnings and income were not treated as community property for state income tax purposes.
The next major legislation passed on September 29, 2006, and became effective January 1, 2007. 7 This legislation requires RDPs to file as married filing jointly or married filing separately for their California income tax returns on terms similar to those governing spouses, and the law characterizes the earned income of RDPs as community property. 8
IRS Ruling and Opinions
Since California’s RDP laws have become effective, the IRS has issued two opinions and one Letter Ruling dealing with them. In 2006, the IRS issued CCA 200608038 9 that considered the holding in Poe v. Seaborn. 10 In Poe v. Seaborn, the Supreme Court held that a wife has a vested property right in the community property, equal to that of her husband, and in the income of the community, including salaries and wages of either husband or wife. The IRS held in CCA 200608038 that Poe v. Seaborn does not apply to the application of a state’s community property laws outside the context of a husband and wife; therefore, the Supreme Court’s decision in Poe v. Seaborn does not extend to California RDPs. Based on this CCA, an RDP continued to report all income earned from the performance of personal services as earned income on his or her respective federal income tax return while filing in California as married filing jointly or married filing separately.
On May 28, 2010, the IRS issued Letter Ruling 201021048 11 in response to a request by taxpayers in a California registered domestic partnership for rulings on the following questions:
(1) Whether a taxpayer must report on his individual federal income tax return one-half of the combined income that the taxpayer and his domestic partner earned from the performance of personal services and one-half of the combined income derived from their community property assets?
(2) Whether a taxpayer is entitled to one-half of the credits for income tax withholding from the wages of the taxpayer and his domestic partner?
(3) Whether the requirement under California law to treat for state property law and income tax purposes a taxpayer’s earnings as community property, and of one-half of the taxpayer’s earnings as vested in his partner, results in a transfer of property by the taxpayer to his partner for federal gift tax purposes?
The letter ruling stated that the taxpayers had to report 50% of the combined earnings and 50% of combined income earned from community property on their respective income tax returns. The ruling also said that each person is entitled to 50% of the total withholdings and that the transfer of earnings and income is not considered a gift because the transfer occurs as an operation of law and not out of a transfer.
In a related ruling released the same day as the letter ruling, CCA 201021050 12 modified CCA 200608038. The IRS said for federal income tax purposes, community property should apply to California registered domestic partners because federal law respects state property characterizations. This change is effective for tax years beginning after December 31, 2006.
For tax years beginning after December 31, 2006, and before January 1, 2010, the CCA allows RDPs to amend their returns to report income in accordance with this revised opinion. For tax years beginning after December 31, 2009, RDPs must report 50% of their total earnings and income from community property on each partner’s federal income tax returns. The CCA made it absolutely clear that taxpayers are not entitled to file as married filing jointly or married filing separately. Instead, they must continue to file as single or head of household.
Community Versus Separate Property
All of the tax and nontax ramifications from this ruling are too numerous to include in this article, 13 but some of the more common issues that practitioners will encounter are discussed here. This article discusses California community property rules. Other community property states may have different rules, so practitioners should review each state’s laws. It is important to remember that items of income classified as community property can be characterized as separate property through a domestic partnership agreement that effectively "transmutes” otherwise community property to separate property (and vice versa). 14
Separate property is property owned before registration; property acquired after registration by gift, bequest, devise, or descent; and rent and profits from such property. 15 California law says that all property acquired during registration while domiciled in California, real or personal and wherever situated, is community property. 16 Therefore, wages and withholdings are community property. Interest, dividends, and capital gains are community property unless the income is generated from separate property. State income tax refunds will be community property unless the refunds are from RDPs filing separate income tax returns. 17 Generally, business income (including income from flowthrough entities) will be community income. IRA distributions are not community income per IRS Publication 555. 18 Pension benefits accrued prior to registration (or accrued while the taxpayers lived in a common law state) are separate property. 19 Rental income is community property unless the rental property was acquired prior to registration or was acquired through gift or inheritance (i.e., the income is from separate property). Unemployment compensation is community property. 20 According to the IRS, whether or not Social Security benefits are community property is determined under state law. 21
Tax Planning
Income Tax
CCA 201021050 22 has provided tax planning opportunities for California RDPs. 23 RDPs have been reporting their respective earnings, income, and withholdings on their federal income tax returns. RDPs can look back and determine what their federal tax liabilities would have been if they split their income, earnings, and withholdings on their 2008 and 2009 federal income tax returns. 24 They can choose to file amended tax returns if the amendment would generate tax refunds. RDPs are not required to file amended returns if the amendments would generate tax liabilities. However, if one RDP files an amended tax return to report half of the community income, the other RDP must also file an amended tax return to report the other half.
RDPs with unequal earnings that were already splitting their deductions will benefit the most from splitting their income.
Example 1: RDP A earns significantly more than RDP B , and on their original returns they were splitting only their deductions, as shown in Exhibit 1. If they also split their earnings, income, and withholdings, RDP A is allowed to shift his or her income into a lower tax bracket, which as a couple saves them $10,036.
These taxpayers could also amend their 2008 tax returns provided doing so would generate tax refunds.
Example 2: RDP A earns the same as in Example 1; however, RDP B earns $300,000, paid $30,000 in state income taxes, and had $75,000 withheld for federal income taxes. Exhibit 2 shows this couple would owe $1,134 additional income tax if they evenly split earnings, income, and withholdings.
A comparison of Examples 1 and 2 highlights the advantages to RDPs who have unequal earnings and income. The tax savings result from shifting a portion of the higher earner’s income to the other partner who is in a lower tax bracket.
An unexpected result could occur if one RDP usually reports itemized deductions and the other RDP takes the standard deduction. The rules for community property require not only that the earnings and income be split, but deductions must also be split if paid from community property funds. 25 If RDPs do not have domestic partnership agreements in place to transmute community property to separate property or separate property to community property, all earnings deposited into each partner’s respective bank account used to pay real estate taxes, mortgage interest, charitable contributions, and other itemized deductions are community property deductions that must be split on each partner’s respective federal income tax return.
Example 3: The RDPs have similar earnings, two kids, and one RDP’s filing status is head of household. Exhibit 3 shows that the overall tax for these RDPs will increase by $1,212 because RDP A has to share his or her itemized deductions with RDP B and RDP B loses the standard deduction.
RDPs can transmute community property to separate property with a domestic partner agreement, which would allow one partner to itemize his or her deductions while the other partner takes the standard deduction. This is allowed because the agreement can state that each partner’s earnings are separate, and as long as the earnings are deposited into a separate bank account, tax-deductible expenses paid with those funds would be deducted by the partner who paid the expenses. Also, Sec. 63(c)(6), which disallows the standard deduction to a spouse who files a separate return if the other spouse elects to itemize deductions, would not apply to RDPs because federal law does not recognize same-sex relationships.
The head of household filing status may not be available for RDPs splitting their income on their federal income tax returns. A taxpayer filing as head of household must not be married and must maintain as his or her home a household that is the principal home for more than 50% of the year for a qualifying child of the taxpayer or any other person who qualifies as a taxpayer’s dependent as defined in Sec. 151. The taxpayer is considered to maintain a household only if the taxpayer provides over 50% of the cost of maintaining the household during the year. 26 A registered domestic partner may not be considered to be maintaining a household if each partner is splitting 50% of their respective incomes with each other and no separate property income is used to maintain the household. However, this result usually can be corrected with proper planning.
Self-Employment and Social Security Tax
Net earnings from self-employment are community property income split 50% between each partner unless the partners have a domestic partnership agreement that provides otherwise, and net earnings from self-employment are split between each partner in calculating the self-employment tax. 27 Arguably, this may be one of the most controversial positions taken by the IRS with respect to CCA 201021050.
The IRS’s position is that RDPs must split their self-employment income when calculating the self-employment tax. Many legal experts and tax practitioners who work with same-sex couples do not agree with this position. The IRS’s position is grounded in the word "spouse” as it is used in Sec. 1402(a)(5). Sec. 1402(a)(5) says that if trade or business income is community income, "the gross income and deductions attributable to such trade or business shall be treated as the gross income and deductions of the spouse carrying on such trade or business.” Since federal law does not recognize same-sex spouses, the IRS holds that this paragraph does not apply to same-sex couples, and therefore same-sex couples must split their self-employment earnings in calculating the self-employment tax. 28
Sec. 1402(a)(5) was amended in 2004 29 to read as stated above, but the prior wording of this paragraph was: "all of the gross income and deductions attributable to such trade or business shall be treated as the gross income and deductions of the husband unless the wife exercises substantially all of the management and control of such trade or business” (emphasis added). It is clear that Congress’ intent was to allocate self-employment income to the taxpayer who carries on the trade or business for self-employment tax purposes, not that self-employment income should be split in community property states for same-sex couples and not split for traditionally married couples. The laws for same-sex couples are still in their infancy, and terminology is still being defined for same-sex couples and RDPs. Therefore, the word "spouse” was used in the amendment to Sec. 1402(a)(5) instead of a more generic word such as "partner” or "taxpayer.”
Additionally, the IRS’s interpretation of Sec. 1402(a)(5) is inconsistent with Rev. Rul. 71-116, 30 which held that in a community property state, the portion of income to which the "wife” is entitled as her own is not received by her as the result of her employment but the result of community property laws. Therefore, the remuneration for employment received by the "husband” is the husband’s wages and the husband’s tax imposed by the Federal Insurance Contributions Act attaches with respect to the total wages of a married employee irrespective of the fact that such wages are community property of the husband and wife.
The tax impact to RDPs has to be analyzed on a case-by-case basis. For example, the tax cost could be substantial if only one partner has net earnings from self-employment.
Example 4: RDP A owns a sole proprietorship. RDP A spends 100% of his or her time working at the business and exercises substantially all of the management and control of the business. RDP B does not work. Allocating one-half of the self-employment income to each partner would cost the couple $9,660 in self-employment tax. See Exhibit 4.
The result in Example 4 occurs because the Social Security wage base limitation ($106,800 in 2009) is more than the split amount of RDP A’s self-employment income.
Alternatively, the tax savings could be significant if one partner is employed and the other partner is self-employed.
Example 5: The facts are the same as Example 4 except RDP B earns $300,000 in wages. See Exhibit 5.
The tax savings occur because the requirement to split community property wages does not change the Social Security tax withholdings for the partner earning the wages. If one RDP earns above the Social Security limit, splitting his or her wages for income tax purposes will not result in the RDPs’ paying more Social Security tax because the Social Security wage limitation is not split between RDPs. 31
Observation: In the authors’ opinion, the practitioner community’s disagreement over the calculation of self-employment tax is not rooted in the tax cost or savings that may arise from splitting or not splitting self-employment income. The argument stems from the fact that same-sex couples are not legal beneficiaries to their partner’s Social Security benefits and it is not clear how the IRS’s position will change RDPs’ Social Security benefit amounts. For example, it is possible RDP A in Exhibit 4, Scenario 2, will have his or her Social Security benefits reduced because this method reduces the taxpayer’s earnings record at the Social Security Administration. Conversely, will RDP B in Exhibit 4, Scenario 2, get credit for RDP A’s earnings? What happens in a situation where an RDP has net earnings from self-employment less than $5,000 and is required to split this amount with his or her partner? This will reduce the RDP’s earnings below the amount ($4,520 for 2012) needed to earn four credits for coverage under the Social Security system, the maximum number of credits a taxpayer can earn in one year. This could cause the RDP to be ineligible for Social Security retirement benefits because taxpayers must earn 40 credits to qualify for retirement benefits.
With so many unanswered questions and the uncertainty of reducing or jeopardizing an RDP’s Social Security benefits, it is no surprise that the IRS’s position for calculating self-employment tax for RDPs is coming under great scrutiny by the tax practitioner community. What is certain is that this issue will likely be challenged in court if the IRS does not change its position.
Withholding and Estimated Tax Payments
The law requires that income tax withholdings be split on each RDP’s respective federal income tax return. If RDP A earned $100,000 and $20,000 was withheld for federal income taxes, RDP A would report $50,000 earnings and $10,000 federal income tax withholdings; RDP B would report $50,000 earnings and $10,000 federal income tax withholdings. RDPs cannot split estimated tax payments because the payments were made with an estimated tax payment voucher that reported only one RDP’s name and Social Security number. Regs. Sec. 1.6654-2(e)(5)(ii) allows the allocation of estimated tax payments for a husband and wife if the estimated tax payments were made using a joint estimated tax payment voucher. The IRS has said the estimated tax payments reported on the return have to reconcile with the first name and Social Security number listed on the estimated tax payment voucher. This result can have significant ramifications.
Example 6: RDP A makes estimated tax payments and is not allowed to split his or her estimates with RDP B. If these taxpayers amend their returns to recover the $3,135 refund, RDP B will have to pay $127,002 plus interest because all quarterly estimates were paid listing RDP A’s name and Social Security number. See Exhibit 6.
The result in Example 6 should apply only to 2007 through 2010 tax returns since practitioners can advise their clients to split their estimated tax payments for 2011 and later.
At this point, the IRS has stated that they are unable to split the estimated tax payments between two tax returns. The IRS has said each RDP is required to file an estimated tax payment voucher. 32
Conclusion
Tax planning and compliance for registered domestic partners in community property states has become even more complicated with the recent IRS announcement. Practitioners should ask their clients if they are in a registered domestic partnership, including practitioners in common law states working with taxpayers who live in community property states or who have recently moved from a community property state. Tax organizers should be updated to ask this question, in addition to questions such as:
- Do you have a domestic partnership agreement?
- Have you entered into any agreements (written or oral) that transmute community property to separate property?
- List income-producing property acquired prior to registration or acquired by gift or inheritance.
Failure to ask these questions may result in the preparation of an incorrect federal individual income tax return and could subject the practitioner to malpractice claims. Practitioners will be required to perform more due diligence and may be required to partner with an attorney, to provide competent tax compliance and planning to registered domestic partners in community property states.