What’s Mine Is Mine, Or Is It?
@Law, The NALS Magazine for Legal Professionals · Winter 2012-13 ·by Laura Hoexter
On May 5, 2010, the Internal Revenue Service (IRS) issued Public Letter Ruling 201021048 and CCA 201021050, which announced a change in the way the IRS was going to treat income earned by registered domestic partners (RDPs). This change attempted to bring the treatment of income earned by same-sex couples closer to the treatment of income earned by married opposite-sex couples.
In 1999, the California legislature passed Assembly Bill 26, creating a domestic partner registry system. Under this law, couples could register as domestic partners and receive certain rights and benefits. However, these rights were limited to non economic rights, such as the right to hospital visitation and the right to be named as next of kin. The bill did not provide many financial rights to registered domestic partners (RDPs), such as the right to accumulate community property.
Four years later, in 2003, the California legislature passed the Domestic Partner Rights and Responsibilities Act (with a delayed effective date of January 1, 2005). This new law significantly expanded the rights and benefits previously conferred on RDPs in California. Most importantly, this law conferred community property rights to RDPs. However, it is important to note that the community property rights only applied to assets owned and acquired by RDPs. It did not apply to income earned. In other words, a registered couple could purchase a house and take title as community property, but income earned by one partner was still his or her separate property. Thus, at the state level, RDPs were still treated as individuals and required to file as single on their individual tax returns.
On September 29, 2006, under a law that became effective January 1, 2007, California again expanded the rights and responsibilities of couples enrolled on the domestic partner registry and re-characterized income earned by RDPs from separate property to community property. From this point forward, California began to require RDPs to file their state income tax returns as married couples (either married filing jointly or married filing separately). However, at the federal level, the IRS did not recognize community income and required each registered partner to file a separate tax return and declare his or her own income as his or her separate property.
Since the passage of the 2006 law, the IRS has issued two major opinions and one letter ruling to address the characterization of community property owned and community income earned by RDPs.
First, the IRS issued Chief Counsel Advice (CCA) 200608038. In this advisory opinion, the IRS looked at the United States Supreme Court position in Poe v. Seaborn, 282 U.S. 101 (1930). In this case, the Supreme Court held that in a community property state, a wife had an interest equal to her husband’s interest in all community property and held a similar interest equal to her husband’s in all income of the community, including all salary and wages. However, in the CCA opinion, the IRS said that the characterization of community property in Poe vs. Seaborn did not apply outside of the context of a husband and wife and, therefore, they would not apply those characterization rules to California RDPs. Based on the CCA opinion, a registered domestic partner was required to report all income, earned or passive, on his or her respective federal income tax return, regardless of whether he or she filed jointly at the state level.
However, in May 2010, the IRS issued Private Letter Ruling 201021048 and CCA 201021050, in which it reversed its earlier position. The IRS now found that for federal income tax purposes, community property rules would apply to California RDPs because the federal government is required to respect state property characterizations. This change in position became known as the “income-splitting requirement.” Shortly after the 2010 opinion and ruling, the IRS issued a revised Publication 555, which instructs taxpayers on how to report community property and specifically refers to California, Washington, and Nevada registered domestic partners and California same-sex married couples. To fully understand the new reporting requirement, we need to understand the definition of community property and community income.
What is Community Property? The definition of community property and community income varies slightly among the community property states. In general, community property consists of:
a. Assets that you or your registered domestic partner (or your California same-sex spouse) acquired during your partnership (or marriage) while you were domiciled in a community property state;
b. Property that you or your registered domestic partner (or your California same-sex spouse) agreed to convert from separate to community;
c. The portion of property purchased with community funds, if you hold property that was purchased with a combination of community and separate funds; and
d. Any property that cannot be identified as separate property.
What is Community Income? Community income is any income from:
a. Community property;
b. Salaries, wages, or pay rendered for services that you or your registered domestic partner (or California same-sex spouse) received during the registered domestic partnership (or marriage); and
c. Real estate that is treated as community property under the laws of the state where the property is located.
What is Separate Property? Again, the definition of separate property and separate income varies slightly among each of the community property states. In general, separate property consists of:
a. Property that you or your registered domestic partner (or your California same-sex spouse) owned separately before you registered your partnership (or got married);
b. Money earned while domiciled in a non-community property state;
c. Property either of you received as a gift or inherited separately during your registered partnership (or same-sex marriage);
d. Property bought with separate funds or exchanged for separate property during your registered partnership (or same-sex marriage);
e. Property that you and your registered domestic partner (or your California same-sex spouse) agreed to convert from community to separate property through an agreement valid under state law; and
f. The portion of property purchased with separate funds, if you hold property that was purchased with a combination of community and separate funds.
What is Separate Income? Separate income is income from separate property. Separate income belongs solely to the registered domestic partner or California same-sex spouse who owns the property.
Who is affected by this reporting requirement? The income-splitting requirement affects RDPs who are domiciled in a state that confers community property rights. There are only nine community property states: Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington, and Wisconsin. Of these nine community property states, only four of them give any rights to RDPs: California, Nevada, Washington, and Wisconsin. However, of these four, only California, Nevada, and Washington allow RDPs to acquire community property and community income. In addition, the IRS applied the income-splitting requirement to California same-sex couples who were married before November 5, 2008, when California’s Proposition 8 took effect.
Are only same-sex RDPs in California, Nevada, and Washington affected? In both California and Washington, opposite-sex couples may register as domestic partners as long as one partner is at least 62 years of age and the other requirements of entering into an RDP relationship are met. In Nevada, both same-sex and opposite-sex couples may register as domestic partners as long as both partners are at least 18 years old and as long as the other requirements of entering into a domestic partnership are met. The IRS’s position on income-splitting treatment does not distinguish between same-sex RDPs and opposite-sex RDPs. Thus, community property for both types of couples is subject to the income-splitting requirement.
Can RDPs opt out of the income-splitting rules? Yes, RDPs—like opposite-sex married couples—are permitted to enter into agreements to re-define what is community property and income and what is not. This conversion is often referred to as transmutation. As long the agreement is valid under state law, the state will honor a couple’s characterization of their property and income. However, unlike opposite-sex married couples who currently enjoy an unlimited federal marital deduction for all transfers within the community, there is no such federal deduction for transfers between RDPs. Therefore, such transfers may result in a federal gift tax. Unmarried couples should always consult with an attorney or tax professional with expertise in this area before entering into an agreement to change the character of property or income.
What is the effect on needs-based benefits? Needs-based benefits are benefits provided by the state or federal government that are based on an applicant’s income and/or assets, such as supplemental security income, Medicaid, and academic financial aid. Because these benefits, or the amount of the benefits provided, are determined in part by the income of the applicant, the income-splitting rules may affect a partner’s eligibility. The federal government no longer focuses solely on the applicant’s income, but instead, looks at one-half of the applicant’s income and one-half of his partner’s income. Thus, a partner with no income may fail to qualify for needs-based benefits because his or her partner earns too much income. Conversely, a partner whose income was formerly too high to be eligible for a certain benefit may now qualify as a result of only being imputed with half of his or her income.
What is the effect on the tax exemptions and deductions for RDPs? Some RDPs may lose the ability to claim their partner as a dependent. For example, if Partner 1 earns very little income, Partner 2 may claim Partner 1 as a dependent on his or her tax return, giving Partner 2 an additional exemption. However, with income-splitting, Partner 1 must recognize one-half of Partner 2’s income. Therefore, Partner 2 is no longer fully supporting Partner 1 and will most likely lose the ability to claim Partner 1 as a dependent.
Additionally, the income-splitting requirement will affect an RDP’s deductions. RDPs are required to split certain deductions that once appeared on only one partner’s return. For instance, if a couple pays a mortgage on a community-owned residence with income earned by Partner 1, the mortgage interest deduction must be split between their returns, rather than taken entirely on Partner 1’s return. However, expenses incurred to earn or produce separate income are deductible only by the RDP who earns that separate income. For example, expenses to improve a separate residence are deductible by the partner who owns the separate residence. The treatment of deductions for charitable contributions depends on the source of funds used to make the contribution. If separate property is contributed, only the partner who contributes claims the deduction. If community funds are contributed, the deduction must be split between both partners.
When did these new reporting rules become effective? For tax years beginning 2010, RDPs were required to income-split. However, for the 2007–2009 tax years, the IRS allowed California RDPs to amend their returns and file as if income-splitting were permitted in those years, provided they were on the registry at the time. In Washington, couples can amend their returns as of the later of (1) the date they registered, or (2) June 12, 2008 (the date when Washington conferred community property rights on RDPs). In Nevada, couples can amend their returns as of the later of (1) the date they registered, or (2) October 1, 2009 (the date when Nevada recognized community property ownership for RDPs). While they are permitted to income-split, RDPs are still required to file their federal returns as single or head of household and not as married filing jointly or married filing separately.
What do practitioners outside of California, Nevada, and Washington need to know? It is quite common for RDPs living in California, Nevada, and Washington to move to a non community property state, taking with them property acquired while in a community state. Since most non-community property states recognize the character of property acquired while domiciled in a community property state, it is important for practitioners in other states to be able to recognize these issues.
Where can I find out more about the new IRS position?
- IRS Chief Counsel Advice 201221050
- IRS Private Letter Ruling 201021048
- IRS Publication 555
- Lambda Legal
Originally published in @Law, The NALS Magazine For Legal Professionals, Winter 2012-2013, Vol. 61, Issue 3.