January 05, 2011 - Community Property: General Considerations (Portfolio 802)
By Deborah M. Beers, Esq.
Buchanan Ingersoll & Rooney PC, Washington, D.C.
Income from services performed by a spouse in a community property state are taxable one-half to each spouse if the services are performed while the spouses are married.1 A trio of 2010 private letter rulings and Chief Counsel advice memoranda extends this rule to domestic partners registered under California's Domestic Partner Rights and Responsibilities Act of 2003 (as amended by California Senate Bill 1827, effective January 1, 2007).
PLR 201021048 addresses three issues that arise with respect to the amendment of California's Domestic Partner Rights and Responsibilities Act of 2003 by California Senate Bill 1827 (effective January 1. 2007), as follows:
1. Inclusion in Income. Whether, in light of a change to California law, the taxpayer, a California registered domestic partner, should report one-half of his partner's community income on his federal returns.
As background, the IRS noted that, in 2005, California law significantly expanded the rights and obligations of persons entering into a California domestic partnership for state property law purposes, but not for state income tax purposes. Specifically, the California Domestic Partner Rights and Responsibilities Act of 2003 (the California Act), effective on January 1, 2005, provided that "Registered domestic partners shall have the same rights, protections, and benefits, and shall be subject to the same responsibilities, obligations, and duties under law … as are granted to and imposed upon spouses." However, the California Act provided that "earned income may not be treated as community property for state income tax purposes."
On September 29, 2006, California enacted Senate Bill 1827. Senate Bill 1827 repealed the language of the California Act providing that earned income was not to be treated as community property for state income tax purposes. Thus, effective January 1, 2007, the earned income of a registered domestic partner must be treated as community property for state income tax purposes (unless the partners execute an agreement opting out of community property treatment). As a result of the legislation, California, as of January 1, 2007, treats the earned income of registered domestic partners as community property for both property law purposes and state income tax purposes.
Federal tax law generally respects state property law characterizations and definitions.2 In Poe v. Seaborn,3 the Supreme Court held that for federal income tax purposes a wife owned an undivided one-half interest in the income earned by her husband in Washington, a community property state, and was liable for federal income tax on that one-half interest. Accordingly, the Court concluded that husband and wife must each report one-half of the community income on his or her separate return regardless of which spouse earned the income. U.S. v. Malcolm,4 applied the rule of Poe v. Seaborn to California's community property law.
The IRS concluded that federal tax treatment of community property should apply to California registered domestic partners. Consequently, it ruled that, for tax years beginning after December 31, 2006, a California registered domestic partner must report one-half of the community income, whether received in the form of compensation for personal services or income from property, on his or her federal income tax return.
2. Credits for Income Tax Withholding. Whether a registered domestic partner is entitled to one-half of the credits for income tax withholding earned by his partner.
The IRS notes that §3402 of the Code provides that every employer making a payment of wages must deduct and withhold income taxes from wages, and that, under §31 of the Code, the amount withheld under the withholding provision shall be allowed to the recipient of the income as a credit against the income tax imposed on such income.
Regs. §1.31-1(a) provides that the recipient of the income is the person subject to the tax imposed under the income tax provisions upon the wages from which the tax was withheld. In an example, the regulation states that if a husband and wife domiciled in a community property state file separate returns, each reporting for income tax purposes one half of the wages received by the husband, each spouse is entitled to one half of the credit allowable for the tax withheld at source with respect to such wages.
Therefore, the IRS concluded, because the taxpayer is the recipient of half of the community property income, he is entitled to half of the amount withheld as a credit against the income tax imposed on the income.
3. Gift Tax Consequences. Whether the treatment, for state property law and income tax purposes, of the taxpayer's earnings as community property, half of which are vested in his partner, results in a transfer of property by the taxpayer to his partner for federal gift tax purposes.
The ruling concludes that, because the vesting of the earnings of one registered domestic partner to the other occurs "by operation of law," there is no transfer, deemed or otherwise, by one partner to another of community earnings.
We note that this result is comforting, since there is no federal gift tax marital deduction available for transfers to registered domestic partners (yet).
CCAs 201021049 and 201021050 extend the rationale of PLR 201021048 to other areas of federal income taxation.
CCA 201021049 concludes that the IRS may consider the assets of a California registered domestic partner when determining the reasonable collection potential of a taxpayer's Offer In Compromise (OIC) as the IRS generally considers the assets of both owners of community property in community property states. California state law provides that both domestic partners have equal interests and liability in community property, including the debts to which that property may be subject.
CCA 201021050 affirms the ruling in PLR 201021048, that, for tax years beginning after December 31, 2006, a California registered domestic partner must report one-half of the community income, whether received in the form of compensation for personal services or income from property, on his or her federal income tax return. In addition, for tax years beginning before June 1, 2010, registered domestic partners may, but are not required to, amend their returns to report income in accordance with this rule.
In an earlier Chief Counsel Advice memorandum, CCA 200608038,5 the Chief Counsel's Office had concluded since that a registered domestic partner's earned income was not treated as community property for state income tax purposes, it would also not be treated as such for federal income tax purposes. Registered domestic partners who reported their income in accordance with this CCA after December 31, 2006, and before June 1, 2010, therefore may, but need not amend their returns to comply with the new rules.
This commentary also will appear in the January 2011 issue of the Tax Management Estates, Gifts and Trusts Journal. For more information, in the Tax Management Portfolios, see Treacy, 802 T.M., Community Property: General Considerations.
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