IRS Rules on Cal. Partnership

Volume 5, Number 9 | March 2 – 8, 2006


IRS Rules on Cal. Partnership

No income splitting on separate returns, despite “community property”

Responding to a request for guidance about how to deal with registered domestic partners’ tax returns, the Internal Revenue Service’s Office of the Associate Chief Counsel issued a guidance memorandum to its top enforcement officers dated February 24, and released it publicly Monday.

To the disappointment of registered domestic partners in California, the memo advises that registered partners in that state, who have virtually all the legal rights and responsibilities of married couples under state law, must nonetheless file their federal income tax returns as single individuals, and may not use the device of “income-splitting” allowed for married couples to reduce their taxes.

The “income-splitting” privilege is based on the concept of community property that is followed in various forms in nine different states, according to the IRS memo. In a 1930 ruling, the Supreme Court determined that in Washington State, a community property jurisdiction, where the husband and wife are each considered to “own” 50 percent of their total marital income and assets, they can reduce their income tax by filing separate returns, each reporting half of the total marital income for the year. In many cases, especially where one spouse earned all or virtually all of the income, this would result in their total income being taxed at a lower rate than if they filed jointly.

For example, if the wife earned $100,000 and the husband, working part-time, earned $10,000, they could each file single returns reporting $55,000 of income, if it proved advantageous for them to do so in light of the tax brackets for single taxpayers. In subsequent decisions, the Supreme Court confirmed that the income-splitting option also applied to California, Arizona, Texas, and Louisiana, and presumably to any state where, for purposes of state law, spouses automatically have a half ownership interest in all assets and income earned while married.

In California, the Domestic Partnership Rights and Responsibilities Act that was passed in 2003, and went into effect January 1, 2005, provided that registered domestic partners “shall use the same filing status as used on their federal income tax returns, or that would have been used had they filed federal income tax returns,” but stated: “Earned income may not be treated as community property for state income tax purposes.”

Last June, after the Act had gone into effect, the Legislature passed a new package of Family Code amendments making technical adjustments. One new provision stated that for purpose of the laws governing community property, “the date of marriage will be deemed to refer to the date of registration of a domestic partnership with the state,” and another amendment provided a window period of six months, from January 1 to June 30, 2005, for those who had previously registered as domestic partners to make enforceable agreements—similar to pre-nuptial agreements—to modify or avoid the application of the state’s community property laws. 

Taking account of all these developments, which the IRS memo sets out in great detail, the memo concludes, “We do not believe that the [1930] decision applies to the application of a state’s community property law outside the context of a husband and wife. In our view, the rights afforded domestic partners under the California Act are not ‘made an incident of marriage by the inveterate policy of the State’ [using language taken from the 1930 Supreme Court opinion]. The relationship between registered domestic partners under the California Act is not marriage under California law. Therefore, the Supreme Court’s decision… does not extend to registered domestic partners. Consequently, an individual who is a registered domestic partner in California must report all of his or her income earned from the performance of his or her personal services, notwithstanding the enactment of the California Act.”

The result is that those California domestic partners whose income situation would have benefited from the income-splitting option will not be able to use it. The IRS memo makes clear that it is merely an internal opinion for the guidance of tax enforcement officers, and “may not be used or cited as precedent.”

One of the many false economies of the Bush administration has been a decrease in the budget for IRS auditing staff, which means a reduction in the auditing of returns submitted by middle-class taxpayers. However, since income-splitting means reporting a different amount of income than one’s employer reports to the IRS on the W-2 form, the computers processing the returns might be programmed to flag those returns for examination, depending on how focused the IRS is on this situation.

A Berkeley tax attorney, Donald H. Read, told the San Jose Mercury News, “I can’t say I’m shocked, but it strikes me as an indefensible position.” Jenny Pizer, an attorney at Lambda Legal’s Western Office, criticized the IRS analysis as “defective,” commenting that “the federal government seems to have created another exceptions for gays and lesbians.” Fred Hertz, an Oakland tax attorney with a gay-oriented practice, said that it was better to have the guidance, even if it failed to respect community property rights of domestic partners, since at least it gave instructions on what to do in a situation where people had been guessing.