Chapter 36 - § 36.5 • TAX CONSIDERATIONS

• Jurisdiction: Colorado

§ 36.5 • TAX CONSIDERATIONS

§ 36.5.1—Taxes During Marriage

Income Taxes

Spouses, civil union partners, or fiancés can contractually agree to the division of income tax liabilities during their marriage or civil union. However, they typically do not contractually agree to their filing status of married filing jointly or married filing separately to maintain flexibility during the marriage.

On February 27, 2014, Colorado Governor Hickenlooper signed into law SB 14-019, requiring any two taxpayers who legally file a joint federal income tax return to file a joint state income tax return. The Act applies to income tax years commencing on or after January 1, 2013. C.R.S. § 39-22-107 provides for same-sex couples who are legally married in another state recognizing same-sex marriages to file their state return jointly if their federal return is filed as a joint return. Now, all married couples residing in Colorado, including those married in the State of Colorado, are able to file a joint state income tax return if they decide to file a joint federal income tax return.

Colorado civil union partners now may also have the option to file personal Colorado state income tax returns jointly or separately. SB 14-019, effective for tax years beginning on or after January 1, 2013, and any open tax years; C.R.S. § 14-15-117. Because they are not "married" under Colorado state law, civil union partners might want to address these tax issues in an agreement in case the laws change, the couple moves to a state that does not permit joint state tax return filing, or they get married.

Marital agreements that address income taxes typically agree that all such taxes will be apportioned between the parties each year based upon the proportional taxable income, deductions, and credits of each party in that tax year. While providing flexibility over the years, this requires three computations for each year's income taxes if the couple actually files as "married filing jointly." They will need to compute each spouse's separate income as if the spouse filed as "married filing separately" to determine proportional liability and then compute the joint return. With tax preparation computer programs that enable changes to the taxpayer information, this becomes a relatively simple process. To avoid these computations, the wealthier spouse may want all the responsibility for income taxes along with control over the tax returns, or the couple may want the computation to apply only when the couple cannot otherwise agree on the allocation of tax liability in any year of the marriage.

In dividing the tax between spouses, allocation can be based on gross income, adjusted gross income, or taxable income. Only the latter includes all taxable income and deductions permitted to the parties, but still does not include tax credits. Actual tax liability, before withholding and estimated payments, for each party would reflect tax credits for each party along with their taxable income.

Allocation of income tax liability between the couple based upon taxable income computed as if the spouses were single will be more equitable than using their gross or adjusted gross incomes, and make their allocated tax liabilities more accurate. For example, if one party receives retirement income that is not fully taxable, the taxable income computation will reflect the non-taxable portion. Also, if one spouse has significant deductible medical expenses one year, this could reduce that spouse's separate tax liability regardless of which spouse actually paid for the medical costs.

The parties' separate taxable incomes should reflect all adjustments to the gross or adjusted gross income, including deductions, but tax preparation programs computing married filing separately may allocate all deductions equally between the spouses. Such an allocation could lead to dispute between the parties if their taxable incomes or deductions are widely disparate. Simply computing each party's income taxes as if they were single and then comparing the relative tax liabilities gives exemptions and deductions related to one spouse's income to that spouse for tax apportionment in the same manner the IRS would allocate them. The marital agreement might, nonetheless, specify that identifiable separate items of income and deductions will be allocated to the spouse whose efforts or property created the tax item.

The marital agreement will not be binding upon the IRS, in part because the IRS is not a party to the marital agreement. Cooper Indus., Inc. v. Compagnoni, 162 F. Supp. 2d 702 (S.D. Tex. 2001). Further, federal law — i.e., the Internal Revenue Code — controls over an agreement under state law. The marital agreement should therefore include indemnification of each spouse by the other for taxes owed by one spouse but not paid. This will be important if one spouse does not report all income or erroneously overstates any deductions on a joint income tax return.

Tax liability for a joint return is joint and several, even if assessed after the couple divorces. The IRS does not allocate taxes owed to the party whose income or deductions created the increased tax liability. Both spouses sign the tax return and, therefore, both will be liable for the entire tax owed. Without indemnification from the other spouse, either spouse can be forced to pay the entire amount owed to the IRS without recourse, unless the paying spouse can prove he or she was an "innocent spouse" under the IRS regulations. See IRS Publications 971 and 504. The indemnification will only be effective to rectify the situation where the responsible spouse has the resources at some time to repay the injured spouse, but it is the best protection available for jointly filed returns, unless the "innocent spouse" provisions apply.

Business Taxes

If one spouse or civil union partner has a business with employees, there will be "trust fund" tax liability in addition to the business income taxes. Trust fund taxes are those employment taxes withheld by the employer that are owed to the IRS on behalf of the employee, thus called "trust fund" taxes. The IRS can collect all the tax and severe penalties from any party who should or could have made the payments. This party is called the "responsible person." I.R.C. § 6672. This is like the joint and several liability of personal income taxes — the IRS does not need to pursue the business owner first or the person who absconded with the withheld funds. Responsible persons include all directors, officers, people with authority to sign checks, and those with access to the business financial records. Id.

Since spouses and partners often name each other as officers, managers, or directors in a small family business, the risk of an ex-spouse or ex-partner being liable for unpaid trust fund taxes is very real. Therefore, if either party to a marital agreement currently owns or has any expectation of owning a business during the marriage, the agreement should provide for all business taxes not paid by the business directly to be paid by each spouse who owns the business in proportion to each spouse's relative ownership. This will at least allocate tax liability to the party who could receive distributions from the business profits as an owner. Again, indemnity for the non-responsible spouse or partner is recommended to provide some chance of restitution in state court, even though the IRS will not be bound by the marital agreement or indemnification.

Gift Taxes for Gifts to Third Parties

Gift taxes can be incurred for gifts made by either spouse to third parties. I.R.C. § 2501. Civil union partners will remain third parties for gift tax purposes until they are actually "married" under state law and qualify as "spouses" under the tax code.

Gift tax returns cannot be filed jointly. Each spouse or partner must file his or her own return for gifts made by that person during the tax year if any such gift exceeds the annual gift tax exclusion ($15,000 per recipient per year in 2020) or does not qualify for the annual exclusion. A gift tax liability will be created if the donor has used up or elects not to use his or her lifetime gift tax exemption amount ($11.58 million in 2020) for that gift. Gift tax liability is not joint and several, unlike income taxes on a joint return.

During their lives, spouses cannot use each other's gift tax exemption amounts, but married couples can elect to treat all gifts made in any tax year as "split." I.R.C. § 2513. This means that a gift made by one spouse, from that spouse's separate property, can be deemed on a tax return to have been made one-half by each spouse. Id. This enables non-charitable gifts from one spouse's separate property of up to $23.16 million in 2020 without incurring a gift tax.

Gift splitting can create a gift tax liability for, or use the lifetime gift tax exemption amount of, the non-gifting spouse for a gift made by the gifting spouse. This "gift splitting" cannot be done without the non-gifting spouse's consent, because that spouse needs to sign the gifting spouse's gift tax return consenting to such gift splitting and file his or her own gift tax return if the gifts exceed or do not qualify for the annual exclusion amount. While the non-gifting spouse must consent to gift...