Community property rules and registered domestic partners.

• Author: Paddock, David A.

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 noncom-munity 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.

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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 otherwise 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 2006080389 that considered the holding in Poe v. Seaborn[TM] 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 20102104811 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.

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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...