Treatment of community income for spouses living apart: Sec. 66 may relieve a separated spouse of the duty to report a portion of the other spouse's community property income. Part I of this two-part article discusses the requirements for relief under sec. 66(a) and denial of community property benefits under sec. 66(b).

• Author: Karnes, Allan
• Position: Part 1

EXECUTIVE SUMMARY

* Sec. 66 can provide a spouse relief from reporting and liability for the other spouse's income when the nonearning spouse does not receive a benefit from such income.

* If a spouse qualifies for Sec. 66(a) treatment, all items of community income must be allocated under the Sec. 879(a) rules.

* Under Sec. 66(b), a spouse may be disallowed the benefits of reporting

only his or her share of community income.

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This two-part article offers guidance on Sec. 66 relief for married clients who are separated and reside in community property states. Part I, below, discusses the requirements for relief from the community property laws under Sec. 66(a). It also examines Treasury's power to deny the benefit of the community property laws to a spouse under Sec. 66(b). Part II, in the April 2006 issue, will explain Sec. 66(c), which provides traditional or equitable relief to spouses in certain cases. By properly advising clients who may benefit from Sec. 66 relief, practitioners can determine that those clients do not unwittingly cause a relief request to be denied.

Background

Equal Allocations

The basic premise of state community property laws is that marriage is a partnership. As a result, all earned income by either spouse (community income) is arbitrarily allocated evenly between the two spouses, much like a business partnership with two equal partners. The question of whether items of income, earned or unearned, are considered community income to be allocated evenly to each spouse is determined under state law. Prior to the enactment of Sec. 66, allocating community income between spouses on separately filed returns often had significant tax consequences.

Example 1: C and M separated in December 1977.They live in a community property state. M stayed in the family home and supports herself with a $12,000 annual salary. C moved to another city and supports himself with an $88,000 annual salary. No funds are transferred between the spouses; C did not make the mortgage payments on the family home or pay any other household expenses after they separated. If M and C did not file a joint return for 1977, (1) M would face a tax liability on gross income of $50,000 (.5 x ($12,000 + $88,000)), even though she had access only to the $12,000 she earned. Additionally, C may be unjustly enriched by only owing tax on $50,000 of gross income, instead of the $88,000 to which he had access. (2)

Congress recognized this potential inequity and provided relief by enacting Sec. 66 as part of the Miscellaneous Revenue Act of 1980. (3) Originally, Sec. 66 allowed spouses to disregard state community property laws for Federal income tax purposes if they lived apart, did not file a joint return and met certain other criteria. However, in 1984, Congress expanded the scope of Sec. 66.The provision was broadened to provide (1) criteria under which the IRS may disallow the benefits of community property law to a spouse, and (2) additional circumstances under which a spouse might otherwise seek relief from the operation of the community property law, even if Sec. 66's original criteria are not satisfied. (4) In July 2003, final regulations under Sec. 66 (5) were issued to replace 2002 proposed regulations. Later that same month, Rev. Proc. 2003-61 (6) established threshold requirements for taxpayers requesting equitable relief under Sec. 66(c) or 6015.

Community Property States

There are nine community property states: Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington and Wisconsin. (7) Although general rules exist on characterizing an income item as either community or separate income, there are some differences among the community property states. For example, Arizona treats income earned by a spouse after a married couple separates as community income, while California treats it as separate income. (8)

Although income earned from separate property (9) generally is separate income, Idaho, Louisiana, Texas and Wisconsin usually treat it as community income. (10) Idaho, Louisiana and Texas adopted the Uniform Marital Property Act (11) (UMPA), which follows the Spanish-influenced "Louisiana Fruits" rule and classifies income from separate property as marital or community income. (12) Wisconsin also follows the "Louisiana Fruits" rule, but modifies the UMPA to allow a spouse with separate property to unilaterally declare in a written statement that income there-from is separate income. (13) The statement only works prospectively and may not be executed before marriage. (14) The remaining community property states follow the "American Rule" first adopted in California as a result of George v. Ransom. (15) That case held that it is unconstitutional in California to characterize the income from a wife's separate property as community income.

Treatment of Community Income

Congress recognized the inequity of community property laws that cause a nonearning spouse to pay tax on half of the earning spouse's income if the nonearning spouse does not receive or benefit from that income. To qualify for Sec. 66 relief, spouses must meet several specific criteria, one of which, not surprisingly, is that the earned income could not have been transferred directly or indirectly to the nonearning spouse. However, the legislative history indicates that Congress did not intend a de minimis transfer to...