Recent statements by the Chief Counsel of the Internal Revenue Service change the way in which registered domestic partners and same-sex spouses in California must report their community property income for federal tax purposes, and eliminate any concern that the creation of community property will trigger a taxable gift from one partner to the other.
In a series of recent pronouncements, the Internal Revenue Service (IRS) Chief Counsel has recognized the relationships of same-sex couples registered as domestic partners at a level never before seen from the federal government.
Community Property to Be Reported by Both Spouses
In the past few years, California has greatly expanded the rights and obligations of registered domestic partners. In 2005, registered domestic partners were granted many of the same rights and obligations as married couples for state property law purposes, but not for state income tax purposes. This disparity meant that all income earned by registered domestic partners in California was treated as community property when determining each partner’s ownership rights in the earned income, but the earned income was still taxed as if it were separate property for both state and federal income tax purposes.
The California legislature gradually expanded the rights of registered domestic partners so that earned income is now treated as community property for state income tax purposes. Since January 1, 2007, California registered domestic partners have been obligated to report all of their community property income as being earned one-half by each partner for state tax purposes, and to do so on joint state returns.
The same was not true for federal income tax purposes. In 2006, the IRS Chief Counsel concluded that a person registered as a domestic partner in California must report all of his or her income from personal services, despite the fact that the income is treated as community property under state law. Because the federal government did not allow domestic partners to file joint returns and did not recognize the community property rights of the non-earning partner for federal income tax purposes, the change in California law created a disparity in the way registered domestic partners were obligated to report their income for federal and state income tax purposes.
Now, after considering that domestic partners have had full community property treatment under California law since 2007, the IRS Chief Counsel has reversed that prior position and concluded that registered domestic partners in California must each report one-half of the community property income on their separate federal income tax returns. This change in position upholds the general principle that federal tax laws respect state property law characterizations and definitions. California domestic partners must still file joint state returns and separate federal returns, but in both cases, all community property income will be reported one-half by each partner.
The same reasoning underlying the IRS Chief Counsel’s memorandum regarding domestic partners logically and thus almost certainly applies to same-sex couples who are legally married under California law.
What does this change of position by the IRS mean for registered domestic partners and same-sex spouses in California? Beginning in the 2011 tax year, they will be obligated to report one-half of the community property income on each partner’s separate federal income tax return. These couples also have the option, but not the obligation, to amend prior returns beginning in the 2007 tax year to report their income consistent with this new ruling.
No Gift upon Creation of Community Property
The IRS Chief Counsel has also concluded that there is no transfer, for federal gift tax purposes, by one registered domestic partner to another, of community earnings. Because community property is created by operation of law and immediately vests one-half in each partner, there is no transfer, deemed or otherwise, between partners that would be subject to federal gift taxes. Again, this same reasoning should apply to same-sex couples who are legally married in California.
Many practitioners feared that same-sex couples who married or registered as domestic partners would expose themselves to potential federal gift tax liability resulting from the creation of community property, and some advised clients not to register for fear of the uncertainty. However, the IRS Chief Counsel’s recent memorandum lays to rest any concern that there would be a deemed gift when community property has been earned. Instead, the creation of community property in a same-sex relationship should be looked upon as an effective way to minimize estate taxes upon the death of the first partner or spouse. This is especially true in situations where one partner earns significantly more than the other.
Because these recent rulings uphold the general principle that federal tax law respects state property law characterizations and definitions, they make it more likely that same-sex couples will be entitled to the same treatment as their heterosexual counterparts under other federal tax laws. For instance, assuming that the estate tax is reinstated, it is likely that registered domestic partners and same-sex couples who are legally married in California will receive a full step-up in basis for community property assets on the death of the first partner or spouse.
While these recent pronouncements from the IRS stop short of full federal recognition of same-sex relationships, they are a significant step in that direction.