Under IRS Chief Counsel Advisory 201021050 and Private Letter Ruling 201021048 (the "Rulings"), the IRS concluded that income of California registered domestic partners is treated as community property for federal income tax purposes. The effect is that registered California domestic partners must split community income and deductible expenses paid with community property funds when filing their separate tax returns. Further, this vesting in each partner of one-half of the earnings and deductions of the partnership does not result in federal gift tax. Prior to the Rulings, California registered domestic partners had to report all of their own income separately on their own tax return and could only take deductions to the extent they paid for the deduction. Any actions inconsistent with this separate reporting scheme could have resulted in taxable gift made by one partner to the other.
History of California's Community Property Law and the IRS's Application of This Law to Married Couples
California is a community property state. Community property is an ownership right, akin to an equal partnership where each partner contributes labor. To the extent the partnership generates income or acquires property because of this labor, it belongs equally to each partner. The community property system is justified by the idea that such joint ownership recognizes the theoretically equal contributions of both partners to the operation of the community. For federal income tax purposes, the IRS has also long recognized Poe v. Seaborn, 282 U.S. 101 (1930), the Supreme Court case, which held that community earnings and deductions of a husband and wife were to be split equally (the so-called "income splitting rule"). Thus, if spouses elect to file separate income tax returns (e.g., married, filing separately) each spouse reports one-half of all community income and deductions on their separate return, regardless of which spouse earned the income.
California Extends its Community Property Ownership Laws to Registered Domestic Partners, Thus Conflicting with the IRS's Position
It was not until 2005 that California law directed that its community property rules apply to registered domestic partners. Despite the 2005 law, domestic partners' earned income was still not treated as community property for state income taxes. But California later amended that law, and starting in 2007, allowed registered domestic partners the same filing status and income-splitting options as a husband and wife. Thus, the 2007 amendment extended full community property treatment to California's registered domestic partners. California's extension of its community property ownership laws to registered domestic partners however, left the IRS in a legal quagmire. Only one year earlier, in 2006, in Chief Counsel Advisory ("CCA") 200608038, the IRS took the position that the income-splitting rule was not available to California registered domestic partners. Since federal tax law generally respects state property law CCA 200608038 directly conflicted with California's property law.
The IRS Reverses Itself
Given this inconsistency, the IRS has reversed its position with the Rulings, now recognizing California’s community property ownership laws with respect to California's registered domestic partners. Specifically, the Rulings conclude: (1) for tax years beginning after December 31, 2006, a California registered domestic partner must report one-half of the community income, whether received in the form of compensation for personal services or income from property, on his or her federal income tax return; (2) each domestic partner is entitled to half of the credits for income tax withholding from the wages of the other domestic partner; (3) the requirement under California law to treat domestic partner's earnings as community property, does not result in a transfer of property by one domestic partner to the other for federal gift tax purposes; (4) for tax years beginning in 2007, registered domestic partners may amend their returns to report income in accordance with the Rulings.
Potentially Easier Reporting
Although registered domestic partners are still not permitted to file a federal joint income tax return (this is available for opposite-sex spouses only because the Defense of Marriage Act does not recognize same-sex unions), the income splitting rule now available to California domestic partners should make federal income tax reporting easier and potentially decrease overall income tax liability, especially if one partner has a very large income and the other has little or none. For example, under the Rulings, if one domestic partner earns $200,000 in a given year and the other domestic partner earns nothing, each partner reports $100,000 of income and pays approximately $21,709 in income tax, resulting in a $43,418 total tax liability. Prior to the Rulings one partner would report $200,000 of income while the other partner would report nothing, resulting in approximately $51,117 of total income tax liability.
Possible Negative Impact
The Rulings however, could actually have a negative impact on some domestic partners, especially if one partner who has a much lower income than the other qualifies for federal tax benefits or deductions which are phased out at higher income levels. By counting one-half of the higher-earning partner's income, the lower earning partner could lose some of these tax benefits. For example, the child income tax credit is reduced for single taxpayers who earn more than $75,000 and the ability to contribute to a Roth IRA is phased out for single taxpayers earning $106,000 and eliminated after $121,000. Despite some of the potential drawbacks, the Rulings are a positive development for advocates of same-sex marriage. It appears to be another step towards recognizing that a person's federal taxes should reflect the status of their relationship under state law.
Amending Prior Year Returns
If California domestic partners revisit their returns for tax years 2007 - 2009 and realize that they would have paid less income tax by splitting their income and deductions, they should consider filing amended returns in order to claim the refunds. Generally, the deadline to file an amended return is three years from the date the original return was filed. Therefore, for 2007, the first tax year subject to the Rulings, the deadline for filing an amended return appears to be April 15, 2011. However, it is unclear whether the IRS's pronouncement in 2010 could effectively extend this three-year deadline. We suggest domestic partners consult with their tax preparer to determine how this deadline applies and whether they should file amended returns.
Application of the Rulings to Same-Sex Spouses
The Rulings only address registered domestic partnerships. They do not address same-sex couples who were legally married in 2008 under California law. However, since the Rulings address the concept of community property under state law, and same-sex spouses are subject to the same community property laws that domestic partners are, it appears almost certain that the Rulings similarly apply to these same-sex couples.
Legal Precedent of the Rulings
Private Letter Rulings are written memoranda furnished by the IRS National Office in response to requests by taxpayers under published annual guidelines. Technical Advice Chief Counsel Advice (CCA) are written advice or instructions prepared by the Office of Chief Counsel and issued to field or service center employees of the IRS or Office of Chief Counsel. Neither can be relied on as precedent, however, they are often helpful in understanding the position of the IRS with respect to the issues addressed.